4.4 - The Financial Sector Content Flashcards

Question

What are Commercial Banks

Answer 1

* Banks are licensed deposit-takers providing a range of savings accounts * They are licensed to lend money and thereby create money via new bank loans, overdrafts and mortgages * A commercial bank's business model relies on charging a higher interest rate on loans (or other assets) than the rate it pays out on deposits (or other liabilities) * This spread on assets and liabilities pays the operating expenses of a bank and helps them to make a profit

Answer 2

Leveraged loans are loans provided to companies with a high level of debt compared to their equity. These loans are typically used by companies with lower credit ratings and are issued by private equity firms or hedge funds rather than traditional banks. The key characteristics of leveraged loans are: 1. High debt-to-equity ratio: The company borrowing the loan has a high amount of debt compared to its equity, making it riskier for lenders. 1. Floating interest rates: The interest rates on leveraged loans are often variable, which means they can change over time. 1. Higher risk: Leveraged loans carry a higher risk of default, which is why they often have higher interest rates and fees than traditional loans.

Answer 3

* **Accepting Deposits**: Commercial banks offer safe and easily accessible deposit accounts, including savings accounts, checking accounts, and fixed deposits. * **Providing Loans**: They extend credit to individuals and businesses for various purposes, such as mortgages, business loans, and personal loans. * **Payment Services**: Commercial banks facilitate payment and fund transfer services through checks, electronic funds transfers, and online banking. * **Safekeeping of Valuables**: Some commercial banks offer safe deposit boxes for customers to store valuable items securely. * **Currency Exchange**: They provide foreign exchange services to facilitate international trade and travel. * **Financial Services Advice**: Provide insurance, mortgage, and investment guidance (e.g., budgeting, creditworthiness checks).

Answer 4

* **Cash and Reserves** - Funds held in the central bank or as cash on hand * **Loans and Advances** - The money lent out to borrowers * **Investments** - Securities held by the bank, such as government bonds or corporate bonds

Answer 5

* **Deposits** - Funds held in customer accounts * **Borrowings** - Funds borrowed from other financial institutions * **Capital** - The bank's equity, including share and retained earnings

Answer 6

* **Fractional Reserve System**: Banks create credit by using the fractional reserve system, where they are required to hold only a fraction of their deposits as cash / liquid reserves and can lend out the rest. * **Money Multiplier Effect**: When banks lend out a portion of the funds deposited with them, these funds are deposited in other banks, creating a chain reaction of lending and increasing the money supply. * **Credit Creation Process**: As banks make loans, they effectively create new money in the form of additional deposits. This process multiplies the initial deposit and contributes to economic activity measured by GDP

Answer 7

* **Market forces** – the profitable lending opportunities to businesses and households can often fluctuate for example at different stages of the cycle * The **risks** of lending including default risk from the borrower * **Regulatory policies** such as minimum capital reserve requirements as part of regular bank stress tests * **Monetary policy** - level of policy interest rates set by the Bank of England influences total demand for loans

Answer 8

* **Interest-rate spreads** - Charging a higher interest rate on loans than the rate paid to savers * **Service Fees** – Fees charged when arranging business & personal loans * **Brokerage percentages** – Many banks provide currency and share-dealing services and charge a brokerage fee for doing so

Answer 9

A non-performing loan (NPL) is a loan where the borrower has stopped making payments and is in default. The loan is considered non-performing when it is more than 90 days overdue. NPLs are a major concern for commercial banks because they represent a loss of revenue and can also have negative effects on the bank's capital and liquidity.

Answer 10

* **Economic downturns**: During economic downturns, businesses and individuals may struggle to repay their loans, leading to an increase in NPLs. * **Industry-specific issues**: Certain industries, such as construction may be more prone to NPLs due to the cyclical nature of their business. * **Credit standards**: When commercial banks loosen their credit standards, they may lend to riskier borrowers, leading to a higher probability of defaults. * **Fraud**: Some borrowers may intentionally default on their loans through fraudulent behaviour, such as falsifying financial information to obtain loans they can't repay. This is a type of financial market failure.

