Theme 4 CC6 - The Financial Sector

Question 1

Define financial markets

Answer 1

Any convenient set of arrangements where buyers and sellers can buy or trade a range of services or assets that are fundamentally monetary in nature.

Question 2

Define capital markets

Answer 2

financial markets which provide long-term borrowing and lending, usually defined as over one year.

Question 3

Define money market

Answer 3

financial markets that provide short-term borrowing and lending, usually defined as up to one year.

Question 4

Explain retail banks

Answer 4

banks that provide services to individuals.

Question 5

Explain commercial banks

Answer 5

banks that provide services to businesses.

Question 6

Explain investment banks

Answer 6

banks that engage in a variety of activities in different financial markets, such as the foreign exchange market, the money markets, the capital markets and the derivatives markets.

Question 7

What is equity?

Answer 7

in a company, is the value of the assets owned by the shareholders.

Question 8

Explain derivatives

Answer 8

financial instruments based on the values of other financial instruments.

Question 9

What is the role of the financial sector (5)?

Answer 9

• To facilitate savings (Households, Firms and governments)
• To lend to businesses and individuals
• To facilitate the exchange of G&S (payment services e.g. debit/credit cards)
• To provide forward markets in currencies and commodities (buy and sell in future date at set prices to ensure certainty)
• To provide a market for equities i.e. company shares

Question 10

Give 5 forms of market failures in the financial sector

Answer 10

• Asymmetric information
• Moral hazard
• Production externalities
• Market bubble
• Market rigging

Question 11

Explain asymmetric info
- Relate to banking crisis

Answer 11

Where buyers and sellers have different amounts of information, with one group having more info than the other.
- Mortgage buyers unaware of rise in interest rate after fixed period leading to defaults

Question 12

Explain production externalities
- Relate to banking crisis

Answer 12

when the social costs of production are different from the private costs of production. If social costs exceed private costs, then there are negative production externalities.
- When CDO value crashed, caused recession - Loss of jobs/incomes. Negative externality to ordinary people, also the cost to the taxpayer who had to pay to bail out banks.

Question 13

Moral hazard
- Relate to banking crisis

Answer 13

when an economic agent makes a decision in their own best interest knowing that there are potential adverse risks, and that if problems result, the cost will be partly borne by other economic agents.
- Banks Selling sub-prime mortgages to investment banks rated AAA by rating agencies despite the large risk on CDOs which became worthless.

Question 14

Market bubble
- Relate to banking crisis

Answer 14

a market bubble occurs when the price of a particular asset is driven to an unsustainably high level and then collapses.
- House and mortgage prices rose and then became overvalued as house supply was greater than demand - then house prices crashed.

Question 15

Market rigging
- Give example

Answer 15

Where a group of individuals or institutions collude to fix prices or exchange information that will lead to gains for themselves at the expense of other participants in the market
- 5 banks fined over 1bn Euros for rigging foreign exchange market for over 11 currencies. Colluded using online chat rooms to buy/sell currency to manipulate exchange rates.

Question 16

Define central bank

Answer 16

the financial institution in a country or group of countries, typically responsible for the printing and issuing of notes and coins, setting short-term interest rates, controlling monetary policy, managing the country’s gold and foreign currency reserves and issuing government debt.

Question 17

What is lender of last resort?

Answer 17

usually a function of a central bank, it occurs when financial institutions can obtain money from the central bank to balance their accounts when they are unable to do this from the financial markets in which they operate.

Question 18

Shadow banking

Answer 18

parts of the financial market that are either much less regulated than the norm or are completely unregulated.

Question 19

Systemic risk

Answer 19

the risk of the whole financial system collapsing

Question 20

Regulatory capture

Answer 20

An example of government failure, it occurs when firms in an industry are able to influence to their advantage a regulatory body which is supposed to be regulating the behaviour of those firms.

Question 21

What are 4 roles of central bank e.g. Bank of england

Answer 21

1. Issue money (Medium of exchange) and ensure trust (prevent counterfeit)
2. Maintain prices and value of money (Prevent inflation) to ensure market works effectively.
3. Controlling spending through monetary policy - if inflation above target, ^interest rate to encourage saving and reduce spending and vice versa.
4. Financial system - allow payments/transactions, connect savers and borrowers through banking (has risks so banks need shareholder capital and liquid assets)

Question 22

Explain banker to the government

Answer 22

• Bank of England handle accounts of government departments
• Make short term advances to government

Question 23

Explain banker to other banks and when are central banks lender of last resort

Answer 23

• Force largest banks operating in country to deposit money with them, which is used to balance the accounts of banks at end of each day.
  Lender of last resort when:
• Short term liquidity problems: a bank has plenty of assets by they are illiquid (i.e. difficult/impossible to turn to cash) so it borrows from central bank (or sells illiquid assets to central bank) to get cash needed to make urgent payments.
• Serious insolvency problems: a bank has suffered serious losses, its assets have fallen greatly in value, (e.g. due to many bad debts), so that its liabilities exceed its assets, central bank lends money to avoid the bank collapsing, giving the government time to organise a bailout. To avoid business failure, the bank will ultimately need new share capital, i.e. in 2008 this was a gift of money from the UK taxpayer

Question 24

Give example of bank bailout

Answer 24

• RBS on verge of collapse in 2008, nationalised by govt who bought 80% shares to keep it running.

Question 25

Why should banks be bailed out?

Answer 25

• If banks were allowed to collapse, this could create severe recessions.
• People could lose savings
• Consumers and businesses would be unable to borrow.
• Results in a loss of confidence, fall in consumption, investment, AD/AS and GDP.

Question 26

Evaluate with why banks shouldn’t be bailed out

Answer 26

Moral hazard - No incentive to operate correctly if govt/BOE bail out banks whenever they make risky decisions. Therefore banks will continue making risky/poor decisions as taxpayer will pickup costs in result of failure.

Opportunity cost - Govt could have lower govt spending, higher taxes and higher debt as bailing out banks are very expensive. Also public services may suffer e.g. could be spent on education/policing.

Question 27

What are the reasons for regulation?

Answer 27

Regulation is required to avoid the market failures e.g. Asymmetric information, negative externalities, avoiding systemic risk etc

Question 28

What are the three regulators called and their role?

Answer 28

• FPC takes action to reduce systemic risks
• PRA sets standards & supervises individual firms
• FCA ensures customers are treated with fairness and not exploited

Question 29

Explain stress tests

Answer 29

Bank of england test banks to ensure they would survive in interest rates rise, house price rises or recession etc.
- Bank of England can force banks to keep more capital.

Question 30

Evaluate regulations

Answer 30

1. Tough regulations make UK less competitive e.g. banks could move elsewhere where there are less regulations. Loss of jobs, income, tax rev etc
2. Regulation is difficult as financial markets are complex, there are a lot of institutions to regulate, potential for govt failure.
3. Regulatory failure