The role of the banking system

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The importance of the financial system in any economy cannot be overstated. Apart from the general depository duties associated with finance, the scheme bears the primary responsibility of ensuring that the financial market and, by implication, the economy operate properly and efficiently. Governments, in their efforts to stabilize economies and institutions, have been shown to be involved in some of the world's worst financial crises. A common example is the 2008 financial crash, which was blamed on the entire banking and political sector. In certain economies, financial markets are indistinguishable from banking industries. While the two can be interchangeably used in certain situations, they are ideologically different. This failure to have clear boundaries is the first vulnerability to pro cyclical trends and behaviour. Pro cyclical is a phrase adopted in economics, business and finance meaning a tendency to move along with business cycles at the expense of policy objectives, economic goals and inflationary containment. This essay is a discussion of the potential implication of bank and fed behaviour on money supply growth in a pro cyclical manner.

Discuss how bank behaviour and the fed’s behaviour may have caused money supply growth to be pro cyclical before the crisis. What has changed since 2008 – 2009

A bank as a financial institution has a dual mandate to the public and to the shareholders. To the public the bank must offer depository services. To the benefit and growth of the bank, it must offer the public loans as an intermediary institution. This duality of lending and depository services, banks fulfil a number of functions of providing liquidity, payment services, screening and monitoring borrowers’ ability to service their obligations, managing risk and transforming an asset’s characteristics. This is typical bank behaviour.

Money is loosely considered to be anything that is accepted as payment for goods and services in an economy. The actual definition of money has grown with the advent of crypto currencies and complex banking products now on offer in most of the developed world. For the purpose of this discussion, it is important to define the monetary base as the total currency in circulation as registered and recognised by the central bank. Henceforth, any reference of money is implying the monetary base in an economy.

Popular understanding cites the excessive regulation or lack thereof as a single motivator of the emergence of block chain currencies. The failure of the banking sector internationally in 2008 saw the introduction of the online currency bit coin as an alternative trading currency. It has since gained acceptance and adoption for online transactions were anonymity is a buyer’s concern. The inconsistencies and uncertainty surrounding the way central banks regulate the banking sector and applies its policy for the wellbeing of the public.

The 2008 financial crunch exposed this global pro cyclical behaviour as central banks and depository institutions were exposed to the credit crisis that hit the American’s housing marketing before spreading to the rest of the economy (Mishkin, 2016). Many analysts argued that the exposure within the US credit market should not have spread to other economies if some measure of financial autonomy, economic regulation and prudence was exercised. Worst still, geo political trends that favour alliances and co operations that were culpable in the 2008 have continued to develop without reflection.

The personal consumption expenditures, chain type index which measures the expenditure of US citizens as recorded from the year 2000 had an average of 2.3% between 2000 and 2001. In the same period, expenditure would have a 0.3 difference with the targeted inflation rate. An attempt by the Federal Reserve to target inflation would be futile as a hike in interest rate would ‘cyclical’ hurt the output (GDP) and further push up inflation. Permitting money supply in this situation would be tantamount to being pro cyclical.

2001 ended on a low owing to the terrorism that hit America in September 2001. While GDPC! Remained steadily increasing from 12700s going upwards, the federal fund rate fell drastically from a millennial high of 1.9% in the year 2001 to -2.4% in the third quarter of 2001. The federal fund rate is a rate is the interest rate the Federal Reserve sets for banks and credit institutions to lend reserve funds to other institutions. When this rate falls to negative, it is a sign that the Federal Reserve is attempting to stimulate economic activity through offering banking incentives. While the cause of this action is bore out of tragedy and the motive of raising the spirits of a country through relaxing interest rate levels is noble, the trend of increasing money supply emanating from a cyclical event is evident again.

The Federal Reserve is also known as the fed is the central bank of the United States of America. It was created in 1913 through the passing of the Federal Reserve act with the dual mandate of stabilising prices or inflation targeting and maximising employment. The fed has the responsibility of monitoring the banking system and providing banking services for the US government. More specifically, the tools of achieving the dual mandate of the fed are open market operations, discount rate and the reserve requirements. By virtue of it being the central bank of the most powerful economy in the world, it becomes the most influential monetary institution in the world. This position means that the rest of the world ‘pegs’ its policy in line with the federal reserve in the blind belief that they have the best counsel on monetary affairs.

The approximation of responsiveness of the nominal interest rate and adjusting it to key economic variables like output and inflation is called the Taylor rule or principle (Johnson, 2003). It states that for each one percent increase in the inflation rate, the central bank would increase nominal interest rates by more than a percentage point. This principle is used as a guide in assessing monetary policy and not a tool for setting nominal interest rates. It is therefore useful to compare the actual federal fund rate with the Taylor rule approximation for the determination of inflation impact through interest rate changes.

