4.4 The financial sector

The financial policy committee

• identifies and reduces system risk and supports government economic policy (macroprudential)

• look out for unsustainable levels of leverage- lending too much money to untrustworthy people who won’t be able to pay it back 

The Prudential Regulation Authority

• creates policies for firms to follow and watches aspects of their business (supervision)

• tailored supervision by supervising firms by its potential impact on the economy if it goes bust

• forward-looking approach by testing stressful scenarios on firm to see how they would respond

The Financial Conduct Authority 

protects consumers, promotes competition and enhances the integrity of the system by preventing market rigging

Liquidity ratios 

require banks to hold a certain % of their deposits in liquid form 

• an increased liquidity ratio causes banks to lend less, potentially slowing down economic growth by reducing available debt finance for businesses 

capital ratios

limits a bank’s lending to a certain % of its capital or equity

• ensures that banks have sufficient capital reserves to cover potential losses from bad loans or financial shocks

• increases financial stability

‘Irrational exuberance’ Alan Greenspan  

describes the excessive/unfounded optimism in the financial markets, where this investor enthusiasm drives up asset prices beyond their fundamental value 

• creates an unsustainable asset bubble 

contingency fund

a business’s risk management strategy for unexpected/catastrophic events, by setting aside money to cover potential financial losses

role of financial markets 

• to mobilise savings for lending to businesses and individuals to invest or consume 

• to facilitate the exchange of goods and services by providing a flat currency 

• to provide forward markets in currencies and commodities to reduce risk 

• to provide a market for equities to facilitate raising finances by businesses  

reasons why the UK Central Bank used quantitative easing following the financial crisis (2008)

• to stimulate growth by increasing the money supply

• to increase bank liquidity so they would be more willing to lend

• interest rates were already very low so limited the scope for further reductions

• prevent deflation by increasing the money supply

externalities (market failure) 

• a negative externality occurs when young buyers end up paying more or being forced out of the market due to higher prices, when investors speculate on property prices 

moral hazard (market failure)

where individuals make decisions in their own best interests knowing the potential risks

• take adverse risks in order to increase their salary e.g Financial crisis 2008

• central bank is the lender of last resort so banks take excessive risks which reduces market discipline

example of moral hazard 

‘the china hustle’ documents how investment funds and stockbrokers played up obscure Chinese companies who presented fake financial data- stimulated investor demand and temporarily pushing up prices   

creation of market bubbles (speculation and market bubbles)

when the price of particular assets rise massively then fall

• investors continue to buy assets as they see that prices are rising continuously

• mass selling then occurs as investors see that asset prices have exceeded their fundamental value

housing market bubbles (speculation and market bubbles) 

• lending too much in mortgages and increasing demand for houses  

• the bubble bursts e.g due to higher interest rates, which causes demand for houses fall → negative wealth effect → aggregate demand falls 

• e.g wall street crash 1929,m dotcom bubble 1990s  

market rigging (market failure)

when a group/individuals/institutions collude to fix prices or exchange information that will lead to gains for themselves at the expense of others in the market

• insider trading- where an individual or institution has knowledge about something that will happen in the future that others don’t know → buy or sell shares to make a profit

market rigging (market failure)

individuals or institutions affect the price of commodity, currency or asset to benefit themselves e.g large traders in a currency will shift its value, making a difference to individuals buying/selling assets with this currency

• e.g Libor Scandal 2008, where financial institutions were accused of fixing the London Interbank Lending Rate (LIBOR), one of the most important roles in the world

control of monetary policy (role of central banks) 

controlled through the use of interest rates and controlling the money supply in order to keep inflation low and stable  

banker to the government (role of central banks)

they often hold the government’s bank account and lend to them, holding government debt as well as holding gold and foreign exchange reserves

banker to other banks (role of central banks)

banks deposit their money within the central bank, often being used to balance the accounts of banks at the end of each day when banks owe eachother money because cheques have been paid in by consumers

lender of last resort (role of central banks)

banks can turn to the central bank so sell their illiquid assets or take a short term loan, if they experience liquidity problems 

• the central bank can lend banks money if they’re on the brink of collapsing due to their assets falling too far in value e.g the financial crisis of 2007-2008 

financial regulation (role of central banks) 

• banning market rigging 

• preventing the sale of unsustainable products 

• maximum interest rates to prevent consumer exploitation and excessively risky lending 

• deposit insurance to protect consumer deposits and increase stability 

• liquidity ratios- forced to hold a certain percentage of liquid assets 

what is a forward market for currencies

• firms buy their currency in advance

• firms agree on a fixed price for the purchase of foreign currency in the future

arguments that the government providing support to banks is the best policy for financial crisis 

• the economy is dependent on the financial system working smoothly

• the government recoups much of its money that was invested on bailing out the banks anyway

• potential risk of depression if the government had not intervened

arguments that the government providing support to banks is not the best policy for financial crisis 

• stimulates moral hazard as a result of dependency culture- banks take excessive risks, reducing market discipline due to the expectation of bailout 

• other policies e.g expansionary fiscal policy, quantitative easing may have been more effective 

• bailout is a huge expenditure for the government and the UK already has a large national debt- will have to be repaid by future generations of taxpayers