4.4 FINANCIAL MARKETS Flashcards
What are financial markets and what do the different financial institutions do?
Financial markets are where buyers and sellers can buy and trade a range of goods and services or assets that are fundamentally monetary in nature
§ Range of different financial institutions. Retail banks provide services to households- payment of direct debits, saving accounts, loans and mortgages
§ Commercial banks provide services to businesses.
§ Investment banks trade in foreign exchange, commodities, bonds, shares and derivatives for speculation purposes as well as giving advice to firms on how to raise finance and on mergers. Some smaller companies also
take part in speculation.
§ Savings vehicles exist to help individuals save, for example pension schemes, trusts, hedge funds and assurance companies, whilst insurance companies insure against a range of risks.
§ The central bank is a financial institution that has direct responsibility to control the money supply and monetary policy, to manage the country’s gold and foreign currency reserves and to issue government debt.
Go over hedge, pension and mutual funds
What are the role of the financial markets?
Facilitate savings, which allows people to transfer their spending power from the present to the future. It can be done through a range of assets, such as storing money in savings account and holding stocks and shares.
§ Lend to businesses and individuals which allows consumption and investment- financial intermediary, the step between taking money from one person to give to another since money from savings is used for investment.
§ Facilitate the exchange of goods and services by creating a payment system. Central banks print paper money, institutions process cheque transactions, companies offer credit card services and banks and bureau de changes buy and sell foreign currencies.
§ They provide forward markets . This is where firms are able to buy and sell in the future at a set price - exists for commodities and in foreign exchange and helps to provide stability.
§ Provide a market for equities company’s shares. Issuing shares is an important way for companies to finance expansion but people would be unlikely to buy shares if they were unable to sell them on in the future. Financial markets provide the ability for shares to be sold on in the future, making the asset more appealing.
What are the reasons for commercial bank failure?
Liquidity Crisis. A commercial bank does not have enough S/T liquid assets to meet its S/T liabilities. This could happen if commercial banks run down their liquid cash assets from savings to make l/t loans where there’s greater profit to be made or if they borrow s/t in the money markets and use this to increase less liquid assets, lending long term- consequence is that if S/T liabilities need to be met e.g. if savers come to the bank and demand their savings- commercial bank won’t be able to meet this obligation causing panic and a run on the bank, known as a liquidity crisis.
§ Insolvency. This is where a commercial bank does not have enough capital (shareholder’s funds or retained profit) to offset any losses in longer term asset values. For example if excessive risk is taken by banks and any mortgages or other loans default they will be underwritten, cancelled out by a reduction in capital. However if the level of capital is large enough, the bank will owe more than it owns - not a long run sustainable position. Overall liabilities will be greater than assets, an unbalanced balance sheet, culminating in the failure of the commercial bank
What are the consequences of back failure?
Systemic Risk. Bank failure can increase systemic risk in the economy where the collapse of one commercial bank can ripple through the industry leading to further banking collapses and eventual meltdown of the entire industry. This is because as one bank fails, assets held by another bank may become worthless and will need to be offset by a reduction in capital. If capital is not enough to offset this loss this bank = insolvent and fail causing problems for other banks in the same way.
§ Recession. Given imp of financial industry for growth- bank failure/ systemic risk = lead to deep recession or depression = increases U/E and reduces incomes and SOL not just for those who work in industry but negative multiplier effects occur - create job losses throughout entire economy. Businesses, individuals and governments = reliant on commercial banks and financial markets to borrow and spend. Businesses and individuals = directly affected - risk averse banks = unwilling to lend, reducing borrowing for investment and consumption hampering AD significantly. Financial sector collapse= limit borrowing by GOV for GOV spending to stimulate recovery deepening crisis, heightening U/E.
§ Negative Externalities and Moral Hazard. Bank failure -significant impact on tax payers if GOV feel systemic risk is too great a possibility and thus agree on bank bailouts. Tax payers money used to fund bailout BUT if funds do not currently exist at level required to cover the bailout, gov =substantially increase borrowing, creating a L/T burden of debt repayment and debt interest servicing, impacting current/ future gens with higher tax rates.
§ The deeper consequence of bank bailouts is that it incentivises further excessive risk to be taken by commercial banks either by not holding enough liquid assets, deciding instead to convert cash assets into loans or by a bank deciding to offer more risky loans for profit seeking purposes. Banks take such risks knowing that if they fail as a result, either becoming insolvent or suffering a liquidity crisis, the gov will bail them out to continue operating= moral hazard, where excessive risk is taken due to third parties paying the consequences of decisions going wrong as banks believe there are too big to fail. Despite the gov being able to regulate bank decisions and operations after a bail out, if a bail out is expected, this will not stop excessive risk taking with the tax payer suffering the most as a result of more likely bank failure.
