Compare and contrast the financial systems of two different countries. Use an institutional approach to describe the system. Comment on the impact on, and response to the GFC in each country Essay
Compare and contrast the financial systems of two different countries. Use an institutional approach to describe the system. Comment on the impact on, and response to the GFC in each country
A financial system inquires for efficient allocation of resources among the surplus and deficit units (Viney 2009) as such it encourages more savings where funds are provided for investor to invest and also ease the transactions for goods and services (Viney 2009). There are three main components in the financial systems which are the financial institutions, financial instruments and financial markets. All three types of financial system each carry different function, roles and regulations.
However, financial institutions will be mainly focus in this research essay. Global Financial Crisis (GFC), also known as the ‘great recession’ occurs in the year of approximately 2007-08. GFC has caused a several impact on the economy which leads to a several collapse of the financial institutions. For instance, the collapse of Lehman Brothers, one of the major investment banks in US (Australia Bureau of Statistics 2010).
Thus, the objective of this essay is to examine both financial system of the chosen countries which are United States and Australia, also the impacts and responses on the GFC in both of the chosen countries.
2.0 Compare and Contrast both Financial Systems
2.1 Central Bank
The central bank of the United States (U.S.) is known as Federal Reserve System (FED) whereas the central bank of Australia is known as the Reserve Bank of Australia (RBA).
The Federal Reserve System’s structure consist of the Board of Governors which are duly appointed by the president, the Federal Open Market Committee (FOMC), and 12 regional Federal Reserve Banks located throughout the major states in the country (The Federal Reserve Board 2003).
Banking in U.S. is regulated at both federal and state level. Unlike U.S., Australia has only one central bank which is the Reserve Bank of Australia. However, both central banks are independent within their government (Reserve Bank of Australia 2001) whereby for FED, the monetary policies decisions do not have to go through the President’s authorization, and for RBA, they have statutory authority established by an act of parliament which grants them specific powers and obligations to carry out necessary policies (Reserve Bank of Australia 2001).
On the other hand, RBA has two board, which are the reserve bank board and payment systems board (Reserve Bank of Australia 2001). The reserve bank board is responsible for monetary and banking policy whereas the payment systems board is responsible for controlling risk in the financial system, promoting the efficiency of the payments system, and promoting competition in the market for payment services, consistent with the overall stability of the financial system (Reserve Bank of Australia 2001).
The role of FED is to conduct the country’s monetary policy, which includes full employment, stable prices and moderate long term interest rates as stated in the Federal Reserve Act (Board of Governors of the Federal Reserve System 2008).
Furthermore, they maintain the stability of the financial system, supervise and regulate banking institutions, provide financial services to depository institutions, and foreign official institutions. FOMC will determine the cost and availability of money and credit in the country’s economy by affecting the discount rate, reserve requirements and controlling the open market operations (Board of Governors of the Federal Reserve System 2012).
Likewise, the role of RBA is to conduct monetary policy as well, which includes the maintenance of price stability, full employment and the economic prosperity and welfare of the Australian citizens (Reserve Bank of Australia 2001). Besides that, they also set the cash rate to meet a medium term inflation target (Reserve Bank of Australia 2001).
Moreover, RBA must maintain a strong financial system and efficient payments system and the issuing of the nation’s bank notes. Selected banking services are provided to the Australian government, agencies, official institutions, and a number of overseas central banks (Reserve Bank of Australia 2001). 2.2 Commercial Bank
Commercial banks in the U.S. are quite similar to those of Australia whereby their main role is to act as a financial intermediary by channeling funds
from agents who deposit money and lenders who needs fund and wants to borrow. These agents and lenders include households, businesses, governments and foreigners.
Australia offer products and services which include balance sheet transactions and off-balance-sheet transactions (Viney 2009). For balance sheet transaction, the first purpose is to loan activity to match the available amount of deposits that they received from customers. This activity is known as assets management (Viney 2009). The second purpose is to manage their sources of funds in order to ensure that they have sufficient amount of funds available to meet the loan demand or any other form of commitments. This activity is known as liabilities management (Viney 2009).
For off-balance-sheet transactions, it includes a substantial volume of business that is not recorded either an asset or liability on their balance sheet. In comparison, U.S. obtains their funds (liabilities) by issuing deposits, checking deposits, time deposits, saving deposits (Samolyk 2004). For their use of funds (assets), it includes making commercial, consumer, and mortgage loans, and by buying U.S. government and municipal bonds (Samolyk 2004).
