The Financial sector

Financial markets

Any place or system that provides buyers and sellers the means to exchange goods/services and trade financial instruments

• Includes bonds, equities, international currencies and derivatives

The different roles of financial markets

• They facilitate saving

• They lend to businesses and individuals

• They facilitate the exchange of goods and services

• They provide forward markets in currencies and commodities

• They provide a market for equities

Financial markets facilitate savings

Storing money for future use is essential for households and firms, it also provides a pool of money that financial institutions can lend i.e. one person’s savings is another person’s borrowing

Financial markets lend to business and individuals

Access to credit is a requirement for economic growth and development, being able to borrow speeds up consumption by households - and investment by firms. It also allows households or firms to purchase assets and pay them off over an extended period of time e.g mortgages.

Financial markets facilitate the exchange of goods and services

Each purchase of goods and services requires the movement of money between at least two parties.

Financial markets provide multiple ways for this to happen including phone apps (Google pay), debit cards, credit cards and bank transfers

Financial markets provide forward markets in currencies and commodities

Forward markets are also called futures markets. They provide some price stability in commodity markets and enable investors to make a profit by speculating on future prices.

Futures markets

A type of agreement to buy or sell a specific commodity, asset or currency at a set future date or price

Financial markets provide a market for equities

Equities are shares in public companies that are listed on stock exchanges around the world. Financial markets facilitate both long term investment and speculation by providing platforms which connect buyers and sellers e.g. E-trade

Market failure in the financial sector

When the financial market leads to a less than optimal allocation of resources from society’s point of view

Types of market failure in financial markets

• Asymmetric information

• Externalities

• Moral hazard

• Speculation and market bubbles

• Market rigging

Asymmetric information

Many financial products are complex and difficult for consumers to understand

• The sellers often have a significant information advantage over the buyers

• This was demonstrated in the financial crisis

Externalities

Negative externalities of production and consumption exist in the financial market

• When investors speculate on property prices, a negative consumption externality occurs as young buyers end up paying more due to to the higher prices caused by speculation

Moral hazards

This occurs when an economic agent is willing to take more risks because if they fail, the consequence lies on another agent

e.g

• Governments have stepped in to save individual banks from failure (e.g RBS)

• Banks seem to be considered “too big” to fail and governments bear the consequences of their risky behaviour

Speculation and market bubbles

• The higher the money supply in an economy, the greater the speculation and potential for market bubbles

  • Significant amounts of quantitative easing since 2008 have increased the money supply and created potential bubbles in different markets

Market rigging

• There have been allegations that some banks and individual bankers have been involved in rigging key interest rates in order to profit maximise

• This is considered fraudulent but difficult to identify unless there is a whistleblower

Role of central banks

• Implementation of monetary policy

• Banker to the government

• Banker to the banks

• Regulation of the banking industry

The central bank being a banker to the government

The government sets the annual budget but it is the central bank that manages the tax receipts and payments.

The gov decides what to spend, but the central bank helps move money in and out of the governments accounts

The central bank banking banks

Commercial banks are able to borrow from the central bank if they run into short term liquidity issues. Without this help, they might go bankrupt leading to instability in the financial system - and a potential loss of savings for many households

The central bank regulates the banking industry

The high level of asymmetric information in financial markets requires that commercial baanks are regulated to protect consumers, one key regulatory action is to manage money supply and promote stability in the financial system is the implementation of required reserve ratios. Raising the ratio decreases the money supply in an the economy and vice versa

Required reserve ratios

The minimum percentage of deposits that commercial banks must keep as reserves rahter than lending out.

Raising the ratio decreases the money supply in the economy and vice versa