Answer 11

Banks must balance holding liquid assets to meet deposit withdrawals and fund operations with investing in higher-yield, often less liquid assets for profit. Higher liquidity ensures safety and quick access to funds but typically offers lower returns, while investing in less liquid assets can boost earnings yet increases risk. This trade-off is further managed by regulations, such as minimum liquidity requirements imposed by central banks, to safeguard customer deposits and maintain overall financial stability.

Answer 12

* **Poor management**: This can include taking on too much risk, making bad loans * **Lack of diversification** in the bank’s loan portfolio - for example, excessive lending to the volatile property market. * **Insufficient reserves to cover bad loans**: Banks must set aside a certain amount of money to cover the possibility of loan defaults * **Run on the bank**: A bank can fail if too many depositors withdraw their money at the same time, this is called a run on the bank. * **Economic downturns**: Recessions can lead to an increase in loan defaults and a decrease in the value of the bank's assets * **Regulatory failure**: Inadequate regulatory oversight can lead to risky practices, fraud and corruption, and ultimately bank failure.

Answer 13

* **Northern Rock**: This bank failed in 2007. The government had to step in and nationalize the bank in 2008. It was eventually sold to other investors including Virgin Money. * **RBS (Royal Bank of Scotland)**: RBS required a government bailout in 2008 due to its exposure to bad loans and toxic assets. The government took a majority stake in the bank, and it eventually returned to private ownership.

Answer 14

1. A credit crunch, also known as a **credit squeeze**, is a period when the availability of credit from banks decreases, making it harder for individuals and businesses to borrow money. 1. During a credit crunch, lending institutions may become more **risk-averse** and increase their lending standards, making it more difficult for borrowers such as households and businesses to qualify for new loans or to extend their existing debts. 1. Banks may also **call back loans** or reduce credit lines for existing borrowers. This can lead to a decrease in consumer spending and capital investment, which can slow down AD and perhaps cause a recession. 2. **Example**: 2007-2009 crisis saw banks like Lehman collapse, causing global lending freezes.

Answer 15

The crisis was triggered by the collapse of the **subprime mortgage market** in the United States, which led to a decline in the value of mortgage-backed securities held by banks and other financial institutions around the world. This caused a **decrease in the availability of credit** and shortly after, an economic recession. Commercial banks became more **risk-averse** and tightened their lending standards, making it harder for individuals and businesses to borrow money. **Credit supply contracted**

Answer 16

1. **Encourages Market Discipline**: Creates an incentive for financial institutions to adopt sound lending models and **avoid high leverage** 1. **Promotes Competition**: Challenger banks can step in whereas bail outs make financial markets less contestable – which is bad for customers in long run 1. **Avoids Moral Hazard**: Government bailouts create a **moral hazard** by providing a **safety net** for banks, which may encourage them to take on excessive risk, knowing that they will be rescued in the event of failure. 1. **Protects Taxpayers**: Bailing out failing banks can be costly to taxpayers. Allowing banks to fail means that losses are absorbed by shareholders and creditors of the bank, not taxpayers.

Answer 17

1. **Preventing Systemic Risk**: A bailout of a failing bank can prevent a bank run, which can trigger a domino effect leading to the failure of other banks in the financial system, creating a systemic risk 1. **Protecting Depositors**: Bailing out a bank can protect depositors' savings and reduce the risk of them losing their money. Deposits in UK banks are insured up to a certain amount. 1. **Externalities from financial market failure**: There are negative externalities from allowing a systemic banking failure – justifies intervention and regulatory reforms

Answer 18

Market failure happens when the price mechanism fails to allocate scarce resources efficiently or when the operation of market forces lead to a net social welfare loss.

Answer 19

1. Externalities from financial instability 1. Monopoly power in financial markets 1. Market rigging 1. Speculative bubbles/irrational behaviour 1. Moral hazard and attitudes to risk 1. Asymmetric information and complexity

Answer 20

A bubble exists when the market price of a financial asset is driven above what it should be such as a speculative boom in housing, crypto, NFTs, commodities or share prices. Speculation can be amplified by herd behaviour where many people take the same decision.

