A financial system is a system that enables lenders and borrowers to exchange funds by channelling funds between deficit and surplus units, made up of institutions, markets, individuals, and governments. It creates a link between savers (surplus units) and borrowers/investors (deficit units). A financial system has financial assets, markets and intermediaries. Core functions of the financial sector include turning large numbers of small savings into small numbers of large amounts.
“Financial instruments are financial contracts of different nature made between institutional units”(cba). They are known as monetary contracts between parties including equities, bonds, mortgages and currency. They are assets that can be traded in many different markets. The market they are sold in depend on the characteristics of the instrument. Instruments such as stocks, bonds and treasury bills which are long term maturities, are traded within the capital market. Capital markets are markets which trade debt (bonds) and equity (stock) with maturities of over one year. Contrastingly, short term maturities including instruments such as loans and deposits are traded within money markets. Money markets are markets that trade debt securities with maturities of one year or less. Capital markets have substantial risk of capital loss but promised higher return, whereas money markets have little or no risk of capital loss, but there is low return.
Financial instruments can also be distinguished by the type of claim its being dealt with.
Financial instruments are monetary contracts between parties, distinguished along two dimensions. Financial instruments can be traded in primary and secondary markets. Primary markets issue new securities where funds are raised by issuing stocks and bonds, which are examples of financial instruments.
Equities are also known as shares; securities representing an ownership interest.
2. Discuss the key functions of the Bank of England. Describe the main responsibilities of the Federal Open Market Committee (200)
The Bank of England is the UK’s central bank; a key financial institution responsible for the execution of national monetary policy. A central bank is given the task of managing the money supply and interest rate in the economy. ‘Our mission is to promote the good of the people by maintaining monetary and fiscal stability’ (Bank of England website). The Bank of England’s main functions are to regulate other banks, issue bank notes, set monetary policy and maintain stability within the country and the economy. The Bank of England holds deposits for commercial banks, provides services for the government and holds the government account. The implementation of monetary policy by the Monetary Policy Committee (MPC) allows them to control interest rates, which influences consumer activity as well as business behaviour such as investments and savings. It promotes the injections and leakages into the circular flow of money in the economy and helps anticipate aggregate demand.
In the United States, the Federal Open Market Committee (FOMC) control the interest rates. The FOMC’s primary responsibility is ‘to conduct monetary policy is open market operations: the buying and selling of federal government bonds in order to influence the money supply and interest rate’ (lumen learning). Central banks use Open Market Operation (OMO), usually as the primary means of implementing monetary policy. Expansionary monetary policy is a method banks use to stimulate and encourage spending. the Central Bank will buy treasury bills, which will increase demand, leading to an increase in price, causing interest rates to fall, resulting in an overall increase in the money supply. This is just one of the few methods that can be used to encourage spending. Another popular method is lowering the base rate which means there are lower interest rates across the economy, which encourages investment and spending.
3. Discuss the ways in which the Federal Reserve use open market operations and discount lending to influence the economy. Discuss what happens when the Bank of England conducts a restrictive open market operation. (800 words)
The Federal Reserve system is the central banking system of the United States and is given the task of managing the money supply and interest rates in the economy. It performs ‘general functions to promote the effective operation of the U.S. economy and, more generally, the public interest’ (the fed). The Federal Open Market Committee (FOMC) is a part of The Federal Reserve System which decides on monetary policy. They enact monetary policy by implementing Open Market Operations, discount rates or other strategies to help achieve target levels within the economy. Open Market Operations refer to ‘the buying and selling of government securities in the open market in order to expand or contract the amount of money in the banking system’ (Investopedia). The purchases of these instruments inject money into the banking system which helps to stimulate growth and are the main policy tool used to reach targets. The FOMC use Open Market Operations as its primary tool to influence the supply of bank reserves as they are flexible, making them the most frequently used tool. Another tool that can be used is discount lending. “The discount window is a central bank lending facility meant to help commercial banks manage short-term liquidity needs.”(investopedia2). This tool is helpful as it allows the Fed and other central banks to lend loans at an administered discount rate to commercial banks and is a short term process. Banks borrow at the discount rate during short term liquidity shortfalls and require quick cash. This method is not actually preferred by banks, as the discount rate (also known as primary rate) is higher than the federal funds rate. The discount window was majorly utilised during the 2008 crisis when banks ran short of funds. If the Fed decreases the discount rate (interest rate) that they are lending to commercial banks at, then demand for funds will increase and the Fed will lend out more, resulting in an increase in the supply of money. However, ‘if it increases the discount rate, it raises the price of borrowing and the money supply drops’ (enotes). We know this happens because a rise in price of a good would lead to a decrease in demand. Less demand for money from commercial banks means there is less money in the economy, therefore less credit will be available for consumers to borrow. This will prevent lending further into the economy, hindering growth.