Therefore, commercial banks play an important role in funding business borrowers. The percentage of non-financial business borrowing that commercial banks fund on their balance sheets has not declined remarkably in the past five decades or so.
The commercial banks in U.S. provide trade financing, foreign exchange, corporate finances and miscellaneous banking services which include currency specified credit cards, corporate checking accounts and lock boxes (Ireland n.d.). Moreover, the existence of commercial banks made reliable transfer of funds between different countries all over the world possible. Furthermore, the distribution of valuable economic and business information among clients around the world is made possible as well (Samolyk 2004). Similarly, there are basically two functions of a commercial bank in Australia.
The primary functions are obviously to accept deposits from individuals, and grant loans and advances for personal or corporate purposes. The secondary functions consists of collecting and supplying business information, providing reports on the credit worthiness of customers, standing guarantee on behalf of its
customers for making payments for the purchase of goods, vehicles, machinery, and so on. Besides that, they also provide customers with foreign exchange facilities; and they also provide safe deposits vaults or lockers for valuables, important documents and securities.
In a nutshell, for both countries, there are several similarities in the roles of commercial banks. Commercial banks promote capital formation whereby they accept deposits from individuals and businesses, whereby these deposits are then made available to the businesses which will make use of them for industrious purposes in the country (Ireland n.d.). Moreover, they also provide short and medium term loans for entrepreneurs to invest in new enterprises or businesses. Furthermore, they also promote trade and industry since they offer the use of bank draft, bill of exchange, check, credit cards and letters of credit.
In one way or another, they also influence the level of economic activity by influencing the rate of interest and the availability of credit in the market. Most importantly, they implement the monetary policy proposed by FED or RBA to bring about price stability, full employment and promote economic growth within the country. There are several sources of funds for these commercial banks.
The main source would of course be from the current account deposits. However, they do have other sources as well such as demand deposits, term deposits, negotiable certificates of deposits, bills acceptance liabilities, foreign currency liabilities, loan capital and shareholders’ equity. 2.3 Non-bank Financial Institutions
2.3.1 Depository Financial Institution
Depository institutions (DPI) act as a financial intermediary similar to a commercial bank, whereby its main task is to accept deposits from surplus units and then issue loans to the deficit units in the financial system (Viney 2009). The main regulator for Australia is Australia Prudential Regulation Authority (APRA) whereas for U.S. is the Federal Deposit Insurance Corporation (FDIC).
As for U.S., there are about 9, 000 functional depository financial institutions in the U.S. They operate through 92, 000 branch offices located in different states (Finance Maps of World 2011). Their role is to set a benchmark for DPI in the ground of commercial banking. The funds that are collected is used to meet the credit need of others (Finance Maps of World 2011). On the other hand, Australia’s DPI consists of three main institutions which are banks, building societies and credit unions (Reserve Bank of Australia 2001). There are a total of 171 institutions of which 55 are banks, 11 are building societies and 105 are credit unions (Reserve Bank of Australia 2001).
2.3.2 Investment banks and Merchant banks
Investment banks and merchant banks primary objective is to collect funds and invest them in the market to achieve specific goals set for different types of investments (Viney 2009). There are generally two types of investment companies which are open-end or closed-end mutual funds. Open-end funds will accept new investment and trade in old ones, whereas for closed-end funds they only accept funds once and then do not take in any additional new funds. Investment companies have recently become more popular among U.S. and Australia, and have managed trillions of dollars.
As for U.S. investment banks specialize in facilitating financial transactions rather than just providing finance. They have a good reputation as a financial innovator since their responsibilities includes the improvement of new financial products and services which must meet the ever changing needs of clients (Kumar, Chuppe & Perttunen 1997).
In contrast, investment banks and merchant banks in Australia are not considered an authorized bank but often referred to as money market corporations (Viney 2009). They do not have a depositor base to include in their assets. Therefore, they raise funds through the issues of securities from the international money and capital markets (Viney 2009).
