Money, Banking, and Financial Markets - Essay Example

Money, Banking and Financial Markets Assignment Find a recent (September Dec. money and banking related article in the media (the Economist, Globe and Mail, National Post, New York Times, etc.,), and attempt to explain parts or all of it using the tools we learned in class. Highlight the sentences that you analyze, and hand in the article along with your work. Use written and graphical explanations. (approximately 3 double spaced pages; 20 marks) Selected article: Global Monetary System: Thrills and Spills. The article gives its opinion about the global monetary system by discussing how America is likely to be at the center of this global financial system. In the article, the author (anonymous/staff) of the Economist utilized the John Maynard Keynes theory of the 19th century regarding the global financial system to inspect how the monetary system influences the America’s soft power. Several concepts, ideas, and issues pertinent to money and banking that were addressed in the paper are analyzed here. According to the Economist (2015), the global monetary system has for a long time been the world’s greatest headache. The article justified this claim by recalling the gold standard that existed in the 19th century. The world financial system has been termed by economists across the continents as a headache because it plunged into the depression and predicaments in the 1930s. Besides, the after war Bretton Woods system of pegged exchange rate fell in the 1970s necessitating an unexpected replacement by a flexible or floating exchange rate and mobile capital (The Economist 2015). Also, Madeley accused the volatile global financial system of failing to support trade in products and manufactured goods. Trade in goods and manufactured products are not assisted, concerning growth, by the volatile world monetary system (Madeley, 2007). The argument here is that the fluctuating currencies in the global money markets imply increased uncertainty of developing countries that levels the actual amount of money that would be received for the goods sold by these developing countries. Thus, the fact that the western nations control the global financial system cause the third world’s greatest headaches by exploiting the system by causing inefficiency and injustice of the worldwide trading system. It is quite unfortunate that the western countries cause the headaches of developing countries but given little attention and effort to putting things right (Madeley, 2007). Furthermore, the article addressed the issue of resolving the imbalances between countries that exist in their current-account deficits and surpluses. One of the 19th century’s greatest economists, Keynes, is said to have wrestled with the issue of correcting the imbalance that exist between countries. Global imbalances or what is called current global imbalances is defined as the large current account deficits and surpluses, which have appeared in the world economy in the recent ten years. Economists and financial institutions of different countries have recently become more concerned about how these imbalances between countries would be solved. Adams (2012) echoed this claim by alleging that the imbalances had lit a spotlight on the great current account deficits of U.S that peaked at nearly 6 percent GDP in 2006. Apparently, the current account deficit or surplus equals to negative or positive net savings and considering that the imbalance only affects a few countries or a small group of regions. The issue of trade imbalances between countries or current account deficits and surpluses has been widely discussed and how it has affected the euro zone especially in the field of money and banking. Seemingly, nations that attempt to cheapen the value of their currency to bolster the exports could trigger retribution devaluations that are costly for nothing. Moreover, the volume of capital flows spilling about the world is another problem addressed in the article. The money and banking knowledge hold that it is logical for the country with a current account surplus or deficit to invest overseas, or even attract, net finances of equal amount. This is supported by the argument that the 19th and 20th-century economists postulated that the gross capital flows circulating the world would approximately mirror the current account surplus or deficit amount. However, two decades of monetary globalization have caused capital flows to dwarf the current account imbalances (The Economist, 2015). Whether poor countries harvest tangible benefits from world globalization is one of the much-debated issues among economists and worldwide policymakers (Schularick, 2006). Based on the concept of global capital flows, less-developed countries should access some opportunities whereas savings of rich countries could be used to invest in the poor countries. Cross-border asset flows, for instance, boomed in the recent decade and thus influencing the expansion of financial globalization Schularick, 2006). Another statement is that the dollar and the role of America in the global financial system is a big issue. The argument here is that the greener supremacies top by every yardstick for a worldwide currency that has all the characteristics of money. For