This paper examines three foundational concepts of global financial markets: the base interest rate, the foreign exchange (FOREX) market, and the distinctions between international and domestic banking. Beginning with the causes of the global economic crisis, the paper explains how central banks set benchmark interest rates and use them to regulate liquidity and control inflation. It then explores how foreign exchange markets function as tools of monetary policy, tracing the system's origins to the 1945 Bretton Woods conference. Finally, the paper contrasts domestic and international banking in terms of customer base, currency operations, product offerings, and access to capital resources.
Several economists have blamed the emergence of the global economic crisis on the difficulties encountered in financial markets. Primary causes of the crisis, as argued by Joe Miller and Brooks Jackson at the Annenberg Public Policy Center, include the fact that the government significantly reduced interest rates during the dot-com bubble burst era, thereby increasing access to credit and allowing unnecessary inflation in real estate prices. A further major cause was the government's allowance of flexible interest rates, which initially attracted buyers but ultimately worked to their disadvantage. Third, the crisis stemmed from the failure of Wall Street organizations to properly manage and supervise the risky loans they were packaging into Mortgage Backed Securities.
The financial market can therefore be blamed for at least supporting the emergence of the crisis, but it can also be credited for other significant achievements. In order to better assess the achievements and failures of the global financial market, one should first gain 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 the differences between international and domestic banking.
The interest rate generically refers to the amount of money an individual will pay back when repaying 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 factors include the credit score and rating of the applicant, previous experiences and relationships with the lender, income of the applicant, marital status, and so on. What all interest rates have in common, 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 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" (Bank of England).
The following guidelines must be analyzed when central banks set the base interest rate:
The main objective is to achieve more effective regulation of banking system liquidity. The actual calculation of the base interest rate is achieved through an analysis of monetary developments (both projected and recorded), inflation movements and expectations, as well as 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 cap on the interest rate, generally due to a political agenda. This 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 not fully disclosed to the public. Central banks will generally reveal the forces considered when calculating the value of the repo rate (base rate). These may include: the size of the capital considered; the duration for which the capital will be used (both size and duration are directly proportionate with the base rate); the market ratio, or the interest rate practiced on the free market; the development and stability of the national and international economy; and the financial and monetary policies of the respective country, including the inflation rate.
Some central banks in less developed and less stable economies will modify their base interest rate 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 interest rates do not change 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 following presents 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 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 press release, and by way of the Legal Directorate is submitted for publication in the State Gazette (Bulgarian National Bank, 2005).
A final point regarding the base interest rate is that central banks use it as a means of controlling 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 consideration in discussing the benchmark interest rate is that it directly influences inflation. A simple explanation of this relationship is that the central bank modifies its base interest rate as a means of controlling expenditure within the economy. When the population consumes and spends at a rate higher than the growth rate of production, inflation occurs. In response, the central bank modifies the base rate to bring inflation under control.
The new regulations relative to the base rate will first influence the banking sector, which borrows from the central bank. These changes then influence industries, the retail prices of commodities, products and services, and ultimately consumption within the market. A lower interest rate will shift individuals' attention from saving to borrowing, real estate prices will increase, and spending habits will also rise (Bank of England).
The monetary policies implemented by a national bank have the ultimate purpose of controlling the financial market within that country. Their effectiveness is complete only if the national currency is floating. If the national currency is pegged — as is the case for most states — monetary policies must operate within the foreign exchange market.
The basis of the modern foreign exchange market was established during the 1945 Bretton Woods conference, attended by representatives from highly developed and industrialized countries. Prior to this conference, exchange rates were extremely volatile and based on national policies. The participants "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, representatives decided it would be more appropriate for some currencies to remain floating rather than all being pegged.
Today's FOREX market is a complex system of computers and networks across the globe, allowing various parties to trade. While some transactions are aimed at profitability, others serve policy goals. Investopedia defines the FOREX market as "the market in which participants are able to buy, sell, exchange and speculate on currencies. The forex market 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). In simple terms, the foreign exchange market is the place where one currency is sold and another is bought — for example, an American selling dollars and purchasing euros in exchange.
The foreign exchange market is the largest single market in the world. Its median daily trade volume is approximately $1.5 trillion — almost 100 times more than the daily trades of the New York Stock Exchange. Upon entering the FOREX market, an investor must meet several criteria, including a minimum capital requirement. These criteria are set and enforced by the SEC (Securities and Exchange Commission), which in certain respects makes the market more rigorous than the stock market (Miliaresis, 2005).
"Key differences in scope, products, and customers"
In terms of money transmission and cash management, international institutions generally offer more advanced capabilities compared to domestic banks. Regarding credit facilities, international banks have wider access to resources and are therefore able to make more favorable offers to consumers and corporations; they can also provide corporations with a broader range of commitments and guarantees. Syndicated loans — offered to a single borrower by a combination of two or more lenders — provide increased access to resources and greater stability in the event of financial market disruptions. International banks also allow their corporate clients to raise funds through bond issuance, with the most common instruments being Eurobonds, foreign bonds, and global bonds (Casu, Girardone and Molyneux, 2006).
International and domestic banking institutions differ across several important dimensions, primarily in the currencies in which they operate, the types of customers they serve, their access to resources, their ability to form partnerships, and the diversity of their product and service offerings. Together with the base interest rate mechanism and the foreign exchange market, these distinctions form the structural foundation of global financial markets and help explain both the vulnerabilities that contributed to the economic crisis and the sophisticated tools available for managing financial stability.
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