Answer 21

* Gold rushes in the late 19th century * Real estate bubbles * Dot com boom from 1997-2000 * Crypto-currencies

Answer 22

1. **Displacement stage** - excitement grows about a new product/emerging technology 1. **Prices boom** as demand surges + limited (inelastic) supply causing market prices to spike higher 1. **Euphoria** as more investors look to take advantage (Robert Shiller calls this "irrational exuberance") 1. **Profit taking stage** – some investors sell as they realise prices are out of line with fundamentals 1. **Panic** - the herd mentality switches to desperate selling and prices fall fast inflicting big losses **Example**: Dot-com bubble (1997-2000) followed these stages

Answer 23

Herd behaviour is where individuals act in a certain way because they believe that others are acting in the same way, even if it may not be the most rational decision. * **Fear of missing out (FOMO)** - investors may feel a sense of urgency to participate in the rally, even if it is not based on sound analysis. * **Availability bias** - investors may place too much emphasis on recent information and ignore longer-term trends. * **Overconfidence** - investors may overestimate their ability to predict the market and make riskier investments. * **Social influence** - investors may be influenced by the actions of others in their social network or by media coverage

Answer 24

* The hot-hand fallacy is a cognitive bias that leads investors to believe that a series of successful investments is indicative of future success, even if it may be due to luck or randomness. * During a financial bubble, investors may become overconfident and continue to make investments based on the assumption that their previous success will continue. This can lead to over-investment in a particular asset, creating a bubble that is not sustainable in the long run. * The hot-hand fallacy can lead to irrational decision-making, as investors fail to recognize that their previous successes may not be predictive of future outcomes. This can result in significant losses when the bubble eventually bursts and the underlying asset's value plummets.

Answer 25

* In his book "Irrational Exuberance," Robert Shiller coined the term to describe the tendency of investors to become overly optimistic during economic booms, leading to a financial bubble. * Shiller argues that this exuberance can cause investors to ignore risks and make irrational investment decisions, leading to a bubble that eventually bursts, causing significant losses. * The concept of irrational exuberance is particularly relevant during periods of rapid economic growth, where investors can become overly confident and lose their ability to accurately assess the risks involved in investments.

Answer 26

**Prospect Theory** (Kahneman & Tversky) argues investors make irrational choices during financial bubbles by: * **Framing decisions around gains vs. losses:** They overvalue potential profits (e.g., "This stock could double!") and downplay risks (overweighting gains). * **Loss aversion**: Fear of losses outweighs desire for gains, leading to: * *Risk-taking*: Chasing high returns (e.g., buying overvalued assets). * *Holding too long*: Refusing to sell declining assets to avoid "locking in" losses. * **Result**: Overconfidence and herd behavior inflate bubbles. When the bubble bursts, loss-averse investors panic, deepening crashes (e.g., 2008 housing crisis). **Key insight**: Emotions distort rational risk assessment, fueling instability.

Answer 27

* Manipulating the market to make a gain at the expense of others. * Eg. Insider trading - using confidential information to buy or sell shares to your advantage. Causes misallocation of resources * For example if high profits of a firm are about to be announced, those with inside information can buy the shares first before the information is public * Banks can also collude to fix interest rates. (RBS and Barclays} * Example: LIBOR scandal (2008) where banks manipulated interest rates for profit. * 2014 Forex Rigging: UK/US fined banks £2.6bn for colluding on currency trades. Traders exploited client data for personal bonuses (e.g., RBS, HSBC)

Answer 28

Occurs when there is imbalance in information between agents. For example, financial markets often use complex information – a borrower (such as a small business) has better information on whether they can afford to repay a loan than the lender.

Answer 29

Insider information is confidential, non-public data (e.g., mergers, earnings) that unfairly benefits traders. Using it (insider trading) is illegal, as it distorts market fairness, leading to fines, jail, or reputational harm. Laws prohibit exploiting undisclosed info to protect equal investor access. Key: Unethical advantage → legal penalties.

Answer 30

* **Credit risk**: Banks may have incomplete information about the creditworthiness of borrowers, which can lead to risky lending decisions. This can result in loan defaults and financial losses for the bank. * **Rating agencies**: Banks rely on rating agencies to assess the creditworthiness of borrowers and investments, but these agencies may not always have complete or accurate information. This can lead to inaccurate ratings and further misinformation in the market.

