Essay on financial institutions and markets

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Money is composed of the notes, coins and other forms of components which are used for transactions. Without money, trade would be impossible in contemporary times. The worth of any commodity on offer is measured in terms of money. The contemporary for ms of money replaced the olden day’s barter trade due to convenience as suggested by Sundaresan, (2009),

The Reserve Bank of Australia views money as a commodity supplied and demanded by the public. Both the demand and supply determine the amount availed and the form in which the commodity is availed. The RBA avails the money in different aggregates in a bid to maintain economic factors in check. Since it has no control over the demand, the entity can only control the supply of money in different composition (McAllister et al, 2003). The money supply relationship can be viewed from the point of view of the characteristics of financial institutions or the interest rates set by the banks. Despite the different points of views, the money supply (M) is defined by a certain multiple (m) of the base (B).

M=m × B

As outlined by McAlister et al (p213), “the multiplier represented by ‘m’ is determined by the currency ratio, k (notes and coins as a proportion of deposits), as the banks reserve ratio, s (total bank reserve to deposits)” thus,

m= (k+1)/ (k+s).

The different aggregates used by the Reserve Bank of Australia number 7 as outlined below. Base money (B) which includes all the notes and coins in circulation as well as any deposits held at RBA. Narrow money (M₂) defines the notes and coins inclusive of deposits in the commercial banks in Australia. Narrow money and any deposits held in other banks are classified as M_3.

M₄ depicts all narrow money and deposits in other banks as well as building societies. Deposits in finance companies, building societies and banks including narrow money are classified as M₅. The total of M₅ and any deposits with the corporate in the money market is defined as M₆ while broad money describes the money supply incorporating deposits will all Non Bank Financial Institutions (NBFI).

Regulation of the Financial System

The financial industry operates on the strength of investor confidence (Sundaresan, 2009). Turbulent financial climate is a major deterrent to short term and long term stability of any financial system. Each component of the financial system has a role to play in safe guarding the investors’ funds thereby upholding high levels of confidence. Confidence is a product of fair competition between all players in the market thus enabling inventors to choose the products and institutions to invest through. Confidence also emanates from sufficient disclosure of the underlying factors to enable investors to make informed choices regarding their investment options as posited by McAllister et al (2003).
The ability of a financial institution to safely hold deposits and satisfy client and investor needs is a major requirement for each institution in the financial market of any country. Without assurance of safety and security of their investments, most individuals will shy away from the financial institutions and invest else where. Depositor and common stock holders have the most limited ability to protect their interest incase of failure.

Banks and other financial institutions are regulated in the magnitude of the risks they engage in .in a bid to protect the shareholders investments, each institution has to operate within a certain risk level so as to ensure that the investments are safeguarded (Sundaresan, 2009).

Banks and other financial institutions have the capability of establishing monopolies in an economy. By varying strategy and characteristic banks can limit the choices available in an economy. Thus the government institutions are established to ensure that such monopolies do not crop. By eliminating monopolies, the government helps to encourage competition thereby rewarding the citizens with improved service delivery.

Recent bank failures have resulted to massive losses to investors and clients. The regulatory institutions have moved to limit such instances so as to stem such occurrences. Unlike other institutions, bank failures have far reaching impact and can brew an economic crisis with monstrous effects. Similarly, a bank failure adversely affects ling standing relations between banks and customers thereby interrupting clearance processes (Sundaresan, 2009).

Being the major financial institutions in an economy, banks play a major role in socio-economic development in a growing economy. Thus the government institutions can use the banks to advance policy measures so as to boost economic development of a specific sector. Such directives are time bound and are reverted once the objectives have been achieved.

Function of the Financial System

The financial system aids in pooling financial resources to fund comprehensive investment ventures. An efficient financial system is able o accumulate resources with an aim of availing funds for investment in ventures which require huge financial input. By attracting finances at attractive rates of return, the system is able to source funds from the surplus for use in the deficit sectors in varying terms according to Sundaresan (2009).

