ECS3701 ASSIGNMENT 2 SEMESTER 1 & 2 2021

QUESTION 1 Discuss how collateral and indirect finance are used in explaining the basic facts aboutfinancial structure around the world. Collateral is a prevalent feature of debt contracts for both households and businesses. Collateral is property that is pledged to a lender to guarantee payment in the event that the borrower is unable to make debt payments. Collateralized debt (also known as secured debt to contrast it with unsecured debt, such as credit card debt, which is not collateralized) is the predominant form of household debt and is widely used in business borrowing as well. The majority of household debt in South Africa consists of collateralized loans: Your automobile is collateral for your auto loan, and your house is collateral for your mortgage. Commercial and farm mortgages, for which property is pledged as collateral, make up one-quarter of borrowing by nonfinancial businesses; corporate bonds and other bank loans also often involve pledges of collateral. Indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets. Direct finance involves the sale to households of marketable securities, such as stocks and bonds. The 43% share of stocks and bonds as a source of external financing for American businesses actually greatly overstates the importance of direct finance in our financial system. Since 1970, less than 5% of newly issued corporate bonds and commercial paper and less than one-third of stocks have been sold directly to American households. The rest of these securities have been bought primarily by financial intermediaries, such as insurance companies, pension funds, and mutual funds. These figures indicate that direct finance is used in less than 10% of the external funding of American business. Because in most countries marketable securities are an even less important source of finance than in the United States, direct finance is also far less important than indirect finance in the rest of the world Downloaded by: lilliem637 | Distribution of this document is illegal This study source was downloaded by from CourseH on :25:08 GMT -05:00 This study resource was shared via CourseH S - The Marketplace to Buy and Sell your Study Material QUESTION 2 Differentiate between the main factors in the initiation of financial crises between the advanced and emerging market economies. Financial crises in advanced economies can begin in several ways: mismanagement of financial liberalization/ innovation, asset-price booms and busts, or a general increase in uncertainty caused by failures of major financial institutions. Mismanagement of Financial Innovation/Liberalization The elimination of restrictions on financial markets and institutions, or when new innovations are introduced. Often there is a lack of understanding of the changing situations which leads ultimately to banks taking greater risks and then having to face the consequences of bad debts arising from these risks. When this occurs banks are forced to restrict lending (deleveraging) and this puts pressure on the economy, leading to a severe decrease in economic activity. Lending boom becomes a lending crash Asset price booms and busts Irrational expectations” tend to drive asset prices above the real value of these assets. Assetprice bubbles (tech stock market 1990s, house prices 2007) are often driven by credit booms, where the large increase in credit is used to fund purchases of assets, thereby driving up their price. When “reality” eventually prevails, the assets are largely devalued and the consequences for an economy can be devastating. Increase in uncertainty During periods of uncertainty (after a recession, stock market crash or failure of major financial institution) accurate information is harder to obtain and consequently the problems of adverse selection and moral hazard increase, financial frictions increase, lending declines and economic activity decreases. Crises in emerging market countries develop along two basic paths: either the mismanagement of financial liberalization and globalization, or severe fiscal imbalances. Mismanagement of financial liberalization/globalization. The opening up of economies to flows of capital and financial firms from other nations is called globalization. Problems arise when institutional weakness (fiscal imbalances, ineffective screening and monitoring of borrowers and lax government supervision of banks) prevents a country from successfully handling the liberalization or globalization process. Only when prudent regulation and supervision are strong, the lending boom and bust that often follows the opening up the emerging market economies will not occur. Severe fiscal imbalances. Governments that run up high deficits often persuade or even force the banks to purchase government debt (bonds). When investors lose confidence in the ability of the government to repay the bonds, the price of the bonds plummets and this means that banks that are holding such bonds have a serious decrease in the value of their assets. With less capital, lending will decline and a worsening of adverse selection and moral hazard problems will occur. Some additional factors: rise in interest rates from events abroad which are most likely to be agreed to by riskier firms. The loans that are made therefore become high risk. Downloaded by: lilliem637 | Distribution of this document is illegal This study source was downloaded by from CourseH on :25:08 GMT -05:00 This study resource was shared via CourseH S - The Marketplace to Buy and Sell your Study Material QUESTION 3 “The independence of the Reserve Bank means that it is unlikely to focus on the long term objectives but seeking short-run solutions.” Is this statement true, false, or [10] uncertain? Explain you answer. FALSE. The South African Reserve Bank, in pursuit of its primary object, must perform its functions independently and without fear, favour or prejudice, but there must be regular consultation between the Bank and the Cabinet minister responsible for national financial matters. The independence of the Reserve Bank means that it is able to focus on the long term objectives because politicians tend to be motivated by self-interest (i.e. election) they are inclined to be short-sighted in regard to objectives. They are inclined to focus on finding short-term, popular solutions which may not have good longterm outcomes. It is believed that a politically insulated (independent) central bank is more likely to be concerned with long-term objectives, such as a sound currency and stable price level. The political business cycle is also a reason for keeping the SARB independent. Expansionary policies are generally followed immediately prior to elections, and the bad consequences are only felt afterwards. A strong argument that supports independence is that the subjecting of SARB to political pressures would cause an inflationary bias to monetary policy. The control of monetary policy is too important to leave to politicians. This can be stated in terms of the principal-agent problem: both the SARB and the politicians are agents of the public (the principals) and both have incentives to act in their own self-interests. It is argued though that the principal –agent problem is worse for politicians than for the SARB. Recent research seems to support the idea that the central bank should be independent: when central banks are ranked from least independent to most independent, inflation performance is found to be the best for countries with the most independent central banks. In addition, countries with independent central banks are no more likely to have high unemployment or greater output fluctuations than those with less independent central banks.