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In this article we will discuss about the role of NBFIs in influencing monetary policy.
The Radcliffe Committee in Britain studied the growth of financial intermediaries since World War II and came to the conclusion that they adversely affected the power of Bank of England to control credit. Gurley and Shaw also came to the same conclusion.
According to Gurley and Shaw, NBFIs perform the intermediary role of purchasing primary securities such as government securities, mortgages, common and preferred stocks, consumer and other short-term debt. On the other hand, they issue and sell indirect securities such as time deposits, common funds stocks, saving and loan-shares, and insurance policies to the ultimate lenders.
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By buying primary securities from the ultimate borrowers and selling indirect securities to the ultimate lenders, the intermediaries influence the availability of credit and the structure and level of interest rates. They create credit different from commercial banks. But they create new assets and liabilities which tend to influence the supply of money and thus hinder the operation of an effective monetary policy.
According to them, the savings deposits of NBFIs resemble the demand deposits of commercial banks because it is not difficult for NBFIs to convert their savings deposits into cash. These savings deposits, whether of commercial banks or of NBFIs, are for all practical purposes as liquid as demand deposits.
Such savings deposits held by NBFIs are known as near-monies. Since the demand deposits are not controlled by the central bank, it follows that the savings deposits held by NBFIs will hinder the successful operation of a successful monetary policy.
If the central bank wishes to control excess liquidity in the economy only through the reduction in money supply, it will not be successful because the savings deposits of NBFIs can be converted into cash. Similarly, if the central bank tries to control lending by commercial banks, it will not be successful if the lending of all other NBFIs are not under its control, as is the case.
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According to Gurley and Shaw, this problem arises especially when the central bank adopts an anti-inflationary monetary policy. Suppose the central bank reduces the money supply in order to control inflation. Among other effects, the interest rates on market securities rise. In anticipation of higher yields and profits, NBFIs will raise the interest rates on their savings deposits to attract more funds in order to invest them in higher yielding securities.
Persons already holding securities find that their prices have fallen because of the rise in interest rates on present securities. They will, therefore, sell them and deposit their funds with intermediaries in order to earn higher interest rates on savings deposits. In the meantime, attracted by higher interest H rate, others holding idle cash balances will also deposit them c with intermediaries. So when NBFIs raise the interest rates on their savings deposits, the public reduces its demand for money 3 which, in turn, reduces the market rate of interest.
Thus NBFIs make tight monetary policy less successful or effective. This is explained in Fig. 1 where the demand and supply of money are taken on the horizontal axis and the rate of interest on the vertical axis. MS is the money supply curve and MD the money demand curve. Both intersect at E where r, rate of interest is determined. Suppose there is an inflationary situation and the central bank reduces the money supply by a certain amount to control it.
The reduction in money supply is shown by the shifting of the MS curve to the left as MS, so that the new equilibrium point is established at E1and the rate of interest rises to r2. The NBFIs also raise the interest rate on their deposits which, in turn, reduces the demand for money by the public. The MD curve shifts to the left to M1D1 and intersects the M1S1 curve at E2 .The interest rate is now reduced from r2 to r1. Thus the NBFIs are able to counteract tight money policy.
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NBFIs make monetary policy ineffective even when the central bank adopts a restrictive monetary policy by selling securities in the open market and raising requirements of commercial banks. As a result, money supply with the bank is reduced and interest rates tend to rise. Non-bank financial intermediaries also find arise in the interest rates of their primary securities.
They, therefore, raise the interest rate on indirect securities in order to attract more funds from individual savers. This increase in interest rates, in turn, encourages savers to shift their savings from commercial bank demand deposits into time deposits, saving and loan shares, and other indirect securities of non-bank financial intermediaries.
This tends to increase funds with the intermediaries for lending purposes and they are able to purchase more primary securities. Thus the supply of available credit is increased in the economy even though the money supply remains unchanged.
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“When this happens, the intermediary, in effect, acts as an agent facilitating the process of dishoarding cash balances.” Ultimately, the purchase of primary securities by intermediaries causes money to flow back into the commercial banks which end up with the same amount of deposits which they had before the operation of intermediaries.
Thus when money supply is reduced by a restrictive monetary policy, the non-bank financial intermediaries are able to increase velocity of money and total spending by turning primary securities into indirect securities for the portfolios of ultimate lenders.
Similarly, non-bank financial intermediaries can make an expansionary monetary policy ineffective by reducing the velocity of money.
The question arises as to what extent non-bank financial intermediaries have actually been instrumental in offsetting the monetary policy. If they have been doing so on a large scale, then it is advisable to extend the controls of the central bank over them. There has been a hot controversy over the issue. But the consensus is that the role played by intermediaries in under-cutting monetary policy is minimal.
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As the United States Commission on Money and Credit noted:
“The evidence, for either the cyclical or the secular periods, does not support a case for an extension of the direct monetary controls over non-bank financial intermediaries. Their contribution to cyclical changes in velocity appears to be too small to warrant such an extension.”
The Radcliffe Committee of Britain rejected the idea of controlling the intermediaries because it was not politically feasible in England. It further observed:
“Such a prospect would be unwelcome except as a last resort, not mainly because of its administrative burdens, but because the further growth of new financial institutions would allow the situation continually to slip from under the grip of the authorities.” But unlike the Radcliffe view, Gurley and Shaw have argued that the central bank’s control over the non-bank financial intermediaries should be extended.
In the absence of control over NBFIs, the central bank would behave in a discriminatory manner against the commercial banks. If NBFIs remain outside its control, they would expand very rapidly, thereby making monetary policy less effective. Gurley and Shaw opine that consequently the monetary authorities “crack down” on the good boys (commercial banks) for the mischief done by the bad boys (NBFIs).
They, therefore, opine:
“The lag of regulatory techniques behind the institutional development of intermediaries can be overcome when it is appreciated that ‘financial control’ should supplant ‘monetary control.’ Monetary control limits the supply of one financial asset money. Financial control, as the successor to the monetary control would regulate creation of financial assets in all forms that are competitive with direct securities in spending units’ portfolios. “Tight finance” and “cheap finance” are the sequels of “tight money” and “cheap money”.
However, Johnson does not agree with Gurley and Shaw. He observes that there seems to be no empirical case for empowering the central bank to extend its control over financial intermediaries similar to that exercised over the commercial banks.
According to him, there is little reason for believing that the central bank’s control is weakened by the presence of financial intermediaries. Moreover, so long as the public does not switch easily from bank deposits into indirect securities of intermediaries, the presence of intermediaries may increase the leverage of the central bank on economic activity.
It implies that it is not possible for the interest rates to settle back at their old levels even by the operation of non-bank financial intermediaries. Rather, interest rates would tend to rise further. The money supply will remain tight and its influence on spending would be restrictive.
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