Financial Services: The Commercial Environment - Essay Example

Financial Services: The Commercial Environment The question requires a descriptive and critical discussion of the UK financial industry’s initial development and its role in the shaping of monetary policy. The Second part of the question however focuses on the different techniques of inflation targeting adopted by the European Central Bank and The Bank of England.The different historical premises and the inflation experiences on which these policies are based are also appreciated. (Greiber, C and Lemke, W 2005) ..Before discussion the role of the financial institutions in delivering monetary policy it is worth appreciating that the forming of ECB and its monetary policies has entailed the concept of a single nominal interest rate in an integrated currency union. (Greiber, C and Lemke, W 2005) At a preliminary stage of analysis it is worth appreciating this “one size fits all” approach to interest and inflation rates can lead to manifest injustices with countries with faster inflation, (often accompanying stronger growth), who will technically be facing lower ‘real’ interest rates than those countries currently going through lower inflation. (Aharony 1986)Therefore an excessively deflationary monetary policy in the slower growing regions of the Eurozone will be a cause of concern.In this case Bank lending and housing prices with in the member states can counter the effects of such a uniform treatment. (Greiber, C and Lemke, W 2005) . Another perspective very much connected to the first part of the question is the differences in the national requirements, especially in retail banking which become a threat to the retail market. Now coming back to the first part of the question,a thorough understanding of the intricacies of the banking and financial system of any country is integral to the effective management of any economy.Infact the world economy is the ultimate beneficiary of the health and wealth of the financial institutions of major economies like those of the United Kingdom. The development of UK’s financial sector has its roots as far back as the Roman age where it is reported that professional banking still existed even in its most basic forms and banks were able to receive deposits and advance credit. (Fama, E.F. and K.R. French.1992.) Indeed the mention of a “pound of flesh” by Shakespeare in the medieval England indicates that credit lending existed even back then even though in a very crude form! The Bank of England emerged as a joint stock bank during the industrial revolution as the advent of improved transportation and improved means of communication paved the way for further financial development (for example the development of the NatWest bank which was the first UK national bank.By the 18th and 19th century the banking systems had been divided into Clearing “High Street” Banks Merchant Banks; and other financial institutions; such as Building Societies. (Fama, E.F. and K.R. French.1992.) The United Kingdom’s financial markets have gone through radical changes in the past few decades particularly in the area of credit risk. (Fama, E.F. and K.R. French.1992.)This is particularly because of the large banks expanding into the area of credit risk this accelerating the process of disintermediation.Instead of holding it in their balance sheets the financial intermediaries have made Credit something which has a market of its own. (Fama, E.F. and K.R. French.1992.)This has led to an increased trading of securitized credit instruments and in turn caused an explosive growth in the market for credit derivatives.The UK financial markets have also seen the growth of derivatives and structured products in other risk categories, such as interest rates, foreign exchange and equities. (Mishkin, F. 2007). There has also been a quantitative shift in the growth of hedge funds and private equity funds. Also private equity funds have increased in their role as devices of restructuring corporate asset and the deviation towards innovative loan structures and financing techniques which has almost led to them being distinguished from hedge funds. (Fama, E.F. and K.R. French.1992.) Since the UK banking system is extremely advanced in terms of the globalization of its financial markets means that it will have a significant effect on UK monetary policy is shaped. (Mishkin, F. 2007). It is worth noting that the constant development and innovation in its financial operations and strategies has changed both its operational and structural financial landscape. Currently the financial services industry is highly influenced by the Basel Committee (under the Bank of International Settlements) which was formed in response to the crises caused by the insolvency of Bankaus Herstatt and the problems caused by Nixon’s announcement of the closure of the Golden Window ,has worked since 1974 to prevent such risks from injuring the health and wealth of such financial institutions. (Mishkin, F. 2007). This interaction between financial markets, economic growth and monetary policy ensures a smooth running economy as the financial services industry continues to integrate and expand thus becoming a tool of the monetary policy makers.This is done to ensure a steady medium-term price stability orientation. (Greiber, C and Lemke, W 2005) ‘ Credit risk within the financial services industry will play a large role in the price formation mechanism and this will lead to a more efficient allocation of financial resources. Since the UK financial industry currently