The Significance of Financial Intermediaries and the Role of the Central Banks - Term Paper Example

INTRODUCTION TO FINANCIAL SERVICES Introduction This paper is about the significance of financial intermediaries and the role of the central banks along with the effect of reduction of base rates on mortgages and bonds. This paper is divided into two sections in the order of the assignment questions. a) Discuss the significance of financial intermediation in the financial system. Introduction A financial intermediary is a firm or an institution that acts an intermediary between a provider of service and the consumer. It is the institution or individual that is in between two or more parties in a financial context. In theoretical terms, a financial intermediary channels savings into investments. Financial intermediaries exist for profit in the financial system and sometimes there is a need to regulate the activities of the same. Also, recent trends suggest that financial intermediaries role in savings and investment functions can be used for an efficient market system or like the sub-prime crisis shows, they can be a cause for concern as well. Financial Intermediation Financial intermediaries work in the savings/investment cycle of an economy by serving as conduits to finance between the borrowers and the lenders. In the financial system, intermediaries like banks and insurance companies have a huge role to play given that it has been estimated that a major proportion of every dollar financed externally has been done by the banks.1 Financial intermediaries are an important source of external funding for corporates. Unlike the capital markets where investors contract directly with the corporates creating marketable securities, financial intermediaries borrow from lenders or consumers and lend to the companies that need investment. In the following sections we look at: The role of the financial intermediaries The need for regulation And recent trends in this sector Role of the financial intermediaries The reason for the all-pervasive nature of the financial intermediaries like banks and insurance companies lies in their uniqueness. As outlined above, Banks often serve as the “intermediaries” between those who have the resources and those who want resources. Financial intermediaries like banks are asset based or fee based on the kind of service they provide along with the nature of the clientele they handle. Asset based financial intermediaries are institutions like banks and insurance companies whereas fee based financial intermediaries provide portfolio management and syndication services. Financial intermediaries have a central role to play in a market economy where efficient allocation of resources is the responsibility of the market mechanism. In these days of increased complexity of the financial system, banks and other financial intermediaries have to come up with new and innovative products and services to cater to the diverse needs of the borrowers and lenders. It is the right mix of financial products along with the need for reducing systemic risk that determines the efficacy of a financial intermediary2. Need for regulation3 The very nature of the complex financial system that we have at this point in time makes the need for regulation that much more necessary and urgent. As the sub-prime crisis has shown, any financial institution cannot be made to hold the financial system hostage to its questionable business practices. As the manifestations of the crisis are being felt and it is now apparent that the asset backed derivatives and other “exotic” instruments are amounting to trillions, the role of the central bank or the monetary authorities in reining in the rogue financial institutions is necessary to prevent systemic collapse. As capital becomes mobile and unfettered, it is the monetary authorities that have to step in and ensure that there are proper checks and balances in the system so as to prevent losses to investors and the economy in general. Recent trends Recent trends in the evolution of financial intermediaries, particularly in the developing world have shown that these institutions have a pivotal role to play in the elimination of poverty and other debt reduction programs. Some of the initiatives like micro-credit reaching out to the masses have increased the economic well being of hitherto neglected sectors of the population. Further, the financial intermediaries like banks are now evolving into umbrella institutions that cater to the complete needs of investors and borrowers alike and are maturing into “financial hyper marts”. Conclusion As we have seen, financial intermediaries have a key role to play in the world economy today. They are the “lubricants” that keep the economy going. Due to the increased complexity of financial transactions, it becomes imperative for the financial intermediaries to keep re-inventing themselves and cater to the diverse portfolios and needs of the investors. The financial intermediaries have a significant responsibility towards the borrowers as well as the lenders. The very term intermediary would suggest that these institutions are pivotal to the working of the economy and they along with the monetary authorities have to ensure that credit reaches to the needy without jeopardizing the interests of the investors. This is one of the main challenges before them. b) Discuss three key functions of a Central Bank and show how a reduction in base rates affects mortgages and the price of bonds in the capital markets. Introduction In this section we discuss the role of a central bank, its functions and also see how a reduction in base rates affects mortgages and the price of bonds in the capital market. Central Bank4 A central bank is an institution that is mandated by constitutional decree to function along certain principles and entrusted with managing the fiscal side of the country’s economy. The Fed Reserve and Bank of England are examples of central banks. These banks have many functions, some of which are listed below. The central bank manages the monetary policy and sets interest rates to spur growth and rein in inflation. The role of the central banks has become prominent in these days of globalization and laissez- faire economics since the financial system has become more integrated and needs intervention by the central banks from time to time to keep the system together. Key functions5 