The actual federal fund rate decrease represents an increase in money supply and a decrease represents an increase in the money supply. According to the excel tables provided, the actual federal fund rate is at its highest between the year 2000 to 2001. After that, the Fed appears to have kept the funds less than 5% for the following 12years. This sustained policy of maintain a low interbank lending rate suggests an intension for banks to have access to money despite the obvious risks in cases of misappropriation of funds. Banks create money by lending out money through loans, mortgages and an assortment of other banking products. It is known that during the period 2001 – 2008, banks enjoy a season of deregulation and slack oversight. A combination of easy access to money in a low regulatory environment and a housing bubble exacerbated the risk of a financial collapse.

A ‘bubble’ is a trade of a particular asset or sector is on the rise based on the intrinsic value of the respective asset. A bubble can be speculative, market, price or financial. It describes an optimist rise in an asset price that is based on perception of a good future. It can also be based on inconsistent and implausible views about the future. The USA has seen a number of ‘bubbles’ like the tech bubble, renewable energy bubble and the housing bubbles.

When a bubble occurs, banker deliberately or through unconscious bias will lend money to investors of a booming sector, stock or asset. This is done on the obvious self assured reality of returns on the good run of investment. 2005 personal expenditure data as well as actual federal fund rate point to money supply increases based on a blossoming housing market bubble. The calamity of this bubble in the year 2008 had clear and undeniable consequences.

The Gross domestic product of a country is the total amount of value generated from the goods and services a period under consideration (Bruce, 1995). The potential gross domestic product (GDPOT) may mean a perfect scenario with full employment, optimal resource usage, zero tax code distortions, no information frictions and no suboptimal government policies. While theoretically, the realistic potential GDP is a contested metric because its composition is not satisfactory to some economics scholars; it is a beneficial variable to compare against the actual GDP for performance evaluation.

GDPC1 is the inflation adjusted gross domestic product that was produced by labour and property located within the United States. According to the excel sheet, in the third quarter of 2005 the GDPC1 was larger than the GDPPOT by 77.2. This is abnormal as the actual inflation adjusted GDP was larger than the potential of the economy. This could be a calculation error or a cue to the increased money supply observed by the increased inflation gap of 1.1%.

When the pro cyclical nature of the fed and the banks is on the spotlight, it is necessary to consider material information that has financial consequences but cause by political challenges. Examples like the anti competitive behaviour of China currency fixing, political speculation of possible regime changes to administrations and geo political events have a bearing that further show the money supply decisions will become pro cyclical and less principled.

A typical example is when the fed decides or is instructed to print more money to finance a war. This money will in most cases find its way back to the shores to the United States. Because of this dynamic, the central bank would have been complicit in the inflationary impact of their decision to print more money. Non financial matters that involve national security and defensive have enjoyed ballooning budgets since the early 2000s. When we look at the GDPC1 figures, the growth has been steady and constant since the beginning of the millennium. Even during the financial crisis, the setbacks on GDP were hardly noticeable.

From 2004 to 2006 the inflation gap is positive. This means that the fed had met its inflation target of 2%. At the same period the Actual federal fund rate indicates that they had increased slightly. A potential explanation to this could be the exchange rate. The United States dollar is the standard currency for international transactions. This means that the Federal Reserve must ensure that there is enough US currency internationally to meet trade demands.

The Brics nations and other emerging economies may present a challenge to this effort. China for example has been on a path of self discovery and economic renewal. This national agenda has been the sole reason for Chinese dominance in trade against the United States. At the present moment, the United States debt to China is well in the trillions. While trade may be a non banking issue, debt settlement is. In trying to normalise at service their debt obligations the Federal Reserve has the mandate to ensure debt payment and stabilise the markets. To pay trillions of dollars of debt while keeping the markets stable may require printing more money.

The money demand must be matched by the money supply. The central bank uses a wide range of analytical tools and metrics to assess the level of demand in the economy. One obvious way is to check the progression of the GDPC1. This metric guides them on what reserve requirement rate to set on depository funds, the discount rate to determine interbank lending rates and conditions and finally, the open market operations to try and influence the money in circulation by issues securities and other financial products.

In the excel sheet we notice that the GDPC1 has been booming ever so consistently. This means that the local money demand has been on an upward trajectory. This observation alone would tempt the Federal Reserve to enact a policy of steady money supply growth on the consistent GDPC1 trend and inadvertently becoming pro cyclic in their money supply.

If there are shocks to the financial system or an inconsistent variable that makes money demand inaccurate, the heightened financial uncertainty must not warrant reactionary monetary developments. The monetary base from 2001 to 2003 is attributed to shifts in preferences of investment products is said to have been a motivator for the development of derivatives and similar financial assets. This behaviour of the banks adopting more financial products to cater for the preference in liquid assets by the bank is a sign of being pro cyclic in their behaviour.

Identifying whether monetary developments, policy and generation is driven by money demand or money supply is a material issue in establishing the relationship between money, asset price changes and the wealth in the economy. While the demand of money is considered to be independent of external influence other than those personally made by the economic agent, the money supply may exert some persuasion on the individual or entity to acquire more wealth if the money supply is in excess.

