4.4.1 and 4.4.2 Flashcards
(23 cards)
what is the role of the financial market in the wider economy?
- To facilitate saving by businesses and households: Offering a secure place to store money and also earn
interest
* This allows households to smooth their consumption over time, and build up deposits/ funds for
large purchases - To lend to businesses and individuals: Financial markets provide an intermediary between savers and
borrowers
* Banks channel funds from savers to borrowers, who would otherwise be unable to connect in an efficient way - To allocate funds to productive uses: Financial markets allocate capital to where the risk-adjusted rate of return is highest
- To facilitate the final exchange of goods and services: They provide payments mechanisms e.g. contactless payments
* Money is essential in a market economy in which division of labour is used
* Money allows a much more efficient operation of an economy, because without money, there would
be a barter system - To provide forward markets in currencies and commodities: Forward markets allow agents to insure against
price volatility - To provide a market for equities: Allowing businesses to raise fresh equity to fund investment and growth
* Businesses gain finance for investment and growth from a number of sources, including retained profits, loans from banks, borrowing from money and capital markets via issuing corporate bonds (“debt financing”), or gaining funds by issuing shares (“equity financing”)
what is narrow money vs broad money?
- Narrow Money
o The narrow money definition of the money supply is a measure of the value coins and notes in circulation and other money equivalents that are easily convertible into cash such as short-term deposits in the banking system - Broad Money
o Broad money is a measure of the total money held by households and companies in the economy o Broad money is made up mainly of commercial bank deposits — which are essentially IOUs from
commercial banks to households and companies — and currency — mostly IOUs from the central bank
what are the different types of loans and examples?
long term loans= finances whole business over many years e.g retained profits, mortgages and long term bank laons
medium term loans= finances major projects or assets with a long-life e.f bank loans, leasing, hire purchase and government grants
short term loans= finances day-to-day trading of a business e.g bank overdraft, short term loans and trade creditors
what are the key features of bank loans?
Key Features of Bank Loans
1. Loan is provided over a fixed period (e.g. 5 years)
2. Rate of interest payable is either fixed or variable
3. Timing and amount of loans repayments are set by the lender e.g. a commercial bank
4. Non-performing loans (“bad debts”) occur when the borrower is unable to repay some or all of the debt
what are secure loans vs unsecured loans?
Unsecured loans
* Money supported only by a borrower’s creditworthiness, rather than by any type of collateral
Secured loans
* Money you borrow that is secured against an asset you own, usually your home
what are examples of equity finance?
Angel Investors - Individuals who inject capital for business start-ups
* Venture Capital - Firms specializing in building high risk equity portfolios
* Stock Market Listing - Offering shares to public & institutional investors e.g. via an initial public offering (IPO)
* Crowd Funding - Raising capital from a large number of individual investors via platforms such as Crowd
Cube
What are the main functions of a commercial bank?
- Commercial banks provide retail banking services to household and business customers
- Banks are licensed deposit-takers providing savings accounts
- They are licensed to lend money and thereby create money e.g. via bank loans, overdrafts and mortgages
- Commercial banks are nearly all profit-seeking businesses
- A bank’s business model relies on charging a higher interest rate on loans than the rate paid on deposits
- This spread on their assets and liabilities is used to pay the operating expenses of a bank and make a profit
Banks create credit by extending loans to businesses and households. They do not always need to attract deposits from savers to do this. When a bank makes a loan, it credits their bank account with a bank deposit of the size of the loan/mortgage. At that moment, new money is created in the financial system.
how do commercial banks make a profit?
- Interest-rate spreads – i.e. charging a higher interest rate on loans than the rate that is paid to savers
- Service fees - Includes fees charged by a bank to borrowers when arranging loans
- Brokerage percentages - many banks provide currency & share-dealing services and charge a brokerage fee
for doing so
how can banks fail?
- Run on the bank
a. Depositors panic and withdraw their money fearing that the bank may collapse
b. This creates a liquidity crisis for the bank, and they may need to find emergency sources of funding - Credit crunch
a. A bank may be unable to borrow money from other banks even on an overnight basis
b. Heavy losses and collapsing capital threaten their commercial viability - High losses from bad debts / loan defaults as borrowers fail to repay
a. Credit rating of bank declines and their share price falls – this makes it harder to raise fresh finance
what are the limits to credit creation by banks?
- Market forces – i.e. the scale of profitable lending opportunities
- Regulatory policies e.g. higher capital reserve requirements imposed by a central bank
- Behaviour of consumers and businesses e.g. decisions about how much of their debt to repay
- Monetary policy – the level of policy interest rates influences the demand for loans from households and
businesses, for example the demand for business loans and mortgage loans in the housing market
what are liquidity risk and credit risk?
