Global Financial Markets Several Economists

Global Financial Markets

Several economists have blamed the emergence of the global economic crisis on the difficulties encountered on the financial market. Primary causes of the crisis, as believed by Joe Miller and Brooks Jackson at the Annenberg Public Policy Center of the University of Pennsylvania, include the fact that the government has significantly reduced the interest rates in the dot-com bubble burst era, increasing as such the access to credits and allowing the unnecessary inflation in real estate properties. Also, a major cause is that the government allowed the implementation of the flexible interest rate, which attracted buyers, but then came to their disadvantage. Thirdly, the crisis was due to the failure of the Wall Street organizations in properly dealing with and supervising the risky loans they were building into Mortgage Backed Securities.

The financial market can then be blamed for at least having supported the emergence of the crisis, but it can also be praised for other major achievements. In order to better assess the achievements and failures of the global financial market, one should first get a thorough understanding of three of its most important concepts: setting the base interest rate, the features of foreign exchange markets through the lens of monetary policies and third, the differences between international and domestic banking.

1. The Base Interest Rate

The interest rate generically refers to the amount of money an individual will pay back when reimbursing a previous loan. "There is no single interest rate for any economy; rather, there is an independent structure of interest rates. The interest rate that a borrower has to pay depends on a myriad of factors" (Fabozzi and Mann, 2005). Some of these forces include the scoring and credit rating of the solicitor, previous experiences and relationships with the lender, income of the solicitor, marital status and so on. The commonality of all interest rates however, is that they are established in accordance with the base interest rate.

The base interest rate is also known as the benchmark interest rate and it refers to the interest rate on the securities issued by the government. These are backed by the federal institution and their risk is considered minimal to nonexistent. The interest rate on a loan is generally established by adding to the base interest rate the spread (or risk premium), a mathematical reference to the additional risks investors face when lending to non-governmental organizations (Fabozzi and Mann, 2005).

The base interest rate is the rate "at which it (the central bank) lends to financial institutions. This interest rate then affects the whole range of interest rates set by commercial banks, building societies and other institutions for their own savers and borrowers. It also tends to affect the price of financial assets, such as bonds and shares, and the exchange rate, which affect consumer and business demand in a variety of ways. Lowering or raising interest rates affects spending in the economy" (Website of the Bank of England).

The following guidelines have to be analyzed when central banks set the base interest rate:

the main objective is to achieve a more effective regulation of the banking system liquidity the actual calculi of the base interest rate is to be achieved through an analysis of monetary developments (projected and recorded), inflation movements and expectations, as well as the expected and previous movements in the national currency all operations on the money market will be influenced by the established base interest rate (National Bank of Serbia)

The central bank will sometimes set a maximum rate on the interest rate and this is generally due to a political agenda. It revolves around the desire to "channel cheap funds to favoured enterprises or individuals (and to government itself), using administrative discretion over the rationing of funds made necessary by demand exceeding supply at the capped interest rate" (Shipman, 2002).

Setting or modifying the base rate is a complex process, undisclosed to the public. The central banks will generically reveal the forces considered when calculating the value of the repo rate (base rate). They could include:

the size of the capital considered the duration for which the capital will be used; both size and duration of capital are directly proportionate with the base rate the marker ratio, or the interest rate practiced on the free market the development and stability of the national and international economy the financial and monetary policies of the respective country, or inflation rate

Some central banks, in less developed and less stable economies, will modify their base interest monthly and the result will be the average of the monetary interventions from the previous month. Within more stable economies, where the forces generally influencing the interest rates do not modify easily, the central bank will move "base rates by changing the dealing rates at which it buys bills from the discount houses" (Money Extra, 2008)

The lines below present the methodology by which the central bank in Bulgaria sets its base interest rate (BIR):

1. The size of the base interest rate (BIR), effective from the first day of each calendar month, equals the simple average of the values of the LEONIA (LEv OverNight Interest Average, a reference rate of the concluded and settled Bulgarian lev overnight deposit transactions) for the business days of the preceding month (basis period).

2. The BIR is effective for the period from the first to the last day of the calendar month it is set for.

3. The BIR is on an "actual / 360" day count convention. The format of the base interest rate is with 2 decimal places.

4. After the calculation and the publication of the LEONIA reference rate for the last day of the basis period, the person empowered to compute the LEONIA calculates the size of the BIR according to Points 1 and 3.

5. The value of the BIR is approved by the Director of the Bank Policy Directorate and confirmed by the Deputy Governor in charge of the Banking Department, upon which it is published on the BNB website and in the media via a pressrelease, and by way of the Legal Directorate is submitted for publication in the State Gazette" (Website of the Bulgarian National Bank, 2005).