instance, the Economist recognized the collapsing value of the euro, yen and Chinese Yuan. Such inefficiencies and issues affecting the international currencies have raised eyebrows about the America’s primary role in the global financial system. This is all made up of America, the nations whose currency float in pity against the U.S dollar, and those countries that have dollar pegs, for example, China (The Economist, 2015). The Forbes magazine differs with this article by arguing that America’s power and its role in the international currency have been overstated. American Power cannot predict the collapse of the dollar or the relative reduction of the dollar’s international function that can only be interpreted from a global political perspective (Krishner, 2015). Perhaps, the changes to relative power are likely to have substantial and proactive political ramifications. According to the article, the world financial system is unreformed, unbalanced, and perhaps unsustainable. The reform, balancing, and sustainability of the global monetary system has been widely discussed by the global financial institutions including the European Central Bank and the Bank of England. Bush, Farrant & Wright (2011) point out that the global financial crisis imposed considerable costs on the world economy and unearthed deficiencies in its policy frameworks across the world. This has initiated commencement of reforming the financial regulation to create a more resilient financial system that can eliminate the massive international capital flows. The three objectives discussed by these three authors include internal balance, efficient allocation, and financial stability. Apparently these concepts also feature in the discussions relating to money and banking. 2. Outline the adverse selection and moral hazard problems that existed in the Euro crisis of 2009. (approx. 2 double spaced pages; 10 marks) During the 2009 economic crisis, adverse selection and moral hazard problems involved uncertainty about the future, wide information asymmetry, and worse incentives for creditors. One adverse selection problem witnessed during the 2009 financial crisis was investing in subprime mortgages. When the housing market bubble burst, subprime mortgages advanced to high-risk borrowers resulted in mortgage delinquencies that forced banks to write off hundred billion dollars as bad loans. Before the crisis, the housing prices began to fall making many subprime home owners unable to refinance the mortgage with majority of them being unable to continue with repayments (Haan, Oosterloo & Schoemaker, 2012). The resulting default in mortgage repayment was as a result of adverse selection of the subprime borrowers. The moral hazard associated with subprime mortgages occurred as a result of the uncertainty about the future of these loans making the borrowers believe that the housing market prices would rise in future, making the banks bear the loss. The banks that were issuing the subprime mortgages created another source of moral hazard when they issued the loans to borrowers yet they had proper knowledge that the borrowers might not service payments of the mortgages in the long-run. Since the banks and other lenders had suspected that there were signs of a housing bubble from the few years of an unstable housing market, it was obvious that the loans were not worth the risk (Schmidt, 2014). Given that many borrowers of the subprime mortgages flocked the banks with tempting requests, the banks decided to take the risk with knowledge about possible consequences in the long-run. Other moral hazard problems include; the federal government implemented monetary policies that caused moral hazard and the federal government, and financial regulators failed to regulate sufficiently the nonbank mortgage investors or control the activities of investment banks. Also, the agencies tasked with rating credit provided flawed credit ratings, irresponsible risks taken by investors, and the unrealistic assumption by homebuyers that housing prices would continue to rise indefinitely. Adverse selection problems occurred as a result of increased information asymmetry between the borrowers and lenders including banks and other private loan providers. The private ownership of information regarding repayment capacity or information about the behavior of mortgage borrowers influenced the decision of the banks and lenders of loans. Information asymmetry caused inadequate evaluation of borrowers by the banks to discriminate between risky and safe borrowers. As a result, the banks offered loans indiscriminately depended on their poor evaluation of borrowers thus causing adverse selection of loan borrowers. The weak or bad borrowers were treated equally with good borrowers due to the wide information asymmetry. The last adverse selection problem that occurred in the loan market during the 2009 global economic crisis was the choice of subprime mortgages in place of the conventional mortgages. According to its definition, a subprime mortgage is a housing loan given to high-risk borrowers that have weak or bad borrowing history, especially those borrowers who are not eligible for a conventional mortgage. Subprime loans are relatively risky though they represented approximately 20% of all newly given out mortgages in the U.S in 2005 to 2006 (Haan, Oosterloo & Schoenmaker, 2012). In this case, adverse selection the problem was that the banks decided to issue high-risk loans to borrowers known to have a weak or bad credit history instead of simply issuing out the conventional loans. Perhaps the conventional loans would have attracted borrowers with good borrowing reputation. Accordingly, preferring to issue subprime loans rather than fewer risk loans implied that the banks deliberately elevated the risk of loss associated with the expected returns. 