4.4 Flashcards
5 roles of financial markets
They facilitate saving: storing money for future use is essential for households & firms. It also provides a pool of money that financial institutions can lend i.e. one person’s savings is another person’s borrowing
They lend to businesses & individuals: access to credit is a key requirement for economic growth & development. Being able to borrow money speeds up consumption by households & investment by firms. It also allows households or firms to purchase assets & pay them off over an extended period of time e.g. mortgages on home purchases
They facilitate the exchange of goods & services: each purchase of goods/services requires the movement of money between at least two parties. Financial markets provide multiple ways for this exchange to happen including phone apps (Google Pay), debit cards, credit cards & bank transfers
They provide forward markets in currencies & commodities: forward markets are also called futures markets. They provide some price stability in commodity markets & enable investors to make a profit by speculating on future prices
They provide a market for equities: equities are shares in public companies that are listed on stock exchanges around the world. Financial markets facilitate both long term investment & speculation by providing platforms which connect buyers & sellers e.g. E-Trade
5 types if market failure that can occur in the financial sector
Market rigging
Moral Hazard
Speculation and market bubbles
Externalities
Asymmetric information
What is market rigging and how can the Government resolve this market failure
There have been allegations that some banks & individual bankers have been involved in rigging key interest rates or exchange rates in order to profit maximise at the expense of other participants in the market.
eg LIBOR scandal of 2008 where financial institutes were accused of fixing the London Interbank Lending rate
Rules can be put in place to supervise and prevent scandals while also ensuring banks pay very large fines for not complying
What is Moral Hazard and how can the Government resolve this market failure
Where an economic agent makes decisions in their own best interests knowing there are potential risks. This can be seen by individuals taking adverse risks in order to increase their salary as worse that can happen is they lose their job as well as by financial institutes taking excessive risks because they know the central bank is the lender of last resort and so will allow them to fail because of the impact it would have on the economy. Banks seen as “too big to fail” thus Gov vear the consequences of their risky behaviour
EG Global financial crisis where employees sold mortgages to those who would not be able to pay them back due to higher salaries and bonuses
Gov could use preemptive solutions such as separating the Retail banking from Investment banking thus allowing failure of investment banks without impacting retail banking
After the event - bailing out banks may be necessary to prevent a larger economic collapse but it creates a precedent that might reinforce the moral hazard in the banking sector
What is externalities and how can the Government resolve this market failure
- Cost to the taxpayers of bailouts
Loss of saving
Lost jobs, incomes, growth
When investors speculate on proper prices, a negative consumption externality occurs as young buyers end up paying more
EG Cost to the taxpayer of bailing out the banks the banks after the 2007-8 financial crisis - long term costs to the economy due to effects on demand and growth
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 crisis, the financial regulation in the UK was completely overhauled in an attempt to be more effective
Once a crisis/ recession has taken place, th Gov might respond through expansionary demand-side policies
What is Speculation and market bubbles and how can the Government resolve this market failure
Assets are bought cheap and sold at a higher price. What if prices fall and the deal is leveraged? High money supply in the econ can cause; Excessively high estimates of future price increases can create a market bubble of overpaying for assets
Eventually, a fall in demand (mass selling - herd mentality) and prices leading to worthless assets and huge debts
eg Wall street crash 1929
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
What is asymmetric info and how can the Government resolve this market failure
Financial institutions often have more info compared to their customers. This means they can sell them products they don’t need, are cheaper, elsewhere or are riskier than the the buyer realises
Additionally there may be asymmetric info between financial institutions and regulators. The institutions have little incentive to help regulators understand their business and thus there may be difficulties for the regulators so may allow institutions to undertake harmful activities
EG - The global financial crisis was partially caused by banks selling packages of prime and subprime mortgages, but advertising them all as prime mortgages- buyers not know risk involved
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
Explain the role of Central banks in implementation of monetary policy
Base rate changes, quantitative easing, buying and selling domestic/foreign currency
BOE aim 2% CPI
Explain the role of Central banks in banker to the Government
Make payments on behalf of the Government
Manage the public debt of the country
Explain the role of Central banks in lender of last resort
Central banks provide temporary funds for banks with short term cash problems - without this help, may ngo bankrupt leading to instability in financial system and loss of savings for households
Particularly relevant if banks are not lending to each other, as happened in the 2007/08 financial crisis
Bank of England resolved this problem by injecting money into the system to boost capital and liquidity
Explain the role of Central banks in regulation of the banking industry
Regulation can include: banning market rigging; preventing the sale of unsuitable products; and liquidity ratios, when banks are forced to hold a certain percentage of liquid assets.
● There are three key bodies for financial regulation:
o The FPC identifies and reduces system risk and supports government
economic policy (macroprudential)
The PRA ensures competition, ensures consumers have access to services, minimises risk should a bank fail and ensures banks take responsible action. (microprudential)
o The FCA protects consumers, promotes competition and enhances the
integrity of the system by preventing market rigging.