Answer 31

* **Adverse selection**: Insurers may not have complete information about the riskiness of policyholders, which can lead to higher premiums or lower coverage. Policyholders may also have an incentive to conceal information about their risk level, leading to more adverse selection. * **Real-World Impact**: US health insurance premiums rose 55% (2007-2017) due to adverse selection. * **Moral hazard**: Insurance may lead to increased risk-taking by policyholders, since they are shielded from the full costs of their actions. For example, a driver with collision insurance may drive more recklessly than one without insurance.

Answer 32

Moral hazard exists in a market where an individual or organisation takes greater risks than they should do because they know that they are either covered by insurance, or that a government will protect them from any damage incurred as a result of those risks. For example, creditors might be insured from risk by prospects of a government (state) bail-out. Bail-outs may encourage risker behaviour Eurozone Example: Greece assumed EU bailouts, leading to unsustainable deficits. Mervyn King (2007): 'Liquidity support undermines risk pricing... sows seeds of future crises.'

Answer 33

A financial crisis is a major disturbance / shock to financial markets, associated typically with falling asset prices and insolvency amongst debtors and intermediaries, which ramifies throughout the financial system, disrupting the market’s capacity to allocate financial capital.

Answer 34

* **Currency crisis** when a fixed exchange rate regime collapses, or a currency goes into a free-fall (depreciating rapidly) * **External debt crisis** – when a country cannot attract the capital needed to finance a current account deficit * **Sovereign debt crisis** – when a government cannot afford to pay the interest on their existing debts * **Banking crisis** – when stability of banking system is low leading to a sharp rise in savings deposits and possible run-on banks * **Broad financial crisi**s – which combines elements of all the above

Answer 35

* **The Venezuelan crisis (ongoing)** - an economic collapse characterized by hyperinflation, food and medicine shortages, and political instability. * **The Turkish currency crisis (2018)** - a sharp decline in the value of the Turkish lira, caused by economic mismanagement and political tensions with the United States.

Answer 36

* **USA financial crisis (2007-2008)** - known as the "global financial crisis," was caused by a collapse in the housing market and a wave of mortgage defaults. * **Greek banking crisis (2012-2015)** - caused by the country's debt crisis and the imposition of strict austerity measures, leading to a run on the banks and a loss of confidence in the Greek banking system.

Answer 37

* Financial market failures / behavioural finance * “Irrational exuberance” among investors – see the work of Robert Shiller * Increased complexity arising from financial innovation – such as mortgage bonds * The Minsky Hypothesis – where “financial stability breeds instability” * Macroeconomic and financial policy failures * Unintended consequences of financial deregulation as a supply-side policy * Banks too big to fail? Ever-riskier behaviour due to moral hazard * Failures of credit ratings agencies in pricing risk accurately * Structural changes in the global economy including economic imbalances including global savings glut and extended period of low /negative real interest rates * **Macro Effects**: Austerity policies, underemployment, youth unemployment, regional GDP disparities (e.g., UK’s 6% GDP drop 2008-09).

Answer 38

Many US banks began offering mortgages to subprime borrowers by relaxing lending standards. This led to a rapid rise in housing prices followed by mass defaults as the market collapsed. Mechanism: Securitization of subprime mortgages into CDOs (collateralized debt obligations).

Answer 39

The increased issuance of subprime mortgages drove housing prices up rapidly; however, when the market reversed, the high prices and defaults contributed to a major financial collapse.

Answer 40

The crisis was fueled by: * Relaxed lending standards and packaging risky mortgages into securities. * Speculation in the housing market, leading to overvaluation of properties. * The use of complex financial instruments paired with a lack of transparency in financial markets. * CDOs: Toxic assets spread risk globally, causing interbank distrust and credit freezes

Answer 41

The repeal of the Glass-Steagall Act, which allowed banks to engage in riskier behaviors by mixing commercial and investment banking, was a significant factor.

Answer 42

Low interest rates and loose lending standards created an environment rich in easy credit, which led to a flood of subprime mortgages and toxic loans, ultimately fueling a housing bubble.

Answer 43

Credit rating agencies, such as Moody's and S&P, gave high ratings to junk securities—often backed by subprime mortgages—misleading investors about their safety.

Answer 44

They assess the creditworthiness of companies, governments, and other entities by assigning ratings (from AAA to D) that indicate the likelihood of debt repayment, which investors use to gauge risk.

