4.4 The Financial sector Flashcards
Role of financial markets
To facilitate saving - financial markets provide opportunities for consumers and businesses to store their funds (i.e. transfer their spending power from the present to the future). This may be rewarded with interest payments
To lend to businesses and individuals - financial markets act as an intermediary to enable the temporary transfer of funds from one agent to another. The funds can be used for investment or consumption
To facilitate the exchange of goods and services - financial markets facilitate the transfer of real economic resources, providing a way for buyers and sellers to transfer funds (paper money, cheque transactions, credit card services, foreign currency exchanges).
To provide forward markets in currencies and commodities - financial markets enable economic agents to buy and sell with an agreed price in the present, but a delivery and payment in the future (for example, if a farmer wants to sell the crop they are growing at a guaranteed price in a month’s time). This is to reduce risks and to provide grater certainty.
To provide a market for equities - 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 traded.
Market failure in the financial sector
Asymmetric information:
- this exists in any transaction where one party has less information than the other
Examples:
- subprime mortgages - a lender does not know how likely a borrower is to repay their loan
- insurance - a car insurance company cannot tell the risks associated with each driver
- the buyer of a financial product who is unaware of the true level of risk
- regulators in the financial sector who may have insufficient information compared with bankers about the true risk associated with different financial products
Externalities:
Bankers did not fully take into account the external costs of managing risk when lending. In the Great Recession of 2008-09 the financial sector imposed huge negative externalities on the real economy as the financial crisis triggered worldwide falls in GDP. Banks enjoyed the upside during the good years, but taxpayers took the losses post crisis
Moral hazard:
Moral hazard refers to the risk that one party may take on excessive risks because they believe they are protected from the full consequences of their actions.
In the financial sector, moral hazard can arise when banks and financial institutions believe they will be bailed out by the government in the event of a financial crisis. This can lead to reckless behaviour and excessive risk-taking.
For example, governments offer banks an implicit guarantee that they will step in with extra funding to prevent a bank, collapsing. however this creates a strong incentive to take on risker lending behaviour, knowing that the bank will be bailed out. Another example is membership of the euro, as it implies that a country will be bailed out (e.g. Greece)
Speculation and markets bubbles:
A speculative bubble is a spike in the value of an asset. Poor lending decisions by bankers can help to fuel a market bubble through irresponsible lending caused by exaggerated expectations of future growth in the value of an asset. Investors believe that the value will rise which causes the value to inflate further. Once belief sets in that the asset has reached its peak value, investors will quickly try to sell, causing the artificially high value to fall. As the bubble burst there is usually a fall in confidence and AD - the wealth effect operates in reverse.
- The bursting of the housing bubble in the US, combined with the risky trading in subprime mortgages, worked together to cause the Global Financial Crisis of 2007 and the Great Recession of 2007-9
Market rigging:
Market rigging refers to the manipulation of financial markets to gain unfair advantages.
Examples include insider trading (trading based on non-public, material information), market manipulation (e.g., pump-and-dump schemes), and collusion among market participants to distort prices.
Market rigging undermines market integrity and can lead to investor losses.
Roles of central banks
Implementation of monetary policy:
Central banks have the primary responsibility for formulating and implementing monetary policy, which involves managing the money supply and interest rates to achieve specific economic objectives, such as price stability and economic growth.
Tools of monetary policy include open market operations (buying and selling government securities), setting interest rates (e.g., the policy rate), and reserve requirements for banks.
Central banks adjust these tools to influence borrowing costs, inflation rates, and overall economic activity.
Banker to the government:
Central banks act as the government’s banker by managing the government’s bank accounts, facilitating payments, and helping with debt issuance and management.
They often oversee the issuance and redemption of government bonds and treasury bills, helping the government fund its operations and manage its debt.
Central banks also provide advice on fiscal and monetary coordination to ensure overall economic stability.
Banker to the banks:
Central banks serve as a lender of last resort to financial institutions, especially during times of financial crises or bank runs.
In this role, central banks provide emergency funding to banks facing liquidity problems to prevent systemic financial instability.
By offering short-term loans (often referred to as the discount window), central banks help maintain confidence in the banking system.
Regulator of the banking industry:
Central banks often play a critical role in supervising and regulating the banking sector to ensure its stability and soundness.
They set and enforce prudential regulations, including capital adequacy requirements and risk management standards, to prevent excessive risk-taking by banks.
Central banks may also conduct regular bank examinations to assess the financial health and compliance of financial institutions with regulatory standards.
