Banking & Research — IV

Financial markets are being constantly reshaped by many factors. In the recent past, factors such as introduction of the euro, growth in electronic trading, shifts in the assemblage and behavior of market players, technological innovations, etc. have tremendously altered the very functioning of the financial markets. Of course, it is the forex and derivatives markets that have been the first to get transformed by the convergence in digital and the telecommunication innovations.

With the advent of technological innovations, the transaction costs and the cost of obtaining information have drastically come down. Today, forex transactions can be executed instantly, settlement can be completed automatically and one can even hedge automatically from the futures market availing the services offered by certain platforms.  These developments have simply redefined the relationship between dealers and end-investors. Electronic trading has blurred the demarcation between the inter-dealer market and dealer-customer market.

The ongoing mergers and acquisitions and the resulting consolidation in the financial markets are yet another factor that has changed the constellation and the behavior of the market participants. This phenomenon has changed the market functioning in a variety of ways. Today, there are fewer market makers in the forex market, who can give a two-way quote in any currency pair at any time, than in the past. This has also led to the entry of new players such as Institutional Investors, Pension Funds, Insurance Companies, Mutual Funds and other Non-Bank Financial Companies who are playing a more prominent role in the financial markets today. The entry of new players has obviously changed the market participants’ perception about Risk Management practices, more so with the collapse of Long Term Capital Management. This has in turn reduced the number of market players who are willing to take a contrarian view. There is also a considerable shift in the supply of available instruments. In certain parts of the globe, there has been a continuous expansion in the supply of government debt owing to widespread fiscal deficit while in certain others issuance of bonds by corporates, financial institutions and other non-governmental borrowers has soared high.

These structural changes have obviously impacted the functioning of financial markets that is essentially meant for providing liquidity and information on prices. This change has also affected the asset pricing. In this context, yield curves in various segments of the debt market have assumed importance in predicting the future of macroeconomic fundamentals. These changes in market functioning are posing policy challenges to central banks and this theme is what is being articulated in the article: “Changes in Market Functioning and Central Bank Policy: An Overview of the Issues” by Marvin J Barth III, Eli M Remolona and Philip D Wooldridge.

In the changing market scenario, virtually every industrialized nation and academicians from the faculties of law and economics have seriously engaged in defining the kind of “governance” that should be in operation to manage the economic activities. Yet, very little attention is being paid towards corporate governance in banks though, ironically, banks arrogate to themselves the role of ensuring the right kind of “corporate governance” in the businesses to which they lend money. In the light of these realities, corporate governance in banks should address itself to two very different issues: Whether corporate governance in banks should exclusively focus on their shareholders’ requirements or should it extend to non-shareholder entities, too.  

This dilemma becomes more intriguing because the Anglo-American model of corporate governance usually focuses on maximization of the shareholders’ wealth while the Franco-German model looks at corporates as “industrial partnerships” and thus extends its focus beyond the immediate requirements of the shareholders. One school of thought, looking at corporates as “a complex web of contractual relationships among the various claimants to the cash flows of the enterprise” argues that the fiduciary duties of managers and directors of companies should not confine to maximization of the firm value for shareholders but extend to ensure safety and soundness of the enterprises as well. 

The need for such an extended coverage of governance becomes obvious if one looks at the structure of the bank’s balance sheets which reflect high leverage coupled with embedded mismatch between assets and liabilities and the very special role they play in maintaining the stability of the financial system. In the light of these imperatives, the authors, Jonathan R. Macey and Maureen O’ Hara, analyze the need for redefining corporate governance in terms of the banks’ needs and recommend extending of the fiduciary duties of the bank directors beyond the immediate requirements of shareholders in their article, “The Corporate Governance of Banks.”

Convergence in financial services has become the buzzword in the global financial markets. One such resulting phenomenon is “bancassurance” which means selling of insurance products manufactured by a bank’s own insurance company through its branch network. Conventional wisdom argues that coming together of banking and insurance enables the system to enjoy the benefit of “operational leverage” in terms of reduction in distribution costs and thereby maximization of the net margin. However, such coming together of banks and insurance particularly in EMEs is fraught with risks since it is certain to expand the risk horizon of banks that are known to shun risk while insurance companies treat ‘risk’ as their raw material.  Their coming together is, therefore, prone to result in concentration of risk which is potential enough to lead to contagion risk. Against this backdrop the article: “Bancassurance in EMEs: Assessing its Impact on the Financial System with Specific Reference to India” traces the current risk profile of banks in India and analyzes the likely consequences that can arise underwriting ‘risk’ from banks. It also stresses the need for coordinated regulatory efforts from all concerned to monitor and manage the risks effectively.

The quantity theory of money (QTM) and the purchasing power parity (PPP) are considered the two pillars of the monetary analysis. The PPP states that exchange rates move in the same proportion to prices in the long run, while the QTM expounds that prices move in the same proportion to money in the long run. However, these propositions were not tested earlier jointly. Secondly, it is also not quite clear if high and low inflation countries experience different transmission processes of money to prices and to exchange rates. Paul De Grauwe and Marianna Grimaldi have since analyzed the proportionality hypothesis between money, prices and exchange rates implied by these two theories by using a pure cross-country dataset covering more than 100 countries over a 30-year period instead of the usual time series data. The study reveals that the proportionality between money and the exchange rate is strong in high inflation countries and weak in low inflation countries and the PPP works better than the QTM in low inflation countries. On the contrary, the influence of the real GDP growth on inflation and the exchange rates is not distinctly decipherable in low inflation countries. The authors discuss these results at length in their article: “Exchange Rates, Prices and Money: A Long-run Perspective”. The authors are very innovative in using cross-country evidence to check monetary neutrality in terms of QTM and PPP and in the process opened a new line of research for further exploration.

(IJBM- Vol II No 3)