Answer 45

They were criticized for: * Overrating subprime mortgage-backed securities, which later were downgraded. * Conflicts of interest due to payment by the banks issuing the securities. * A slow reaction in downgrading risky securities as the housing market deteriorated.

Answer 46

Because the agencies are paid by the entities they rate, this can create a conflict of interest and may incentivize inflated ratings to preserve business relationships.

Answer 47

* **Losses**: If people default on loans, a bank will suffer losses that erodes capital reserves and reduces its ability to lend. Investors may be unwilling to cover losses. * **Liquidity**: If a bank sees a sudden loss of confidence from depositors and investors, they may struggle to obtain fresh funding in the interbank market and face liquidity problems. This can cause a run on the bank.

Answer 48

Systemic risk is when the **failure of a single financial institution** leads to a **contagion effect** that spreads throughout the financial system and beyond, affecting the stability of the system perhaps **creating a wider crisis**.

Answer 49

* **Credit crunch** - where businesses and households find it difficult to obtain loans, which can in turn lead to a decline in capital investment by businesses and consumption causing weaker real economic growth. * **Fiscal effects** - Rising national debt if commercial banks are wholly or partially bailed-out by the government. This can lead to higher interest rates on bonds & more expensive mortgages and a medium-term rise in taxes * **Negative Multiplier Effect**: Job losses in unrelated sectors due to reduced lending * **Case Study**: Northern Rock (2007) collapsed due to liquidity shortages, causing the first UK bank run in 150 years.

Answer 50

**For** * A bail-out can limit wider systemic risks and mitigate the negative consequences for the real economy. It can prevent negative externalities. **Against** * Letting banks fail can promote market discipline and prevent moral hazard. It encourages creative destruction as new banks and banking models replace failed institutions.

Answer 51

* **Credit risk** is the risk that a borrower will fail to repay their debt (bad debts) * **Liquidity risk** is when a bank does not have enough cash or liquid assets to repay depositors and other creditors if they want their money back.

Answer 52

A central bank is the monetary authority and major regulatory bank in a country. A central bank is responsible for monetary policy and maintaining financial stability. Examples of central banks * Bank of England (UK) * European Central Bank (ECB) for all member nations of the Euro Area * United States Federal Reserve (The Fed) * Bank of Japan (BOJ)

Answer 53

* **Setting interest rates**: Central banks adjust interest rates to control inflation and promote economic growth. * **Regulating banks**: They regulate banks to ensure they are financially sound and to protect depositors. * **Maintaining financial stability**: They act as a lender of last resort, providing liquidity to financial institutions in times of crisis. * **Issuing currency**: They are responsible for issuing and managing the country's currency. This might involve operating with a managed floating exchange rate. * **Conducting research**: They conduct research and provide advice to policymakers * UK Structure: FPC (systemic risk), PRA (bank stability), FCA (consumer protection).

Answer 54

The main interest rate set by a nation’s central bank. This is the rate of interest charged to commercial banks if they must borrow from the central bank when short of liquidity. Market interest rates often take their cue from changes in the Base Interest Rate.

Answer 55

* Rate of growth of real GDP and the estimated size of the output gap * Forecasts for price inflation * Rate of growth of wages and other business costs * Movements in a country’s exchange rate * Rate of growth of asset prices such as house prices * Movements in consumer and business confidence * External factors such as global energy prices and inflation in other countries * Financial market conditions including the rate of growth of credit / money

Answer 56

Lender of last resort is a role central banks play in times of financial distress. When other financial institutions are unable to provide loans, the central bank steps in to lend money to banks and other financial institutions. This prevents liquidity crises and helps to maintain financial stability. * **Emergency lending**: Central banks provide emergency loans to financial institutions in times of crisis to prevent their collapse and limit systemic risk. * **Discount window**: They also provide short-term loans to banks at a slightly higher interest rate than the market rate. This is known as the discount window. * **Collateral requirements**: Central banks require collateral from financial institutions as a condition for lending. This helps to mitigate the risk of default. * **Reputation**: Central banks are known as the lender of last resort due to their ability to provide loans in times of crisis, which can help to prevent financial panics.

