10 - Banks & finance

What are the three functions of money?

Medium of exchange

Why is crypto not considered real money?

It is too volatile to be a reliable store of value and behaves more like a financial asset.

What is a stock?

Ownership in a company with higher risk and potentially higher returns.

What is a bond?

A loan to a government or company that pays fixed interest and is generally safer than stocks.

What is a derivative?

A financial contract used to hedge or speculate on risk; can stabilize or destabilize markets.

What type of money does the central bank supply?

Base money (cash and reserves).

What type of money do commercial banks create?

Bank money created when banks issue loans.

How do banks make money?

They charge borrowers higher interest than they pay to depositors.

What is maturity transformation?

Banks take short-term deposits and give long-term loans.

What is liquidity risk?

The risk a bank cannot get cash quickly enough to meet withdrawals.

What is default risk?

The risk that borrowers do not repay their loans.

Why are banks fragile?

They keep only a small share of deposits as cash and lend out the rest

What prevents bank runs?

Deposit insurance and central bank support.

What is the central bank’s role in crises?

It acts as the lender of last resort to prevent bank collapses.

Why do financial bubbles form?

Herd behaviour

What happens when a bubble bursts?

Prices crash

What is the financial accelerator in housing?

Rising house prices increase collateral value

Why might low interest rates fuel bubbles?

Cheap credit encourages borrowing to buy assets

Do rising stock prices always help the real economy?

No

What is a credit crunch?

When banks restrict lending due to fear of defaults

What causes fire sales?

Panic selling that pushes asset prices down even faster.

What is the principal–agent problem in finance?

Managers may take excessive risks because they don’t bear the full consequences.

Why do governments borrow?

To fund investment

What is a sovereign bond?

A government-issued loan with no collateral

What determines a bond’s interest rate?

Default risk and overall market interest rates.

How do interest rates affect saving and borrowing?

Low rates encourage spending; high rates encourage saving and reduce borrowing.

What is the money market?

A place where banks borrow from each other for short-term liquidity.

Why did interest rates rise after COVID?

To combat inflation caused by shortages and increased demand.

Why do banks need access to interbank lending?

To meet liquidity requirements and stay stable.

What caused the 2008 financial crisis?

Risky mortgage lending

How do derivatives spread financial risk globally?

By linking financial institutions so that losses spread across countries.