The Role of Banks to the Flow of Funds in Australias Financial System (Essay Sample)

The Importance of Banks to the Flow of Funds in Australia’s Financial System
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City Money University
Author Note
This paper was prepared in partial fulfillment of the examination requirements of ECO 305: Money and Banking course taught by Professor Ann DavidAbstract
During the previous three decades, financial systems around the world have been revolutionized with most financial markets; aided by technology, globalization, and de-regularization embracing market-based capital markets. As result; people, businesses, financial institutions, and state governments can access credit at affordable interest rates, share risks with other people across the world on real time basis, and invest in a variety of instruments depending on their risk appetite. Australia’s financial system is faced by persistent challenges: prolonged current account deficits which have necessitated the inflow of investment capital or offshore wholesale funding in excess of its local savings. Given that currently most superannuation funds are investing Australian capital into international financial assets, it implies that the current financial architecture is integrated into global financial network and hence susceptible to global risks as evident during the 2007’s global financial crisis (GFC). Therefore this study will examine the ability of Australian banks and regulatory authorities to maintain stability as they efficiently allocate capital and manage risks in Australia’s internationally integrated financial system.
The Importance of Banks to the Flow of Funds in Australia’s Financial System
Australia being the 21st Century’s Lucky Country, its hybrid financial system has in line with the past three decades of economic prosperity buoyed by the mining boom and close trading with China recorded high growth in terms of market capitalization, turnover, and product development especially with respect to securitization and superannuation funds (Erskine, 2014; Kearns & Lowe, 2014). This development and the fact that Australia’s financial sector was among the few markets that proved resilient during the global financial crisis and attendant recession. This notwithstanding, it is held that just like its peers this financial market’s status quo was disrupted with profound effects on funding patterns, structure, and regulatory framework (Erskine, 2014). Regarded as an ‘old economy’ around 2000, the recent notable developments in the Australian financial have been driven significant investments in technology, deregulation and institutional change. However notable obstacles to credit intermediations such as transactional costs and information asymmetry still persist (Rajan, 2005). Thus as financial systems embrace arm’s length transactions it is imperative that effective risk management strategies are developed to avoid the negative effects of the inherent hedge-fund-led disruptions.
The efficacy of the banking industry’s credit intermediary function relative to other funding options is declining as financial markets transform from bank-based to market-based systems (Adrian & Shin, 2009). This is due to stiff competition from non-bank firms and a drop in customary balance sheet based income streams. To remain as profitable, avoid bankruptcy or a market share reduction, banks opted to expand into new markets, investing in riskier products like mortgage financing, and embracing off-balance-sheet activities such as shadow banking to shore up the banks’ non-interest income (Edwards & Mishkin, 1995). However, it should be noted that since the 2007’s GFC’s recession, to enhance economic stability and reduce the bank’s liquidity risks, Australian regulatory authorities have emphasized dependency on deposit funding as opposed to offshore wholesale funding (Stewart, Robertson, & Hearth, 2013). The need to regulate without stifling the banks’ capacity to innovate is informed by the fact that with A$ 2.7 trillion in total bank assets or 56 percent of gross financial assets (A$ 4.9 trillion); as of 2010 the financial sector contributed 11 percent or A$ 135 billion to Australia’s GDP (ATC, 2011).
Financial Market Structure and the Flow-of-Fund Framework
Australia’s financial system is robust and it is market-based with its main financial institutions comprising authorized deposit-taking institutions (ADIs)/banks, fund managers, and insurance companies. The largest four ADIs include the ANZ, NAB, Commonwealth Bank, and Westpac (Hunt & Terry, 2011). Australia’s financial system is represented by local and foreign institutions offering banking and financial services: retail banking, wholesale banking, mortgage originators, investment banking, and merchant banks. Ideally, the Australian financial system is made up of the money, bonds, and equity markets with a marked growth in a range of foreign exchange and derivatives products (p. 15-16). In terms of regulation, at the apex of Australia’s financial system is the Reserve Bank of Australia (RBA) - established in 1960 to replace the Commonwealth Bank. The functions of RBA are to execute the monetary policy, regulate the payment system, issue notes, maintain financial stability, and serve as the Commonwealth Government’s Banker. Other regulatory authorities include: the Australian Prudential Regulation Authority (APRA), Australian Securities and Investments Commission (ASIC) and Australian Treasury; these four bodies constitute the Council of Financial Regulators (CFR) (p.17-18).
The flow-of-funds model defines the sources (i.e. savings by individuals, business entities, and government bodies) and destination of capital (i.e. people, firms, & statutory bodies) in a competitive economy. These funds are utilized for both consumption and investment expenditure and as such these transactions entail the exchange of assets and liabilities across entities (Murinde, 2009). Essentially the channels used to transmit these loanable funds include: inter-mediated funds (e.g. ADIs), capital markets (e.g. equity and bond markets), and firms issuing structured products such as securitization trusts (Wylie, 2014). The proportionate or aggregate amount of capital transmitted through these channels depends on the economic-wide forces of demand and supply, but this is also exogenously influenced by the interplay of fiscal and monetary policies. In the global financial system, the cross-border financial architecture is such that international finance is inter-mediated by large financial firms (e.g. UBS) that transact on payment and settlement systems operated from selected countries (e.g. Sydney, London, New York etc.) serving as the ‘global common lenders and borrowers’ (Moghadam & Vinals, 2014).
The Significance of Banks to the Flow of Funds in Australia’s Financial Market
Merton (1995) notes that in addition to transferring funds from surplus entities to deficit segments in the money market; the financial system further facilitates the efficient settlement of financial transactions, manages risks, reduces information asymmetry, and minimizes incentive problems and moral hazards in the market (Hunt & Terry, 2011). Hence, under the supervision of the RBA, the banks’ key role is to transmit and facilitate the implementation of Australia’s monetary policy (Gobat, 2014; Peek & Rosengren, 2013). While Central Banks (e.g. RBA) control (i.e. expand or shrink) money supply in the national economy, commercial banks are responsible for distributing funds in their operational markets (Gobat, 2014). The banks facilitate the transmission of monetary policy through the following mechanisms: bank lending, interest rate, exchange rate, asset (e.g. equity, bonds, & real estate) prices, balance sheet, and credit channels (Juurikkala, Karas, Solanko, 2009; Hsing, 2013; Kuttner & Mosser, 2002; Peek & Rosengren, 2013). Through these mechanisms the financial system promotes investment, stabilizes national currencies and inflation, contributes to economic development, and improves the people’s welfare and standards of living (Bollard, Hunt, Hodgetts, 2011; RBA, 2014).
The interest-rate channel theory posits that an “expansionary (contractionary) monetary policy lowers (raises) money market interest rates, thereby reducing (increasing) borrowing costs and boosting (reducing) loan demand, investments, and consumption” (as cited in Juurikkala, Karas, & Solanko, 2009, p. 5). Thus based on this channel, the banking system under the RBA’s ‘open-market operations’ facility, is able to transmit monetary policy initiatives and determine the magnitude of the monetary policy’s impact on the economy (Peek & Rosengren, 2013). The impact of the interest-rate pass-through is dependent on the banks’ compliance rate or level at which interest rates (on deposits & loans) are adjusted with respect to the policy initiatives. This further depends on the industry’s competition and market development levels and the quality of the banks’ and borrowers’ balance sheet status (ECB, 2008). Based on the fact that Australia’s financial system is market-based, apart from interest rate;...