4.4.1+2 Role of financial markets and market failure

What is a financial market

A place where buyers and sellers can buy and trade a range of services or assets that are fundamentally monetary in nature.

What are the 6 main roles of financial markets

To facilitate savings, to lend to businesses and individuals, to facilitate the exchange of goods and services, to provide forward markets, to provide a market for equities, to provide insurance

Define derivative

This is a financial instrument where the value is derived from the price of an underlying asset, such as commodities such as wheat or coffee, or financial assets such as a bond or a share.

What are 6 different types of financial institutions

Retail banks, commercial banks, investment banks, saving vehicles, speculators, insurance companies.

What are 6 different types of financial markets and explain what each market provides

Money markets (short term borrowing and lending up to one year), capital markets (longer term financing more than one year contracts), foreign exchange markets (where different currencies are traded), commodity markets (where commodities are traded), derivative markets (where derivatives are traded), insurance markets (provides insurance for individuals, firms and governments and reinsurance for insurance companies)

Define reinsurance

Where an insurer reduces the risk on the insurance it sold, by selling part of the liability to other insurance companies, so in the case of natural disaster or other cases, no one insurance company has carried too much risk

Give 3 application points related to the UK’s financial sector (hints: trade surplus, jobs, GDP and include years)

In 2021 the UK had a trade surplus in financial services of £44 billion, in 2022 3% of all UK jobs were in financial services (1.08 million), in 2021 financial services contributed 8.3% of the UK’s GDP

What are retail banks (including the 6 main services they provide)

These are banks which offer a wide range of services to individuals, such as savings accounts offering interest, Overdraft accounts, loans, mortgages, credit cards, foreign exchange, etc. These banks make profit from borrowing money at low or zero rates of interest, and loaning the money out with a higher rate of interest.

What are commercial banks (including their 5 main services)

These are banks which offer a wide range of services to businesses. Their roles include accepting deposits, providing loans, payment services, safekeeping of valuables and currency exchange.

What are investment banks (including 3 main services)

These banks specialise in activities related to capital markets, such as underwriting securities, facilitating mergers and acquisitions, and providing advisory services to corporations.

What is a common example of an investment bank (include global market share in 2023)

JP Morgan, which had a market share of revenue of leading global investment banks of 8.5% in 2023.

What is a saving vehicle (include three examples of services)

These financial institutions have a primary function of helping individuals make a return on their savings. This involves pension funds, hedge funds, investment trusts, etc.

What is a speculator as a financial institution

These are financial institutions whose sole purpose is to speculate on financial markets, but this is usually incorporated into investment banks also. It could be argued that hedge funds are part of this group of financial institutions.

What are insurance companies

These are firms that provide insurance against risks by charging customers a premium.

What is an important note about large banks in the US, UK and most of Europe

the largest banks in these countries are combined retail, commercial and investment banks, but there are some banks that specialise in one of these roles

What is the importance of facilitating saving?

This allows individuals and firms to transfer their spending power from the present to the future.

What is the importance of lending to businesses and individuals?

This function allows consumption and investment to grow, which in turn allows both long term and short term AD to increase.

What is the importance of facilitating the exchange of goods and services?

This allows goods and services which are delivered at one point in time to be paid for at an other point in the future

What is the importance of forward markets

Forward markets help provide stability in certain markets, as they allow people to hedge against price volatility or exchange rate fluctuations.

What is the importance of providing a market for equities

Providing this market provides the ability for shares to be sold on in the future easily, making the asset more liquid and therefore more appealing. These assets are important as they allow firms to finance their expansion

What are the 5 main causes of financial market failure

Externalities, asymmetric information, market rigging, moral hazard, speculative bubbles

Define financial crisis

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

What are the 5 types of financial crisis and define each one

Currency crisis (when a fixed exchange rate regime collapses, or a currency goes into a free fall meaning it depreciates 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 a banking system is low leading to a sharp rise in savings deposits and possible run on banks)

Broad financial crisis (elements of all above)

Define speculative bubbles including a few examples

These exist when the market price of a financial asset is driven above what it should be such as the speculative boom in housing, crypto, NFTs, commodities or share prices. These can be amplified by herd behaviour.

Define herding behaviour

This is how speculative bubbles form, and it is when investors base their actions on what others are doing rather than the underlying value of the asset they are investing in.

What are the five stages of a speculative bubble including brief descriptions

Displacement stage: Excitement grows about a new product/ emerging technology

Prices boom: Prices rise as demand surges and inelastic supply causes market prices to spike higher

Euphoria: Euphoria as more investors look to take advantage (Robert Schiller calls this ‘irrational exuberance’)

Profit taking stage: Some investors sell as they realise prices are out of line with fundamentals

Panic: The herd mentality switches to desperate selling and prices fall fast inflicting big losses

Give an application point relating to speculative bubbles in the UK

The UK is particularly prone to housing bubbles, partly because too few new housing bubbles are being built and partly because a high proportion of households own their own properties.

Define market rigging and state two forms of market rigging.

This is a form of anti-competitive behaviour 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. Two forms of this are fixing prices and market rigging

Give a real life example of market rigging

A group of traders from several major banks, including Barclays, JP Morgan Chase, UBS, etc colluded to manipulate the prices of currencies in the FX market, at the expense of other market participants

Define insider trading

This is a form of market rigging, where an individual or institution has knowledge about something that will happen in the future that others do not know and so buy or sell shares based on this knowledge in order to make a profit.

Define fixing prices

This is another form of market rigging where individuals or institutions fix the price of a commodity, currency or asset. For example, sudden large trades in a currency can shift the currency’s value, which can allow traders to benefit from buying and selling related assets.

Define asymmetric information

This occurs when there is an imbalance of information between agents.

What is the main way asymmetric information appears in commercial banking, how is this solved, and how is the solution evaluated

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.

This is solved by the existence of rating agencies, which banks rely on to assess the creditworthiness of borrowers and investments, but thee agencies may not always have complete or accurate information leading to inaccurate ratings.

What is the effect of asymmetric information in insurance

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.

(OPTIONAL) explain how asymmetric information played a key role in causing the 2008 financial crisis

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Define negative externality in the context of financial markets

This is a cost of a transaction or group of transactions which took place in financial markets which is not borne by the financial markets

Give two examples of negative externalities in financial markets

Short term: The cost to the taxpayer of bailing out the banks after the 2008 Financial crisis. At its peak, this cost was £1.2 trillion

Long term: The long-term cost to the economy of the crisis due to its effects on demand and growth.

Define moral hazard

This is where individuals make decisions in their own best interests knowing there are potential risks, where the cost will be partially borne by other economic agents.

Explain the three ways which moral hazard occurs in financial markets

In investment banking, traders and senior executives can make large bonuses by generating profits for the bank, which incentivises them to take short-term excessive risk without considering long-term risks, leading to moral hazard.

Financial institutions may take excessive risks because they know the central bank will bail them out, this played a central role in the 2008 financial crisis.

Insurance may cause policyholders to take excessive risk as they know they are shielded from the full costs of their actions.

What are 5 examples of recent financial crises (details on OneNote)

The Eurozone crisis (2010-2012), the Chinese stock market crash (2015), the Venezuelan crisis (ongoing), the Turkish currency crisis (2018), USA financial crisis (2008-2010)