Money, Banking and the Financial Crisis - Assignment Example

Money, Banking and the Financial Crisis Table of Contents Table of Contents 2 Money and banking 3 Financial crisis of 2007-2009 5 Measures taken to prevent another euro crisis. 7 Statement analysis 9 Balance sheet analysis 10 Works Cited 12 Name of the student Name of the professor Course Number: Date of submission: Money and banking Article -A review of banks in Europe gets results, The New York Times, 14/03/2014. The article, “A review of banks in Europe gets results” that was published in The New York Times, dated 14/03/2014, has been selected for this study. The article lays emphasis upon scanning the functions of European banks in order to get a true picture of their financial strength. The stress test and the asset quality review are being done by ECB (European Central Bank). The process is seen to be going well till now. The analysis reveals that Italy and Spain were the countries that were most troubled in the banking area. ECB hopes that in the near future the regulation of all European banks will be brought under one consistent standard. The assessment of the banks had made several banks to shed their non profitable assets and raise new capital. Also a significant challenge faced by the review process was that, different banks followed different standards of accounting as their regulatory authorities differed. In order to be able to analyze banks on the same platform, it is important to review them on the same standards. However this system has been greatly opposed by the United States. The US is of the belief that the nature of the economy and financial standards of different nations in the Euro zone vary highly. As a result they cannot be measured under the same parameters. Crisis in the Euro zone mainly rose from the lack of liquidity and fall of reserves in bank. As a result the overall economy was getting hugely affected. ECB had proposed to counter this debt crisis by undertaking bond purchasing from the banks (Norris, Floyd, “A Review of Banks in Europe Gets Results”). The article significantly lays light upon the fact that consistent review and change of accounting policies with changing business environment are crucial ways of preventing the downfall of a banks financial position. However in order to understand the importance of regulating banking activities, it is necessary to know the role banks play to shape an economy (“The Eurozone in Crisis”). Integral part of the Financial system- A financial system consists of different types of markets such as debt market, equity market, primary and secondary market and so on. Broadly it can be classified into the capital and money markets. Capital markets provide different types of options for raising long term and short term capital, whereas money market caters to the liquidity needs of businesses. Banks play an important role as an important intermediary between the investors and the takers of investments. Flow of money is affected through banks in the financial system. The financial markets cannot function without the support of banks who are the prime intermediary. Hence regulating banking functions becomes important so as to be able to generate greater transparency and efficiency. Loan and interest rates- The value of money is constantly decreasing. This is the reason why banks charge interest on the loans provided by them. There are basically two components of interest rates, real and nominal. Nominal interest rates do not account for drastic effects on inflation where as real rates of interest are adjusted with the changing level of prices which influences the borrowing pattern of the economy. Money supply and interest rates- In general when there is increased inflation and increased level of income, the rates of interest are likely to increase. The opposite happens in the case when inflation is low. However during inflation liquidity becomes high. In order to check the liquidity and consumer spending, interest rates are increased, thereby causing an increase in prices (Alessi, Christopher,“Eurozone crisis explained”). The above analysis clearly shows the importance banks play in shaping an economy. Therefore regulating their functions become an important criterion in order to develop a more stable and highly regulated economy. However the challenge faced by authorities is the huge differences in the accounting standards and perception. In a globalized economy where every nation interacts with another in some way or the other, following similar grounds of accounting and reporting becomes essential so that performance review and monitoring gets simplified (“Why Do We Regulate Banks?”). Financial crisis of 2007-2009 The financial crisis that sprung up in the year 2007 can be stated as a perfect example of what mismanagement and lack of regulation in the banking sector can lead to. The crisis can be well described as a banking crisis than financial crisis as the main cause of the economic meltdown was the fall of banks across US, UK and in Europe. Takeovers and government intervention were seen to be the last resort to bail out the banks from the severe down fall (“The Evolution of the Financial Crisis of 2007-8”). The crisis began with the real estate boom in the US. The prices of houses were rising highly during the period. As result, in order to support the lower income group to invest in house property, the government relaxed some of the regulations related to housing loan facility. As a result the demand of housing loans increased in the market. The rising prices of house and reduction in regulation led to the prosperity of this sector. However no one really bothered about the risk associated with the returns