What is the role of the central bank?
To implement monetary policy through manipulation of interest rates, the money supply and the exchange rate to meet an inflation target. -In times of deep economic turmoil central bank can place other macroeconomic objectives above inflation targeting in aim of achieving macroeconomic stability.
To act as a banker to the government where gov bonds can be bought and sold on behalf of the gov and debt interest can be managed down with the central bank also offering advice to the gov on various economic matters.
A banker to the banks acting as a lender of last resort. When commercial banks suffer liquidity problems. where they do not have enough short-term liquid assets to meet needs of depositors and other short-term liabilities, the central bank (Bank of England) can step in and provide emergency liquidity, either emergency or non-emergency to prevent a full blown liquidity crisis and bank failure. Financial stability. GFC- banks not lending to each other- xcredit crunch, no transparency between banks
§ Conditions needs to be met for banks to be eligible for these funds and strict regulations will be imposed once liquidity has been transferred, with money being paid back with interest, but objective of this function is to prevent bank failure and reduce systemic risk in the economy maintaining the stability of the financial sector. In this sense, the central bank acts as a lender of last resort to banks facing a liquidity crisis
Regulator of the financial system. Both Financial Policy Committee (FPC) and Prudential Regulation Authority (PRA) are regulatory bodies within the BOE whose job is to look out for risks to financial stability, prevent bank failure and thus negate systemic risk in the financial sector. Since the financial crisis of 2008, the regulatory role of the BOE has become much more important.
What is the lender of last resort pros for a central bank?
Prevent a liquidity crisis actually resulting in bank failure thus preventing systemic risk and potential for full financial sector collapse. Individual savers know that their money is safe and panic does not surface- crucial for confidence in the banking sector to remain, otherwise growth and living standards would suffer as the economy experiences deep recession. Liquidity provision comes with strict regulatory conditions from BOE and repayments with I/R above market levels, therefore the chance of such a crisis happeningagain should in theory be limited.
§ This role for the Bank of England allows them to advise the government on where a bailout might be necessary. The Bank can identify where serious concerns in the banking sector lay and therefore where state intervention may be necessary to prevent systemic risk sector collapse and the disastrous consequences that accompany it.
What is the lender of last resort cons for a central bank?
The biggest issue with liquidity assurance schemes is that they promote further excessive risk by commercial banks the central bank will be there to provide emergency funds. This is known as moral hazard, where excessive risk is taken due to third parties paying the consequences of decisions going wrong. Despite the central bank being able to regulate bank decisions and operations after a liquidity provision, this may not stop excessive risk taking
Strong argument to question why banks should be treated differently to any other business. In a market economy losses and failure signal shut down and a transfer of FOP into other areas. This is true for any other private business where no central or gov support is available. Despite regulation after liquidity provision, moral hazard is likely to increase with banks believing they are too big to fail.
There is a risk of regulatory capture with such intervention by central bank- managers of commercial banks in the industry form close relationships with central bank regulators influencing decision making over liquidity provision and conditions imposed thereafter to favour the commercial bank rather than doing what is in the best interests of society. Consequently there is significant gov failure, and risk of liquidity crisis going forward could remain high. The likelihood of this happening is strong as often regulators were themselves managers and CEOs of banks in previous careers and therefore have good working relationships with those who remain in the sector.
What is financial market failure and regulatory capture?
- Financial market failure- when free financial markets fail to allocate financial products and services at the socially optimum level of output resulting in a net loss of social and economic welfare
- Regulatory capture-when regulators of different industries act in favour of producers not consumers
What are the causes of financial market failure?
