4.2.4 Financial Markets + Monetary Policy Flashcards
Define Monetary Policy.
- Monetary Policy: changes to interest rates, the money supply + the exchange rate, by central bank in order to influence AD.
- Primary role is to control inflation (2% inflation target).
Define Expansionary Monetary Policy.
Policies to increase AD.
State why Expansionary Monetary Policy is used.
- Increase inflation: boost AD, raise demand-pull inflation- if inflation rate is below target
- Increase economic growth
- Reduce unemployment
- Example: 2008 - 2021 UK: expansionary (loose) monetary policy- very low i.r. + QE.
Explain what the Monetary Policy Transmission Mechanism is why it is used.
Knock on effect of reducing interest rates to boost AD.
- Reduce credit card interest rates: borrowing for consumers- increases MPC- more likely to spend on big ticket items (e.g. cars), thus AD boosts as C rises.
- Decrease in S rates: as interest on saving accounts falls, reduces incentive to save, increase incentive to spend.
- Decrease in mortgage rates: households pay less mortgage payments, increases their disposable income + increases their MPC.
- Decrease rates on business loans: increases incentive for business to borrow + increases I.
- Weaker exchange rate:** increases (X-M)
Explain the effects of Expansionary Monetary Policy on LRAS.
- As interest rates on business loans decrease, + I increases
- I boosts LRAS, due to increase in the quantity of capital, increase in the quality of capital,+ an increase in the productive efficiency of economy.
State + explain the problems with Expansionary Monetary Policy.
- Demand-Pull Inflation: too much AD in the economy may lead to demand-pull inflation.
- Current Account Deficit: lower interest rates that stimulate AD, may widen the current account deficit, due to there being more growth in economy, incomes rise + households will spend more of their income on imports.
- Negative Impact on Savers: when interest rates fall, the rate of interest rates fall. If inflation is higher than the nominal interest rates in the economy, then the real returns on savings could be negative- rate of return is less than the rise of prices.
- Time Lags: takes a long time for an interest rate cut to fully feed through the different channels of the transmission mechanism, + to boost AD fully (18 months- 2 years).
Evaluate the use of Expansionary Monetary Policy.
- Size of the Output Gap: if economy is already very close to full employment, with a very small negative output gap, then any cut in i.r. may boost AD but we wont see much reduction in unemployment rates, instead its likely to see inflation overshooting the target.
- Consumer Confidence: need to be confident in their job prospects, in order to borrow + consume when interest rates are lower.
- Business Confidence: need to be confident in the future state of the economy, in demand+ profitability for their business, if they’re going to borrow + invest.
- Banks Willingness to Lend/Pass On the Full Cut: may not be willing to lend if there’s a banking crisis/financial sector crisis in the economy, then may haud cash instead of lending at lower interest rates- renders expansionary monetary policy completely useless + if central banks cut the interest rate, will banks follow with the same rate, if they don’t we wont see the boost in Ad in which we want to see.
- Size of the Rate Cut: if we want expansionary monetary policy to really boost AD, then a big cut is more desirable, makes it much cheaper for consumers + firms to borrow- incentivises borrowing, promotes C + I
Define Contractionary Monetary Policy.
Policies to decrease AD.
State + explain why Contractionary Monetary Policy is used.
- Reduce inflation: reduce AD
- Prevent asset/credit bubbles: i.e. prevent excessive growth of house prices + prevent excess credit borrowing by households + businesses
- Reduce excess debt + promote S: if economic growth in economy is very debt fuelled, then higher interest rates reduce the incentive to take out so much debt, thus more sustainable growth is promoted.
- Reduce current account deficit: consequently by reducing AD, because as AD falls, growth falls, incomes fall, therefore less spending on imports.
- Example: 2022- contractionary (tight) monetary policy- rising i.r. + reducing QE.
State + explain the benefits of Contractionary Monetary Policy, via higher interest rates.
- Reduction in Inflation (demand-pull)
- Discourage Household/Corporate Debt: takes away pressure on banking sector- reducing the chance of bank failure + systemic risk, reducing risks of recession.
- More sustainable Borrowing + Lending: only those who need to borrow + can afford to borrow at higher interest rates enter the market. Less likely to get asset price bubbles- less chance of bubbles, less chance of recession.
- Encourage Saving: those living of their savings (i.e. pensioners) are likely to see a rise in living standards, those saving to reach financial goals are able to reach them faster. Also a safety net for households/business getting into financial difficulty.
- More Affordable Housing: by increasing the cost of mortgages, can cool down demand for housing- helps lower the price.
- Reduce CA Deficit: reducing incomes, can lower spending on M.
