Capital Adequacy, Financial Repression and Financial Liberalisation - Assignment Example

?Introduction The paper tries to address the financial concepts with due emphasis on various models which provides the basic and limitations of the models. Section A Question 1: a) Define financial repression. Answer: The government often involves itself in channelizing the funds towards themselves which in the deregulated market can flow in other sectors. The term that is used to describe such measures is called financial repression. The financial repression can have its effects in liquidating debts. McKinnon and Shaw first introduced the term in the year 1973. The term was used to describe the emerging financial systems of the market in the period of 1960s to 1980s. b) On what basis do McKinnon and Shaw argue for financial liberalisation? Answer: McKinnon and Shaw were of the opinion that ceilings in interest rates, requirements of high reserve and restriction on allocation of credit can be accounted for the poor performance of investment mechanism. The work of the researchers is based on the role of the liberalized rates of interest on mobilization of savings as well as distribution of funds to investments that are high in earning. They indicated the role of the financial sector in order to increase the volume of savings. c) What imperfections in financial markets were disregarded by the McKinnon-Shaw style models and with what result? Answer: The hypothesis of Shaw and McKinnon is of the opinion that savings can be chocked by financial repression. They opined that only financial liberalization can lead to higher savings as well as investment which are the step to achieve accelerated growth. The hypothesis has failed to settle the debates on financial liberalization. The process of financial liberalization is not at all smooth and continuous. Exogenous shocks can be held responsible for liberalization reversals in the developing countries. It is difficult to take the costs and benefits of financial liberalization into account. Joseph Stiglitz opined that other forms of interventions from the government can help to make the market perform in a better fashion. Question 2: a) What is recorded on the balance of payments? Outline the different types of financial capital flows. Answer: The BOP consists of two sections namely the current account as well as the capital account. The net earnings of a country are recorded in the current account while the net change in the ownership is recorded in the capital account. The former is the sum total of balance of trade, cash transfers as well as factor incomes. The later consists of reserve account as well as the loans and investments between the country and the globe. There are mainly three types of financial capital namely equity capital, debt capital and specialty capital. The debt form of capital is injected into a business knowing that the capital must be returned back at a future date that is predetermined. The equity form of capital is the cash written by the holders of shares as well as the owners of the business into the organization that has no offsetting liabilities. The last from of capital is gold standard. It is among the few sources of capital that have almost zero economic cost. b) What are the dangers associated with international debt flows? Answer: The dangers of international debt flows are dangers in credit rating, bankruptcy danger, judgments, loans and late payments. The credit rating is negatively affected by debts. Bankruptcy can also be thought of as one of the dangers of debt. When the debt level reaches at such a height that is infeasible to pay, bankruptcy acts as the option. But it will be unfair to think bankruptcy as debt free card. A situation of bankruptcy can also negative effects on the credit report and can also affect the availability of credit in future. A high level of debt can result in multiple late payments if the available resources are not able to cover up the payments. c) Have developing countries benefited from FDI? Answer: FDI plays a more significant role in the developing countries than in the developed countries. FDI is a zero sum game where one country has the potential to attract FDI but only at the expense of the other. FDI can have negative effects on the local industries. FDI will increase the aggregate demand and so can contribute in economic growth. Buy often FDI is relatively small constituent of the aggregate demand. Multinationals ignore to take the risks in case of developing countries. There is lack of skilled labor in developing countries and so they are likely not to get the benefit from FDI. Environmental concerns can also accrue with FDI. Strings like reciprocal spending are attached with FDI. d) What are the arguments in favour of capital account restrictions? Answer: Restrictions on the capital account is a way by which corruption can affect the flow of capital. Capital controls are likely to be imposed by the corrupt countries as corruption reduces the ability of the government in collecting revenues from tax. Therefore politicians are dependent on capital controls in order to raise revenue. Capital controls increases the dependence on the monetary policies as well as promotes the reserves of foreign currency. It can also contribute to redistribute to labor from capital. The Government fails to monitor