Excessive Risk: Speculation = common feature of financial market activity. Speculators – buy financial assets cheap and then sell them on at a higher price sometimes leveraging the transaction
1. Issue is when excessively high prices are paid for assets that are clearly overvalued -. asset bubble is formed- overproduction of assets that carry excessive risk of collapsing. Investors realise assets aren’t worth price and market - peaked, reducing demand and lowering the price. As soon as prices fall, panic sets in and investors in possession- sell to minimise losses (herding behaviour) pushing price down even further. Assets = worthless but borrowed money to buy them up needs paying back resulting in damage to investor but also banks who lent out money for this purpose – increasing risk of insolvency. Bubble burst= reducing AD, negative wealth effect
- Excessive risk: asymmetric information -MORAL HAZARD. Excessive risk can be encouraged if banks know that either the gov will bail them out or central banks – provide emergency liquidity if they have a liquidity crisis: moral hazard where banks feel they are too big to fail. Asymmetric infor will limit their effectiveness as banks can always conceal risky deals or loans being issued, incentivised to do so given safety of intervention= increases systemic risk risking sector collapse, economic recession and U/E; not in interests of society. Credit rating kept putting them as triple A – when they weren’t
- Asymmetric information -Adverse selection issue when providing insurance in the financial industry leading to the problem of adverse selection where the most likely buyers of insurance i.e are those the sellers would be least happy selling to i.e. those who carry excessive risk by needing pay outs.Health insurance premiums (monthly charges) are based on who the company believes will buy the insurance. Healthier customers (good, profitable for seller = feel that premiums are too high they won’t need a pay out whereas unhealthy customers (bad, loss making customers for the seller) - always feel premiums are good value = they need healthcare. Insurance company - never able to screen customers perfectly, premiums offered will attract bad, unprofitable customers - not attract enough good customers = excessive risk taking and potential collapse.
- Externalities: Excessive risk culminating in bank failure =significant impact on tax payers if GOV feel systemic risk is too great a possibility = agree on bank bailouts. Tax payers money = fund bailout. If funds don’t exist at the level required to cover bailout, gov = substantially inc borrowing = long term burden of debt repayment and debt interest servicing impacting current and future generations. Individuals can lose savings from bank collapse if no government savings assurance scheme. Banking sector collapse = recession and high U/E in sector itself but also throughout economy= negative externalities are ignored by self-interested banks leading to an overproduction of excessively risky loans increasing the chances of bank failure.
- Collusion and Price Fixing: The practise of market rigging occurs when traders, banks and/or intermediaries collude to manipulate markets away from equilibrium levels and make huge profits. Recent examples include LIBOR and FOREX fixing scandals where heavy fines and regulations were clearly not strong enough to detract such behaviour= against the interest of society who suffer drastically through extra charges depending on the nature of the fix. Regulation is therefore important to curtail such behaviour but only if strict enforcement and punishments exist. Example-insider trading, - individual or institution - knowledge about something that will happen in future that others don’t know and so can buy or sell shares to make a profit. Libor scandal of 2008, financial institutions were accused of fixing London Interbank Lending Rate (LIBOR), one of most important rates in the world.
- Externalities- Number of costs placed on firms, individuals and the government that the financial market does not pay . One example of this is the cost to the taxpayer of bailing out the banks after the 2007-8 financial crisis . Even higher than this, was the long-term cost to the economy of the crisis due to its effects on demand and growth. Moral hazard also shows some external costs
What is the role of uK Financial market regulators?
. Financial Policy Committee (FPC). FPC = macro prudential regulator, part of BOE - main objective to monitor/ protect against systemic risk within financial sector. Financial regulation has been improved. inc resilience of system
§ The committee = instruct PRA and FCA on how to limit systemic risk concerns once potential shocks = identified - advise the GOV on potential state intervention. A key feature and role of the FPC is to perform annual stress tests to assess the health and functionality of banks to actually identify potential shocks in the financial sector (look at whether they have enough capital), worse case scenarios- role that’s become extremely significant post 2008 GFC Ability to provide emergency liquidity utilising lender of last resort function of the BOE. Stress tests- look at whether they have resilience
- Prudential Regulation Authority (PRA).Micro prudential regulator- ensures competition, ensures consumers have access to services, minimises risk should a bank fail and ensures banks take responsible action. part of BOE = role to maintain stability of banks and banking sector as a whole, preventing bank failure and systemic risk in this way. PRA supervise the management of risk and set industry standards for management and conduct within banking industry. Power to enact and enforce banking regulations such as reserve requirements, capital and liquidity ratios. 1700 banks, building societies
- Financial conduct authority (FCA)- Protects consumers, promotes competition and enhances the integrity of the system by preventing market rigging. Gov regulatory body reporting to treasury with the main role to protect the public interest and consumers – promoting confidence in financial products and institutions. FCA= supervise conduct of firms in the financial sector - ensure that all activity is legal and no market rigging takes place. They can incentivise comp by deregulating and reduce COP for banks- easier to set up and sell various financial products. Regulatory role to protect consumers and public by banning misselling of financial products like life insurance- harming consumers who don’t have dependence. Furthermore, can ban changes