- Flexibility for Expansionary Monetary Policy: now have space for i.r. cuts in the next financial crisis/recession.
State + explain the problems with Contractionary Monetary Policy, via higher interest rates.
- Lower Growth + Higher Unemployment (Cyclical): demand-side shock by raising i.r. may lead to a recession
- Impact on the Indebted: if i.r. goes up + its more expensive to service debt/repay loans, for households it may mean bankruptcy + homelessness, if businesses can’t afford to pay loans it may mean business bankruptcy + higher unemployment
- Reduces Investment: by increasing the cost of borrowing, takes away incentive for businesses to borrow + fund their investment projects, bad for SR + LR growth.
- Worsen CA Deficit via Exchange Rate Strengthening: ’ hot money inflows’ savings that chase the best i.r. internationally. Thus, if the UK has the highest i.r. savings from abroad will flood into UK financial institutions, increasing D for £, strengthening the value of £. M become cheaper X becomes more expensive-links to a worsened CA Deficit.
Define Financial Markets.
Financial Markets: where buyers + sellers can trade financial assets.
* Primary role is to bring together lenders (those sitting on excess cash) with borrowers (those that need cash but don’t have it).
Lenders Include:
* Savers
* Investors
Borrowers Include:
* Individuals
* Firms
* Government
* Lenders can go directly to bond markets (buy gov bonds)/ stock markets (buy shares from companies- equity capital).
* Lenders could go to intermediaries (commercial banks, investment banks, pension funds, hedge funds, mutual funds, e.t.c.)
Explain money markets.
- Buying + selling of financial assets have a maturity/pay back date of a year or less (e.g. gov bonds with a maturity date of a year or less).
- Interbank lending- commercial banks lending to another commercial banks.
Explain Capital Markets.
- Buying + selling of financial assets which have a pay back date of greater than a year- not quite as liquid as money markets.
- Debt Capital: any financial asset that pays back an i.r- form of borrowing for issuer (e.g. gov bond with a maturity date over a year).
-
Equity Capital: have a share in business- return is a dividend.
2 Types Of Capital Market: - Primary Market: new issue market- brand new bonds issued (e.g. through investment back).
- Secondary Market: existing bonds Can be bought + sold- highly liquid- easy to convert to cash (e.g. through stock exchange, investment back, e.t.c.).
Explain currency markets.
- Spot Markets: buy curency at current exchange rate + get it to delivered to you immediately.
- Future Markets: buy currency at given exchange rate, but given to you at some time in future.
State + explain the functions of money.
- Medium of Exchange
- Store Of Value: can’t deteriorate over time- although inflation could erode value over time.
- Measure Of Value: unit of account function- different prices show different values.
- Standard Of Deferred Payment: people that don’t currently have money can borrow- pay back money overtime- idea of brining lenders + borrowers together.
State + explain the characteristics of money.
- Acceptable: act as a medium of change.
- Portable: easily portable.
- Durable.
- Divisible: easy to have it + understand it- easily broke down (e.g. into pence + pounds).
- Limited In Supply: so that it keeps its worth.
- Difficult To Forge: otherwise people will lose faith in money.
Explain the difference between commodity + fiat money.
- Commodity Money: any money that has intrinsic value (e.g. gold)
- Fiat Money: has no intrinsic value (e.g. notes + coins). If notes + coins become worthless due to hyper-inflation, can’t trade in notes + coins for something else- has lost value.
Define the money supply.
• Money Supply: total amount of money circulating in economy
State + explain the types of money supply.
• Narrow: M0: measure of money supply- total number of notes + coins in economy, as well as total number of deposits that individuals have in bank accounts. Highly liquid form of money.
• Broad: M4: broad way of looking at money supply- notes + coins + deposits, as well as non-cash financial assets that can still be easily converted into cash (e.g. bonds, certificates of deposits) with maturity dates of 5 years or less.
Explain the Fisher Equation - Quantity Theory of Money.
Links money supply + inflation.
Variables Of Fisher Equation:
* M (money supply)
* V (velocity of circulation)- number of transactions of given money (e.g. how many times the same £10 note is spent)
* P (average price level - inflation)
* Q (quantity of goods/services sold - i.e. real GDP)
Fisher Equation:
MV = PQ
MV: what is bought by nominal GDP (expenditure , consumption) expenditure method.
PQ: What is sold by nominal GDP (final goods + services sold x P) output method
P = MV / Q
* V + Q are fixed- don’t change by enough to have an influence on P.
* Only changes in M influence P
State + explain the factors affecting the money supply.
