The Financial Sector:

What is the main purpose of banks and other financial institutions?

To make money available to those who want to spend more than their income, using the savings of those whodon’t currently want to spend

What are everyday forms of borrowing for individuals?

• Personal loans

• Mortgages

• Credit cards

• Pay-day loans

• Overdrafts

What is equity finance?

Raised by selling shares in a company, meaning whoever buys the shares becomes a shareholder and can claim some ownership of it, entitling them to a share of profits in the form of dividends

WHat is debt finance?

Borrowing money that has to be paid back (usually with interest) can involve borrowing from financial institutions or issuing corporate bonds

How does the financial sector help economic growth?

• Effective/efficient financial markets/institutions enable economic growth to occur, aid with stability

• EG driven by spending/investment, lots relying in credit

• Businesses unlikely to grow without credit

Financial institutions are regulated to:

• Reduce the impacts of financial market failure

• Protect consumers by policing individuals/firms to ensure they act fairly and legally

• Ensure the integrity and stability and financial institutions and the services they provide

• Maintain confidence in the financial sector and avoid sudden panics

What do money markets do?

Provide short-term finance to banks, companies, governments, and individuals, this short term debt will have a maturity (repayment period) of 24 hours to a year

What do capital markets do?

Provide medium and long-term finance to governments and firms, who can raise finance by issuing bonds. Firms can also issue shares and borrow from banks

What two markets are within the capital market?

The primary market, for new share and bond issues

The secondary market, where existing securities are traded, increasing their liquidity

What happens on foreign exchange markets?

Trading of different currencies, usually done to allow international trade and investment, or as speculation

What are the two aspects of the foreign exchange markets?

The spot market, for transactions that happen now

The forward market, for transactions that will happen at an agreed time in the future

Process of bonds:

1. Government/large firms issue bonds

2. Investors buy new bonds at their ‘face value’

3. Interest is paid to the bond holder

4. The amount of interest paid is called the coupon

5. After they’ve been issues bonds can be traded on the secondary capital market at any price

6. The bond’s yield is the annual return an investor will get from the bond, the less someone pays for a bond, the higher its yield

7. When the bond matures, the current bondholder is paid the nominal value of the bond

How to calculate the yield of a bond?

Yield=(coupon/market price) x100

What are commercial banks main roles?

• Accept savings

• Lend to individuals/firms

• Be financial intermediaries (move funds from lenders to borrowersAllow payments from one person or firm to another

What do investment banks do?

• Arrange share and bond issues

• Offer advice on raising finance and on mergers and acquisitions

• Buy and sell securities on behalf of their clients

• Act as market makers to make trading in securities easier

What are financial institutions other than banks?

• Pension funds

• Insurance firms

• Hedge funds

• Private equity firms

What is the shadow banking system?

Unregulated financial intermediaries and the unregulated activities of otherwise regulated financial institutions. Supplies an increasing amount of credit but causes a financial risk

What is narrow money?

The notes and coins in circulation and balances held at a central bank-very liquid

What is broad money?

Less liquid assets as well as all the things that make up narrow money

Inter-bank lending:

Lending between banks and occurs on the inter-bank lending market (a money market). The loans are very short term, enables banks to borrow to meet customers needs, f=banks with excess liquidity earn interest on what they loan

Balance sheets:

• A look at a banks assets and liabilities on a particular date

• Total assets should always equal total liabilities

Relevance of capital on a balance sheet?

Total of a bank’s share capital+reserves

Decides how much credit a bank can create

If the value of an asset falls, the capital is reduced by the same amount so total assets still equal total liabilities

Relationship between market interest rates and bond prices?

Inverse

Yield=coupon/market price x100

Market price=coupon/yield x100

Meaning as interest rates rise, bond prices fall and vice versa

How does a financial crisis create a systemic risk?

A problem in one part eg a single bank, can lead to the breakdown of a whole market or financial system. Issues in one country’s financial sector can spread around the world

What are market bubbles?

Speculation means aiming to make a profit by buying assets relatively cheaply and selling them at a higher price. Speculation always carries risk. Very high estimates can lead to market bubbles where prices in a market are much greater than the actual worth.Investors eventually lose confidence and the bubbles burst, investors rush to sell the assets, prices plummet, leaves investors in debt or with worthless assets. Banks can create bubbles if they give out credit too easily.

What are the negative externalities in financial markets? (based on 2008 credit crunch)

• Mismanagement of risk

• Large drops in GDP

• Falling salary levels

• Rise in unemployment

• ‘Too big to fail’ → systemic risk → UK govt rescuing banks

What is the significance of the central bank’s role of the lender of the last resort?

• Crucial for a country’s financial stability

• The central bank can provide liquidity to banks when they face a temporary shortage of liquidity to sue to the nature of banks borrowing short term and lending long term

Advantages of lender of last resort?

• Helps to prevent panic and run on the banks

• Helps to reduce the impact of financial instability

Disadvantages of lender of last resort?

• Can lead to moral hazard and encourage excessive risks

• Can lead to banks not holding sufficient liquidity

• Can seem unfair to non-financial firms that the bank won’t try to save them

What are the central bank’s other functions?

• Act as ‘banker to the government’

• They can help to regulate the financial sector

• They can implement monetary policy

What does the debt management office do?

Issues ‘gilts’ (government bonds)

What does regulation of financial markets focus on?

• Competition

• The structure of firms and risk management eg requiring firms to meet capital and liquidity ratios

• Strengthening rules and principles that institutions must abide by or face punishment

• Identify systemic risks

What are the two types of financial regulation?

Microprudential: ensure firms act fairly towards customers, not taking excessive risks or breaking the law

Macroprudential: tackle systemic risks and avoid large-scale financial crisis

What is the Basel committee and what do they do?

A committee of global banking authorities

Make recommendations on minimum liquidity and capital levels for banks

What is the financial policy committee?

• Regulatory body that identifies/monitors/protects against systemic risks

• Issues instructions to the PRA and FCA to tackle problems that threaten the financial system

• Advising the government on managing the financial markets

What is the prudential regulation authority?

• Maintaining the stability of banks and promoting effective competition

• Supervising firms to ensure the effective management of risk

• Set industry standards for conduct and management and make sure they’re followed

• Specifying capital and liquidity ratios

What is the financial conduct authority?

• A microprudential regulator

• aims to protect consumers and increase confidence in financial institutions/products

• Supervise conduct of firms/markets to ensure actions are legal and fair

• Promoting competition for better deals

• Banning financial products that don’t benefit consumers

• Banning or forcing firms to change misleading adverts for financial products/services