the foreign investments as efficiently as the domestic ones. Capital being more mobile than labor a significant part of the revenue from taxes goes unrealized. Capital controls limits the size of the opaque foreign investments in order to restrict the plight of capital and thereby increases the tax revenue. Question 3: a) Why do we need international financial regulation? Answer: The international finance integration does not appreciate failures of the market. The countries create this type of regulation primarily as the response to the concerns of the banks to international competition. In situations where the regulators set the rules, some of the banks might be operating in more stringent conditions than others. The national regulation will create differentials in costs that can hurt or help the banks. The banks operating in slack regulations experiences lower costs than the other banks which operate in stringent conditions. The potential benefits includes smoothing of consumption, domestic investment and growth possibilities, enhancements of the disciplines of macroeconomics, increased efficiency in the banking system and financial stability. b) What is the economic rationale behind “capital adequacy”? Answer: The capital adequacy is used in order to protect the interests of the depositors as well as promote the stability and maintain or enhance the efficiency of the financial system around the globe. Asymmetry of information between the managers of the bank and the depositors can result in market failure. The failure of the market may require the government to intervene. This type of intervention from the position of the government would take the form of capital adequacy. It forces the banks to hold more capital or remain in the stronger capital position when compared to the situation devoid of intervention. c) Outline the 3 Pillars of Basel II Answer: The first pillar takes into consideration the maintenance of the regulatory capital that is calculated for the three main constituents of risk that is faced by a bank namely risk of credit, operational risk and the risk of the market. The second pillar takes into consideration the regulatory response of the former pillar and gives the regulators an upgraded tool than those available to them under the principles of Basel I. The third pillar tries to balance the minimum level of requirements of capital and the review process. The participants of the market are allowed to measure the capital adequacy of the institutions by creating a set of disclosure requirements. d) Why has Basel II failed to prevent the current financial crisis? Answer: There is unavailability of independent standard with which the metrics of the banks can be measured. The Fed does not have the potential to judge the risk assumptions of the banks. The banks were highly influenced during the periods of housing bubble. No regulatory authority or the banks were concerned with the downturn effects. The Basel II is an exercise of mathematics that relies upon the good beneath the data. The assumptions were wrong in the calculation of mortgage related risk. Historical mortgage data were used by the banks. This made the calculation much rosier than it actually was. Section B 4. a) What are the causes and consequences of market failure in rural credit markets in developing countries? Answer: In presence of market imperfections, the true scarcity values will not be reflected by the prices of the services and goods. The reason being the failure of the private sector to develop institutions that will take care of efficient functioning of the market. The credit markets in the rural regions might be affected by the lack of information regarding alternative expenditures and opportunities of borrowing in other regions. The markets can also be hampered by the absence of institutions for formal lending that have the potential to mobilise savings. (b) Could credit rationing be an equilibrium outcome? Explain. Answer: A temporary feature o f the market is disequilibrium credit market. It occurs due to some frictions that prevents clearing. This may also result from interventions of the government. This is a situation of temporary disequilibrium as the economy will still move towards equilibrium in the long run when external shocks are absent. Disequilibrium credit markets are not a feature of the long term and can be avoided simply through policy changes. (c) What is the role of the state in the process of privatisation? Answer: The state is expected to offer the necessary regulatory, security as well as legal environment for the smooth functioning of the private sector. The functions include the need to provide property rights, appropriation of the results arising from the researches, facilitation of contractual obligations. The state should also provide provisions for pure public goods as well as services. The desire or objectives of the government to prevent the monopoly of the private sector is also essential in the process of privatisation. 