Answer 57

* In 2012, the European Central Bank (ECB) provided emergency loans to banks in the eurozone to help stabilize the region's financial system. * In 2020, during the COVID-19 pandemic, central banks around the world acted as lenders of last resort to support their economies. For example, the Bank of England provided emergency loans to UK businesses and the Reserve Bank of India provided liquidity to Indian banks.

Answer 58

* **Issuing government bonds**: Central banks can issue and sell government bonds on behalf of the government to finance its budget and borrow money. * **Managing government debt**: Central banks can help governments manage their debt by buying and selling government bonds in the market, helping to stabilize prices and maintain liquidity. * **Providing advice**: Central banks often provide economic and financial advice to governments, helping them to make informed decisions about fiscal policy and other issues.

Answer 59

* **Operation of monetary policy** – setting base interest rates to meet the inflation target (2%). No direct intervention in the exchange rate – the UK operates a free-floating currency * **Lender of last resort** to the financial system during a liquidity crisis / credit crunch.

Answer 60

* **Lower interest rates**: By purchasing large amounts of government bonds, the central bank increases demand for these assets, which pushes up their prices and reduces their yields. This can lead to a fall in mortgage interest rates and corporate bond interest rates * **Currency depreciation**: Another effect of a large increase in QE by the UK central bank might be a depreciation of the currency. QE increases the money supply and some of this extra liquidity will leave the UK economy – sterling is sold – causing the pound to fall

Answer 61

* **Regulation and Supervision**: The FCA is responsible for regulating commercial banks, investment firms, insurance companies, asset managers, and consumer credit providers. It sets regulatory rules and standards for these firms, conducts prudential supervision, and ensures that they comply with applicable regulations. * **Consumer Protection**: The FCA focuses on protecting consumers by ensuring that financial products and services are fair, transparent, and not misleading. It enforces rules on consumer protection, including those related to the sale of financial products, conduct of business, and treating customers fairly. * **Market Supervision**: The FCA actively monitors financial markets to identify risks and emerging issues * **Deregulation**: Reduces barriers for challenger banks to boost competition

Answer 62

* **Prudential Supervision**: The PRA is responsible for prudential supervision of banks, building societies, credit unions, insurers, and designated investment firms. Prudential supervision involves assessing and ensuring the financial soundness of these institutions to prevent financial instability. * **Setting and Enforcing Prudential Standards**: The PRA establishes prudential standards and requirements that financial institutions must adhere to. These standards encompass capital adequacy, liquidity, risk management, governance, and other aspects of an institution's financial stability. The PRA enforces these standards to ensure that financial firms maintain appropriate levels of financial resources to withstand economic and financial shocks.

Answer 63

* **Prudential regulation**: Require banks to maintain adequate capital to absorb potential losses and withstand adverse economic conditions. Use of stress tests. * **Direct interventions**: Setting maximum loan to valuation ratios in the mortgage market. Increasing the cash-to-deposits ratio for a commercial bank.

Answer 64

**Purpose**: To prevent collusion, manipulation of interest/exchange rates, and artificial price-fixing (e.g., LIBOR scandal). **Mechanism**: Regulatory bodies (e.g., FCA, SEC) monitor trades and enforce penalties for unethical practices. **Impact**: Ensures rates/prices reflect free-market forces, protecting consumers, businesses, and institutions from exploitation. **Example**: Post-2008 reforms penalized banks for rigging Forex and LIBOR rates.

Answer 65

**Purpose**: Stop firms from selling complex or unnecessary products (e.g., Payment Protection Insurance (PPI) mis-selling in the UK). **Mechanism**: Regulations like MiFID II require firms to assess customer suitability and provide clear information. **Impact**: Protects consumers from products that harm welfare (e.g., selling life insurance to individuals with no dependents). **Example**: UK banks paid £38 billion in PPI compensation by 2020.

Answer 66

**Pros**: * Protects borrowers (e.g., households with mortgages) from predatory lending. * Reduces banks’ incentives for high-risk loans (e.g., subprime mortgages). **Cons**: * May restrict credit access for high-risk borrowers. * Can discourage banks from lending in underserved markets. **Example**: EU’s 2014 caps on payday loan interest rates.

