Bank of England Performance - Essay Example

The world experienced the worst ever financial crisis in the year 2008. This is the period when financial assets suddenly lose their fair value in the market. Majority of the past financial crisis have been associated with the panic of banks, this coincides with the recessions. Financial crisis will normally lead to loss of paper wealth but will not affect the real economy. In the time of financial crisis banks suddenly experience large withdrawals by their depositors, this is normally be referred to as “a bank run.” This is a major challenge to the bank because banks will lend out the money they get from the depositors. This becomes difficult to pay back all the deposits when the depositors suddenly demand them. At the time of the financial crisis, banks tend to raise interest rate to discourage investors from borrowing money that is due to depositors. Yield curves are used to predict the changes in economic output and its overall growth. The line plots the interest rates at a given point in time of bonds having similar credit quality but differing in their maturity period. A normal yield curve is shown when the longer maturing bonds have higher yields that short maturing bonds as a result of the risks associated with time and value of money. The shape arising from the yield curve is significant to the investors as it helps give an idea of what the future interest rates change and the change of the economic environment of the country. Yield curves are of three types; The normal yield curve; This type of yield curve has lengthier maturity period of bonds and a greater yield returns as compared to shorter-term maturity bonds due to the risks associated with time. An inverted yield curve; Under this type of a curve bonds with a shorter-term maturity period will normally yield higher than bonds with longer-term maturity period, which will tend to have lesser returns, this can be a sign of the upcoming recession. A flat yield curve; When yield curve is flat, it means that shorter- and longer-term yields are relatively close to each other in terms of their yield; this can be a prediction of an economic transition. The gradient of a yield curve is a significant factor to investors; the bigger the gradient of the yield curve, the bigger the difference between short- and long-term rates of return to investment. The bank of England having been established in 1694 it becomes the second-oldest bank in the world after SverigesRiksbank. The UK government is prudent to note the liability of the economy. The liability nominal yield curves are retrieved from UK gilt prices and General Collateral (GC) rates and the UK index-linked bond prices. Gilt edged securities are Foreseeable and guaranteed for a future pay by the Government to the holder of the gilt. The payment is made in a fixed cash payment (coupon) semi-annually until the maturity date. At maturity, the holder receives the final coupon payment and the principal. Index-linked gilt is intended to: 1. Guard the worth of investment from wearing away by the effect of inflation. 2. This is achieved through adjustment of the coupon, and principal payments consider accrued inflation ever since the gilt’s issue. What is the Importance of Bond Yields? Cost of Government Debt: in the event that the yield on yields deteriorates the government is in a position to the subject debt at comparatively squat interest rates. This is conducive for the government to obtain cheaper funding from investors. In the recent past the UK government spent close to £45bn on payment of interest in year 2011/2012. In case the bond yields were much higher, then the government would have paid much more interest to lenders. Economies like Spain and Italy that have higher yields on their bond spend much large % of tax money on the payment of interest arising from borrowed funds. In an environment where bond interest yields are low, means that the market is willing to buy government debt. This creates more room for the government to borrow more funds. If bond yields rise suddenly, it means that investors are no longer interested in government bonds. This puts pressure on the government to reduce its borrowing. Bond yield help forecast on the future growth and inflation of the economy. Squat bond yields could be an indication of public unwillingness to invest in private sector investment and reflect low growth of the economy. Some economies, bonds yields, have increased suddenly as a result of worries on government debt amounts. For re-stance, the UK government has very huge annual private borrowing considering an example in year 2011/12 where the annual deficit was nearly 10% of its GDP. The bond yields have fallen. This is; as a result of: Increased saving rates. Private sector savings have been on the rise; as a result, the demand for safe investment assets such as government bonds has also increased thus investment in government bond that are much more secure. Poor returns in the private sector: the high rate of recession experienced in some economies has made investors run out of the private sector which, as a result, become less attractive. Investors feel much more secure in the investment in government bonds which provides low-interest rate returns rather than the much riskier shares and private sector investment. The bank of England is in fears of another financial crisis which financial analyst have warned that it could be even worse than the previous. Tough principles that have been levied on banking institutions had raised lending costs and encouraged organisations and investors to pursue funding from other sources. From the data from bank of England, the rate of interest rate went very high in the year 2008 to a point of 5.18% on short-term loans that were provided by the bank. There was a very slight difference to the loans that investors requested with longer payment period. This high-interest rates meant that fewer investors were willing to invest in government bonds due to the risk of losing their investment due to the rise of government debt. The interest rates are seen to change drastically in the period between Jan and Dec of the year 2008. This became very challenging time to investors to make effective decisions that would bear in mind that the future interest rates were very unpredictable. Rising in banking by individual investors means that the bank of England will have to charge greater rates on loans than those before the financial crisis. Carney the bank governor put on record that “the bank of England will need to limit the interest it charges investors.” The Bank has presently indicated that its expected base rates will growth in the following two to three years to an extreme of 3%. This is a positive increase from 0% interest rate at the moment. Tough regulations enforced on banks had sky rocked the lending costs of local banks and consequently encouraged organisations and investors to seek funding from other sources. But while reducing the domination of bank in the lending industry was a positive measure that could, lead to the protection of financial markets from collapse in another financial crisis or recession. References Bodie, Zvi, Alex Kane, and Alan J. Marcus, 2008, Investments, Chicago: Irwin McGraw-Hill. Elton, Edwin J., and Martin J. Gruber, 1995, Modern Portfolio Theory and Investment Analysis Wiley: New York. Chinn, M. and K. Kucko, 2014 “The predictive power of the yield curve across countries and time”, mimeo available at http://www.ssc.wisc.edu/~mchinn/Chinn_Kucko_Feb2014.pdf Diebold, F. X. and G. Rudebusch, 2013. “Yield curve modelling and forecasting: the dynamic Nelson-Siegel approach”, Princeton: Princeton University Press. Diebold, F. X., G. Rudebusch and S. B. Arouba, 2006. “The macro-economy and the yield curve: a dynamic latent factor approach”, Journal of Econometrics, 131, 309-338 Hördahl P., O. Tristani and D. Vestin, 2006. “A joint econometric model of macroeconomic and term structure dynamics”, Journal of Econometrics, 131. Hördahl P., O. Tristani and D. Vestin, 2008 "The Yield Curve and Macroeconomic Dynamics," Economic Journal, Royal Economic Society, vol. 118(533). Lancaster, P and ˘ Salkauskas, K 1986. ‘Curve and surface fitting: an introduction’, London: Academic Press. Mastronikola, K 1991. ‘Yield curves for gilt edged stocks: a new model’, Bank of England Discussion Paper (Technical Series), No 49. Nelson, C R and Siegel, A F 1987. ‘Parsimonious modelling of yield curves’, Journal of Business, Vol 60, page 473 Rudebusch, G. and T. Wu , 2007. “Accounting for a shift in term structure behaviour with no-arbitrage and macro-finance models”, Journal of Money, Credit and Banking, 39, 395-422. Rudebusch, G. and J. Williams, 2009. "Forecasting Recessions: The Puzzle of the Enduring Power of the Yield Curve," Journal of Business & Economic Statistics, American Statistical Association, vol. 27(4). Svensson, L 1994. ‘Estimating and interpreting forward interest rates: Sweden 1992–94’, IMF Working Paper, No 114. Svensson, L 1995. ‘Estimating forward interest rates with the extended Nelson & Siegel method’, Sveriges Riks bank Quarterly Review, 1995:3, page 13. 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