Economics 4.4 - The financial sector

What is the financial market?

Financial markets are where buyers and sellers can buy and trade services or assets that are monetary in nature. They exist to meet the demand for services, such as saving and borrowing, and to allow financial gain

What is the role of the financial market?

Role of the financial market:

Facilitate savings, which allows people to transfer their spending power from the present to the future.

Lend to businesses and individuals which allow consumption and investment.

Facilitate the exchange of goods and services by creating a payment system.

Provide forward markets. This is where firms are able to buy and sell in the future at a set price, for example if a farmer want to sell the crop they are growing at a guaranteed price in a month’s time. Exists for commodities and in Foreign exchange and helps to provide stability.

Provide a market for equities - Company’s shared. Issues sharing is important for companies to finance expansion but people would be unlikely to buy them if they were unable to sell them in the future. Financial markets provide the ability for shares to be sold on in the future, making the asset more appealing.

How is asymmetric information and externalities a source of market failure in the financial sector?

Asymmetric information - One problem with the financial sector is that financial institutions often have more knowledge compared to their customers. This means they can sell them products that they don’t need, are cheaper elsewhere or are riskier than the buyer realises. The Global Financial Crisis is an example as it was caused by banks selling packages of prime and subprime mortgages, but advertising all of them as prime mortgages. Could also be asymmetric information between financial institutions and regulators. Institutions have no incentive to help regulators and this can lead to hiding details of their institution.

Externalities - There are a number of costs placed on firms, individuals and the government that the financial market doesn’t pay. One example is the cost of the taxpayer bailing out banks after the 2008 financial crisis. Alongside this was the long-term cost of the economy due to this crisis and how it affected demand and growth.

How is moral hazards and speculation and market bubbles a source of market failure in the financial sector?

Moral hazard - This is where individuals make decisions in their own best interest knowing there are potential risks. This can happen in 2 ways in the financial Market. Will occur where individual workers take adverse risk in order to increase their salary, as any problem they cause is placed on the company. The financial crisis was caused by a moral hazard, as employees sold mortgages to those who wouldn’t be able to pay them back. Another way that it could occur is financial institutions taking excessive risk because they know that the central bank is the lender of last resort and so will be there if they fail.

Speculation and market bubbles - Almost all trading in financial markets is speculative and this can lead to the creation of market bubbles, where the price of an asset majorly rises then falls. Tend to occur because investors see the price of the asset rising so buy it. This leads to price being excessively higher, causing investors to think that the price will fall, causing mass selling. This is known as herding behaviour. One example is in the housing market, where lending too much increased the demand for housing. When the bubble burst, for example due to a rise in interest rates, there was a major crash in house prices, reducing AD and leaving banks with unpaid loans.

How is market rigging a source of market failure in the financial sector

Market rigging - This is when groups or institutions collude to fix prices or exchange information that will lead to gains for themselves at the expense of others in the market. One example is insider trading, where an individual or institution has knowledge about something that will happen in the future and buys or sells shares accordingly for a profit. Another example is where individuals or institutions affect the price of a commodity, currency or asset to benefit themselves, for example large trades in a currency shift which shift its value.

What is the role of the central bank

The central bank controls monetary policy through interest. Rates and controlling money supply to keep inflation low and stable.

Acts as a banker to the government, such as holding the government’s bank account and lending to them, holding government debt and holding gold and foreign exchange reserves.

Act as a bank to other banks by providing key financial services to commercial banks. This includes holding their reserves, offering emergency funding through the lender of last resort function, and facilitating interbank payments to ensure smooth financial transactions. When commercial banks face short-term liquidity issues, the central bank can lend them money to maintain stability in the banking system. It also sets the base interest rate, which influences the rates at which banks lend to each other and to customers. By doing this, the central bank supports overall financial stability and ensures trust in the banking system.

In some countries, central banks regulate the financial system. This is important to prevent financial institutions from undertaking activities which harm consumers or engage in risky activities which would lead to collapse and prevent systemic risk - the risk of the whole system collapsing.

What is financial regulation and what are the 3 bodies for financial regulation?

Regulation can include banning market rigging, preventing the sale of unsuitable products, maximum interest rates to prevent exploitation, deposit insurance to increase stability and liquidity ratios - when banks are forced to hold a certain percent of liquid assets.

There are 3 bodies for financial regulation - FPC identifies and reduces system risk and supports government economic policy, PRA ensures competition, ensures consumers have access to services and minimises risk if a bank fails, and the FCA protects consumers, promotes competition and prevents market rigging.