The double coincidence of wants between the surplus and deficit sector seldom matches. The surplus sectors may avail more or lesser than required levels of finance. Due to demand and supply factors, the fluctuating rates of returns may distort the earnings schedule of investors. Thus the financial system is charged with availing financial resources without constraints of time and distance. The advent of information technology and globalization has provided immense advantages relating to the time and place value of surplus and deficit units (Madura, 2008).

Banks and other deposit taking institutions have carved their services to include provision of modes of payment to people involved in domestic and international trade. Through provision of cheques and other secure modes of funds transfer banks have made the process of transaction safer and more reliable. Similarly, letters of credit offer guarantees in foreign trade, thus enabling strangers to transact business without incurring risks of default Bell (2004).

Insurance companies have designed packages which help to mitigate loss occurring from unforeseen happenings. Such losses are deterrent to success in business. However, by pooling risks, insurance companies are able to reduce the cost of covering risks over a large population. The contributions are invested to bear returns which help to compensate the insured.

The financial system is run on quality and quantity of information. Such information is available from the media. Investors can access information relating to investment opportunities, interest rates and process of investments according to Madura (2008). Investors are able to access information about the products and characteristics from the websites of each institution as well as

Primary and Secondary Markets for Securities

Borrowers normally issue new debt instruments in the primary debt market, securities which are traded at par. By so doing investors get a chance to a chance to lend their surplus funds to those with deficits. As outlined by Sundaresan (2009) such funds are used be federal and corporate to supplement their budgetary allocations. However, since these debt instruments are long-term or short term the requirements of the investors may change necessitating and increase or decrease in the amount. The most convenient location to accomplish their wish is the secondary market where the debt instruments are traded for their worth. Secondary markets thus provide an avenue for exchange of the securities. The secondary market is composed of over the counter trading and dealer markets as can involve electronic exchanges on a global scale.

With the availability of such instruments both corporate and individual investors are able to invest excess funds as well as borrow funds under varying maturity and interest rates. Companies are able to raise finance by selling their debt instruments which can be held for a convenient period of time for realization of the coupons or traded in the secondary market. Buyers and sellers negotiate over the coupon and book value thus enabling transfer of finances to deficit settings. Unlike in primary markets, the issuers’ financial status is not affected by trading in secondary markets.

However the equity market varies from the debt market due to since returns are not contractual. The equity units are however not redeemable since equity is fixed source of finance. However, the primary and secondary equity markets operate similarly. However, the issuers are not party to the transfer transactions unlike the debt market where the issuer has to redeem the debt. Equity securities do not have statutory obligations regarding returns unlike debt securities which have a coupon rate.

ADIs and Long-Term Savings Institutions

In the Australian financial system, authorized deposit taking institutions (ADIs) are those corporations which were mandated to receive deposits from the public. They comprise banking and credit corporations, as well as building societies. Deposits are defined as amounts of money given by an individual to another accruing the duty for later repayment on a specific schedule or on demand (Goosen et al, 1999). Deposit taking institutions accept deposits and offer loan to the general public so as to generate revenue from the lending. By assigning higher interest rates for lending than that they offer for deposits, deposit taking institutions are able to generate revenue.

Long term saving institutions on the other hand provide a source and destination of long term finance in the form of capital
Similarities

Both classifications of institutions help to bridge the gap between the deficit and surplus components of the economy. Individuals with surplus funds can deposit the funds into an account, buy a life cover, or join a pension plan. Institutions offering such opportunities are available in Australia and offer different rates of return (Goosen et al, 1999).

Both financial system entities are involved in safe guarding the future in their own capacities. Through providing financial products to the public, ADIs and ling term saving institutions safeguard the future of the individuals. ADIs offer a safe deposit facility for money and valuables for a fee. Since such deposits are available at specific times, rather on credit or real terms, their convenience is no contestable. Long term savings institutions, insurance companies in particular, on the other hand offer facilities which mitigate loss by spreading risk over a large populace. Mortgage companies are also involved in safeguarding the future. By providing finance for capital investments to the population, individual are able to acquire possessions which they can use as collateral for emergency funds as proposed by Bell (2004).