5. a) What are the possible ways of minimising agency costs between managers and shareholders? Answer: One of the possible ways to reduce the costs of agency is by monitoring the duties of the agent by the principle. But it may be difficult to monitor the job of the agent effectively. When a manager expands a firm through acquisition which has resulted in reduction in share price it may be difficult to examine whether the manger had personal interests in mind or was trying to maximize the value of the shareholders and was unlucky. Another way that is devoid of this effect is to diversify the interests of the agent with that of the principal. b) What are the basic propositions of Modigliani-Miller theorem? Answer: There are two types of propositions: with taxes and without taxes. First consider the proposition without taxes. The first proposition under it states that the value of the firm that is leveraged is equal to the value of the firm that is unleveraged. The second proposition states that a higher ratio of debt to equity will result in higher equity return as high risk is associated with for the holders of equity in the indebted company. Now, consider the propositions with taxes. The first proposition states that the value of the leveraged firm is equal to the sum of the value of the unleveraged firm and the tax rate with value of debt. The second proposition states that the required equity rate is equal to the financing premium and equity that is unleveraged. c) Why Modigliani-Miller propositions may not hold in case of conflict of interest between managers and shareholders? Answer: The efficiency of the managers is enhanced by high leverage. It is the tendency of the investor to take into account the newly issued debt in a favourable way. The managers may also lie upon some riskier projects. The equity holders favour the indebtment of the bank as they may consider that the bank has more powerful ways to control the managers. 6.a) What is the meaning of economic entrenchment? Answer: In the country of the United States as well as United Kingdom, a few wealthy families usually posses the controlling powers of large corporations. In the case of most countries, these wealthy families have the potential to control the economies of that country. These structures of ownership allow the emergence of agency problems along with misallocation of resources. The political influence is dependent on what one controls instead of what one controls. This type of influence can distort the public policy. This type of phenomenon is regarded as economic entrenchment and a relationship between allocation of the control of the corporation and development of the institution can also be posited. b) Discuss some possible means used by businesses to strategically promote economic entrenchment. Answer: The mechanisms within a firm allow the owners to enhance their control within a firm in spite of not maintaining a sufficient proportion of equity. This inequality between the right of flow of cash and the control rights has the potential to alter the incentives of the controlling owners. Firms which have proportional structures of ownership are inclined to efficient investment. c) What is the role, if any, of legal institutions in promoting corporate financing opportunities? There are two mechanisms through which legal institutions can promote the corporate financing opportunities. The first mechanism referred as political mechanism states that the protection of the rights of private contracting will form the basis of financial development while the second mechanism referred as the adaptability mechanism emphasise that the legal traditions with efficient adaptation will influence the financial development. SECTION A A Question 1 1. Explain why Pareto efficiency conditions may not hold in real world? Answer: Pareto efficiency may not hold in the real world as most markets are characterised by asymmetric information as Pareto efficiency does not hold in case of such types of markets. 2. What are the possible outcomes of incentive problems in the credit market? Answer: The problem of repayment is the fundamental problem in the rural credit markets. This problem can be nullified by appropriation of institutions. In some cases it is very difficult and costly for the lender to evaluate the value of the collateral. If the costs results high relative to that of the volume of credit the attractiveness of the collaterals will get hampered. 3. What are the problems of ensuring equity in a democracy? Answer: The problems are as follows: Access to e-technology Problem of providing universal access The problem of citizen compliance Role of integration of the back office to promote participation of the citizens Question 2 (i) Identify at least two possible cases of agency problems in corporate finance. Answer: The two possible cases of agency problem is the conflict between shareholders and the bondholders and the effort problem. (ii) Using the definition of weighted average cost of capital, explain the basic propositions of Modigliani-Miller theorem. Answer: In the proposition of Modigliani and Millar, the equity of the unleveraged firm is equal to D/D+E * (debt of leveraged firm) + E/E+D * (equity of leveraged firm) where D and E refers to debt value and equity value of the leveraged firm respectively. Substituting equity of leveraged firm equal to the return on assets of the leveraged firm, it can be found out that the return on assets is equal to the sum of the proportion of debt multiplied by debt and proportion of equity multiplied by equity of leveraged firm which is equal to the return on the cost of capital. The weighted average of the cost of capital of the firm is not dependant