The excel sheet provides a FRED graph that maps the actual federal fund rate against the prediction of Taylor’s rule. The vertical axis measures the percentage interest rate and the horizontal axis records time biannually. The actual federal fund rate is a smoother curve but they both follow the same direction of movement. The biggest disparity between the two curves is when the regulation was put in place in 2009 were the Predicted rate according to Taylor’s rule dipped into negative territory by close to -4%.

The interest gap which we can consider to be the difference between the targeted interest and the Actual fund rate is negative for ten year since 2000 to 2016. That means the actual interest rate is well over the intended 2% target. We also observe the inflation rate to be constantly fluctuating without mitigation. The Fed’s power to influences the inflation targeting may have been due to external variables independent to interest rate. The central bank however appears to be pro cyclical in their approach to combat inflation using the interest rate.

The pedagogical understanding of how the monetary policy influences the money supply in an economy is based on the money multiplier approach. The multiplier has the ability to compound a monetary strategy and cause the monetary policy effort to spiral beyond the targets of the central bank. The Federal Reserve may be dealing with a multiplier like effect on the negative output gap that is observed between 2000 from time to time.

The concept of money multiplier can be derived from the basic feature of depository banking. Under normal conditions when there is confidence in the banking system banks are required to maintain highly liquid cash equivalent assets as reserves. The rest can be used to obtain high yielding and less liquid assets as loan which is the standard process by which banks make money. From 2000 – 2008 the regulatory environment was too relaxed leading up to the financial crush. Some of the assets held by banks defaulted at unprecedented levels causing uncovered exposure also known as the credit crisis in the second part of the 2008 crush unravelling. The drop in the PCECTPI PC1 from 4.0 in the early quarter of 2008 to -0.5 in 2009 is an indication of that banking failure; suggest pro cyclical behaviour through their money creation system.

In 2008 the financial system crushed. It started as a housing crisis. Subprime mortgages were defaulting at unusually high rates. The housing crisis became a credit crisis. Analysts, banks and the Federal Reserve were caught unaware. This crisis then crossed borders to the Asian market, the FTSE companies, European countries and the Chinese exporters. Incidentally, it came at the time when the United States was preparing for a presidential election. President Bush, Federal Reserve Chairman Ben Bernanke, and Treasury Secretary Henry Paulson tried to save the system from collapse. The economy was official in recession.

The extension of survival funds to prevent a system shutdown is known by different names. Some call it a bailout others call a stimulus package. Academics favour quantitative easing. The goal however was to inject a sum of money into the financial system to avert further disaster by resuscitating failing institutions. Essentially the Federal Reserve prints money to maintain core financial and banking operations active. However, this whole situation may have been partly caused by the Federal Reserve’s pro cyclical supply of money and excessive risk taking by the banking industry. The quantitative easing program was also an indication of the Federal Reserve’s pro cyclical behaviour is money supply.

In the excel sheet we notice that they was that the PCECTPI PC1 fell from 4.0 to 1.5 in the last quarter of 2008 and proceeded further to 0.0 in the first quarter of 2009. It then became negative for the following six months. The GDPC1 slowed down slightly because of the swift intervention by the government to curb the situation from spiralling out of control. The Actual federal fund rate was kept at a minimum of zero for the following few years. The Taylor’s principle became a metric to watch in strategy development in an effort to manage the situation.

When President Obama was elected, some complex mortgage products that were offered to subprime borrowers were banned by regulation. The new government constrained the compensation schemes for all parties in the line of mortgage related securities to their distributors. High executive compensation for failing or bailout corporations and financial institutions were significantly cut as a condition of accepting the survival package. The Federal Reserve hiked the capital requirements for banks and other financial intermediaries. Extra supervision for their operational activities was mandated by the government to steer the economy out of recession.

The data on the excel table after 2009 indicates calculated and monitored effort to reform financial and banking practises and set the global economy on a path of growth and prosperity. While GDPC1 continued to be firm, the PCECTPI rebounded as consumer confidence grew with the firmer regulation on financial systems. Property prices that had plummeted because of the failed system became stable and started gaining.

The behaviour of banks has since become more cautious and risk averse. The lessons of the 2008 are still fresh and the failure of money supply growth in a pro cyclical way are a mistake the Federal Reserve and the banks are keen never to repeat.

References

Bordo M. D. (2008). An historical perspective on the crisis of 2007-2008, NBER Working Paper 14569

Brunnermeier, M. K. (2009). Deciphering the Liquidity and Credit Crunch 2007–2008, the Journal of Economic Perspectives, 23 (1), pp. 77-100.

Mishkin F. S. (2016). “The Economics of Money, Banking and Financial Markets”, 11th

Edition. Pearson Ed.

Taylor, John B. (1993). Discretion versus Policy Rules in Practice. Carnegie-Rochester Conference Series on Public Policy. 39: 195–214. (The rule is introduced on page 202;p see also the Lecture slides and textbook material on monetary policy)

Taylor, John B. (2008). “The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong”, NBER Working Paper No. 14631

November 23, 2022
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