Answer 67

**Pros**: * Reduces bureaucracy (e.g., easier to start/close banks). * Boosts competition, lowering borrowing costs and raising savings rates. **Cons**: * Increases systemic risk (e.g., 2008 crisis linked to relaxed lending rules). * May enable reckless behavior (e.g., Lehman Brothers’ collapse). **Example**: The 1986 "Big Bang" deregulation in London spurred growth but contributed to later instability.

Answer 68

**Mechanism**: Government-backed protection (e.g., UK’s FSCS covers up to £85k per account). **Purpose**: Prevents bank runs by assuring savers their funds are safe. **Impact**: Maintains public confidence even during crises (e.g., 2007 Northern Rock collapse). **Global Example**: US FDIC insures up to $250k per depositor.

Answer 69

* **Purpose**: Isolate household deposits from risky trading activities to prevent systemic collapse. * **Mechanism**: UK’s 2013 Vickers Report mandated structural separation (e.g., HSBC’s ring-fenced UK bank). * **Impact**: Reduces contagion risk (e.g., 2008 crisis where commingled funds led to bailouts).

Answer 70

* **Function**: Provide emergency liquidity (e.g., BOE’s 2008 £185bn bailout). * **Conditions**: Loans require collateral and carry penalty interest rates (Bagehot’s Rule). * **Impact**: Prevents solvent-but-illiquid banks from failing (e.g., saved Barclays during 2008).

Answer 71

* **Core Principle**: Minimum capital requirements (e.g., 8% capital-to-risk-weighted-assets ratio). * **Purpose**: Ensure banks can absorb losses and avoid insolvency. * **Limitation**: Overly simplistic—ignored operational and market risk, leading to Basel II/III reforms. * **Criticism**: Overlooked operational risk, leading to Basel II/III reforms

Answer 72

* **Formula**: Cash Assets (cash + reserves) ÷ Current Liabilities (deposits + short-term borrowing). * **Purpose**: Ensures immediate liquidity to meet withdrawals (e.g., bank runs). * **Limitation**: No Basel mandate—varies by country (e.g., India’s 4% cash reserve ratio).

Answer 73

* **Formula**: High-Quality Liquid Assets ÷ Net Cash Outflows (30-day stress scenario). * **Requirement**: 100% coverage by 2019 (e.g., banks hold gov. bonds to cover liabilities). * **Impact**: Prevents repeat of 2008 liquidity freezes (e.g., Lehman’s illiquid mortgage assets).

Answer 74

* **Mechanism**: Central banks (e.g., BOE) mandate a % of deposits held as reserves. * **Purpose**: Limits lending excesses and ensures liquidity. * **Example**: The Fed’s 0% reserve requirement post-2020 vs. China’s 12.5% ratio.

Answer 75

**Cause**: Repeal of Glass-Steagall (1999) allowed banks to gamble with deposits. **Outcome**: Risky mortgage-backed securities led to collapses (e.g., Bear Stearns). **Reform**: Post-crisis Dodd-Frank Act reintroduced safeguards (e.g., Volcker Rule).

Answer 76

* **Capital Ratio**: Measures capital (shareholder funds + retained profit) as a proportion of risk-weighted assets (e.g., Basel III requires 8%). Focuses on offsetting losses from risky loans. * **Leverage Ratio**: Measures capital against total loans and investments (Basel recommends 3%). Includes all assets, not just risky ones, to prevent insolvency from unexpected defaults.

Answer 77

* **Profitability**: Maximize returns for shareholders by charging higher interest on loans than paid to savers. * **Liquidity**: Hold short-term liquid assets (e.g., cash, reserves) to meet depositor withdrawals and avoid bank runs. * **Security**: Minimize default risk by lending to creditworthy borrowers, even if it sacrifices some profit.

Answer 78

**Pros**: * Prevents liquidity crises and systemic collapse (e.g., BOE’s 2008 bailout). * Maintains public confidence in banks. **Cons**: * Moral hazard: Banks take excessive risks, expecting bailouts. * Regulatory capture: Close ties between banks and regulators may bias decisions.

Answer 79

* **Issue**: High-risk individuals (e.g., unhealthy people) are more likely to buy insurance, while low-risk individuals avoid it. * **Outcome**: Insurers face losses, raise premiums, and drive away healthy customers, destabilizing the market.