Liquidity risk:
* Banks tend to attract short term deposits e.g. from savers
* They often lend for longer periods of time e.g. a 20-year mortgage
* As a result, a bank may not be able to repay all deposits if savers decide to withdraw their funds in one go
* To reduce their risk, commercial banks will try to attract long term deposits and also hold some liquid assets e.g. cash as capital reserves
Credit risk:
* This is the risk to the bank of lending to borrowers who turn out to be unable to repay some or all of their
loans
* Credit risk can be controlled by research into the credit-worthiness of borrowers and also by banks having
sufficient capital in reserve. Minimum capital reserves may be imposed by the financial authorities Investment Banks
JPMorgan Chase Goldman Sachs Deutsche Bank Morgan Stanley UBS
What are investment banks?
- An investment bank provides specialized services for companies and large investors:
o Underwriting and advising on securities issues and other forms of capital raising o Advice on mergers, acquisitions & corporate restructuring
o Trading on capital markets (bonds and equities)
o Corporate research and private equity investments - An investment bank trades and invests on its own account
- Commercial banks can provide investment banking services
what is market failure?
Market failure occurs when a market fails to deliver an economically efficiency and/or socially equitable allocation of scarce resources. Market failure is a justification for government intervention e.g. through financial regulation although this too might lead to governmental / regulatory failures as a result.
what is asymmetric information?
Asymmetric Information
* This type of market failure exists when one individual or party has much more information than another
individual or party and then uses that advantage to exploit the other party.
* Finance is a market in information – often a potential borrower (such as a small business) has better
information on the likelihood that they will be able to repay a loan than the lender.
what are externalities?
- A negative externality exists when a market transaction has a negative consequence for a 3rd party.
- A positive externality exists when a market transaction has a positive consequence for a 3rd party.
Examples of external costs (negative externalities) arising from financial crises:
- Taxpayers (taxpayers bear the cost of bank bail-out costs and the impact of fiscal austerity)
- Depositors (Risk of lost savings if a bank collapses)
- Creditors (A rise in unpaid debts can create difficulties)
- Shareholders (Lost equity from falling share prices)
- Employees (Lost jobs in finance & the wider economy especially if a financial crisis turns into a recession)
- Government (increased fiscal deficit and national debt)
- Businesses (reduced demand for goods and services and higher borrowing costs for those needing loans)
what is moral hazard?
Moral hazard exists where an individual or organisation takes more risks because they know that they are covered by insurance, or they expect that the government will protect them (i.e. bail them out) from any damage incurred as a result of those risks.
what are examples of moral hazard?
- Individuals with large insurance policies to cover specific risks are more likely to claim against such policies.
- Government bail-outs of commercial and investment banks encourages them to engage in riskier behaviour
- Sub-prime mortgage lenders prior to 2007 were able to repackage loans into bundles bought by other
institutions
What is a speculative bubble? What factors can cause a speculative bubble?
- A speculative bubble is a sharp & steep rise in asset prices such as shares, bonds, housing, commodities or
crypto-currencies - The bubble is usually fuelled by high levels of speculative demand which takes prices well above fundamental
values - Behavioural factors e.g. the herd behaviour of investors
- Exaggerated expectations of future price rises (i.e. people expect property prices to carry on increasing)
- Irrational exuberance of investors – a term coined by Nobel-winning economist Robert Shiller
- A period of very low monetary policy interest rates – which encourages risky investment by people and by
other agents in financial markets in search of higher yields
what is market rigging?
- This market failure is effectively collusion or abuse of the power resulting from operating in a concentrated
market. Market rigging happens when some of the companies in a market act together to stop a market
working as it should in order to gain an unfair advantage - When there is a small number of firms in a market, they may choose to work together to increase their joint
profits and exploit consumers. - The Competition and Markets Authority report on UK banking in August 2016 said that “the older and larger
banks, which still account for the large majority of the retail banking market, do not have to work hard enough
to win and retain customers and it is difficult for new and smaller providers to attract customers.” - Price rigging is illegal because it interferes with the natural market forces of supply and demand and harms
consumers by inhibiting competition.
how does monopoly power manifest in financial markets?
Market failure can arise when a market is not sufficiently competitive. The UK banking sector for example is dominated by a few very large banks, including the Lloyds Group, Barclays, the Royal Bank of Scotland (RBS), and HSBC. In term of market shares for all categories of business, the market is clearly oligopolistic. There are significant barriers to entry into the market which make life hard for new entrants as they seek to establish themselves and make a profit.
Examples of barriers to entry into commercial banking
- Regulatory barriers – i.e. the need to be given a banking licence by the central bank
- Natural or intrinsic barriers to entry – costs of entering the market including marketing costs, building IT and
payments infrastructure - Strategic advantages of larger banks – including vertical integration, branch network, low rates of customer
switching - First mover advantages including strong brand loyalty for established banks
What is systemic risk?
- Systemic risk is the possibility that an event at the micro level of an individual bank / insurance company could
then trigger instability or collapse an industry or economy. - The Global Financial Crisis (GFC) illustrated how deeply inter-connected the financial world has become.
- Shocks in one location (e.g. the USA) or one asset class (e.g. sub-prime mortgages) can have a sizable impact
on the stability of institutions and markets around the world. - Since the crisis, financial regulators have tried to make the banking system less vulnerable to economic shocks
and create firewalls to prevent damage from systemic risk