- Reserve Requirement: amount of money that commercial banks need to keep in BoE by law- doesn’t exist in UK economy. To reduce i.r., could reduce reserve requirement- commercial banks don’t need to keep as much money in BoE- keep more in real economy- increasing money supply + reducing i.r. in money market.
- Bank Rate: rate at which commercial banks borrow from BoE in order to meet their liquidity needs short term. Dominant way BoE alter i.r. in money market to meet inflation targets. If BoE decide to reduce bank rate- borrowing from BoE is cheaper- less money sucked out off economy- increasing money supply + reducing i.r.
- Open Market Operations: buying + selling of gov bonds. If BoE wanted to reduce i.r. would need to increase money supply- via buying bonds- replaces paper with cash, increasing money supply out there + reducing i.r.
Define + explain what bonds are.
Bonds: IOU, piece of paper that guarantees holder of bond- regular interest payments + getting face value of bond back when its matured.
* Gov issues bonds to raise finance for their spending (e.g. on infrastructure, education, health, e.t.c)
* Corporations can issue bonds- that are looking to I, but don’t have retained profit
* Anybody can buy a bond- return/yield on bond may be better than return on other financial assets, + because its safe- gov bonds- gov very unlikely to go bankrupt
* Bonds always has: a name, coupon (interest rate fixed over duration of bond- doesn’t change), maturity (when bond expires), market price (determined by D + S) + nominal value (what bond is + what end worth of bond is).
* Bond Yield = (coupon / market price) x 100
* Inverse relationship between market price + bond yield
Explain commercial banks.
- Accept Savings
- Lend: to borrowers- convert S to loans.
- Act As Financial Intermediaries: give smaller rate of return on S compared to interest rate charged to borrowers, so that they can make profits.
- Allow Payments From One Agent To Another
- Advice: offer advice (i.e. insurance advice, financial advice, e.t.c.)
Explain investment banks.
More profitable than commercial banks.
* Proprietary Trading: taking excess capital that I banks are sitting on + investing it- trying to get a better rate of return (e.g. buying bonds, shares, e.t.c.), in order to make a high profit.
* Market Making: ensuring markets exist- bonds, shares, e.t.c can be bought + sold on behalf of lenders + borrowers.
* Mergers + Acquisitions: key advisory role that I banks have. If a company is looking to take over / merge they may go through I banks to gain advice on when to go through with takeover, how to structure deal, due diligence to make sure everything is okay with takeover firm, make sure all paperwork is done + that it meets regulators wants, e.t.c.
* New Issues: if companies want to issue bonds / shares to raise finance, they can go to I banks for help. Underwriting (where no one wants to buy new shares / bonds) so I banks buy them on behalf of company, then charge % fee on top of whatever value is- making huge sums of money.
Explain systemic risk.
- Banks engaging in both activities (commercial + investment) have a greater systemic risk- failures on one side (especially I side) can bring down other side- risk of bank failure much higher.
- As banks are interconnected, if 1 bank fails, risk of whole financial system coming down (i.e. 2008 financial crisis) is much greater.
Define the balance sheet.
Balance Sheet: record of all assets, liabilities, + capital (shareholder’s equity) at any given point in time.
* Balance sheet must balance where:
Assets = Liabilities + Capital
State what assets include, as part of a commercial bank’s balance sheet.
Most - Least Liquid
* Cash
* Reserves at BoE
* Money at call of short notice: any interbank lending that commercial bank takes part in- can get back very quickly.
* Short-term investments (short-term gov / corporate bonds)
* Long-term investments (long-term gov / corporate bonds, shares)
* Advances: issuing mortgages, loans (for entrepreneurs / firms wanting to I / to individuals)
* Fixed Assets (property, machinery, e.t.c.)
State what liabilities include, as part of a commercial bank’s balance sheet.
- Deposits: that individual savers / firms have put in commercial bank. Short-term as depositors can come back whenever they want + bank has to pay it back right away.
- Short-Term Borrowing: bank decides to borrow from interbank market / BoE- short-term money market transactions.
- Long-Term Borrowing: if commercial bank decides to issue corporate bonds / shares to raise finance.
State what capital includes, as part of a commercial bank’s balance sheet.
- Shareholder’s Funds
- Retained Profit (reserves)
State + explain the ways commercial banks can fail.
2 Ways A Commercial Bank Can Fail:
1) Liquidity Crisis (Bank Run): Not enough liquid short-term assets (current assets) to meet short-term liabilities (current liabilities)- bank run- liquidity crisis- bank doesn’t have enough liquid short term assets to meet their short-term liabilities.
2) Insolvency: Not enough capital to offset losses in asset values (i.e. liabilities > assets)- owe more than they own- leads to insolvency
State + explain the commercial bank failure preventatives.
