The Importance of Financial Intermediation in Economic Growth - Case Study Example

The significance of financial intermediaries in the financial system With the world turning into a small global village and the advent of new technologies, business opportunities around the world have turned to take an upward surge. The new technologies and globalisation has created easy room for households in one continent to invest in another continent and even buy shares in one company especially with the use of the stock markets. But increasingly, investors and households are faced with the dilemma of how to best carry out their planned investment. But financial intermediaries that include banks, mutual funds, investment companies, or insurance company serves to connect the two sectors and made investments easier. Definition Financial intermediary can be defined as that group of middlemen who interact between households by channelling their capital invested in the form of savings with banks, mutual funds, investment companies, or insurance company and the business sectors that have investments to carry out and need the funds to do so.1 The financial intermediary in this case who may be financial institutions as banks, mutual funds, investment companies, or insurance company serves to connect the two sectors and make some profit for themselves. The unique characteristic of the financial intermediary here is that their assets and liabilities are overwhelmingly financial.2 It should be noted here that the households who here are the saver is out to maximise the savings that they have saved but with minimal risk, while the investor is out to get money they badly need for their investments from the financial intermediaries at the cheapest rate and with less strings involved, while the bank is out to make the better deal of a large profit as possible for their role their perform. The financial intermediaries in this case can be referred to as movers of the economy since they provide investors with the money to make meaningful investments that give rise to an economic growth and development for the society.3 The role of financial intermediaries can not be undermined here. Efficient financial intermediaries through the role they play in any economy are seen as the best means for any economy to be able to achieve higher levels of output production, employment, and income which invariably enhance the living standards of the population. According to J.O. Sanusi (2002), availability of investible funds for investment in any economy is seen as the key in any growth process in any economy especially as it is realised that these funds are a necessary condition for output production and employment growth. Countries that have enjoyed or are enjoying economic prosperity such as the Western countries can be identified with such an efficient mechanism for mobilising financial resources and allocating same for productive investment.4 Banks from time memorial are considered to be the best financial intermediary since they are able to positively mobilise the savings of their customers, and allocating these funds to the investors for the financing of investment projects that help in developing the economy and providing jobs for the economy that help in the fight against poverty and unemployment. They provide these funds to inventors at affordable low interest rates, and act as the sole providers of liquidity in the whole monetary system and payment services, and helps in the implementation of monetary policies by influencing the savings – investment process that help accelerate the rate of economic growth and poverty reduction. Efficient banking systems therefore are seen as being able to control bank credit and direct same to areas of the economy that required these credits to make an economic growth. The success of banks to act as good financial intermediaries is due in part to the Central banks who have had the effective control of the activities of these banks and help them perform their duties well by putting in place a sound, stable, and efficient banking sector through effective surveillance and enforcement of prudential standards of the central banks through a licensing procedure that places an emphasis on a fit proper paper criteria that should make the banks trustworthy. The cost of financial intermediation over the past decades has been increasing tremendously. These costs include cost of acquiring information, cost of enforcing contracts between parties that is households and inventors, and exchanging goods and financial claims. The increasing cost is all due to the current high lending rates caused in part by the expansionary fiscal polices of Central Banks, which are of course fuelling inflation and tightening monetary policies around the world, and on the other hand by the oligopolistic structure of the banking system where some large banks take advantage of the information they have to block competition and protect some firms at the detriment of others, and the inadequacies of infrastructural facilities in certain cases to meet the high demand for investment funds. Many people are gradually shifting their ideas of considering banks as the best financial intermediaries that can stimulate economic growth to the markets of bands and equities especially as some large banks that have very few restrictions on their activities are looked as often colluding with some firms against other creditors to block efficient corporate governance. Bond markets versus banks as financial