accounts for 7% of the total GDP and employs over 1 million people while managing and providing services to national and international banks it keeps a check on the money supply for the entire monetary aims. (Mishkin, F. 2007). The interest rate and inflation rate will be controlled through the London Stock Exchange which is the largest trade centre for foreign equities in the world. The monetary policy is also impacted through the Foreign Exchange market (which has a daily turnover of $464 billion. and 23 billion Pounds in 1996 equal to 3.5% of the GDP).The same goes for the insurance markets in the UK(currently holding 520 banks) as the Lloyds and the London Insurance Market account for the majority of cash inflows and outflows.. The UK bond markets and equity markets operate through the London Stock exchange is responsible for helping the UK companies raise capital through the main market,the AIM, the Professional Securities Market and the Specialist Fund Market. (Mishkin, F. 2007). The LSE deals with a wide range of securities, including equities, debt, covered warrants, exchange traded finds , fixed interest, contracts for difference as well as depositary receipts(www.londonstockexchange.com). (Goodhart, C.A.E. and Hofmann, B. 2006) The LSE is also highly computerised to accommodate its workload ( as it has 600,000 trades executed daily and each trade completing in 6 milliseconds see (www.londonstockexchange.com)) and uses systems like TradElect, to expedite its trade and services.Last but not the least it deals in equity derivatives through its branch called EDX London and deals in a number of high level Blue-chip stocks and indices in the UK and around the world. (www.londonstockexchange.com). In this regard any monetary strategy of the Central Bank will be manifested through these dealings of the LSE like all the other financial services industry. The activities of all these markets are duly controlled to keep a check on inflation and price stability. Currently these are regulated through the Ffinancial Services Authority (FSA) which took over UK bank and financial services regulation in 1998 and under the Financial Services and Markets Act 2000 (FSMA). (Goodhart, C.A.E. and Hofmann, B. 2006) The FSA aims to regulate the United Kingdoms monetary and fiscal policy by keeping a check which firms are authorized to deliver financial services, setting standards for firms in line with the Prudential and Conduct of Business standards and the delivery of these standards. Currently the monetary policy is delivered through the Bank of England and it monitors and identifies systemic financial risk by closely monitoring the financial system infrastructure, particularly payments systems. (Goodhart, C.A.E. and Hofmann, B. 2006) The Bank while monitoring economic and financial market developments makes decisions on interest rate policy through its Monetary Policy Committee, chaired by the Governor of the Bank and composed of top Bank officials and outside members.Inflation targeting is done through a common understanding between the FSA, HM Treasury and the Bank of England where all three of these supervisory authorities will play their part with in financial stability. Therefore UK’s current monetary policy is aimed at delivering price stability and low inflation (with the Government’s inflation target of 2%. expressed in terms of an annual rate of inflation based on the Consumer Prices Index (CPI).)The decade of the nineties demonstrated low and relatively stable interest rates in contrast to the high and volatile interest rates which haunted the economy in the seventies.The interest rates also fell following the 9/11 incident,yet the UK financial sector saw definite booms with in the housing sector as interest rates increased in 2004. (Goodhart, C.A.E. and Hofmann, B. 2006) The mid-seventies saw bank failures(for example the Secondary Banking Crisis of 1973-74 ) and then there was a heightened influence of EU law(leading to the Banking Coordination Directive of 1977) and all this resulted into proposals for a radical change in the to the legislative framework.(Boehemer 2005) However the FSA model’s credibility is still under debate today in terms of its accountability and reporting .Academics have expressed the opinion that today the UK is better supervised post FSA in terms of its accountability mechanisms and executes its functions in a more accountable way than the bank of England.(Boehemer 2005) Recent statistics show that things are improving in terms of microeconomic indicators like that of employment and reduced inflation.The diagram below gives a rough estimate of the UK interest rates This is because during the past few years the UK has had much success in controlling interest rate fuelled inflationary problems. New evidence from the Bank of England however Inflation Report1 suggests that UK has been hit by stagflation in its financial sector “In the central projection, higher energy and import prices push inflation above the target in the near term. Inflation then falls back to settle around the target in the medium term. The risks to growth are on the downside, while those to inflation are balanced.” (National Statistics 2007-2008) Last but not the least it would be worth mentioning the nature of bond payments and debt instruments in the UK which are a core sector of the UK capital markets.The UK regulation emphasises upon organised marketplaces.Under the Requirements for Recognised Investment Exchanges (RIEs) the businesses are under a duty to ensure that business conducted by means of their facilities is conducted afford proper protection to investors.The transparency of UK financial markets has been much debate and interest due to the fact that its highly regulated.Critics have even gone ahead to argue that the UK financial markets are losing sensitive and strategic details due to stringent disclosure requirements.