3. If you your stock broker tells you that you should buy stock in Ford as it has devised a new hybrid engine system that will reduce consumption of fuel by 90 percent, would you follow this advice and buy Fords stock? (approx. 1 double spaced page; 10 marks) No. Instead I would apply the concept of efficient market hypothesis to evaluate Ford’s portfolio and determine whether it is worth an investment. Groh (2013) point out that the efficient market hypothesis (EMH) could be applied in measuring the market efficiency. According to EMH, whatever change occurs in prices of stock is inherently unpredictable but could be entirely accounted for by new elementary information (Hirschey, 2003). The theory holds that stock prices only vary when investors react to new information regarding changes in market assets. Therefore, depending on the EMH it means I would be skeptical about the information delivered by the broker. The statement from the broker that Ford has moved to devise a new hybrid system does not reflect all the available information regarding the value of Ford’s stock. The decision as to whether to invest in Ford’s stock should entirely be influenced by informational efficiency because stocks change whenever information change. If the stock market is efficient, then it has already determined the price of stock such that the expected return equals the equilibrium return. Since market efficiency is achieved when the stock market is at equilibrium, the forces of demand and supply regulate the price of stock. The equilibrium point between demand and supply determines the price of stock (Groh, 2013). Based on this concept, the price of Ford’s stock would be set by the demand for its stock from those investors who feel that Ford’s stock has been undervalued and those who think its stock is inflated. Otherwise, I would invest if the return on Ford’s stock is valuable. 4. Explain the relationship between return on assets and return on equity. What incentives does this relationship give a bank manager? Is this the desired outcome preferred by regulators? Discuss. (approx. 1 double spaced page; 10 marks) First and foremost, both return on assets (ROA) and return on equity (ROE) are vital indicators of financial performance. Return on equity is computed as ROE=(after tax profit)/capital and it is equated to return on assets (ROA) as ROA ×EM=(after tax profit)/(total asset) ×[(total assets)/capital]. Hence, ROE derived from ROA and the equity multiplier as well. Apparently, the return on assets offers a metric of a company’s profitability by measuring the assets presented in the balance sheet. Managers could manipulate the return on equity by increasing liabilities that may cause a reduction in capital. When the return on equity is found to be higher that return on assets then the new increased level obligations could mean that they are being managed well (Tracy, 2012). Given the relationship between ROA and ROE, a bank manager could increase the profitability of the bank to its equity holders, ROE, by simply increasing the equity multiplier. However, cannot be approved by regulators because increasing the equity multiplier to high values may increase the risk of insolvency. Seemingly, a bank’s capital often acts as a cushion against possible financial losses on the banks credit ventures. In any case, even scanty default on loans could result in bankruptcy if the bank has inadequate capital. 5. Describe the transaction the Bank of Canada makes when wanting to raise the overnight interest rate ( 6 marks). Also outline the effects on economic activity (the way monetary policy works) when the interest rate rises. (approx. 2 double spaced pages; 10 marks) For the central bank of Canada to raise the overnight interest rate, it undertakes a transaction called the sales and repurchases transaction or simply referred to as repos and specials. If the overnight general collateral rate trades below the Target Rate, the Central Bank of Canada often intervenes with its Sale and Repurchase Agreements (SRAs) or what is usually called the reverse repo transactions so as to raise the overnight interest rate. The sale and repurchase agreements (SRAs) and reverse repos provide room for flexibility and security to carry out its monetary policy (Rochon & Rossi, 2003). If the Central Bank of Canada wants to raise the overnight interest rate, it intervenes the financial market by selling government securities to major commercial banks with an agreement to buy back these securities on the next business day. The central bank repurchases the securities with the price difference equivalent to a one business day’s value of interested computed at the target for the corrected overnight rate. The SRAs