Differences

ADIs are avenues for short term and medium term investments and sources of funds. Deposits in banks and credit unions are available for specific terms and are also available on demand. Similarly, loans from banks are destined investments whose realization period is short and medium term. The nature of the sources of funds limits the availability of such funds for long term purposes. However, insurance and mortgage companies are engaged in availing capital for long term purposes. They are thus engaged in sourcing for funds in form of capital unlike deposit institutions which source for monetary instrument. The investment projects which they lend to range from medium to long term Bell (2004).

Some long-term investment categories are statutory in Australia unlike the deposits to banking institutions. Federal policy has appreciated the financial and economic benefit of including long term savings to policy formulation. Thus contributions to some insurance covers and trust funds have been sanctioned by the state and contribution is done through a check off system. However, deposits to banking institutions are discretionary. Individuals are free to save through banks and credit unions.

Long term saving institutions are specialized in the category of investments they engage in. the global financial system has calibrated the product category offered by the institutions (Bell, 2004). Such a division of roles accrues from the nature of these investments. Due to the necessity of these institutions, the state reserves control over how they perform. Thus, they are classified as insurance, mortgage and unit trust companies. However, the operations of the commercial banks are not restricted in the products they offer. They are authorized to offer a wide range of products in a market where perfect competition endures.

ADIs provide a medium of exchange for the citizens of a country. In Australia banking institutions provide avenues where individuals can trade both domestically and internationally. By providing the traders with cheques and letters of credit, ADIs provide and avenue where trade can occur. However, as suggested by Madura (2008), long-term saving companies are not involved in provision of such services. Since their funds are tied in long term investments, their ability to provide short term credit assurances.

Long term savings companies offer loans with lower interest rates than ADIs. The interest rate structure for long term loans differs from that of short term loans due to the inflationary characteristics and the characteristics of the collateral. Banks have in the recent past introduced unsecured long term loans which accrue higher interest rates. Such loans are secured on the income stream magnitude of the borrower. However such loans are only available to individuals with reliable source of income and are well known by the bank. Long term borrowers are however required to avail security for their loans in addition to substantiation that they can service their debts. Similarly, their interest rate calibration is subject to revision over the period owing to the monetary policy manipulations by the RBA.

ADIs avail funds on small and medium scale. The funds availed by most deposit taking institutions avail funds of up to restricted amounts. Since they hold deposits in the form of near cash characteristics, classified as narrow money, their influence on the supply of money in the economy is direct. Therefore their lending capacity is restricted to certain levels set by the RBA through the required reserve ratio. By so doing, the RBA achieves a certain portion of its monetary policy regulation Goosen et al, (1999). However, long term savings institutions are not subject to reserve ratios since the financial capacity is defined as broad money. The ability of broad money to impact the supply of money in an economy is limited by the nature of investments.

Monetary Policy

The RBA has in the past been faced with financial crises of monstrous magnitudes. By employing fiscal, wage and exchange rate policies, their efforts have restricted due to the lack of control over monetary supply. However after settling for the monetary policy, it was able to keep in check the supply of money thus reduce the impact of inflation in the economy. By targeting to control the growth in the supply of money through a process called monetary targeting, the institution was able to arrest the crisis for some time as suggested by Bell (2004).

The monetary policy of any central bank is geared towards maximizing employment, stabilizing prices and standardizing interest rates in an economy as suggested by Sundaresan (2009). The components of the monetary policy have conflicting results when applied in totality so moderation is of necessity. The responsibility of formulating and implementing a monetary policy in Australia rests with the reserve bank

As defined by the www.rba.gov.au, a secure financial system is characterized by smooth flow of finances from one intermediary to another in the market owing to an efficient market infrastructure. Such a system is necessary for development of sustainable growth in an economy. It is the task of each individual in an economy to actively safe guard the stability of the financial system.