from housing market. The risk was shifted to the banks through the mortgage broker. Banks where therefore facing a loss of revenue as more and more loans was getting insolvent and could not be realized back (Crotty 580). Another major contributor of the economic crisis was the subprime lending. People with poor credit records and weak financial conditions were given loans. Hence on the event of default, the bank was left with the mortgage and no financial recovery. The subprime mortgages grew in the market from 10% to 32% (Pol 528). Financial innovation and deregulation were also important causes of the crisis. Regulatory authorities failed to ascertain the risks associated with high levels of mortgaging. Banks are hugely interconnected with each other through trading of derivatives, thus the fall of one banking sector radically affects other banks. Innovation can only be termed as good if it helps to reduce problems and increase the level of efficiency. The financial crisis of 2007 however speaks a different story. The main issue was lack of regulation and monitoring of financial activities. Therefore banks should adhere to a flexible means of operation. This would encourage both innovation and regulation. A restructuring of the financial structure is essential to prevent another massive financial crisis (“Financial Policy Committee statement from its policy meeting”). Mere fiscal and monetary policies cannot be of much help in combating such situations. They can only provide a temporary tide over. Banks play an important role in developing an economy. Almost all the other sectors are hugely affected by the banking policies. Therefore it is extremely essential that the banking sector is highly regularized. Otherwise it would lead to the downfall of the entire economy of nations across the world (Hodson and Mabbett 1061) Measures taken to prevent another euro crisis. In order to combat the financial crisis in the European market, regulatory authorities such as E.C.B have adhered to the following solutions (NDTV,“5 steps ECB has taken to combat Europes debt crisis”): Outright monetary transactions- In order to regulate the money supply in the European zone, E.C.B will adhere to a new bond buying program called the outright monetary transactions by which it will purchase short term bonds of up to three years without any limits. However banks must follow certain criteria’s and conditions under this program. These conditions will be part monitored by the International Monetary Fund. It is expected that the bond purchase will not increase the money supply in almost seventeen countries of the euro zone. Bond purchase would lead to increasing the prices of bonds and reducing the interest yields on the bonds in the long run. Under such circumstances the government can take advantage of selling low yield bonds against those bonds that are becoming due. Reduce Indebtedness- Another important reason behind the bond purchasing is to lower the borrowing cost in indebted countries. The actions taken by the E.C.B has calmed the market for government bonds that were facing huge risks. This has already affected in lowering the borrowing cost in countries such as Italy and Spain. High borrowing cost can lead the countries to financial collapse that may have an effect on the shared European currency. Extending loans- E.C.B has taken the efforts to provide cheap loans to highly indebted banks having duration of three years. Such an action on the part of E.C.B has helped to provide relief in terms of financial stress. The loans were provided mainly to those banks that were facing a crunch in borrowing from other banks. As a result of the availability of such cheap loans, banks could purchase high yielding government bonds which would increase the prices of the bonds and reduce the interest rates. Thereby a lower level of borrowing cost can be achieved. Interest rates on loans- In order to affect the interest rate on loans, E.C.B has reduced its interests to a record low of 0.75%. By providing such loans based on low interest rates, the rates that banks charge on interbank loans will also result to be low. Also the interest rate on the loans that banks provide to consumers and other industries will have low level of interests. This can help many firms to tide over the financial crunch that they are facing. Hence E.C.B’s low interest loans can have a wide effect on the overall all industrial growth and development. Reducing the reserve cut- E.C.B has lowered the reserve requirements that banks need to maintain from 2% to 1%. This releases almost half of the reserves that can be used by the banks for lending purposes. Thereby the excess reserves can be used by the banks in lending purposes and also for purchasing bonds. The above program is held to cut down the debt crisis. But many experts are of the opinion that the implications will be short lived. There might be a subsequent debt crisis if radical measures are not taken. In order to provide a more long term solution for the debt crisis, the E.C.B along with other regulatory authorities will closely monitor the activities of banks across Europe. It will also set some common standards for the banks to enhance accountability and transparency. Although the above moves by the E.C.B will help to enhance the liquidity of other banks, they however will be directed not to invest in risk associated and low yielding investments. As a result of this the level of credit flowing into the industrial and the household sector will be highly regularized and lowered to a large extend. This will help to keep money supply under control. Statement analysis At the expiration date of a futures contract the price of the contract is the