The Significance of Financial Intermediaries in the Financial System - Case Study Example

The significance of financial intermediaries in the financial system Financial intermediaries such as banks borrow s savings and pay an interest on that borrowed money to lend to other customers with the aim of making a return on their investments for themselves and their customers. They therefore act by channelling savings from clients into investment to investors who so need the money to make an economic growth and development for the society.1 The most important thing here is that, financial intermediaries both consists of different set of individuals, the customers who have their money to save, the investors who need money to make meaningful investments, and the financial intermediaries in this case, the bank with each having a different stake in mind and the bank in this case considered the prime mover of the economy. The saver is out to maximise the savings but with minimal risk, the investor is out to get money but 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. (See appendices 1). According to J.O. Sanusi (2002), availability of investible funds is a key factor in the growth process of any economy and may be seen as a necessary condition for output and employment growth. This can only be achieved through efficient financial intermediation which of course contributes to higher levels of output, employment, and income which invariably enhance the living standards of the population. Countries that have enjoyed or are enjoying economic prosperity such as the Western countries can be linked with such an efficient mechanism for mobilising financial resources and allocating same for productive investment.2 The best monetary intermediary from time immemorial is the banks since they provide an important positive externality as mobilisers of savings, allocators of resources to the investors, and providers of liquidity in the whole monetary system and payment services, as well as a fulcrum for monetary policy implementation by influencing the savings – investment process that help accelerate the rate of economic growth and poverty reduction. This is done by allocating the bulk of loanable funds to the financial markets and sectors such as industries, agriculture, and mortgage firms at affordable low interest rates as to generate investments and output growth in the economy. In this light, the banks are able to control and direct the flow of bank credit that is required to make an economic growth through direct control of credit allocation and interest rate structure. The most important condition for banks to be able to amply perform their role as financial intermediaries all lies with the Central Bank who have to make sure that there is a sound, stable, and efficient banking sector through effective surveillance and enforcement of prudential standards by using a licensing procedure that places an emphasis on a fit proper paper criteria that should make the bank owners trustworthy persons. Interestingly, the cost of financial intermediation (such as acquiring information, enforcing contracts, and exchanging goods and financial claims) is taking an upward direction 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 the concomitant tightening of monetary policy, and on the other hand by the oligopolistic structure of the banking system, and the inadequacies of infrastructural facilities in certain cases to meet the high demand for investment funds. With these discrepancies, many are those who tend to think that the banking system is not a good financial intermediary for stimulating economic growth. The market for bonds and equity over the past 35 years has become a more attractive medium for capturing family wealth at the detriment of the banks especially after the setback suffered by the Japanese banks in the nineties.3 The trend is more in the industrialized nations and gradually entering emerging markets, though some firms still prefer using retained earnings to finance their investments. In a research by Ross Levine (2001) to find out whether the banks or the bond markets still remains the best stimulus of economic growth, information was collected from some 48 countries over the period 1980 – 1995 and several regression analysis were carried out in order to explain the per capita average growth rate in terms of different measures of the relative importance of markets to banks. To carry out the comparison, variables such as ratio of market capitalization to private sector credit and the ratio of trading turnover to loans were used. The results did not indicate any significant difference in whatever financial system used as what really matters was the total financial depth irrespective of the division between markets and banks. His conclusion tied with what Allen and Gale (2004) termed a “symbiotic relation” between banks and the capital markets since the banks are there to provide the savings and credit instruments in the early stages of development, while the capital markets instruments emerge as the financial depth increases, with new corporate requirements arising and the degree of sophistication for both the investors and financial agents grow as a result of the symbiosis. (See appendices 2) In conclusion therefore, the significance of the financial intermediary, be it the bank or the capital market for bonds and equity cannot be ignored in the stimulation of economic growth and development. Banks and holders of non-tradable claims like venture capitalists are there to provide the advisory service that markets cannot do especially as the opportunity cost of capital for the venture capitalists is generally small. They all dominate in different sectors as large and well established firms will resort to the markets for funding since markets act mostly using good rating of firms. But newly created firms with low rating on the market will obviously use the banks and venture capitalists for funding and advice. In reality, capital market financing serves as a back up to firms especially when recession sets in and banking credit dries up. When the risk-free rate or bank profits decline, corporations turn to the debt market for financing especially as the fall in the tax-free rate reduces the cost of borrowing on the debt market therefore making the market more attractive for corporations. Three key functions of a Central Bank The Central Bank (CB) is said to perform a key role in maintaining the economic stability of any economy by performing the three main functions of being the sole bank that issues currency for the economy, acts as the banker’s bank, and the bank of the state. 