- Cash Ratio: imposing it or increasing it- forces banks to hold enough cash assets to meet their short-term liabilities- reduces risk of bank run.
- Liquidity (Current) Ratio: includes all current assets- increasing that makes sure that commercial banks hold enough liquid assets to meet its short term liabilities- reducing risk of bank run.
- Leverage Ratio: looks at ratio of capital to advances + long term investments- to make sure that firm holds enough capital to offset any losses in long-term I + advances- which ideally reduces risk of insolvency.
- Capital Ratio: looks at ratio of capital to advances- makes sure commercial banks will have enough capital to offset any losses in loans- to prevent risk of insolvency.
- Reserve Requirement: imposing / increasing that makes sure that when deposits are put in bank, certain fraction is kept in BoE- makes sure bank always has enough liquid assets to meet needs of depositors or any other short-tern liabilities they have to pay- preventing risk of bank run
State + explain the objectives of a commercial bank.
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Profit Maximisation: keep shareholders happy. Borrowing short-term (low interest) + lending long-term (high interest) gives great profit margins (e.g. borrowing money in money market, + lending in terms of mortgages, loan-term I, e.t.c.). By taking risks- offering less secure loans (e.g. offering loans to those where unemployment is likely, where not much deposit int put down, financial history isn’t great, e.t.c.)- by taking more risk gives higher interest. Another way to take risks is offering loans that aren’t backed- offer loans + if they go bad, bank can’t take anything back- can charge higher i.r. However, doing this could lead to bank failure- shareholders lose money, managers lose jobs.
• Liquidity: must ensure they have enough liquidity (cash/easily convertible assets) to meet demands of depositors, who can withdraw their money at any time.
• Security: make sure enough of their assets are secure. Balance between secured loans (e.g. mortgage) + unsecured loans (e.g. credit cards) is needed to maintain stability.
State + explain the consequences of a commercial bank failure.
- System Risk: if bank fails, all other banks may fail- due to financial markets being interconnected.
- Recession: lost incomes (those in industry, as well as those in wider economy), unemployment, lost output.
- Bank Bailouts: tax payer having to pay brunt of bank bailouts- if gov decides bank can’t fail. Also not in interests of commercial banks- after they’re bailed out, tied to regulations + conditions
State + explain the potential conflicts between a commercial banks objectives.
i.e. balancing commercial banks’ objectives + bank failure.
* Liquidity To Avoid Bank Run: holding more cash, reserves at BoE, lending more in interbank market- ensures liquidity to avoid bank run to prevent bank failure- however, not as profitable- reserves only get bank rate, with lending in interbank market you can only get libor (follows bank rate- much lower than if bank offered longer term loans- give more interest)- sacrificing profit to keep short-term liquidity, to meet short-term liabilities to prevent bank-run.
* Security To Manage Risk + Avoid Insolvency: not most profitable for a bank- if issuing loans to very safe lenders- can’t charge very high i.r., issuing more loans that are backed by something- reduces i.r. that can be charged. Reduces profit making potential, although less loans that are likely to go bad- don’t need to hold as much capital to offset loans. Reduces chances of insolvency + bank failure. (e.g. mortgage is secured lending- if customer runs into financial difficulty + can’t repay loan, bank will be able to repossess property as a form of security. Not possible with unsecured loans (e.g. credit cards), as any default on loans means bank’s unable to recover any money- known as ‘bad debt’ + is a cost to bank which reduces both its assets + profitability.)
* Therefore, for commercial banks, having balance in the portfolio of assets they hold is in the best long-term interests of bank, but also best long-term interests of society, given consequences of bank failure.
State + explain the roles of a central bank.
- Implement Monetary Policy: influence money supply, set interest rates- to meet inflation targets + to make sure other macroeconomic objectives are being met at same time.
- Act As A Banker To Gov: in order to set i.r.- central banks need to alter money supply (i.e. open-market operations- engaging in buying + selling of gov bonds- where central banks can buy + sell on behalf of gov- not that prevalent in UK).
Financial Stability Role:
* Act As A Banker To Banks: act as a ‘lender of last resort’- to prevent bank-run- central banks become involved when there’s going to be a liquidity crisis (i.e. short term liquid assets aren’t enough to meet short-term liabilities). Known as liquidity insurance scheme- 2 types- 1) where bank can offer non-emergency liquidity, 2) emergency liquidity (where commercial banks in danger + needs large-scale liquidity immediately).
* Regulate Financial System: powers much greater since 2008 financial crisis.
Explain the financial stability role of central banks.
Financial Stability: crucial for confidence in financial system to remain high.
