Introduction
Non-bank firms acquire and use real assets in a way that makes the value of future benefits received greater than the cost of obtaining them. Banks, on the other hand, acquire and use assets so that the value of their benefits exceeds their costs. A majority of banks hold financial assets while non-bank firms hold real assets. Banks use deposits of their customers (creditors) and owners to acquire financial claims against others.
They may extend loans or may invest in other financial instruments. The returns the banks expect to receive will thus depend on the performance of these investments. Non-bank firms will use funds provided by the owners and borrow loans from financial firms or get credits to purchase real assets.
The returns they receive are from selling the assets at a higher price or use them (assets) to produce other products which they sell at a margin.
Financial intermediaries, by their existence, contribute greatly to economic performance through bringing both borrowers and investors together. Financial intermediaries reduce transaction costs through brokerage and create their own financial instruments. Financial intermediaries also help in reducing agency costs, which come up because of information asymmetry between the market and investors.
Why Is It Important to Have Stricter Regulations on Banks?
There has been a lot of debate on whether strict regulation on banks are necessary. The reasons below show that it is necessary to have strict regulations on banks and other financial institutions:
- The main reason why banks need regulation is to ensure that there is financial stability in the economy. This is to ensure that prices of financial instruments are relatively stable and adequate for an economic growth.
- Regulation of banks and financial institutions is critical to prevent market failure (financial collapse) caused by externalities from the financial system.
- Regulation is necessary to ensure enhancement of consumer welfare including protection from fraud and monetary (macro-economic) policy considerations.
- Regulation is necessary to ensure that banks and other financial institutions are solvent enough by stipulating capital levels required.
- Lastly, regulation is critical to ensure that these institutions are liquid at all times to be able to meet their financial obligations and when they fall due.
Maturity Matching
The term maturity refers to the date or to how long it would take for any financial instrument, such as a loan, to be repayable. It also refers to when the interest would be due. Though there is no clear definition, finance scholars have described the circumstances that show maturity matching.
In Working Capital Management, maturity matching is a financial plan, whereby one matches the expected life of an asset with the life of the source of funds. Others have tried to define it in Asset Management as the situation where an organization controls its cash inflows and cash outflows. An organization does this by matching the expected life of its income-generating assets with the expected life of its interest-bearing liabilities.
In maturity matching, when used, a firm would finance its fixed assets and permanent current assets with long-term sources of funds, while current assets would be financed using short-term sources of funds. When a firm matches the variations of its assets and liabilities of the maturity, it hedges itself against any unexpected changes in interest rates.
Maturity Matching Instead of Borrowing From Financial Markets
If financial institutions used maturity matching rather than borrowing from financial markets, this action would have an enormous effect in the overall economic growth. This is because when firms match the variations in assets and liabilities, it hedge against the uncertainty in changes the short-term interest rates bring.
It is easier for a financial firm to manage its risks caused by changes in interest rates than borrow money from the financial markets. This improves financial markets’ liquidity, which leads to stability in the financial system. Additionally, it helps the firms to maintain high credit ratings since they will rely less on borrowed funds. Therefore, there is less exposure to credit risk.
Maturity matching would help the financial institutions to reduce their liquidity risk and improve their profitability. This is because they pay less interest compared with borrowing from financial markets. Consequently, it increases growth in the economy as a whole.
Therefore, in conclusion, the usage of maturity matching is more advantageous than borrowing from financial markets. This is because it will lead to increased profitability of the firms and reduction of liquidity risk. At the end, it leads to stability in the financial sector and to increased economic growth.
What is Speculation/Hedging/Arbitrage?
Arbitrage
It is a trading strategy, whereby an investor would gain a profit from a transaction without injecting more capital or exposing himself/herself to more risk. For example, purchasing a financial instrument from one market and selling the same instrument in another market with different prices. In this case, the investor takes advantage of the market inefficiencies.
Another definition given by economics is that it is an opportunity to buy a financial asset from one market at a low price and sell it to another market at another higher price thus making profit.
Therefore, arbitrage is the simultaneous purchase and sale of a financial instrument at a low price and selling it at a higher price to make a profit without commitment of more capital by the investor. The investor makes profits by taking advantage of the differences in prices caused by market inefficiencies in the two markets. This ensures that prices do not deviate from the fair value significantly.
Speculation
Investors invest in risky assets with an aim of making profit when the prices change through the process. It is not a form of betting because investors make decisions after evaluating the financial asset’s performance before purchasing the asset. It is not a traditional investment since the risk acquired is greater than the average one.
Another definition of speculation is the commitment to any transaction containing significant risk but with higher chances of huge profits, especially in financial instruments. Speculation is also the considerate assumption of a risk, which is higher than the average short-term risk with an expectation of receiving huge profits from anticipated changes in prices.
Hedging
Hedge is an investment situation position taken by an investor to counterweigh potential losses, which is likely to cause another investment. A number of financial instruments such as swaps, options, futures contracts, forward contracts, insurance, and stocks can construct it.
It is the process of decreasing risks using derivatives. It is also the process of dealing with the risk of price changes in assets by offsetting such risks in the financial markets using financial instruments. It can vary in complexity depending on the number and the type financial instruments used.
Develops an Efficient Market
In an efficient market, the prices reflect all the relevant information about the underlying asset. Thus, no one can take advantage of the market and make above-normal profits. Arbitrage will help in creation or development of efficient market since all investors will act rationally. Hence, they will sell overpriced assets and buy the undervalued assets. Eventually, the market will correct itself and the asset prices will be correct.
Speculation will lead to efficient market through investing in risky assets and expecting their prices to rise. Thus, prices end up in moving towards their intrinsic value. Hedging helps investors to manage risks. Therefore, it allows investments without worrying about unexpected risks. Therefore, financial asset prices will move towards their intrinsic values.
Effect of Short Selling in European Markets
This refers to selling shares of a company with intention to part ownership. It was quite common in the United States before the fall of Lehman Brothers. This triggered a temporary ban on this trade in Hedge Funds.
The aim was to control the use of this derivatives trade to inject poor practice in the stock market. There is also an argument that the risk involved is almost zero. This makes the real owners of the stock to suffer in case of a financial meltdown.
However, it is important to note that this ban has a long-term bad effect on an economy. The shares of a company are adversely exposed. This is because the wholesale trading which swings investors’ confidence. Managements of the various listed companies may sometimes make poor decisions. This may lead to possibility of failure in business models. Short selling mitigates the risk associated with this failure.
Risk Assets
This is because the number of investors available is big. This is unlike a situation where there are limited investors who can easily make radical decisions. This includes selling their shareholding, which may cripple a company.
Investors invest in risky assets with an aim of making profit when the prices change through the process. It is not a form of betting because investors make decisions after evaluating the financial asset’s performance before purchasing the asset.
Speculation
It is not a traditional investment since the risk acquired is greater than average. Another definition of speculation is the commitment to any transaction containing significant risk but with higher chances of huge profits, especially in financial instruments.
Speculation is also the considerate assumption of a risk, which is higher than average short-term risk with an expectation of receiving huge profits from anticipated changes in prices.
Outcome
In this light, it is not a good idea that European Countries ban short selling. This is especially true if it is a long-term ban. The long-term effects outweigh the short-term benefits by far. This is because nobody will have confidence in investing in a company where the threshold for investing is excessively high.
However, if the ban is short-term, like in the United States case, it is possible that the ban will meet the target intended. This is because it will reduce the number of people who want to invest without actually taking a risk.