The report seeks to analysis the policy change by the government of proposing new prudential regulations, which require banks and insurance companies to place 40% of all deposit funds in Government Treasury bonds or Reserve Bank deposits. The intention of this report is three-fold. First, the report offers a brief explanation of the policy change then it proceeds to examine and evaluate the significance and importance of a new policy change between the banking roundabout and the economy.
Secondly, the report also examines how to make a new policy change that can be effective and efficient to produce the desired governmental results and make the economy an environment where the private and public sector have massive investments and most importantly, a place where policy changes are adhered to the letter. Lastly, the report will provide an analysis of the findings, and as a way of highlighting the importance of the report, the report will provide the necessary recommendation for the banking roundabout.
The recommendation includes; first, the expansion in reserve requirement automatically translates to an increase in product prices such as cost of taking a loan due to minimal monetary base. In order to counter the increase, management should dispose their assets portfolio in order to increase their lending portfolio; the second measure is that banks and insurance companies should invest a considerable amount in information capital. This will help eliminate the problem of information asymmetry. Moreover, the government should put in place measures and reforms that will ensure an increase in return on investment, as well as reduce uncertainty.
The report seeks to analysis the policy change by the government of proposing new prudential regulations, which require banks and insurance companies to place 40% of all deposit funds in Government Treasury bonds or Reserve Bank deposits. The intention of this report is three-fold. First, the report offers a brief explanation of the policy change then it proceeds to examine and evaluate the significance and importance of a new policy change among the banking roundabout and the economy and most importantly, the procedure and factors to be considered by the office of the Prime Minister during the policy change process. Secondly, the report also examines how to make a new policy change that can be effective and efficient to produce the desired governmental results and make the economy an environment where there are massive investments by both the public and private sector and most importantly, a place where policy changes are adhered to the letter. Lastly, the report will provide an analysis of the findings, and as a way of highlighting the importance of the report, the report will provide the necessary recommendation for the banking roundabout (Gup, 2011).
Prudent regulation as a policy is gaining momentum in different economies of the world. The policy instrument is essential when an economy wants to protect its engine room of the economy. In practice, the central bank of a country sets out the required percentage of money that banks and insurance companies should deposit as reserve money or in the purchase of securities. The presence of externalities as well as asymmetric information has necessitated the use of prudent regulation. Normally, positive externalities arise from a bank failure leading to erosion of bank deposits, whereas negative externalities comprise of bank runs on condition that contagion leads to impairment of solvent banks and it adversely affect the economy. As a rule, bank loans attract many risks whenever there is asymmetric information. In that connection, depositors during adverse economic times will question the value of a loan provided by the bank.
During times of recession, deposits ought to be withdrawn from both insolvent and solvent banks leading to a banking panic. To avert depositors from such risky exposures regulatory, safety net, such as depositor protection and deposit insurance are made likely. The nature of financial sector according to the Prime minister is intrinsically unstable due to destabilizing financial crises and cycles. In addition, if the market forces are left to operate in the financial sector it will aggravate recession. The Prime minister is proposing comprehensive regulations that will help financial institutions curb excessive risk exposure and risk taking.
Importance of prudent regulations to the economy and banking roundabout
Traditionally, public intervention in different sectors of the economy focuses on ensuring fair distribution of national resources and correcting imperfections in the market. Ideally and according to the Prime Minister, the move is meant to ensure stability, equitable allocation of resources and use of resources effectively, as well. Stemming from this viewpoint, financial sector regulation is essential since allocation and capital accumulation of financial resources is a recipe for a country’s economic development. The regulation will ensure that the banking industry function effectively. The prudent regulation entails control over operation, creation as well as the liquidation of banks. Apart from the prudent regulation ensuring the effective functioning of the banking sector, it aims at safeguarding the interests of depositors.
The focus of such prudent regulation of ensuring that, banks and insurance companies maintain a 40% deposit with the central banks will not only guarantee stability of the financial sector, but it will augment business performance of each bank. In addition, it will aid in the identification and monitoring of problems in the financial sector, taking all the possible measures, like liquidation, to limit and curb the adverse effects resulting from such problems. The role of financial sector in development of different economies is increasing significantly this ensures that they play a crucial role as an equal player in the global market. The operations of banking institutions should be in such a way that it does not jeopardize depositor’s interests. The reliability of the banking sector will strengthen both domestic and international trade, hence economic growth and development.
The policy change concerning prudent regulation acts as a response to changes in the economy market. Therefore, it is essential for government intervention in regulating the financial sector as a way of ensuring that they adjust simultaneously with the changes taking precedence in the economic environment. The banking sector legal authorities should be flexible to give the national authority an opportunity to carry out the changes in policy. Prudent regulation will create a business environment, which is healthy, hence reducing risks associated with the financial sector. The individuals that, normally, suffer due to a bank failure are the depositors hence their interests should take precedence in the list of political issues (Taylor & Schooner, 2009).
In practice, financial institutions maintain excess reserves for two main reasons that include minimal lending opportunities coupled with their unrelenting desire to have enormous amounts of precautionary balances. This nature of behavior increases the unsafe conditions of the banks being involved in risky undertakings. The move to increase the reserve requirements for financial institutions and insurance companies will safeguard the extent which banks expose themselves to risks.
Impact of Prime Minister prudent regulation on the banking roundabout
Economist perceive reserve requirement as a tax on the banking institutions, especially those who issue reservable instruments. When financial institutions have to maintain reserves in Federal Reserve, they tend to forego the opportunity cost in relation to the funds. This is because the money is not accessible for reinvestment and loan, as a result, the institution gain no return from the funds. Moreover, there is extensive agreement of reserve requirements serving as a tax, but there is no consensus on who is in charge for the recompense of the tax. The tax burden can be borne by customers, depositors and borrowers. In relation to the former, borrowers will have to pay high interest rates on their loans.