* Prevents panic + a run on bank
* Make sure risk of financial instability is lower
* Make sure system risk is lower
* Advise gov on bank bailouts- prevent wide scale financial collapse- prevents recession.
Evaluate the ’lender of last resort’ function of a central bank.
- Moral Hazard: occurs when risk is taken- if risk goes bad, cost is borne by a third party (in this case BoE). Encourages behaviour- commercial banks knows if they don’t have liquidity can go to central bank.
- Banks May Not Hold Sufficient Liquidity: knowing they’ll always have central bank to provide liquidity. Dangerous incentive.
- Regulatory Capture: when regulators might be influenced, because they know people still working in industry.
- Why Should Banks Have This Luxury + Not Other Firms: banks can gain essential liquidity- helped out in times of crisis, whereas other firms don’t have this luxury- left to go bankrupt.
Define a financial market failure.
- Occurs when free functioning financial markets fail to allocate financial products at the socially optimum level of output.
State + explain the group causes of a financial market failure.
- Excessive Risks Being Taken: greater chance of bank failure + system risk (overall collapse of financial system), due to overproduction + overconsumption of financial assets. System risk can lead to loss of confidence + lack of faith in banks- significant negative impact on economy. Also leads to recession- lost income, unemployment, + lost output in banking industry + wider economy. May also see bank-bailouts- impacts tax payer- negative externality- as tax payers have to bear cost of bailouts.
- Collusion + Fixing Of Interest Rates / Exchange Rates: banks colluding- leads to monopoly pricing + loss of welfare in these markets.
- Deregulation Of Financial Markets In UK + USA: happened under Thatcher + previous prime ministers that wanted economy to move away from manufacturing + mining- towards financial industry- allowing UK to become much bigger. However economists may argue it leads to a great systemic risk- takes away capital / liquidity ratios, scrapping reserve requirements, using commercial banks funds for investment bank activities (commercial + I banks no longer need be separate)
Explain speculation + market bubbles as a type of financial market failure.
Falls under excessive risk section of financial markets failure.
* Speculation occurs when assets are bought at a low P + then sold at a higher P.
* What if P fall + deal is leveraged (borrowing to amplify end outcome of deal)?
* Can create bubble- where people keep thinking P will rise, bank willing to lend- creates artificially, excessively high estimates of P increases.
* Eventually, investors realise assets aren’t worth these high P- ends up being a fall in D + P- those who’ve borrowed lots + sitting on these assets falling in P- start to sell assets- exacerbating P falls even more- now worthless assets- huge debts- bank may go bust if deals are massive in value- system risk.
Explain asymmetric information as a type of financial market failure.
Encompasses moral hazard + adverse selection.
* Problem as banks always know what they’re doing + what risks they’re taking- can hide info from regulators + gov.
* Excessive risk then taken, knowing that if things go bad they’re going to be bailed out- regulators wont know they’re doing this.
* Adverse selection: when most likely buyers of product are those buyers the seller would prefer not to sell to- due to a assymetric information between buyers + sellers
* Excessive risk taken because those buying are worst kind of buyers (e.g. health insurance companies- premiums issued based on who they think is most likely to buy it- healthy consumers think it’s a bad deal for them, while poor health consumers think its great value- costly, unprofitable for firm)- increasing premiums only makes this worse.
Explain negative externalites as a type of financial market failure.
May be ignored by commercial bankers taking excessive risk.
* Cost to tax payer of bailouts (too big to fail)
* Loss of saving.
* Lost jobs (unemployment), incomes, growth
Explain market rigging as a type of financial market failure.
Falls under collusion + P fixing
* Where traders / bankers / intermediaries collude to manipulate markets + make huge profits (e.g. LIBOR + FOREX markets).
* Even though there’s heavy fines + regulations, can still take place if punishment + enforcement is weak.
Explain the Financial Policy Committee (FPC).
- Set up after 2008 financial crisis to help reduce systemic risk- works within BoE.
- Macroprudential regulators - monitor entire financial sector.
Jose Roles: - Identify, monitor + protect against system risk
- If identify a source of system risk, instruct PRA + FCA in tackling any financial stability issues (e.g. advising PRA on bank regulation needing to be set to protect against systemic risk, or advising FCA over encouraging more competition / banning certain products to reduce system risk)
- Advise gov- warn of systemic risk / macroeconomic shocks- gov can act certain policies to protect against risk, advise gov against bank bailouts- may be necessary to protect against systemic risk.
- Enact stress tests- enact worst case scenario in financial sector + test whether banks are okay to deal with that potential shock (i.e. do they have enough capital to offset any losses / loans, e.t.c.)