intermediaries Due to the setback suffered in the banking sector especially in the nineties when the Japanese banks suffered from financial illiquidity, the market for bonds and equity over the past 35 years were now looked as the best and most attractive medium for capturing family wealth.5 The trend is more seen by firms in the industrialized nations and is gradually entering emerging markets and developing countries, even though some firms in both developed and developing markets still prefer using retained earnings or banks as the preferred means to finance their investments. In a bit to determine whether the banks or the bond markets can be considered as the best stimulus of economic growth, Ross Levine (2001) collected information from some 48 countries over the period of 1980 to 1995 and by using several regression analysis techniques to be able to explain the per capita average growth rate in terms of different measures of the relative importance of markets to banks, variables such as ratio of market capitalization to private sector credit and the ratio of trading turnover to loans were used. He found out that despite the belief that bond markets can be considered as the best financial intermediary that better help in economic growth stimulus, there was no significant difference in whatever financial system used as what really matters was the total financial depth irrespective of the division between markets and banks. Allen and Gale (2004) investigating the relationship between the bonds markets and banks as financial intermediaries, agreed with Levine and termed the relationship that exist between the two as a “symbiotic relationship” especially as banks provide the savings and credit instruments in the early stages of development for investors, and the capital markets come into play when the financial depth of the investments increases. Three major key functions of a Central Bank The Central Bank (CB) is the main monetary authority that is vested with the power to act on behalf of the economy and country. They perform a key role in maintaining the economic stability of any economy by performing the three main functions of the CB are: implementation of monetary policy, managing currency stability, low inflation and full employment. Being the sole bank that issues currency for the economy, acts as the banker’s bank, and the bank of the state, all of this is done through the use of their fiscal and monetary policies – Open market operations, Reserve requirements, and credit deposit requirements. Implementation of Monetary policy The Central Bank as issuer of currency: The Central Bank in any country is the sole authority that is allowed to issue legal tender in the form of bank notes and coins. In some countries, the government issues notes and coins of smaller denomination that also act as legal tender, while the CB issues notes of larger denominations. The amount of currency to be issued, the time at which the currency should enter into circulation, and for the liquidity of which it is responsible are all determined by the CB. It also organises money circulation and regulates the amount of currency in circulation by using the monetary policy of compulsory reserve requirement. The reserve requirement can be said to be some kind of benchmark for the CB to check the ability of financial institutions/banks to “create” chequebook money through the use of loans and investments. Therefore, the reserve requirement limits the amount of money the financial institution can hold and use for financing loans and investments. It is worth mentioning here that, too much money in the economy can lead to inflation while too small money in the economy can lead to stifling of the economy. Therefore through the policy of compulsory reserve requirement, the CB to make sure that there is not much money in circulation. The Central Bank as State’s bank: The CB does not only limit operations to financial institutions, but also provides banking services to the government, by holding the accounts of the government and other state institutions, state special-purpose funds, as well as government entities, and executes their payment orders e.g. payments on public contracts awarded by the state to private contractors, and also can raise money for the government via instruments like bonds or T-Bills. Setting of interest rates: the CB has as very pertinent instruments of the monetary policies such as the setting interest rates which include the interest rate and Cash Reserve Ratio (CRR) (ratio of all deposits that commercial banks are mandated to keep with the Central Bank) amongst others. The CB manages interest rate by changing the discount rate at which the Central Bank refinances commercial banks. By varying CRR, the Central Bank can automatically change the money supply in the economy and can also use this lever of interest rates to encourage or discourage investment and affect employment levels in the economy. Open Market Operation (OMO): OMO is used to maintain exchange rate stability of the country currency. When CB has fears of fluctuations of the local currency, the CB steps in to buy or sell foreign exchange on the currency market. The sale of foreign currency can also be used to reduce the supply of currency in the economy. Inflation: To manage inflation in the economy, the CB just needs to twist the interest rate. Interest rates can be cut to ward off fears of a recession as is the case with the Fed in the USA this January 2008 where interest rates were cut to 2,25% from 