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, determines the amount of currency issued, the time at which the currency should enter into circulation, for the liquidity of which it is responsible. It also organises money circulation and regulates the amount of currency in circulation. It is well known 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 it is the policy of the CB to make sure that there is not much money in circulation by using the monetary policy of compulsory reserve requirement. The CB through the reserve requirements affects the ability of financial institutions to “create” chequebook money through loans or investments. In this way, the financial institutions are subject to the amount of money they must hold and not used for loans or investments. The Central Bank as the banker’s bank: The CB performs regulatory functions with regard to other banks by offering them the financial services that they offer customers all of this in order to ensure the safety of deposits held by the banks and the stability and safety of the whole banking sector. The CB organises the monetary clearing system, services current inter-bank settlements and actively participates in the inter-bank money market. Their participation on the inter-bank market is by using the monetary policy of open market operations through which 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 by the central bank. Through this means, the CB is able to balance the demand and supply of funds held by commercial banks at the central bank and allows them to influence the level of short-term interest rates on the inter-bank market. The CB also acts as supervisor of financial institutions to make sure that they act in accordance with the banking laws of the country and operate in a safe and sound manner. 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 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. How a reduction in base rates does affects mortgages and the price of bonds in the capital markets Short term interest rates otherwise known as official base rates generally affect the whole economic system through what is known as the transmission mechanism of monetary policy. The transmission mechanism here is such that changes in the base rate, intend affects market interest rates such as mortgage and bank deposit rates. The policy actions affect expectations about the future course of the economy and the confidence which these expectations are conceived and as well affects the prices of assets and exchange rates. It is worth mentioning here that changes in official rates do not move in the same direction with long term interest rates. The effect on long term interest rates can go either way since they are influenced by an average and expected future short term rates and to the extend of the impact of the official rate change on future interest rates expectations. (See appendices 3) In a notch shell, a change in the base rate is immediately transmitted to other short term whole money-market rates and money-market instruments of different maturities and other short term rates such as interbank deposits. When such rates do change, banks adjust their lending rates by exactly the amount of monetary change which very fast go to affect interest rate banks charge their customers for variable loans and overdrafts. These changes go a long way to affect changes in rates offered to savers so as to maintain the margin between deposits and loan rates. The least affected are rates variable mortgages as they change slowly. Since official rates change in a transmission mechanism according to monetary policies, such changes also has an effect on prices of market securities such as bonds and equities. But care should be take here because, the prices of bonds are inversely related to long term interest rates, meaning that, if interest rates fall, the prices of bonds will obviously go up. The fall in the prices of securities in this case can be largely attributed to the fact that expected future returns are normally in this case discounted by a large discount factor making the present value of any stream of future income stream to fall. In conclusion, the Central bank has a great effect on the monetary policies of any particular economy and their decisions can have very far reaching effects depending on what economic situation it intends to resolve. Thus, most market analysts who can rightly predict the direction of monetary policies most often benefits a great deal on the market for bonds and securities. It can be seen that the effects of decisions of the CB do also affect consumption and savings from individuals, the value of the currency and the value of the based goods sold on the international market. 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. The transmission Mechanism of monetary policy: the Monetary policy committee, Bank of England. Retrieved from www.bankofengland.co.uk on 15-04-2008 at 17,00pm http://www.hktdc.com/econforum/hkma/hkma041203.htm, retrieved on 14-04-2008 at 18.30pm Appendices 1 This is the case of most large corporations who have a high rating on the market and can therefore invest directly on the market without the use of loans. (Source: of diagram is self formulation) Appendices 2 This is mostly for firms who do not have good marketing rating or are just simply newly created or new market entrants and consequently do not have enough funds for self financing, therefore resort to using loans from intermediaries to finance their investments on the market. (Source of diagram is self formulation) Appendices 3 Transmission effect of Central Banks monetary policy when base rates change. (Source: transmission Mechanism of monetary policy. Retrieved from www.bankofengland.co.uk) Read More