4.4.1 Role Of Financial Markets Flashcards
(35 cards)
Roles of financial system
- payment systems
- facilitate saving
- Facilitate borrowing by firms both short term and long term
- Facilitate lending to individuals
- To provide spot and forward markets in currencies & commodities
- Raise finance for firms. Issue equity (shares)
Role of financial system (payment system)
Systems to settle financial transactions through the transfer money/monetary value
- E.g BACS UK, SWIFT transfers (international)
Role of financial system (facilitate saving)
Retain incomes that is not spent
- E.g savings account (Barclays)
Role of financial system (facilitate borrowing by firms both short term and long term)
Business lending) Borrowing loans to be paid back in a short period or after a long period
- Short term loan: over draft
- Long term loan: bank loans (normally over a year)
E.g corporate bonds (long term loan)
Role of financial system (Facilitate lending to individuals)
- secured loans (collateral/security): if the individual cannot pay it back, they can take an asset e.g house
- insecure loan
- E.g mortgage (secure loan)
Role of financial system (To provide spot and forward markets in currencies & commodities)
- Spot market: exchange of commodities and currencies for immediate cash
- Forward market: a marketplace that offers financial instruments that are priced in advance for future delivery
Role of financial system (Raise finance for firms. Issue equity (shares))
The sale of an equity or stock by a firm to investors. Shares represent part-ownership of a company.
Key purposes of a central bank
- implementing monetary policy (using interest rates & money supply to affect AD e.g quantitative easing)
- managing the currency of a country
- regulating money supply
Why are central banks independent from governments?
- to prevent political influence central bank can’t be used for political motivated targets)
Explain one role of financial markets
One role of financial markets is to facilitate long term borrowing by firms. These loans can help small firms survive downturns in the economy, especially when aggregate demand is low. The extract says that in May 2020, small firms could borrow up to £50,000 at an interest rate of 2.5% for up to 6 years. The loans borrowed by firms from the government would be paid back after a long period when the firm is generating enough allowing them to stay in business.
Roles of the Banks of England
- MPC (monetary policy committee)
- FPC (financial policy committee)
- PRA (prudential regulation authority)
- FCA (financial conduct authority)
MPC(monetary policy committee)
• Inflation targeting Bank of England
• Set interest rate
• Monitor economy
• Maintain price stability - 2%
• Inflation report published every three months
FPC(financial policy committee)
• Policy guidance
• Assess risks facing the financial system and actions needed to tackle
• Meets at least 4 times a year
• Financial stability report twice yearly
• 10 members - 5 within the bank 4 external members 1 chief executive
• Give directions to the PRA and the FCA
• Make recommendation to other bodies
• Lending increases fast —> FPC wants banks to raise more capital as an extra buffer
PRA(prudential regulation authority)
• micro potential regulator
• Regulate individual financial institution to improve safety
FCA(financial conduct authority)
• independent regulator
• Protecting consumers
• Promoting confidence in financial product and services
• Not part of the bank
Market failures in financial system
- Information gaps / asymmetries
- Moral Hazard
- Adverse selection
- Externalities (negative)
- Market rigging / fixing
- Speculation and market bubbles
- Excessive price volatility
Asymmetric information in financial system
Regulators may have insufficient information, relative to the bankers, to ensure the stability of the banking system.
Example of asymmetric information/information gaps in financial markets
- The emergence of new types of security before the financial crash = new types of risk.
- Low interest rates & poor yields from ‘safe’ government bonds = global investors were looking for new assets to invest in = this demand triggered the expansion of securitised debt = encouraged the introduction of new derivatives =holders of debt become increasingly unaware of the risks they were exposed to = they remained ignorant of the possible impact on them.
• In this case, risks tended to be under-estimated and asset values over-estimated
Moral hazard in financial markets
Central bank will always lend = moral hazard
- The assumption by many financial institutions that they were ‘too big or too important’ to fail and would be bailed out if the need arises = failure to understand the level of risk associated with securitised assets = encouraged further risk above a rational level.
- The central bank was seen as an ‘insurance policy’ should the financial institutions suffer excessive losses form imprudent lending.
Adverse selection in financial markets
E.g when a company takes advantage of the buyer’s ignorance to the demerits of a financial asset = they succeed in selling
Negative externalities of financial market failures
• Falling real output
• Rising unemployment
• Falling real wages
• Rising poverty levels
• Falling profits and bankruptcies
Market rigging/fixing in financial markets
A small number of financial institutions dominating particular financial markets = encourage market players to collude and undertake cartel-like behaviour = can extent to market rigging where asset prices are fixed by the dominant firms
• E.g the Libor scandal, 2007, which involved fixing interest and exchange rates.
Speculation and market bubbles in financial markets
poor lending decisions by bankers can lead to market bubbles.
- e.g excessive lending to home buyers who have no deposit and/or poor credit records can result in a housing bubble.
Example of externalities in financial system
in 2009, the UK government had to spend over $45bn of taxpayers’ money to prevent the collapse of RBS.