If the Fed wants to increase money supply in the US economy, it sells securities such as treasury bills. This helps reach the goal of slow inflation, which helps stabilise growth as average prices within the economy do not rise, but they stay stable. Banks try to lend as much as possible as it increases their profit. The process of selling Treasury Bills is contractionary/restrictive monetary policy. This means credit is less available in the economy and people save more and spend less as a lower sum of money is leant out. Banks wanting to make a profit charge higher interest rates, however this does act as a disincentive to consumers. As a result, there is low growth and low employment in the economy due to less investment and business activity. The opposite consequences happen when securities are bought in expansionary monetary policy. Central banks buy treasury bills and banks have more money. This means there is higher credit availability. Consequently, people borrow and spend more as banks lend out more money with lower interest rates, making it more attractive to consumers. Low interest rates act as incentives to businesses as firms to borrow, invest and expand as it is cheaper and would work out more profitable for them. A result of expansionary policy is the risk of rising inflation but lowering unemployment, a trade off which the Fed can implement in line with the US’s economic welfare. It also leads to an increase in reserves, credit availability, money supply and security prices.
The Bank of England is the UK’s central bank and is responsible for delivering monetary and financial stability. The bank would perform restrictive open market operations when the economy is booming, and the target is to slow down growth and spending in the economy. Open market operation sales are made by the central bank to discourage expenditure. When the bank of England sells a treasury bill, the supply of debt in the market increases. ‘An increase in supply without a corresponding increase in demand would cause the price of any commodity to drop.’ (quora). We can interpret from this that the price of a security will drop (which the central bank are trying to sell), and the interest rate will rise. High interest rates are used to combat inflation as they slow growth in the economy; a popular restrictive monetary policy tool. As a result of high interest rates, there will be less investment in the economy and reduced spending. Consumers will have lower disposable income as they have increased payments to be making and loans will be expensive. Businesses selling inferior goods will face an increase in demand and there will be overall low economic activity. This will prevent price rises and the economy can be close to the target inflation rate of 2%.
4. What are the major types of assets and liabilities for commercial banks? Explain why commercial banks hold investment securities. What are the major advantages a bank gains by expanding into international bank services? What are the three disadvantages of international expansion? (300 words)
‘A commercial bank is a profit-based financial institution that grants loans, accepts deposits, and offers other financial services, such as overdraft facilities and electronic transfer of funds.’ (economicsdiscussion). Commercial banks accept demand deposits from the general public, transfer funds between banks and earn profit and are often referred to as high street banks. Major assets of commercial banks include loans, investment securities, cash assets and other assets including premises and equipment and other real estate owned. From these major assets, loans are where the most revenue is generated for commercial banks. Major bank liabilities include capital (contributed by shareholders), reserves, deposits, borrowing and other liabilities such as bills payable.
Commercial banks also buy securities as an alternative to lending. Investment securities are securities acquired in order to be held for investment and include tradeable financial assets, for example equities or fixed income instruments. Investment securities generate revenue for banks from the initial dividend yield and provide banks with liquidity. ‘The change in valuation applied to the firm’(thebalance) is another way the bank would benefit from the securities, as their own worth will increase.
Expanding internationally is a method of growth many firms use. ‘They find potential gains in risk diversification from cross-border mergers’ (dobanksbenefit). Expanding internationally means the banks can spread their risk. If political issues are affecting a currency in one country, which hinders investment, it doesn’t necessarily mean other countries will face issues also. Thus, they can expand in various locations and increase their certainty. Another advantage of international banking is the flexibility it offers; multinational companies are given flexibility to deal in multiple currencies. This will also lead onto the advantage of accessibility. Banks will have access to new markets and be able to penetrate into them. It provides ease of doing business and acts as an incentive to MNCs who trade globally.
A major disadvantage of international expansion is the loss of control. As a business begins to increase in size, involvement of CEOs begins to fall as the company can become too big to manage. Also, it can become harder to manage and the bank could lose its corporate culture. Another disadvantage is increased employee turnover; training and hiring becomes crucial to ensure employees have the required skill for them to work efficiently.
5. Explain why the 2007-08 financial crises caused concerns about systemic risk. (400 words)
At the time of the recession, subprime mortgages were being given out in America and banks that were located there loosened criteria for large loans such as mortgages. This led to a credit crunch which had an effect on the global economy.
Systemic risk is the idea there is a possibility that one single event or cluster of events at a micro level could in theory lead to a domino effect, which could then trigger instability or collapse of an entire industry or economy. A leading example is the sub-prime mortgage market in the US which had a huge effect on financial stability and profitability of institutions and markets around the world and within the UK. The crisis has concerns about systemic risk as there a huge decrease in consumer confidence and there is large uncertainty within the economy. After the crisis, governments decided to increase fiscal austerity, meaning there was less government spending and increased taxation on income, which would increase tax revenue. Businesses could not operate efficiently enough to provide for their workers, so unemployment levels rose. This led to wages being reduced, so spending in the economy was reduced and GDP wasn’t increasing, so the economy became less stable as time went on. This multiplier effect that the recession gave, made people hesitant to reinvest in any financial instruments as there was clearly inefficient systemic risk management. Concerns were also caused about systemic risk because surely banks such as the Bank of England and the Federal Reserve should have anticipated the crisis and could’ve helped prevent it. Its hard for consumers to have trust in the system after such a
Since the financial crisis, it has been “Nearly a decade where many governments in many countries have been trying to deal with and adjust to high levels of fiscal debt and deficits” (Geoff Riley 3). As a result of slow recovery, many economies suffered to get back to a high GDP value and increasing output again. Consumers may be reluctant to restore faith in the economy as they can see the changes for themselves. For example, they have access to the current interest rates, the inflation rate and GDP figures. They could see that the ‘recovery’ period of the economy after the ‘recession’ period was very gradual which means consumer confidence would follow the same pattern; it would be regained in its own time.