transaction and the buyback operations are usually carried out at exactly 11: 45 the next day. This time is considered convenient and is used to encourage participants to trade among themselves during the morning particularly the time when commercial banks exhibit a large proportion of the daily funding activities. Technically, repurchase agreements applied by the central bank of Canada are usually utilized in guiding the overnight interest rates, especially when devaluations from the Central Bank of Canada’s target rate, some repurchase agreements are quite little (International Monetary Fund, 2008). When the central bank of Canada sells government securities such as bonds, the bank then debits the settlement balances of the commercial banks that it transacts with during the repos process. The move to increase interest rates by the central bank has various effects on economic activities in a country, Canada in this case. The most obvious effect of augmented interest rates includes the eventual rise in the cost of borrowing. Raising interest rates affect directly on households through its impacts of mortgage payments, and cost on loans and the consumer debt (Butcher, 2011). As the discount rate of the central banks is raised, the interest payments on loans become more expensive. The resulting effect is that the expensive cost of debt discourages willing borrowers. At the same time, those individuals who are currently repaying loans end up having less disposable income. The income allocated to consumption reduces because more income is used to repay the costly interest payment. Equally, the rise in interest rates also increases the interest payable on mortgages. The same way that the interest rates on normal loans increase, the mortgage interest payments also increases and will have the same impact as the cost of borrowing normal loans. Furthermore, increased interest rate has been found to reduce the investors’ confidence regarding the expected returns on investments. This is because costly credit is highly risky thus discouraging investment. Reduced confidence as a result of high-interest rates affects both consumers and investors. The same way investors become discouraged consumers become less willing to engage in risky purchases. Moreover, the citizens and entrepreneurs would prefer to save more of their income and liquid money when interest rates are increased. This is because elevated interest rates tend to make it more attractive for individuals and firms to save in bank deposit accounts to pocket the likely interest gain on the savings. The increase in interest rates is used by the central bank as a contractionary policy devised to slow down aggregate spending and the economy, and to lower inflationary pressures (Butcher, 2011). Finally, raising interest rates also increases interest payments on the government debt. This is because higher interest rate raises the cost of state interest payments on state debt. The long-run effect of this consequence is that the government would be forced to charge more taxes in future to service its expensive debt. References Bush, O., Farrant, K., & Wright, M. (2011). Reform of the International Monetary and Financial System. Retrieved from http://www.bankofengland.co.uk/financialstability/Documents/fpc/fspapers/fs_paper13. df Top of Form Butcher, K. (2011). Forex made simple: A beginners guide to foreign exchange success. Milton, Qld: Wrightbooks. Bottom of Form Top of Form Top of Form Groh, S. (2013). Efficient market hypothesis in africas sub -saharan stock markets. Place of publication not identified: Grin Verlag. Top of Form Haan, J. ., Oosterloo, S., & Schoenmaker, D. (2012). Financial markets and institutions: A European perspective. Bottom of Form Top of Form Hirschey, M. (2003). Tech stock valuation: Investor psychology and economic analysis. Amsterdam: Academic Press. Top of Form International Monetary Fund. (2008). Canada: Selected issues. Washington, D.C: International Monetary Fund. Krishner, J. (2015). American Power and the Global Financial Crisis: How about now? Retrieved from http://www.forbes.com/sites/jonathankirshner/2015/03/12/americanpower-and-the global financial-crisis-how-about-now/ Bottom of Form Top of Form Madeley, J. (2007). Human rights begin with breakfast. oxford. Top of Form Rossi, S., & Rochon, L.-P. (2003). Modern theories of money: The nature and role of money in capitalist economies. Cheltenham ; Northampton, Mass: Elgar. Bottom of Form Bottom of Form Top of Form Schmidt, A. (2014). Fair Value Accounting and the Financial Market Crisis: To What Extent is Fair Valuation Responsible for the Financial Crisis?. Berlin: epubli GmbH. Schularick, M. (2006). A Tale of Two ‘Globalizations’: Capital Flows from Rich to Poor in Two Eras of Global Finance. International Journal of Finance and Economics. Doi: 10.1002/ijfe.302 The Economist. (2015). Thrills and Spills: America is at the Centre of the Global Monetary Disorder. Retrieved from http://www.economist.com/news/special-report/21668717 america-centre-global-monetary-disorder-thrills-and spills?zid=300&ah=e7b9370e170850b88ef129fa625b13c4 Bottom of Form Bottom of Form Tracy, A. (2012). Ratio analysis fundamentals: How 17 financial ratios can allow you to analyse any business on the planet. Read More