Answer 80

* **FPC (Financial Policy Committee)**: Monitors systemic risk, conducts stress tests, advises on macroprudential policy. * **PRA (Prudential Regulation Authority)**: Ensures banks meet capital/liquidity ratios and manage risks (microprudential). * **FCA (Financial Conduct Authority)**: Protects consumers, prevents market rigging, and promotes competition.

Answer 81

1. Banks accept deposits and lend out a fraction (e.g., 90%). 1. Lent money is redeposited, enabling new loans. 1. Total money supply = Initial deposit × (1/reserve ratio). Example: £100 deposit with 10% reserve → £900 created

Answer 82

**Primary Market**: New securities (e.g., shares, bonds) are issued (e.g., IPOs). **Secondary Market**: Existing securities are traded (e.g., stock exchanges like NYSE).

Answer 83

**Formula**: Total Capital ÷ Total Loans & Investments. **Purpose**: Ensures banks hold capital against all assets, not just risky ones (Basel III requires 3%).

Answer 84

**LIBOR Scandal (2008)**: Banks (e.g., RBS, Barclays) colluded to manipulate the London Interbank Offered Rate (LIBOR), a benchmark for global interest rates. **Impact**: Fines totalling $9 billion; loss of trust in financial markets.

Answer 85

**FSA replaced** by FPC (systemic risk), PRA (bank stability), and FCA (consumer protection). **Ring-fencing**: Retail/commercial banking separated from investment banking (Vickers Report).

Answer 86

* Banks hold a fraction (e.g., 10%) of deposits as reserves. * Lent funds are redeposited, creating new loans (e.g., £100 deposit → £900 new money with 10% reserve).

Answer 87

* **Basel I (1988)**: 8% capital for credit risk. * **Basel II (2004)**: Added operational/market risk. * **Basel III (2010)**: Liquidity ratios (LCR, NSFR) and 3% leverage ratio.

Answer 88

* **Definition**: Agreements to buy/sell assets at a fixed price/date. * **Currencies**: Hedges against forex volatility (e.g., airlines locking in fuel costs). * **Commodities**: Stabilizes prices (e.g., farmers securing crop prices). * **Example**: Farmers use futures contracts to lock in crop prices, sharing risk with the market. This stabilizes income despite price volatility

Answer 89

* **Theory**: Prolonged financial stability encourages risk-taking, leading to crises. * **Stages**: Hedge → Speculative → Ponzi financing. * **Example**: 2008 crisis after years of stable growth.

Answer 90

* **Process**: Simulate crises (e.g., 30% house price drop) to assess capital adequacy. * **Example**: BOE’s 2021 test on UK banks’ climate risk resilience.

Answer 91

**Mechanism**: Insurance against bond defaults, sold widely without reserves. **Impact**: AIG’s $180B bailout after CDS losses.

Answer 92

Process where banks/financial markets channel funds from savers to borrowers. Example: Banks collect deposits to issue loans or underwrite bonds

Answer 93

Securities bundling loans (e.g., mortgages). Sold globally in 2008 crisis; became "toxic" when underlying loans defaulted, causing systemic distrust.

Answer 94

**Bail-in**: Losses absorbed by shareholders/creditors (e.g., Cyprus 2013). **Bailout**: Taxpayer-funded rescue (e.g., UK’s £65bn for RBS/Lloyds).

Answer 95

When mortgage debt > home value. Restricts mobility (can’t sell without loss) and increases poverty (e.g., US 2008 housing crash).

Answer 96

Policies to mitigate systemic risk (e.g., stress tests, capital buffers). Aims to prevent crises, not just manage individual banks.

Answer 97

Simulates crises (e.g., 30% house price drop) to assess bank resilience. Example: BOE’s 2021 climate risk tests.

Answer 98

Taxpayer funds used for banks could instead fund NHS, education, etc. UK’s £65bn bank bailout vs. public service cuts post-2008.

Answer 99

UK reform: Retail/investment banking "ring-fenced" to protect deposits from risky trades (e.g., HSBC’s separated units).

Answer 100

Workers in part-time/low-skill jobs despite qualifications. Rose post-2008 due to credit crunch (e.g., zero-hour contracts in UK).

4.4 - The Financial Sector Content Flashcards

(124 cards)