same as the price of the underlying asset (The Economic Times, “Definition of Futures Contract”). A futures contract can be called an arrangement to either buy or sell an asset at a future date at an agreed upon price today. In the contract a party agrees to pay a certain price for a given underlying asset at a future date. The exchange of the commodity happens only on the date of expiry of the contract. The other party to the contract agrees to sell the asset at the agreed upon price on a future date and provides the commodity to the other party on the specified date. This kind of an agreement helps to hedge off risks that may arise in the future for the buyer of the commodity. On the other had if prices fall, it proves to be an advantage for the sellers who can still receive a high price for the commodity (“Futures Trading Introduction”). In order to understand the concept of futures better, it can be studied with the help of an example. For instance, there is a company which suspects that the prices of jet fuel will rise from its existing three dollars. Therefore in the month of January the firm decides to enter into a contract with a trader to purchase a million gallons of jet fuel in the month of March. So the total investment will be of three million dollars. Now if the price of fuel falls to two dollars, then the firm faces a loss of paying extra one dollar for each gallon which would sum to a million dollars extra. This however would be a favorable scenario for the sellers as they would save on losing revenue due to the fall in prices. However if the prices rise, the tables will be turned. Then the firm will be at an advantage and the traders will be at loss. However on the date of maturity, the commodity is sold or purchased at the agreed upon price. Therefore on the maturity date the price of the contract becomes equal to the price of the underlying asset for the parties involved in the contract irrespective of the prices existing in the market (“Futures Contract”). In relation with the study of the financial crisis, it is important to mention that interbank fund transfer majorly takes place on the basis of derivatives such as futures, swaps, options and so on. However in such a context the underlying asset would be bonds or securities. Balance sheet analysis Figure 1: Balance Sheet extract of First Bank Scenario A The interest rates of banks are at 10%. The bank sells $10 million of its assets and replaces them with rate sensitive assets. The duration of the assets are 2 years. Rate sensitive assets are those assets that are subject to changes of interests rates. Hence when the company purchases $10 million rate sensitive assets, it will have to purchase the same at $11 million including the rate of interests. Hence a gap of $1 million dollars. Now if the rate of interest fall to 7%, then the rate sensitive assets will be valued at $11.77 million dollars. Therefore the firm gets an increased value of 0.77 million dollars at the end of the 2nd year. however if the firm sells the asset at $11.77, its net profits will only be $0.77 against the investment made by it of $1 million additionally to secure the asset in the first place. Therefore the firm loses 0.33 million dollars. Scenario B If $5 million of the fixed rate assets are converted to rate sensitive assets, then the firm is exposed to the risk of interest rate fluctuations. The higher the rate of interest the lower is the value of the assets. On the other hand if the rate of interest is high the value of the asset will be low (“Interest - Rate Risk Management Using Income Gap Analysis”). Scenario C If the rate of interest goes up by 2% then the implication on the value of the rate sensitive assets will be: Value of rate sensitive assets = $20 million * 2% = 0.4. Therefore the value of the rate sensitive asset will increase by $0.4. So net value of the rate sensitive asset will be $20.4 million. Works Cited Alessi, Christopher. “Eurozone crisis explained.” BBC News. BBC News, 13 April 2013. Web. 28 March 2014. Crotty, James. “Structural causes of the global financial crisis: a critical assessment of the new financial architecture.” Cambridge Journal of Economics (2009): 563–580. Print. “Financial Policy Committee statement from its policy meeting.” Bank of England. Bank of England, 2014. Web. 28 March 2014. “Futures Contract.” NASDAQ. NASQAC.com, 2014. Web. 28 March 2014. “Futures Trading Introduction.” Futures-Investor.Co.UK. Futures-Investor.Co.UK, 2014. Web. 28 March 2014. Hodson, Dermot and Deborah Mabbett. “UK Economic Policy and the Global Financial Crisis: Paradigm Lost?” Journal of Common Market Studies (2009): 1041–1061. Print. “Interest - Rate Risk Management Using Income Gap Analysis.” Economy Informatics. Academy of Economic Studies Bucharest, 2014.Web. 28 March 2014. NDTV. “5 steps ECB has taken to combat Europes debt crisis.” NDTV Profit. NDTV Convergence Limited , 7 September 2012. Web. 28 March 2014. Norris, Floyd.“ A Review of Banks in Europe Gets Results.” The New York Times. The New York Times Company, 13 March 2014. Web. 28 March 2014. Pol, Eduardo.“The preponderant causes of the USA banking crisis 2007–08.” The Journal of Socio-Economics (2014): 519– 528. Print. The Ecnomic Times.“Definition of Futures Contract.” The Economic Times.  Times Internet Limited, n.d. Web. 28 March 2014. “The Eurozone in Crisis.” Council on Foreign Relations. Council on Foreign Relations.org, 2013. Web. 28 March 2014. “The Evolution of the Financial Crisis of 2007-8”. Brunel University Research Archive. National Institute of Economics and Social Research, 2008. Web. 28 March 2014. “Why Do We Regulate Banks?” Cato Institute. Cato Institute.org, 2005. Web. 28 March 2014. Read More