Money and Capital Markets: The Banking System

The Federal Reserves. The Securities

Money market and capital market are closely related though they have notable differences putting into consideration the period by which they both mature. Money markets are financial securities that have a short term maturity period normally a year or less (Miranda, 2012). This is considered to be the safest way of investing compared to capital markets. The securities invested according to Miranda (2012) include treasury bills, purchase agreements, bankers’ acceptance, federal funds and many other financial transactions.

Due to the low risks and high liquidity attached to these securities, the returns on the same are relatively very low. Money market is a way through which investors store money for future need or use. Capital markets are on the other hand the opposite of money markets in that they are markets for financial assets which can take quite along time to reach maturity (Akran, 2010). The financial instruments that drive the capital markets take at least a period of more than a year to mature as pointed by Akran (2010). This essay will be focusing on the interbank interest rates, interest rates cuts and the effects of these cuts on Europe, India and China.

The Federal Reserve Banks

When the economy falls, the federal reserves respond with an interest rates cut to encourage more borrowing. This means that interest charged on loans becomes relatively low hence more people are able to borrow. This consequently follows an increase rate of investments. Generally, it is suffice to say that interest rate is the value or cost of money. Just like any other product in the market, the law of demand and supply in the money market applies as well. The cost of money therefore rises with the decrease in its supply and fall with the increase in the same. The supply of money in the market is influenced by trading government securities. This includes government debt or treasuries that the public have invested in.

The Federal Reserve banks have a responsibility to monitor and control national funds rate. This is done to safeguard the stability of the financial systems in a country. Banks are required to deposit reserves in the reserve banks, a factor that sees the fluctuation of interest rates. At the event of a recession, the federal reserves lower the interest rates to cushion the economy from the adverse effects of an economical melt down. In April this year, the reserve bank of Australia decided to leave the interest rate at 4.25 per cent (Massola, 2011).

This decision was informed by the board’s consideration of the projected slow growth in demand which ultimately would result to inflation. Easing of the monetary policy in the year 2011 by the RBA has seen a slow output growth in Australian economy hence prompting the RBA not to consider a further reduction in the interest rate according to Massola (2011). The slowing growth pace of the Chinese market as the governor of RBA pointed out in his speech was having a depreciative effect on the Australian dollar (Massola, 2011).

The Banking System

Banks have declined the RBA’s call for interest rates cuts in Australia. The major reason for this insubordination is due to the effects it may have on the financial market. Banks are worried that this could raise the ultimate cost of borrowing for banks from the reserves. The result will be that the banks will most likely decline to pass the full benefit of interests cut to the customers. This would affect borrowers especially home buyers with the prevalent economic tough times faced all over the world.

The RBA gave this direction concerning money markets without considering the instruments that drive the market itself. In order for the banks to be in a position to adjust the price changes, the equation of demand and supply in regards to money flow must be the first thing the RBA should address (Bofah, 2012). Banks are trying to recover the rising cost of funds through high interest rates to avert possible financial pressures on the banks end. The bankers are warning that, passing on the rate cuts to the consumer will be mounting pressure on the banks operating cost hence lay-offs will be necessary(Farr, 2012).

Banking industry is a thin margin business and reduction in a small percentage of profits could adversely affect the banks operations financially. However, the reasoning tabled by the treasury that banks should pass on cut rates down to the customers is equally valid and timely. Customers should be the first to benefit from the cuts but not the banks. Financial analysts warn that customers of banks that are against the RBA’s directive will be very angry and may take action against the banks (Farr, 2012). It would be very greedy of the banks not to pass on the full range of rates reduction to the customers. The Australian banking system has been very strong and stable invalidating the notion that reduction would lead to a collapse (Farr, 2012).

People’s bank of china also did cut, on a 50 basis point, its bank’s Reserves Requirement Ratio. This move has helped the Chinese banking industry to secure funds to facilitate their loaning services. The move, as many economists have concluded, is to increase lending to keep the economy running. Cut in banks reserves requirements ratio is the only option that the Chinese economy has as the high inflation rate can not allow the reserve bank to effect a reduction in interest rates. The cut reserve ratio has expanded the money supply in China’s money market hence this money will then be re- invested in “risk assets” like the stork market (Farr, 2012)

The global economic crisis left the European central bank in a debt crisis. This prompted the federal reserve to effect almost zero interest rates thought it was not good for the market (Bagehot, 2012). The Federal Reserve reviewed its position and raised it bench mark effectively to 1 percent. The money market consequently was filled with Euros circulating in the economy which led to the current inflation situation. Inflation is what the euro region is dealing with currently.

The half percent point cut in the bench mark interest rates was not very well received by the investors and economic analysts in India (Bagehot, 2012). The popular feeling is that the reserve bank’s action may not achieve the desired goal of encouraging investments. Economists warn that the 50 basis point rate cut may in the long run result to severe inflation. The sole responsibility of a reserve bank is to ensure financial stability and enhance growth of a country economically.

Central banks all over the world felt the impact of the global economic meltdown. They all responded in an attempt to rescue the economy both locally and in the global scale. This is why central banks are very essential in an economy. The banks provide financial council and monitor the global direction of business to safeguard the local economy.

References

Akran, G, 2010, What Is Capital Market? Meaning Faction and Role, Web.

Bagehot, W, 2012, RBI rate cut: Will the joy be short-lived, Web.

Bofah, K, 2012, An Interest Rate Cut: What Does It Mean?, Web.

Farr, M, 2012, Punters believe Reserve Bank will cut, but banks won’t pass on in full, Web.

Massola, J, 2011, Banks may not match RBA’s interest rate cut, Australian Bankers’ Association warns, Web.

Miranda, K, 2012, How to Define Money Market Deposit Account, Web.