(Boehemer 2005).Academics have expressed their discomfort with this as the worse hit by excessive transparency in the UK are the agents who provide liquidity to investors on-demand. (Boehemer 2005) The financial services industry will have a significant bearing on the matter of credit and interest rate management and will control credit supply.It can be said that while the role of the traditional banks in monetary policy transmission has diminished to a large extent the arena of financial services like insurance and stocks account for more efficient, actual and expected changes in official interest rates which will then be readily transmitted to a wide range of financial assets. (Goodhart, C.A.E. and Hofmann, B. 2006) The effects of monetary policy bear strongly upon the range of asset prices as the Central Bank finds itself in a good position to use this as a powerful instrument for affecting the economy. (Greiber, C and Lemke, W 2005) .Market expectations on future policy intentions will affect the long-term rates and the financing conditions even before official interest rates are changed. If the asset prices with in the financial services will vary this will affect consumption and investment decisions.Therefore this will become a kind of policy communication and thus an instrument for the central bank to communicate its policy.On the other hand it should also be noted that policy actions that diverge from the pace expected by economic agents, are a threat to determining long term interest rates and other yields. This may ultimately disrupt the monetary aims of the economy with potentially disorderly effects on liquidity and asset prices. Before I compare the UK approach to inflation targeting to the approach of the European Central bank it will worth reviewing what the UK approach entails and the historical premise behind it.Since the 1970’s the UK has followed a more market-related monetary environment under its Competition and Credit Control policy which entailed the restrictions on bank lending and interest rates to allow for fiscal expansions Since then the Government has set out money and inflation targets and tried to follow them through the “broad money” perspective which was later replaced by the “narrow money perspective” essentially meaning that it was realised that money was bad for controlling inflation. (Greiber, C and Lemke, W 2005) ‘ Therefore the UK government will be instrumental in controlling the supply of notes and coins held by UK non-banks and deposits (in both sterling and foreign currency) held by UK residents with banks in the United Kingdom. Now coming to the monetary policy strategy of the ECB it should be noted from the outset that it is price-stability-oriented as obvious from the wording of its Parent statute within the Maastricht Treaty where Article 105 (1) stipulates: “The primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article 2.5 The ESCB shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources, and in compliance with the principles set out in Article 4.6” (Goodhart, C.A.E. and Hofmann, B. 2006) Therefore the ECB aims to pursue a strategy of a quantitative definition of the price stability objective assigned to the ECB by the Maastricht Treaty. (Goodhart, C.A.E. and Hofmann, B. 2006) Also it will follow the yearly increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%.The HCIP’s use in measuring inflation has been well received as it helps ensure the comparability of prices across the European Monetary Union.The aim is to stress upon the real factors that cause inflation that is the notion that the monetary policy influences inflation in the following manner: Changes In Key Interest Rates Will Influence Short-Term Interest RatesThese Short-Term Expectations With Regard To Economic Activity And Then Through Them, Price-Level Changes. (Goodhart, C.A.E. and Hofmann, B. 2006) The ECB has stated itself that “a broadly based assessment of the outlook for prices and the risks to price stability in the euro area will play a major role in the Eurosystems strategy’. (Greiber, C and Lemke, W 2005) ‘In addition the monetary policy is determined by the interaction and intersection of inflation forecasts which have been derived from wages,forex and bond prices and the yield curve, real prices of goods and surveys of businesses and consumers. (Greiber, C and Lemke, W 2005) ‘ The policy has a more long term perspective of maintaining price stability and to counter inflation.The ECB recognises that it cannot just transmit its monetary policy through the real sector and the financial industries of its member states will also have a bearing upon the monetary phenomenon it aims to control in the long term. (Greiber, C and Lemke, W 2005) ‘ The critics have been skeptical about the superiority of these policies and ability of them to stabilize prices, output and interest rates. (Greiber, C and Lemke, W 2005).The policy of an excessively low inflation target carried the risk of being confronted with a problem of low interest rates on FDI thus discouraging it.If the financial institutions were to refuse to lower their official interest rates the real prices will not be able to cope with an economic