4.4 the financial sector

financial institutions to facilitate saving

they facilitate saving by acting as secure, interest-bearing intermediaries that pool deposits and allocate them for loans. These organizations.also protect funds and provide tools to help you conveniently reach your financial goals

to lend to businesses and individuals

they collect deposits from individuals and lend this money to businesses and indviduals in need of capital

to facilitate the exchange of goods and services

provide a wide range of payment and transaction services that facilitate the exchange of goods and services in the economy. This includes offering checking accounts, electronic fund transfers, debit and credit card services, and online payment systems.

To Provide Forward Markets in Currencies and Commodities

offering forward contracts for currencies and commodities these contracts allow businesses and investors to hedge against currency exchange rate fluctuations and commodity price volatility

providing a market for equities

allowing individuals and institutions to buy and sell shares of publicly traded companies , stock exchanges and enabling investors to participate in the ownership of corporations

investment banks

Assist companies in raising finance through shares or bonds, rather than accepting public deposits

retail banks

financial institutions that provide services to individuals and small businesses, such as checking/savings accounts, loans, and mortgages

insurance companies

that acts as a risk transfer mechanism, taking on financial risks from individuals or businesses in exchange for a fee,

Market rigging what is it ad why is it a form of market failure

• when the price of an asset is intentionally inflated or deflated to increase profit. it is anti-competitive

• Examples include insider trading and collusion among market participants to distort prices. (LIBOR scandal)

• Market rigging undermines market integrity and can lead to investor losses.

* the government could react quickly with a tighter degree of regulation

how can the government tackle market rigging?

Primarily involves legislation & regulation of markets

• Those found to conduct insider trading will face fines and prison

In reality, it can be very difficult to detect insider trading

Additionally, even when suspected it is very difficult to prosecute individuals

Moral hazard

• this is where an individual makes a decision on how much risk to take whilst someone bears the cost if things go badly

• Bearings bank

• In the financial sector, moral hazard can arise when banks and financial institutions believe they will be bailed out by the government in the event of a financial crisis. This can lead to reckless behavior and excessive risk-taking.

how can the government tackle moral hazard?

re-emptive solutions to change the risk taking behaviour:

• Separation of retail banking and investment banking

  • This would allow failing investment banks to close without contaminating the retail sector

• Regulation of banking behaviour

  • E.g. ensuring banks are not over-exposed to risky products

After the event - bailing banks out could be necessary to prevent a larger economic crash, but it creates a precedent that might reinforce the moral hazard in the banking sector

speculation and market bubbles

a bubble is where the price of an asset is above where it should be

• Speculation involves buying assets with the expectation of profiting from price increases, rather than from the asset's intrinsic value.

• Bubbles often burst, leading to market crashes and financial instability.

1 - displacement stage - excitement - demand will surge - price will increase

2 - herding stage - more people invest

4- profit people sell

5 - desperate selling

how can the government tackle speculation and market bubbles

In reality there is little to no way of pre-emptively regulating against market bubbles

Regulation of financial firms to ensure that they have enough liquidity (cash) and a diverse range of risk exposure should help to limit the impact of any crash in asset prices

externalities

• Externalities are spillover effects that affect parties not directly involved in a transaction.

• Negative externalities: Financial institutions may engage in risky practices (e.g., excessive lending) that can lead to systemic risks affecting the entire economy. The 2008 financial crisis is an example of negative externalities.

• Positive externalities: A well-functioning financial sector can benefit the broader economy by efficiently allocating capital and promoting economic growth.

how can the government tackle externalities

The problem is overly risky behaviour, so the main solution is regulation to ensure that banks are not overly exposed to risk

• Following the 2008 financial crisis the financial regulation in the UK was completely overhauled in an attempt to be more effective

Asymmetric information

• Asymmetric information occurs when one party in a transaction has more information than the other. In the financial sector, this can lead to adverse selection and moral hazard problems.

• Adverse selection: Occurs when individuals with hidden information about their riskiness (e.g., borrowers with poor credit history) are more likely to seek financial products (e.g., loans). This can lead to higher default rates for lenders.

• Moral hazard: Arises when one party, typically after a transaction, has an incentive to behave differently because of incomplete information. For example, borrowers may take on excessive risks if they believe they won't bear the full consequences of their actions.

how can the government tackle asymmetric information

To prevent the abuse of power by banks that might lead to mis-selling of financial products, significant fines have been used in recent years, along with forcing banks to compensate mis-sold customers

data is also widely avaliable nowadays - internet

the role of central banks in implementation in monetary policy

• Central banks have the primary responsibility for formulating and implementing monetary policy, which involves managing the money supply and interest rates to achieve specific economic objectives, such as price stability and economic growth.

• Tools of monetary policy include open market operations (buying and selling government securities), setting interest rates (e.g., the policy rate), and reserve requirements for banks.

• Central banks adjust these tools to influence borrowing costs, inflation rates, and overall economic activity.

central banks as banker to the government

• Central banks act as the government's banker by managing the government's bank accounts, facilitating payments, and helping with debt issuance and management.

• They often oversee the issuance and redemption of government bonds and treasury bills, helping the government fund its operations and manage its debt.

• Central banks also provide advice on fiscal and monetary coordination to ensure overall economic stability.

central banks - lender of last resort

• Central banks serve as a lender of last resort to financial institutions, especially during times of financial crises or bank runs.

• In this role, central banks provide emergency funding to banks facing liquidity problems to prevent systemic financial instability.

• By offering short-term loans (often referred to as the discount window), central banks help maintain confidence in the banking system.

central banks role in regulation of the banking industry

• Central banks often play a critical role in supervising and regulating the banking sector to ensure its stability and soundness.

• They set and enforce prudential regulations, including capital adequacy requirements and risk management standards, to prevent excessive risk-taking by banks.

• Central banks may also conduct regular bank examinations to assess the financial health and compliance of financial institutions with regulatory standards.