- Provide emergency liquidity through liquidity assurance scheme of BoE- to protect against systemic risk if there’s a liquidity crisis that banks are suffering from.
Explain the Prudential Regulation Authority (PRA).
- Works within BoE- set up after 2008 financial crisis.
- Microprudential regulators- there regulations are more targeted.
Job Roles: - Maintain stability of banks
- Supervise management of risk (i.e. make sure banks aren’t taking on too much risk that could destabilise financial sector)
- Setting industry standards for conduct + management with enforcement.
- Specify ratios + reserve requirements for bank activity (e.g. capital ratios, liquidity ratios, leverage ratios + reserve requirements).
Explain the Financial Conduct Authority (FCA).
- Don’t report to BoE- report to treasury instead- government run regulatory body.
- Microprudential regulators
Protect consumers + increase confidence in financial institutions / products by: - Supervising conduct of firms / markets to ensure legal business activity: ensures there’s no collusion over setting of i.r. + exchange rates- no market rigging.
- Promote competition so consumers get better deals (e.g. in terms of lower i.r. for borrowing, high i.r. for saving) - through deregulation.
- Banning financial products against interest of consumers- ban mis-selling
- Banning or changing misleading adverts for financial products (e.g. loan sharks)
State + explain the types of financial market regulation.
- Ban Market Rigging With Strong Enforcement: less market rigging / collusion which harms consumers, businesses + other financial institutions.
- Prevent Sale Of Unsuitable Products To Consumers: protect consumers from products with excessive risk, charges + limited benefits.
- Maximum Interest Rates (capping i.r. below equilibrium in capital market): protect consumers- prevent consumer exploitation with them having to pay very high i.r., also prevents excessively risky lending- prevents insolvency + issuing very risky loans. If i.r. are capped- no incentive for banks to offer such products with very high i.r. - encourages security in process.
- Deregulation: encourages more competition (e.g. through reducing amount of red tape in industry- makes it easier for firms to start up without having to take out much insurance). More competition is good for consumers- lower i.r. on borrowing, higher i.r. on S, more trustworthiness taking place in banks- banks have to do this to maintain competitiveness- make sure they’re profitable by attracting consumers to them.
- Deposit Insurance: (i.e. gov backing deposits that consumers have in commercial banks, in case of bank run- maintains consumes can get their money back from commercial banks)
- Ring Fence Commercial Banking Away From Investment Banking: idea of keeping commercial banking separate from I banking- is that commercial bank funds can’t be used to gamble in I side of business- whereby if activities in I bank go bad (e.g. excessive risks)- not commercial bank that’ll suffer, because funds are separate. Reducing chance of systemic risk.
- Setting Limits On Bank Lending: reducing chances of bank failure + system risk. By setting things like cash ratios, liquity ratios, leverage ratios, e.t.c to reduce chances of liquidity crises + insolvency + reduces systemic risk.
- Liquidity Assurance With Conditions + Punishments: punishments in place for banks that need emergency liquidity- high i.r. when paying back to central bank. Curves on lending in future + to make sure there’s enough liquidity in future (e.g. tightening up liquidity ratios, enacting cash ratios + reserve requirement).
Explain Cash Ratios as a form of financial regulation.
- Regulation: impose cash ratio if doesn’t exist already, or raise it if it does.
- Intention: to prevent liquidity crisis (bank run)- to make sure bank always has enough cash to pay any short term liabilities that it owns.
- Basel Recommendation: none- only on liquidity ratios, capital ratios + leverage ratios.
Explain Liquidity Ratios as a form of financial regulation.
- Regulation: impose liquidity ratio if doesn’t exist already or raise it if already exists.
- Intention: to prevent liquidity crisis (bank run)- make sure banks have enough liqduity to pay back any short term liabilities to prevent risk of bank run.
- Basel Recommendation: from 1st Jan 2015- commercial banks need to hold at least 60% liquid assets to meet their short term liabilities, with intention of raising that figure by 10% each year to 2019- where figure would become 100%.
- Liquidity Coverage Ratio (LCR): commercial banks need to have 100% liquidity to cover any liabilities in 30 days or less (immediate liabilities).
Explain reserve requirements as a form of financial regulation.
Fraction of deposits that must be held at BoE.
* Regulation: impose it if doesn’t exist (doesn’t in UK), or if it does exist, raise it.
* Intention: to prevent liquidity crisis (bank run)- make sure banks have enough liquidity in case depositors come back + want money back, in case there’s any short-term lenders that want their money back.
* Basel Recommendation: none in UK- however in USA, federal reserve have imposed 10% requirement.
