econ theme 4

what is a financial market

any system or place which allows buyers and sellers to exchange goods and services and trade financial instruments

• eg. bonds, equities, currencies and derivatives

what are the five roles of the financial sector

• saving

• lending

• facilitate exchange of goods and services

• provide forward markets

• provide market for equities

what is saving

• households store money to access at future date for consumption (of big ticket items) and earn interest on

  • eg. pension fund, savings account, trust fund

• provides pool of money for financial institutions to lend

what is lending

• banks lend personal loans to businesses and individuals for consumption (of big ticket items)

• business loans for investment

• mortgage loans

have to pay back with interest over time

what is facilitate exchange of goods and services

efficiently conduct transactions between individuals and firms or between individuals

• reduces cost of conducting transactions

• done via phone apps, debit cards, credit cards

what is provide forward markets

allow you to agree a fixed price for a purchase or commodity/currency in the future

• provide price stability → allow investors to make profit by speculating on future prices

• protects firms against rising costs in instable markets

what is provide a market for equities

shares of public companies listed in stock exchanges which is bought/sold by investors who share profits

• firms raise money at a lower cost → investment up

what is the difference between a loan and a equity

• loans have to be paid back immediately with interest

• equity can be paid back when you have profit

what are the types of market failure in the financial sector

• asymmetric information

• externalities

• moral hazard

• speculation and market bubbles

• market rigging

what is asymmetric information

when one party has more information than the other in a financial transaction

what is an example of asymmetric information

• bankers > borrowers

• bankers > regulators during financial crisis

what are externalities

costs affecting third parties outside of the price mechanism

what is an example of externalities

• banks failing → unemployment up → GDP down → taxes up to facilitate QE

• imports from developing countries outside of the global mortgage market cut due to global depression during financial crisis

what is a moral hazard

when another party bears the consequences for your risky behaviour

what is an example of a moral hazard

governments bear consequences of risky behaviour from banks considered too big to fail

what is speculation and market bubbles

money supply up → speculation up → risk of market bubbles up

product becomes overvalued → fall in confidence → sales of product increases → excess supply → prices fall → bubble bursts

what is an example of speculation and market bubbles

during financial crisis

• banks speculated house price increase → gave out sub-prime mortgages → demand for houses up → prices up → housing bubble

• excess demand for mortgage backed securities → bubble

what is market rigging

firms distorting the price mechanism by controlling prices instead of leaving interest rates to supply/demand

what is an example of market rigging

Barclays manipulated London Inter-bank Offered Rate (average interest rate of top banks used for mortgages, pensions etc.) after financial crisis

• fined £450m

what are the four roles of the central bank

maintain stability in financial system and meet economic objectives

• implement monetary policy

• banker to the govt

• banker of last resort

• regulation of banking industry

how does the central bank implement monetary policy

use of money supply and interest rates to reach inflation target to maintain price stability

how is the central bank a banker to the government

conducts transactions on behalf of the government by managing tax receipts and payments

• lending, paying, borrowing in the form of bonds

how is central bank banker of last resort

bail out bank if in accordance with public interest

• banks can borrow from central bank if they have short-term liquidity issues

• may go bankrupt without help → instability in financial system → loss of savings for households

how does central bank regulate banking industry

regulate banks to ensure stability and prevent market failure while banks carry out their role

• eg. required reserve ratios

what does the PRA do

prudential regulation

• supervises individuals and banks by ensuring proper management of financial institutions and recommend actions

• allow banks to fail if it doesnt disrupt whole financial system

• focuses on supply/demand of credit

what is the FPC

macroprudential regulation

• identifies and tackles systemic risk across financial system

what does FCA do

• regulates financial conduct

• protects consumers

• promotes effective competition