The Role of the Financial Sector (Theme 4)

4.4.2, 4.5.1, 4.5.2, 4.5.3, 4.5.4

What does the financial sector consist of?

Banks, forward markets, stock markets, pension funds and insurance companies

what is their role?

channel savings into investments

make risky investments safer

transform short term saving opportunities into long-term loans

what does the banking sector consist of?

retail and investment banks, building societies and shadow banks

what is the role of retail banks?

they are used by the public and businesses. They accept deposits, provide loans, and offer various financial services to individuals and businesses.

they assess risk by measuring collateral and income levels and checking credit history

what does an investment bank do?

evaluates mergers and acquisitions

IPO Deals - helping companies transition from ltd to plc

Proprietary Trading - they trade using the firm’s money. This involves speculating, which was controversial during 2008

Private Wealth Management

what are forward markets?

Forward markets are platforms where participants can buy and sell contracts to deliver assets at a future date for a price agreed upon today, allowing for hedging against price fluctuations.

this takes away risk but there is a cost, and firms could miss out on potential profits if prices move favourably.

stock markets

current shareholders can sell shares or new businesses want to raise money. this encourages investment

how do pension funds work?

they accumulate and invest funds from existing workers. they then pay pensions to retired workers

they mostly buy government bonds → secure + guarantee returns

this enables workers to move consumption from today to their futures

what are liability driven investments?

This is when you’re always ensuring that your assets can cover your liabilities

It involves hedging risks (sacrificing huge returns to avoid huge losses) by using interest rate swaps (effectively betting on interest rates falling)

The problem is if gilt interest rates fall - so pension funds hedge the risks by betting on interest rates falling

what are insurance companies?

they minimise exposure to risk of loss of assets which encourages trade

what were the causes of the financial crisis?

recession after 9/11. various firms saw different effects (in terms of shares and profits) and there was a sharp rise in oil and gas prices

low interest rates initially. this increased the demand for mortgages. this drives house prices up - there are lots of price volatility due to PED

sub-prime mortgages became more common - lending to borrowers with poor credit histories at high interest rates, leading to higher default rates and significant financial instability.

CDOs (Collateralised Debt Obligations) were financial instruments that pooled various debt obligations and sold them as securities, often becoming highly risky due to the inclusion of sub-prime mortgages.

Rating Agencies were inadequate

When interest rates rose, prices went down, so many people had to default on their mortgages. Supply increases and prices fall further, CDOs became worthless

insurers fail to pay out on credit default swaps - this was a system wide failure

bank assets were wiped out, confidence plummeted and they stopped lending to each other

what effects did the financial crisis have on the economy?

AS and AD plunging

consumption and business spending down

uncertainty in trade

government spending was the main driver of AD

demand - deficient unemployment

wealth and lending go down

what effect did the crisis have on businesses?

lack of credit so:

lack of demand for goods

lack of small businesses

no working capital and no investment

how did the government attempt to resolve it?

in the UK, they used a bail out and then austerity + QE

they increased banking regulation and put limits on bonuses

what effect did the crisis have on the public?

The financial crisis led to increased unemployment rates, reduced public services, and a decline in household wealth. Many individuals faced foreclosures and heightened economic insecurity.

greater inequality since QE leads to land prices etc increases

what sort of banking regulation was implemented?

increased bank capital requirements

separates retail and investment banking

regulating credit reference agencies and mortgage lending more

there is a deposit guarantee of £85,000

but banks are too big to fail - there is an incentive to take risks knowing that the government can bail them out

what sort of regulation was there before the crisis?

1986 Financial Services Act de-regulated banks and allowed free movement of capital

BASEL 1 established capital adequacy ratios - so they ahead to have a certain amount of capital determined by the risk of their assets. Overall it was 8%

what is capital?

Tier 1 is shareholder money - retained earnings, general reserves etc

Tier 2 is when banks hold subordinated debt and preferred stock. Capital is crucial for absorbing losses and ensuring financial stability.

what regulation came after the crisis

BASEL 3 - common equity Tier 1 ratio was raised from 2% to 6%

stress tests were implemented - ensures that they they can deal with adverse scenarios. They have a strong enough system

Also relying less on short term loans and accepted limits on bonuses

Deposit guarantee (£85,000)

who monitors banks?

Financial Policy Committee (BoE) - systemic risks

Prudential Regulation Authority (BoE)

FCA - competiton and consumer protection

what scandals have occurred in banking?

LIBOR scandal - rate at which banks borrow against each other

Exchange Rate scandal - speculating on exchange rates and bringing in bonuses

what market failure is there is banking

Asymmetric, lack of or misleading information

moral hazard

regulation failing

what problems does implementing banking regulation have?

less profit for banks, so less investment and lending reduced

high bank funding costs which can be passed on to consumers and businesses

costs of administration

regulatory capture

there must be a balance

what role does the bank of england have?

determines monetary policy

provides banking services to the Government and acts as a banker to retail and investment banks

regulates and control banking activity

they are a lender of last resort - provides liquidity and ensures stability (but is this a moral hazard?)

how does quantitative easing work and how does it help?

In response to a sharp fall in demand

The bank purchases assets (usually government bonds) from private sector businesses. This increases prices and reduces yield (income payments received from holding it). So return on these assets fall

So other assets are purchased and their yield reduces

This lowers the cost of borrowing

It can help to increase wealth since cash is spent on other assets

It increases bank liquidity. Consumption and investment increases