2.3.3 Contractual savings institutions
Contractual saving institutions offer contract that specify, in return for periodic payments to the institutions, and the institutions will make payments to the contract holders if any specified event occurs (Viney 2009). They include general insurance companies and superannuation funds. As for U.S., their insurance companies raise money mainly from the issuance of insurance policies and collecting annual premiums. Some might also borrow from the dept capital markets as an alternative source of funds.
superannuation funds, or more popularly known as pension funds in the U.S., they are funded by the deductions from employees’ monthly salary in addition with certain contribution by the employers (Cohen & Schubert 2010). On the contrary, Australia have make it compulsory for their employees to contribute to the superannuation system (Cohen & Schubert 2010) whereby for U.S., an estimated 78 million working Americans which include the sole traders, employees who work for small employers or even part timers, do not have access to a retirement fund (Cohen & Schubert 2010).
For U.S., it has firstly introduced as a beneficial payment of employment whereas for Australia, it was created as a comprehensive system from the start (McLennan 2000).
2.3.4 Finance companies
Finance companies and general financiers are basically institutions who provide loans and charter finance to clients by borrowing funds directly from the financial market (Viney 2009). As for U.S., these institutions raise funds in the debt market by issuing securities. Therefore, they raise funds solely by issuing debt or borrowing from other institutions but not taking deposits directly (Samolyk 2004). Similarly for Australia, they raise funds by issuing commercial paper, bonds and medium-term notes (Reserve Bank of Australia 2001).
2.3.5 Unit trusts
Unit trusts is formed under a trust deed, and is controlled and managed by trustee by selling units to the public as a means to raise funds whereby investors purchase units in the trust (Viney 2009). As for U.S., there are generally two types of unit trusts, one that falls under private management and another that falls under direct state authority.
Their role mainly involves traditional banking activities that are related to issuance of loans and deposits. The major difference between private and state authority trust is state authority institutions obtain funds from deposits and through the sale of shares, whereas private institutions operate as an intermediaries by generating finance through providing investment opportunities to clients (Samolyk 2004).
Likewise, Australia too has two different types which are public unit trusts and cash management trusts (Viney 2009). Public unit trusts focus more on gathering investors’ funds and investing it into specific types of assets (Viney 2009). However, for cash management trusts, they focus more on trust deed which are open to the public by confining their investment to financial securities which are accessible through the short-term money market (Viney 2009). 3.0 The impact of GFC
3.1 United States
The birth of the global financial crisis begin somewhere in 2008. It all started in early 2006 when the subprime mortgage market in the United States (U.S.) began to reveal an increasing rate of mortgage defaults due to the bursting of the housing bubble (Mishkin 2011). Subsequently, in late 2006, these defaults caused a decline in the U.S. housing prices after about a decade of extremely high growth statistics. Later on, the prime mortgage markets were affected as well and were showing a higher default rates by the end of 2007.
Therefore, when the mortgages backing the securities began to fall in value, the value of the securities fell as well (Nielsen 2010). Looking at the fall in price of their assets, investors quickly attempt to liquidate their assets in around late 2007. Consequently, in 2008, a major financial crisis hit U.S. which led to the most severe recession since World War II. The financial crisis in the U.S. economy eventually spread to many foreign nations, affecting the global financial system, resulting in a global financial crisis (Shah 2010).
The degree of the global financial crisis was so severe that some of the world’s largest financial institutions have collapsed. U.S. was no exception. History was made when one of the largest investment banks in the world, Lehman Brothers, collapsed in September 2008. Some other institutions have been vehemently bought out by their competitors at a low price, and in some cases, the governments of the richest countries in the world had no choice but to sought an expensive bail out and rescue plan to save some of the remaining large banks and financial institutions (Shah 2010).
These were all done at the expense of the US taxpayers. Approximately $9.7 trillion of US taxpayers’ money alone have been spent for bailout packages and plans (Dhameja 2010). According to Bloomberg, $14.5 trillion, or about 33%, of the value of the world’s companies have been wiped out by the crisis. Therefore, as credit became scarce and seeing an increase in the lack of confidence in the U.S. financial institutions, international banks started to increase the interest rate for inter-bank borrowing, known as the LIBOR (Mishkin 2011).
Subsequently, a crash in the US stock market was observed, liquidity drying up, and employees were being laid off which cause an increase in the unemployment line (Dhameja 2010). U.S. was in a state of limbo even after eleven months since the fall of Lehman Brothers. Banks virtually stopped lending to each other. Although several proposals for stimulus packages and some bailout plans have provided some relief, it seems that there was nothing more that could be done to ease the situation (Mishkin 2011). At the same time, smaller businesses hardly had any chances for a bail out or rescue plan and more people went into bankruptcy.