The key functions of a central bank are: Regulating the money supply Managing the foreign exchange and gold reserves in a country Managing the cost of credit and it’s availability Acting as the “lender of last resort”. Regulating the money supply6 This includes regulating the size of the nation’s money supply and setting the interest rates and other policy instruments to curb inflation and spur growth. The central banks regulate the money supply by expanding and contracting their assets over a period of time. For e.g. the cash reserve ratio or CRR is used by the central bank to either mop up excess liquidity in the system or inject liquidity in times of low growth. The CRR is the ratio of the reserves that the commercial banks must hold as a proportion of their liabilities. The CRR is a policy instrument that the central bank uses to nudge the commercial banks to maintain a certain amount of liquidity in the system. Typically the central banks in developed countries do not tinker much with the CRR though this is often a tool for fighting inflation in the developing countries. The example of China and India which use the CRR as part of their monetary policy is illustrative of the central bank’s intervention in the economy. Managing the foreign exchange reserves Managing the cost of credit and its availability The central banks manage the cost of credit by using the prime lending rate or PLR and by intervening in the open market to mop up excess liquidity. The main instruments that are available to the central bank are the interest rates that take the form of the main lending rate or prime lending rate as it is known in different countries. The prime lending rate is the interest rate that the commercial banks would get for short term deposits with the central bank. Since this affects the lending rates of the banks as well, any reduction in the prime lending rate would mean that the commercial banks would also cut their lending rate and this would in turn make the availability of credit and access to credit cheaper. Managing the foreign exchange reserves The central bank also intervenes in the foreign exchange market to stabilize the currency in times of foreign exchange turmoil. This takes the form of intervention in the open market to buy and sell the home currency as well the foreign currency. It buys the home currency when the exchange rate relative to the USD is going down and sells home currency when it is appreciating. Though the former option is not used that widely in countries which have export led economies the latter option of selling home currency to keep the exchange rate favorable to the USD is a normal practice in developing countries. Lender of last resort The central bank acts as the lender of last resort by loaning funds to the commercial banks that are in a crisis of payments. This has happened recently in the US in the case of the “bailout” of the investment bank Bear Sterns by the Federal Reserve. Effect of reduction in base rates on mortgages and bonds Introduction The base rates or the interest rates are those policy instruments that determine the level of credit and the money supply in an economy. These are used by the central banks to rein in inflation or spur growth in the economy. Reduction of base rates Any reduction of the base rates or the interest rates would mean that the rate at which the commercial banks borrow from the central bank is lower. This means that the commercial banks have access to cheap credit and this in turn makes the commercial banks lending to the public at large cheaper. This means that more credit is available in the economy as a whole and this would spur growth. On the other hand, this would bring in inflationary pressure on the economy because of increased money supply. Effect on mortgages The real estate market like any other component of the economy depends on the availability of credit and cheaper credit would mean that more and more prospective buyers would find it easier to borrow for buying real estate. Also, the commercial banks (as we have seen above) will lend at cheaper rates. The combined effect of this would be to lower the mortgage rates and this would lead to a boom in the mortgage market. Apart from the securitization and other aspects of the “sub-prime” bubble, the availability of easy credit was one of the contributing factors. Effect on bonds in the capital market7 Base rates and the prices of bonds have an inverse relationship. Whenever interest rates are lowered, bond prices go up and whenever interest rates are raised bond prices go down. However the yields on bonds and interest rates have a direct relationship. This is because when the base rates are lowered, the attractiveness of bonds as an investment vehicle is raised and this causes the bond prices to go up. Once the bond prices rise, the yields on the bonds go down. The converse happens when the base rates are raised and the commercial banks turn to the central banks instruments leading to a flight away from the bonds. And in this scenario, as the bond prices go down, the yields on the bonds go up. Conclusion We have seen that the central bank of any country is the key player in deciding the monetary policy of that country. In these times of increased globalization and diverse needs of the investors, keeping the economy afloat is the challenge that faces the central bank of any country. One of the most keenly watched events these days is when the Fed announces a rate cut or the reverse. The stock markets react immediately as do the other sectors in the economy. The preceding two sections were about how the mortgage rates and the bond prices behave to a cut in the base rate. The monetary policy instruments available to the central bank have to be used diligently and with much thought as far as the outcomes are concerned. Conclusion for the paper in general This paper has attempted to deal with some of the components of the financial system. The role of the financial intermediaries and that of the central bank have been dealt with in some detail. Though it is by no means comprehensive, this paper tries to provide some context for the “Introduction to the financial system”. Note on sources The sources have been used only for the general idea of the concept. The elaboration and the conclusions are the author’s and flow from the underlying concept. Mainly electronic sources have been used. Sources Read More