on the capital structure. (iii) Why Modigliani-Miller propositions may not hold in reality. In this context, explain the problem of underinvestment with risky debt. Answer: The propositions of the theory are only benchmarks. It is not the end result. Financing matters only in case of market imperfections. Shareholders may not be inclined in investing in projects that are low in risks. The value of the shareholders will increase at the cost of the debt holders. It is beneficial for the shareholders to invest in high risky projects as they high profits. This will increase the income of the shareholders and the holders of the debt require only a fixed proportion of cash flow. The holders of the debt do not get any compensation for the additional risk and this may be regarded as the emergence of the problem. Most of the current values can be thought of as the future opportunities of growth. In the low leveraged firms, risky debts that are relatively large in amounts have the potential to create an underinvestment problem in the future. Question 3 (i) What are the consequences of skewed distribution of ownership in developing countries? Explain. Answer: Most of the countries operate under balance of payments constraints if they need to import capital for the industrial sector. Agriculture plays meaningful role in the process of industrialization. The growth in industrialization is dependent on the surplus in agriculture. Most of the developing countries possess a skewed distribution of ownership. Such kind of distribution creates a scarcity which has the potential to increase the power of the owners of the assets. The asset holders will be able to increase their income. (ii) What are the implications for capital allocation if ownership is held by a few corporate elite? Answer: The goal of allocation of capital will not be served if ownership is held by few corporate elites. They will try to accrue the large proportion of the capital and the benefits will not trickle down to the lower classes. (ii) What is the possible role of legal institutions to improve the allocation of capital in this context? Answer: The legal institutions have the potential to speed up the efficiency of the financial system through which they reallocate capital. The countries having the effective legal institutions can channelize the fund flow from the sick firms towards the emerging ones. SECTION BB Question 4: a) What is the theoretical link between financial development and growth? Answer: Financial development includes allocation of capital and monitoring the corporate governance of the firms as well as mobilizing and pooling of the savings. All these functions can influence the decisions on savings and investment which enhances economic growth. b) What evidence is provided by the empirical literature? Please discuss both time series and cross sectional evidence. Answer: Goldsmith in 1969 conducted a study that will assess whether finance can exert any pressure on economic growth. Data on 35 countries was considered from 1860 to 1963. The value of the assets of the financial intermediaries was divided by the GNP. The findings revealed that the size of the financial intermediary increases as the country develops. A positive correlation was found between financial developments with that of economic development. Question 5: a) Define the three different types of financial crises that can occur. Answer: The three different types of financial crisis are as follows: banking crisis, speculative bubbles and crashes and international fiance crisis. b) Can currency crises be predicted? Answer: The signal and the multivariate probit model can help to predict currency crisis but with little bias. The signal approach provides a warning system while the probit madel cannot provide information on the average lead time (Budsayaplakorn, Dibooglu and Mathur, p. 17). c) What is contagion and how does it occur? Answer: When the economic crisis in terms of bonds and equity markets spread to other countries which face the same problems, a situation of contagion arises. A recession of one country can spread to many other countries. It is referred to as contagion. Question 6: a) What are capital controls and why would a country adopt them? Answer: Capital control can be defined as any measure taken by the government or any other authorized agency to restrict the flow of foreign capital in the economy. The government can regulate the flow in and out of the capital account of the country. b) What are the different types of capital flows? Answer: The different types of capital flows are inbound FDI, portfolio flows, sovereign debt, debt of firms and capital outflows. c) What is the effect of liberalising capital flows? Answer: The exchange rate will get appreciated. The domestic currency will get appreciated. The transfer of net finance between the country and the foreign will increase and the net transfer will partly be spent on non-tradable items. Conclusion The questions try to touch up every corners of financial concepts and tries to provide the idea of the underlying concepts. Reference Budsayaplakorn, S., Dibooglu, S., and Mathur, I. Can macroeconomic indicators predict a currency crisis? Evidence from selected Southeast Asian countries. [pdf]. Available at: http://www.umsl.edu/~dibooglus/personal/saksit.pdf. [Accessed:23rd April, 2012]. Read More