The final specification that must be made relative to the base interest rate is that central banks use it as a means of controlling the financial markets. "Control over private banks' own interest rate achieved through the setting of base rates achieves a mechanism for monetary control" (Shipman, 2002). A major considerate in discussing the benchmark interest rate is that it influences inflation. The chart below reveals how the base rate impacts inflation:

Source: Website of the Bank of England simple explanation of the chart is that the central bank modifies its base interest rate as a means of controlling the expenditure within the economy. Given that the population consumes and spends at a rate higher than the growth rate of production, inflation occurs. In response to this, the central bank modifies the base rate to control inflation.

The new regulations relative to the base rate will first influence the banking sector, which borrows from the central bank. These will then influence the industries, the retail prices of commodities, products and services, and ultimately, the consumption within the market. A lower interest rate will make individuals turn their attention from saving to borrowing, real estate prices will increase and the spending habits will also boost (Website of the Bank of England).

2. Foreign Exchange Markets

The monetary policies implemented by a national bank have the ultimate purpose of controlling the financial market within that country. Its control and effectiveness are complete only if the national currency of the country is floating. If on the other hand, the national currency is pegged (as is the case of most states), the monetary policies have to occur within the foreign exchange market.

The basis of the modern foreign exchange market has been set during the 1945 Bretton Woods conference of representatives from highly developed and industrialized countries. Prior to this conference, the exchange rates were extremely volatile and based on national policies. The participants to the Bretton Woods conference "agreed to begin a period of pegged, but adjustable exchange rates. [...] the [...] delegates believed that a more stable system of foreign exchange rates would promote the growth of international trade. They also expected that making countries defend agreed parities would prevent the manipulation of exchange rates for purely domestic policy objectives" (Baillie and McMahon,). During the 1970s however, the representatives decided it would be more relevant if some currencies remained floating, as opposed to all being pegged.

Today's FOREX market is a complex system formed from computers and networks across the globe and allowing various parties to trade. While some of the transactions are indeed aimed for profitability purposes, others have policy goals. For a better understanding of the foreign exchange market, one could look at the simplistic, yet relevant definition offered by Investopedia, a website designed for those interested in financial investments. They state that the FOREX market represents "the market in which participants are able to buy, sell, exchange and speculate on currencies. The forex markets is made up of banks, commercial companies, central banks, investment management firms, hedge funds, and retail forex brokers and investors. The currency market is considered to be the largest financial market in the world, processing trillions of dollars worth of transactions each day" (Investopedia, 2009). Otherwise put, the foreign exchange market represents the place where one currency is being sold and another is being bought, such as an American selling his dollars and buying euros in exchange.

The foreign exchange market is the largest single market on the globe. Its median trade is of $1.5 trillion per day, almost 100 times more than the daily trades of the New York Stock Exchange. Upon entering the Forex market, the investor has to meet several criteria, such as a minimum of capital. The criteria are set and implemented by the SEC (Securities and Exchange Commission) and they make the market superior to the stock market (Miliaresis, 2005).

An interesting aspect of the foreign exchange market is that it can be used as a tool to influence monetary policies. For this to occur however, the currencies cannot be all pegged or floating. The most common intervention in the FOREX market with the purpose of influencing monetary policies revolves around modifying the inflation rates. In this instance then, the state will implement a series of interest rate adjustments and will engage in purchases of foreign currency. "According to the model interventions (purchases of foreign currency) will be negatively correlated with interest rate deviations from the steady state level but positively correlated with interest rate deviations pertaining to non-stabilizing motives or a binding zero lower bound. The model also predicts that interventions will be decreasing in inflation expectations and in the real exchange rate but increasing the expected interventions" (Post, 2006).

Central banks have often intervened on the foreign exchange market and their aim has been a policy one, rather than an economic one, mostly since the quantity of money traded or owned by a country, domestically, would not suffer any modifications. The second reason as to why national banks would interfere on the foreign exchange market is based on the portfolio model balance and sees that a state will be able to influence the exchange rate by modifying the amount of domestic and foreign bounds traded.

Then, a third reason as to why banks intervene on the Forex market is that on trying to maintain or generate price stability. This situation is achieved as interventions on Forex are a discretionary tool in the hand of the central bank, and most importantly, when the monetary tool of interest rate is no longer effective as a means. The transparency of these operations has often been limited to non-existent and as a result, the specialized literature only presents few references to the issues of the Forex through the lens of the domestic monetary policy (Post, 2006).

3. International and Domestic Banking

The latest global modifications impacting the financial sector have led to the creation of international banking, as opposed to domestic banking. In a highly simplistic formulation, domestic banking refers to the banking operations which occur within the enclosed territory of a particular country and are aimed to the benefit of the local consumers, investors, population etc. International banking on the other hand, incorporates all banking operations present in the global field and within international markets.