3,5% in September 2007 or in extreme cases, may be increased when the economy is facing an inflationary situation. Managing the economic stability of the economy The CB has right to act as a regulator and at same time supervisor of the economic system through the following ways; The Central Bank as the banker’s bank: The CB in order to maintain the stability and safety of the whole banking sector, performs regulatory functions with regard to other banks by offering them the financial services that they offer customers such as ensuring the safety of deposits held by the banks. The CB organises the monetary clearing system, services current inter-bank settlements and actively participates in the inter-bank money market. On the inter-bank market, the CB just by using the monetary policy of open market operations, the central bank engages with financial institutions through the conditional and outright sale or purchase of securities or foreign currency, as well as the issue of own-debt securities. This means that CB is able to balance the demand and supply of funds held by commercial banks at the central bank and at the same time, this gives the CB that ability to influence the level of short-term interest rates on the inter-bank market. Upon the request of the commercial bank, the CB acts as a lender of the last resort to commercial banks in times of crisis. This means that, when commercial banks are faced with sudden financial crunch insolvency, the CB upon the request of the commercial bank concerned can step in to restore confidence in the system via devising various bailout packages for the commercial bank. The CB as supervisor of financial institutions makes sure that commercial banks act in accordance with the banking laws of the country and operate in a safe and sound manner that will give credibility to the customers and economy in particular. They make sure that all financial institutions policies are in the interest of the community and therefore supervise applications from banks seeking to merge or from bank holding companies seeking to buy a bank or engage in non-banking activities. The effect of a reduction in base rates on mortgages and the price of bonds in the capital markets Changes in short term interest rates generally affect the whole economic system that intend affects market interest rates such as mortgage and bank deposit rates. The policy actions otherwise known as the transmission effect affect expectations on how the future course of the economy may take and the confidence which these expectations are conceived and as well affects the prices of assets and exchange rates. The effect on short term and long term interest rates do always move in opposite directions. The effect on long term interest rates and expected future short term rates can go either way since they are influenced by an average and to the extend of the impact of the official rate change on future interest rates expectations.  Source: transmission Mechanism of monetary policy. Retrieved from www.bankofengland.co.uk In this situation therefore, a change in the base rate immediately is translated into other short term whole money-market rates and money-market instruments of different maturities and other short term rates such as interbank deposits pushing banks to adjust their lending rates by exactly the amount of monetary change which very fast affect interest rate banks customers on variable loans and overdrafts. These changes affect changes in rates offered to savers so as to maintain the margin between deposits and loan rates. Mortgages most are least affected since they are usually variable and do change slowly. Such changes also have an effect translated into the market and affect the prices securities. But the problem here is that, on the market, the prices of bonds are inversely related to long term interest rates, meaning that, a fall in interest rates relatively pushes up the prices of bonds. The fall in the prices of securities on the market can be largely attributed to the fact that expected future returns are usually discounted by a large discount factor making the present value of any stream of future income stream to fall. In conclusion, effects of the Central bank on the monetary policies of any particular economy and their decisions may have great consequences on any economy and this depends on what economic situation the CB intends to resolve. References Allen Franklin and Gale Douglas: “Financial Intermediaries and markets”, Econometrica, Vol. 72, (2004) No 4, pp 1023 – 1061, July 2004 Dr. J.O Sanusi, Governor, Central Bank of Nigeria (2002): The importance of financial intermediation in sustaining economic growth and development: The banking sector review. A keynote address delivered at the banking seminar, organised by the institute of directors. Levine Ross: “Bank –based or market-based financial system: Which is better? University of Minnesota, Mimeo. (2001) Martin Redrado, Governor, Central Bank of Argentina (2007): Financial intermediation through Institutions or markets? Opening address at session I on Financial intermediation through Institutions or markets? of the 6th Annual Conference 2007. “Financial system and Macroeconomic Resilience”, Brunnen, 18 June 2007. Zvi Boddie et al: Investment. McGrawHill, New York. 5th Ed. (2005). Web sites consulted http://www.hktdc.com/econforum/hkma/hkma041203.htm, retrieved on 28-04-2008 at 18.30pm http://www.investopedia.com/terms/f/financialintermediary.asp, retrieved on 28-04-2008 at 18.00pm Read More