The RBA has since the early 1990 instituted a change in the regulation of monetary policy by introducing overnight interest rates (Bell, 2004). The overnight interest rate, also known as the cash rate is affected by operations in the market. By the RBA having set up an Exchange Settlement Account separate from the required reserve ratio, it ensures that the balances are always in deficit by changing the rate of return. Since the liquidity requirements of each bank are established on a daily basis, it is easy for the RBA to adjust the interest rate so as to achieve the desired amount of money supply in the market Mishkin (2007).

Mahadeva (2000) suggested that a monetary policy describes the process by which regulatory bodies of a financial system manage the supply and accessibility of money as well as the interest rates at which money is available. It is composed of mechanisms which can be used to reduce or increase the total supply of money. In an economy, expansionary policies are aimed at increasing the employment levels since they avail more money into the economy. At lower interest rates, individuals are able to access funds for investment.

Lower interest rates make returns from deposits in banking institutions lower thus individuals are encouraged to invest in other avenues. The reduction in deposits leads to reduced value in the required reserve ratio with the RBA (Mahadeva, 2000). With a high supply of funds the economy manages to expand. However, sustained increase in employment leads to returns and a higher supply of money of money in thee economy. The inflationary effect originating from increased supply compromise the utility of money.

The monetary policy of any economy regulates the money supply by affecting the interest rates and economic activity with an aim of achieving full employment without incurring the inflationary effects. The federal regulatory institution sets the reserve requirement which is a percentage of the total level of deposits in banking institutions thus ensuring that supply of money is kept in check. The federal institutions are armed with several options of regulating the amount of money supply in the market.

The interest rates offered by banks are based on the rates set by the RBA. The gradual change in interest rates allows for costs to be spread over a long period so as to reduce the adversity. The RBA raises the interest rates so as to absorb the excess funds in the economy. The increase in interest rates makes bank deposits an alternative investment. Similarly, lending rates are increase commensurate with the returns to deposits. Thus the availability of cheap funds

The RBA has a stipulated required reserve ratio for all banking institutions. This is the ratio of the total deposits which should be channeled to the RBA at any point in time. This acts as a safeguard of the depositors funds. Since it is a ratio of the total deposits, the higher the deposit value, the higher that reserves kept at the RBA. The amount at disposal to the bank varies with the amount of deposits thus it becomes an efficient way of controlling the supply of money into the economy Bofinger, (2001). By so doing, the lending capacity of the banks is regulated since the RBA has the sole authority of varying the reserve ratio. The central bank of any country has the facilities to vary the required reserve ratio to suit the money supply level. Thus increased deposits lead to increase in the ratio and thus the amount of reserves to be channeled to the central bank.

Mishkin, (2007) suggested that discount lending windows also enable institutions to borrow from the regulatory institution. By availing credit during financial distress, the RBA enables banks to maintain their liquidity at favorable levels and avoid extensive loss for the depositors. Such credit is availed at a cost thus enabling it to be a last resort when it comes to accessing liquidity. However, as echoed by Bofinger, (2001), by so doing, the central bank of any country can avail credit to some or all financial institutions so as to avoid collapse. By availing funds to the financial institutions, the RBA is able to stimulate employment

When the economy faces increased supply of money after boom periods, the federal institutions offers bonds of varying maturity periods so as to reduce the supply of money in the market as outlined by Bofinger, (2001). Such operations are coordinated by the central bank in an economy. Through offering long term debt instruments with attractive coupon rates, the central bank is able to attract the surplus units. Funds raised from such trading are used to provide public goods or to fund federal projects. The advantage of such securities is the ability to be traded in the secondary market for liquidity incase the holders require funds for other uses. Therefore open market operations are necessary in accommodating (Mishkin, 2007)