Additionally, there was a decline in the US imports from its major trading partners such as the European Union, Mexico and China, due to the slowdown in economic activity (Nanto 2009). Private sectors practically stopped borrowing, trade credit was also hard to obtain, and with continuous falling demand, especially investment goods and manufacturing durables like cars, export volume decreases, foreign GDP fell as well, trade volumes eventually collapsed (Dhameja 2010).
Moreover, the risk premium on inter-bank borrowing which used to be close to zero, rose steeply to five per cent. Besides, the risk premium on corporate bonds rose to over six per cent. Although the US government tried to inject liquidity into the financial markets, the damage was already done (Chambers 2010). 3.2 Australia
GFC has less effect on Australia as compared to other countries such as US, UK and etc. Most developed countries had suffered recessions where Australia experienced a down turn in the economy (Stevens 2009). However, there is no government’s support required by the financial institutions in such situations like capital injections or the acquisition of distressed loan portfolios (Australia Bureau of Statistics 2010).
The major impact of the GFC has resulted on the loss of confidence in the household sector (Stevens 2009). This is due of the decline in the equity price causes a reduced of the household wealth (The Parliament of the Commonwealth of Australia 2009). Thus, this leads to an effect of low consumption and investment which resulted to a decline growth of household as they felt insecure about the capacity to spend and borrow (Australian Government n.d.).
GFC has also impacted on the unemployment rate which result shown an increase of number that lead to a decrease in the economic growth (Australian Workers’ Union 2009). The part-time employment has increased which balance to a loss of full time jobs where this also effect on the working hours such as the decrease hours in work (Chesters n.d.). Certain demographic groups have been affected by the job loss. For instance, the generation Y (18-24 years) has been affected (Tanton et al. 2010). However, they remain optimistic and relied heavily on the government benefit (Tanton et al. 2010).
Moreover, competition in the banking system has also been affected by the GFC (Australian Super Investment Conference 2010) which resulted on harm towards the smaller banks and non-bank intermediaries as compared to the large banks where it leads to an increase in the cost of funds (The Senate 2011).
Thus, this has impact on a greater gap between the major banks and other financial institutions (Australian Super Investment Conference 2010). The collapse of the Lehman Brothers, has led to a loss of confidence towards the banks which caused a decrease on the demand for credit (Australian Super Investment Conference 2010).
4.0 The response of GFC
4.1 United States
GFC had seriously impacted the United States (U.S.) as compared to other countries such as Australia where it leads to the collapse of one of the major investment banks, Lehman Brothers. Thus, plans had been made by the U.S. government in response to the impact to prevent the situations to
In comparison to Australia, the financial institutions do not need government intervention to assist them such as injection of capital. Unlike U.S., the government intervene where the central banks has purchased the government debt and the troubled asset which cost US$2.5 trillion in order to raise funds in the financial institutions (Halmarick 2009).
This has resulted in the largest liquidity injection done by the government. They tried to inject liquidity into banks by buying share of banks, and purchase of convertible bonds of banks, whereby the government will be paid certain amount interest and the government will be given an option to convert these bonds into equity (Nanto 2009).
Furthermore, FED tried to reduce the interest rates by cutting the Fed Funds target from 5.0% in September 2007 to an extremely low 0-0.25% as at December 2008. Later on, in March 2009, Fed started a “Quantitative Easing” policy by agreeing to buy a $300 billion in Treasury bonds (Halmarick 2009). The main purpose is to lower the interest rates across the yield curve and to provide additional funds to the banks.
Moreover, US tried to overcome slowdown by stimulus packages of about $10 trillion for banks and guarantees to depositors, and also enhanced public spending (Dhameja 2010). According to Bloomberg, by February 2009, the total US bailout amounted to $9.7 trillion, sufficient to pay off more than 90 per cent of America’s home mortgage and was about 70 per cent of US GDP (Halmarick 2009).
In addition, President Obama signed two packages which are the American Recovery and Reinvestment Act worth $787 billion and 5.5% of GDP. The main features include an estimated $285 billion in tax reduction for individuals and businesses, unemployment benefits, extra spending for food stamps, and also health care subsidies for workers that have been laid off (Halmarick 2009). These packages positively aim to generate at least three to four million job opportunities by the end of 2010.