crisis. (Goodhart, C.A.E. and Hofmann, B. 2006) There is a rather broad-based inflation outlook in this regard involves thus the short to medium assessment with a longer-term perspective, follows suit. (Greiber, C and Lemke, W 2005).The Policy of the Bank of England has been based on the short term in start contrast to the policy of the European Central Bank .As discussed above the money supply has always been non-conducive to the general level of asset prices and property prices which has in turn led to inflation. (Goodhart, C.A.E. and Hofmann, B. 2006) In addition efforts to curb this money supply have been offset and decreased even through the use of an interest rate policy and the inflation has increased in this regard. (Greiber, C and Lemke, W 2005) There have been Keynesian attempts to boost investment by increased interest rates and hence the level of wage demands and settlements, strongly suggest another interpretation of interest rate policy, which can be termed as a sort of market-based incomes policy which may follow the tax policy of yester years aimed at taxing those firms higher which were increasing the wage rate unreasonably. (Goodhart, C.A.E. and Hofmann, B. 2006) All this has been a part of targeting inflation and controlling the money supply.A salient characteristic of the British Monetary Supply package is always its house and asset prices which are aimed at a redistributive effect of income .In this regard the FSA has been currently criticised for not aiming to reduce personal indebtedness in the economy but focusing more on the intricacies of managing the money supply by promoting investment.The danger that is seen by the Bank of England in utilising monetary policy to curb inflation is that given that the current growth of the “broad money” is 14-15%,the use of higher interest rates to curb this might severely damage the real economy through its effect on investment and in the wake of the recent heavy duty financial deregulation there will be little that can be done to control this constantly weakening link between interest rates and money supply growth. (Goodhart, C.A.E. and Hofmann, B. 2006) Indeed in the recent years the rapid financial deregulation of the markets was also aimed at reducing inflation, but sometimes it went contrary to the control of money supply growth.Financial Deregulation was aimed at reducing prices and greater productivity but the use of monetary policy showed that the government was still struggling to ease its control and still desire a free market.That there has been a tension between these two aims is perhaps perturbing to the Bank of England. (Greiber, C and Lemke, W 2005). At this point if we are to look at the ECB monetary policy again it has been rather restrictive learning from the experience of its member states like Britain. (Greiber, C and Lemke, W 2005) ‘ Strangely enough it aims to diminish inflation by slowing down the speed of growth and “over-employment” which will ultimately lead to the build up of employment.This means that there will be lesser wage demands and less demand which means that the prices will not go up and there will be a control in inflation. (Greiber, C and Lemke, W 2005).There is a targeted inflation rate indeed and the ECB intends to maintain it.Following recent trends it seems that the first pillar of the ECB has slowed down growth wise thus reflecting this tight monetary policy.To take care of the second pillar of ECB there has been a broad assessment of inflation development through the stabilization of wage rates.If the wage rates are thus stabilized the ECB will achieve its target of remaining subdued and there being no need to rise prices on a broad level in order to increase profits. (Greiber, C and Lemke, W 2005) ‘ Currently the sole inflationary concern of the ECB are the increasing Oil prices and tax variations with in the EU states.The current ECB inflation target, is as mentioned above between 0%-2% to adjust structural problems. (Goodhart, C.A.E. and Hofmann, B. 2006) Conclusion This paper has discussed the increasingly innovative financial services industry and its role in delivering monetary policy as well as how the Central Bank and FSA will use it to achieve their macroeconomic monetary ends.Secondly it has been discussed that the basis of UK inflation targeting is the use of interest rates to control aggregate demand and therefore inflation through the “ transmission mechanism” which is often criticised as not being conducive to avoiding the supply side uncertainities. The monetary policy of the Bank of England therefore follows the approach of controlling the cost of capital or assets and it has often been the case where its is alleged that they have over predicted the impact and effect of inflation.Last but not the least the paper concludes that the monetary policy on inflation control by the ECB is highly restrictive and often operates at the cost of growth and wage increases to keep inflationary rates down.These approaches have been duly compared and it is concluded that the policy of Broad money may be fatal to the control of inflation as the experience of the Bank of England shows,the ECB should also be vary of its “one size fits all member states” inflation targeting approach. References 1. Aharony, J., A. Saunders, and I. Swary. 1986. "The Effects of a Shift in Monetary Policy Regime on the Profitability and Risk of Commercial Banks." Journal of Monetary Economics 17: 363– 77. 2. Cates, D.C.1978. "Interest Rate Sensitivity in Banking." 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