Explain Capital Ratios as a form of financial regulation.
- Regulation: impose it, or raise it- more capital will need to be held by commercial bank to protect against any losses in loan value.
- Intention: prevent insolvency- bank failure + system risk.
- Basel Recommendation: 8% min capital to loans ratio they recommended.
- Possible to specify which loans are included + which ones aren’t (i.e. safe loans not usually includes such as mortgages)- if ratio doesn’t take into account mortgages + other loans which could go bad, then you’re not necessarily in a safe position.
Explain Leverage Ratios as a form of financial regulation.
More comprehensive than capital ratios.
Tells us how much commercial bank is leveraging their capital in terms of loans + long term I.
Capital / Loans + Long Term I (all loans)
* **Regulation: **impose it or raise it.
* Intention: prevent insolvency- if any loans or long term I go bad, commercial banks will always have enough capital to offset those losses.
* Basel Recommendation: Basel committee like leverage ratios- more comprehensive- better safeguard against bank failure. Min requirement of 3% is adequate.
State + explain the problems with the financial market regulation.
- Moral Hazard: costs of bad decision is borne by 3rd party- if intentions such as liquidity assurance, bank bailouts, e.t.c- creates bad incentives for commercial bankers- take on excessive risk- know that if those risks go bad, it’s going to be a 3rd party that has to bare risk of bad decision.
- Regulatory Capture: regulators form very close relationships with managers + CEOs in financial sector, lapse with regulation, because people they know influence the regulator.
- Asymmetric Information: banks have information- regulators want info to impose good capital ratios, leverage ratios, liquidity ratios, reserve requirements- if banks hide info- makes it difficult for regulators to impose correct, strict regulation necessary to protect against bank failure + system risk.
- Information Failure: intervention that bans misselling of products / bans financial products that are against interests of consumers- regulators dont know what the next product commercial banks or I banks are working are- banks keep this to themselves- regulators always one step behind.
- Unintended Consequences: deregulation- deregulating separating commercial + I banks- dangerous, or deregulating capital ratios, reserve requirements, e.t.c is dangerous. Deregulating to promote competition- does that mean there’s monopoly power? Because incumbent firms could gain strength + increase barriers to entry. Overstrict regulation- limits on bank lending- if commercial banking is unprofitable- promotes bankers to move over to shadow banking industry- where there isn’t as much regulation (e.g. hedge funds, mutual funds- huge profits can be made + less regulation)- less commercial banking + less competition in commercial banking industry- not in interest of society. Maximum i.r.- leads to excess D in market (inefficient)- encourages bad borrowers to come into market, discourages lending- harms economic activity- holding back economic growth + reducing incomes.
- Administration + Enforcement Costs: of regulation- regulatory bodies are very costly to maintain. Links to regulatory capture- if there isn’t much benefit that comes from regulation, then C could exceed benefits- government failure.
Evaluate the financial market regulation.
- Balance Needed To Protect Consumers + Protect Against Systemic Risk But To Maintain Bank Profitability: regulating too strongly, decimating profitability of commercial banking- will lead, ceteris paribus, to not many commercial banks existing, risk of oligopoly or monopoly outcomes- collusive outcomes if competition has been taken away from industry due to harsh regulations.
- Regulation Should Promotes Equity Without Damaging Efficiency: fair outcomes for consumers that protect public interest, but without damaging efficiency- max i.r. harms efficiency drastically- excess D, shortage of lending taking place- not in interest of society / consumers- lack of innovation, lack of competition- why would firms want to enter if they can’t charge i.r. beyond a certain level. Lending restraints harm efficiency- less lending because of tight ratios + reserve requirements harms efficiency with less lending taking place in economy.
- Costs vs. Benefits: if C outweigh benefits- rationale for regulation to not take place at all. However, if benefits exceed C- benefit to protect public interest, prevent system risk + to make sure there’s no financial system collapse- creates ripple effect throughout economy- harms individuals who have lost income through unemployment.
Define Debt.
Debt: money that is owed (financial liabilities)
• For firms, includes all funds that firms borrow directly from banks (i.e. loans, overdrafts, e.t.c)
• Money owed has to be paid back with interest (cost of borrowing)
Define Equity.
Equity: all the assets, physical + financial, that are owned.
• For households + individuals this includes assets such as: houses, shares, cars, money in the bank.
• For firms, raising equity capital means giving the provider of funds an ownership stake + share of future profits. Share capital is equity for a firm.
State the calcuation for a bond yield.
Bond Yield = (Coupon / Bond Market Price) X 100
Explain how banks create credit.
- Banks know customers are unlikely to withdraw their full balances from accounts.