Additionally, US tried their best to prevent more banks from failing. The first case was Fed approves financing loans arrangement for J.P. Morgan Chase to buy over Bear Sterns in March 2008. The second case was government controlled mortgage giant Freddie Mac received $146 million to ease their situation. Next, AIG borrowed $85 billion from Fed to prevent them from failing (Halmarick 2009). However, Fed couldn’t do much to save Lehman Brothers from failing and thus they went into bankruptcy in 2008.
Therefore, US government aim to strengthen the global financial institution mainly to prevent losses of capital flows due to the impact of GFC to the developing and emerging economy by agreed on the increase of funds (Australian Government n.d.). Besides, government also actively plans to purchase equity from the financial institutions to ensure there is a sufficient liquidity which enable them to conduct activities such as investment, issue loan and deposit and much more.
GFC has caused a fall of confidence in the financial institutions. Thus, government had decided to guarantee all senior unsecured debt and also the non-interest bearing transaction deposit account mainly to increase the confidence losses in the financial institutions (Australian Government n.d.). 4.2 Australia
Australia had prepared by implementing an effective monetary and fiscal policy in response to the economy when one of the biggest investment bank in United States (US), Lehman Brothers collapsed in September 2008. This helps to avoid the economy from slowing down and lessen the impact of Global Financial Crisis (GFC) in Australia as compared to other countries such as US, where government responded on the measurement.
In order to strengthen the operation of the financial system, government has increase up to $25 billion of the issue of Commonwealth Government Securities(Britton 2008), more choices of assets provided for Australian Office of Financial Management (AOFM) to invest in, together with a better lending facility of AOFM (Australian Government n.d.).
In response to the recommendations of Financial Stability Forum, legislation has been introduced to establish Financial Claims Scheme (Britton 2008) where the availability of funds is given to the depositors and general insurance policyholders when the financial institutions failed to perform (Australian Government n.d.). Besides, the bank deposits and wholesale funding is guaranteed by the government for a period of 3 years (D’Aloisio 2010).
Additionally, the $10.4 billion Economic Security Strategy has been carry on as this helps to strengthen and stabilize the economy (Australian Government n.d.). This aim to provide protection to households and other financial institutions to gain back confidence lost due to GFC (Australia Bureau of Statistics 2010). Besides, First Home Owners Boost has been introduced mainly to assist the housing sector to stimulate activity which benefits the economy (Australian Government n.d.).
The competition in the market of housing finance has been supported by the government through the purchase of the Residential Mortgage Backed Securities (RMBS) (Australian Government n.d.). However, a total of $840 million has been taken out by RBA from RBMS under a repurchase agreement mainly to ensure there is sufficient liquidity in the market (Britton 2008).
The naked and covered of the short sale securities has been ban for a period of 30 days by the Australian Securities and Investments Commission (ASIC) (Helmes et al. 2009). However, a clarification of the allowable covered shares has been issued by the ASIC in concern of the set requirement (Britton 2008). A draft legislation for the covered of short sales has been released by the government and it is open for the public to comment on till 21 October 2008 (Britton 2008).
Government initiated the plan of Nation Building and Jobs Plan which cost around $42 billion which was mainly to support the jobs in the country where it supported an estimated of 90,000 jobs (Sherry 2009). This help to decrease the unemployment rate and then boost the economic growth where it encourages more activities and also to increase consumption in the economy (Sherry 2009).
In conclusion, the global financial crisis (GFC) had brought so much damage not only to U.S. and Australia, but to the entire nations’ financial system globally. Even some of the wealthiest nations saw the collapsed of its financial institutions while some had to undertake an extremely expensive bail-out package. As for U.S. they suffered more severely compared to Australia. This is because the Reserve Bank of Australia has taken measures in advance of the global financial crisis. Thus, they were not as heavily affected as compared to other countries.
Therefore, U.S. should learn from Australia by implementing policies ahead of any unexpected crisis to minimize the impact and damage done to their financial system. Evidently, it is better for them to prevent and be prepared rather than solving an issue when the damage has already been done. The policies implemented should include healthy control of the discount rate, reserve requirement and also minimal inflation targeting such as two to three per cent.
The right policy implementation will lead to full employment in the country, a healthy level of economic activity and international trades, which will eventually increase the country’s GDP to an optimal and desirable level.
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University/College: University of Arkansas System
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