Reserve requirements were traditionally regarded as a source of liquidity for the day-to-day operations of the financial institutions; however, an increase in reserve requirements will ultimately hike the chances of depository institutions failure. This is because there is an inverse relationship between high reserve requirements and banks profitability. The reduction in profitability is twofold; first, the banking institutions and insurance companies need to maintain a higher proportion of nonearning assets. Secondly, the increase in reserve requirements will lower the banks true liquidity, and by extension, mounting the overall cost of short-term finances. In addition, banks will have a lesser amount of additions of equity capital leading to financial institutions maintaining a thin capitalization.
An increase in reserve requirements in relation to time and demand deposits will leave the financial institution with insufficient reserves. As a result, they will have less reserve to meet their customer needs. In addition, excess reserves will fuel a considerable expansion of credit and money in the future, as well as increase inflation rates. As a result, when there is tightening of monetary policy, recession is more likely to occur this is due to a reduction in money stock. As evident during the current financial and economic downturn of 2008, most financial institutions were in the verge of falling. The increase in reserve requirements as a monetary policy that can help curb the effects of the crisis on the economy resulted to an increase in reserve demand by banks; hence, it reduces the amount of credit and deposits that can result from the present monetary base (Gup, 2000).
Nonetheless, an increase in reserve requirement ratios by the national authority for both banks and insurance companies will reduce the deposits reserve ratios. As a result, it will increase the cost of credit in terms of lending rates, and by extension, the banks will lack on the multiplier effect. Their money creation aspect will experience a slow down. Borrowers will not be willing to take up loans for investment activities, as such, the operations of the financial institutions will be limited and services or products will be less attractive. Through the multiplier effect, banks normally create money since any money lent will create additional deposits in the financial system.
An increase in reserve requirement will affect depository institutions in distinct ways in relation to the difference in institution’s deposit base. The main effect is normally witnessed in the pricing of the financial institutions products and services. For this case, an increase in reserve requirements will see an increase in price schedules for products that the financial institutions provide. In practice, bank charges and credits determination rally with the reserve requirements set by the relevant authorities.
An increase in reserve requirements will limit the banks in terms of bank runs; this is because, in times of harsh economic and financial times, federal banks are less reliable as the lenders of last resort. This is evident because the Fed banks also experience difficulties in harsh economic period. Based on this, when financial institutions maintain high deposits with the Fed bank may experience shortages in deposits that are available to their customers.
An increase in reserve requirement can lead to a failure of the bank economically, this result due to a decline in assets, and conversely an increase in liabilities. As a result, the net worth of the bank is negative. This creates a scenario where the bank cannot fully satisfy the demands of its depositors promptly and in full. Failure of a bank is essential and as such, failure of one may spill over to the different banks in the sector, hence affecting the financial organization. In addition, the shareholders of these institutions will experience a loss in their money invested in the sector affecting private investment and the entire economy at large.
The market rates between different sector in the economy, as well as inflation, will experience a hike. This means that the borrowers and depositors, as well as the banks loss value of their money. The financial institutions and insurance banks dealing in the foreign exchange will find it hard to expand their operations across borders. This is because the cost of business will be extremely high and their operations assuming an unstable condition. Therefore, the future growth prospect of financial institution is adversely affected. The risks that excess reserves expose the banks into are less insignificant compared to the multiplier effects that arise due to immense deposits. The survival of the financial institution and insurance companies rests in their ability to create money. The more money they have for lending, the higher the ability to increase its money creation. In essence, the change of policy to have the reserve requirement increasing to a proportion where deposits is almost equal to reserves, will not only affect the growth of the financial and insurance institutions, but it will, in general, affect the entire working of the economy. This will create banking panic; scaring potential investors away because of unguaranteed rate of return on investment and strict monetary policy, as well (Boot & Thakor, 2008).
Finally, depositors will demand high interest rate compensation from these institutions due to the increased risk. The risk is in relation to the institutions inability to refund the whole deposit in full upon institution failure. This will limit the margin between lending rates and interest rates, hence negatively affecting the profitability of the institution. The business will be less viable, and unattractive, hence limiting competition, which is a key component to the efficiency and effectiveness of a sector, and the economy at large.
The change in financial and insurance institutions reserve requirement calls for the management of these institutions to put in place measures that will arise due to the policy change. The measures should incorporate the interests of the borrowers, depositors, customers, and stakeholders. From this report, the following recommendations are some of the measures that these institutions will consider. First, the expansion in reserve requirement automatically translates to an increase in product prices such as cost of taking a loan due to minimal monetary base. To counter the increase, management should dispose their assets portfolio in order to increase their lending portfolio. This will ensure management of the short-term liquidity. This will counter the uncertainties and risks such as bank failures.
The second measure is that banks and insurance companies should invest a considerable amount in information capital. This will help eliminate the problem of information asymmetry. In addition, there will be a cutback in the fraction of loans that are non-performing, hence lower credit risk. The financial and insurance institutions may respond to the change in reserve requirement by ensuring an increase in their lending rates, so as to offset the high compensation demanded by depositors. Moreover, the government should put in place measures and reforms that will ensure an increase in return on investment, as well as reduce uncertainty. The government does so by encouraging economic growth and ensuring macro stability. However, the government should alter this monetary policy used since financial institutions can increase their deposit reserves despite the policy change. Other measures such as open market operations can be utilized because they have minimal spillover effects in the financial system. Finally, the government should adopt a functional approach to limit the impact of the policy change in the function of the economy at large.