4.4 The financial sector

5 roles of financial markets

1. Facilitate savings

2. Facilitate lending

3. Facilitate exchange

4. Provide market for equity

5. Provide forward markets

Facilitate savings

Provides an opportunity for individuals+firms to save money. e.g. bank account, pension fund

-can receive interest on money in savings

Facilitate lending

Lend money to businesses+individuals who need more cash e.g. restaurant borrows money for machinery, individuals borrow for mortgages

-take out loan + pay back with interest

Facilitate exchange

Provide an opportunity for individuals + firms to exchange

-exchange of money between individuals + exchange of money for goods/ services through credit card

Provide market for equity

Provide a market in which equity can be bought or sold.

• equity: the % of a company sold to investors who are keen to buy + hoping to share companies profit later on (via shares)

  • Uber CEO sold 17.5% of Uber’s equity in 2017

-international banks can sell shares for a company on behalf of the company+help find investors to buy shares.

Provide forward markets

Markets in which forward contracts are drawn up + put in place

-forward contracts: special contracts that guarantee that a trade happens at a later date and at a certain price. They fix prices + dates for future transactions, so there’s no risk of price fluctuations in the future.

• banks organise these

4 functions of the central bank

1. To implement monetary policy

2. Act as a banker to the gov

3. Act as a banker to the banks (lender of last resorts)

4. Regulate the financial system

To implement monetary policy

Manipulate interest rates+money supply to meet macroeconomic targets e.g. inflation, unemployment

-influence exchange rates via interest rates

Banker to government

Buy+sell gov bonds on behalf of the government + reduce interest rate paid on gov bond- help manage national debt

Banker to banks

Lend emergency liquidity for commercial banks in need of large scale liquidity, if the bank thinks there’s a risk to the financial system if they don’t lend it.

-don’t intervene if bank makes too many risky loans

• use a fail-safe method instead (divert funds to other banks, savings are protected)

Regulate the financial system

Financial stability is crucial for confidence in financial system to remain high:

• prevent panic+a run on the bank (quickly removing assets from bank)

• reduce financial instability+systematic risk- excessive credit growth

• advise the gov. of bank bailouts

5 types of market failure in financial sector

1. Asymmetric info

2. Externalities

3. Moral hazard

4. Speculation + market bubbles

5. Market rigging

Asymmetric info

One party has more info than another.

e.g. when a company sells bonds, the buyer doesn’t know the full financial state of the company

e.g. borrowers may not reveal their full borrowing history

Externalities

When a bank fails, this may have a further impact on job losses, bank bailouts, etc.

Moral hazard

Knowing that another party will take the impact when a risky decision is made.

-banks may rely on central bank+gov for a bank bailout if they fail, as authorities fear economic consequences.

Speculation + market bubbles

The price of an asset is predicted to rise significantly- this increases the excess demand of the asset, beyond its value (bubble).

-bubble then bursts as ppl speculate price will ↓ significantly, so they sell assets rapidly, causing excess supply + prices to decrease.

Market rigging

Institutions in financial markets may collude to fix asset prices.

• create a misleading impression of market activity, creating artificial supply+demand to drive asset prices in a particular direction for personal gain (illegal).