- Means banks can create credit by lending out some of their customers deposits to other people who want to borrow money enabling bank to make a profit.
- Fractional Banking: process of banks creating credit by lending out deposits + holding only a small amount of deposits in actual notes/coins.
State + explain the limitations on credit creation.
- Type of Asset Held By Banks: banks wont advance all money out to customers because of balance it seeks in meeting objectives. If it holds more liquid assets/invests elsewhere, credit creation’s limited.
- Demand For Credit: may fall because of higher i.r., or faltering confidence, so if consumers don’t demand credit in first instance, will be limited.
- Central Bank Policy: BOE can change capital ratios/cash reserve requirements to influence amount of liquid assets bank must hold. Larger this requirement, more limits there are on credit creation.
Explain Quantitative Easing (QE).
- Form of unconventional monetary policy- where central banks purchase longer-term securities (bonds) from open market in order to increase money supply + encourage lending + I.
- Buying these securities adds new money to economy + serves to lower i.r. by bidding up fixed-income securities.
- Example: global financial crisis 2008- BoE initially used convention monetary policy + lowered bank rate of interest from 5% to 0.5%. However commercial banks remained unwilling to lend- risk of deflation high due to sudden fall in AD, fear a deep recession would become a prolonged depression, BoE had to find alternative way to stimulate economy.
- QE works by BoE purchasing gov bonds + assets from institutions (e.g. banks, insurance + pension companies).
Has 2 Main Impacts: - Increases supply of money (liquidity), providing more availability of funds for lending.
- Pushes down market interest rates + encourages lending.
Purchase Of Bonds On Large Scale: - Pushes P of bonds up- pushes bond yields down- lower yields push down market i.r. on I + loans offered by banks to businesses + individuals- easier for people to borrow + spend.
- QE should provide additional liquidity + through lower i.r. gives incentives to give + take out loans.
Evaluate the use of Quantitative Easing (QE).
To An Extent Works:
* Intially used in 2009, when conventional monetary policy reached 0.5% + economy was at risk of deep recession.
* Worked to prevent further crisis in banking: providing banks with liquidity.
* Worked to improve confidence in economy: encourage consumers to borrow + increase C.
* BoE believed it worked to prevent prolonged recession.
But:
* Evidence it hasn’t increased willingness of banks to lend to small + medium sized businesses: struggle to get loans- limits I + AD.
* Lost impact due to its continuous use: not having so much effect on confidence + long-term i.r. as these remain low. Now have limited monetary policy options to deal with crises.
* Would gov be better off using fiscal policy + directly influencing AD through G?
Define the bank rate of interest.
Bank Rate Of Interest: rate of interest that BOE pays to commercial banks on their deposits held at BoE.
* Sometimes called base rate.
* Influences market rates that commercial banks + financial institutions charge people to borrow money + pay on S- therefore feeds into wider economy.
Explain the Keynesian Liquidity Trap.
- Liquidity trap occurs when low i.r + high amount of cash balances in economy fail to stimulate AD.
- Sometimes reducing i.r. has little effect if people can’t/wont borrow- liquidity trap.
- This is why QE is needed (unconventional monetary policy).
- However, Keynesians argue we may need to use fiscal policy to stimulate economy.
- Argued UK experienced this type of liquidity trap after financial crisis of 2008.
Explain the process of quantitative easing (QE).
- Central bank creates money electronically.
- Money used to buy financial assets from financial institutions (e.g. gov bonds particularly prevalent in UK - disincentivive people with money to buy gov bonds - take gov bonds away from people + S with cash instead).
- P of gov bonds increases (due to increased D) + yield (i.r.) falls - represents return for investor on cost of borrowing to issuer - cheaper for gov to raise finance as yields have fallen - however because yield is low - reduces incentive for individuals to hold gov bonds.
- Financial institutions either loans this money out / I in riskier corporate bonds (yield on bonds reflects cost of borrowing - for banks issuing corporate bonds - if yield decreases - can raise finance at lower cost) or shares (wealth effect may stimulate I - beneficial for rest of economy).
- P of corporate bonds increases + yield (i.r.) falls - reduces cost of borrowing money - good news for commercial banks who raise finance by issuing corporate bonds.
- Access to credit improves (for commercial banks) - access finance at lower i.r. (cheaper to access finance) + willingness to lend should increase at lower i.r. - more willing to lend to ordinary individuals + firms at lower i.r. themselves
- Stimulates borrowing, spending + I - increases AD + growth - reduces unemployment - recovery stage.
Define moral hazard.
- When individuals + organisation make investment decisions (risks) knowing that others will bear the loss if things go wrong
