4.4 Financial markets Flashcards
To facilitate saving (RoFM)
Banks connect savers with borrowers and provide an incentive to save money since it pays its customers interest on any savings they place in their banks.
Without savings, there are no funds for borrowing.
Lending to businesses and individuals (RoFM)
Banking provides the key role in providing funds rot firms for investment to stimulate capital accumulation. Capital accumulation leads to growth and the possibility of development.
For example in LEDC’s, access to such funds are limited which limits their g + d
To facilitate the exchange of goods and services (RoFM)
Banks helps customers to make payments for goods and services they wish to acquire. This has become more prevalent as consumers have moved away form paying in cash and start using credit/debit cards
Banks also support businesses in selling their product by allowing them a place to store their revenue + support payments made by cards/cheques.
To provide forward markets in currencies and commodities (RoFM)
A forward market is where the price of a financial instrument or asset is set today but the transaction will take place at some future date. This is to protect both the seller and the customer from fluctuations in price in the market.
Contracts entered into a forward market are binding on the parties involved and cover financial instruments such as foreign currencies and commodities e.g oil
To provide a market for equities (RoFM)
A market in which shares are issued and traded aka the stock market. Shares provide part ownership (equity) in a company and provide them with capital which is an important source of finance for the business.
Also, these are markets for government bonds where the government sells debt to raise money to finance the public sector deficit aka gilt edged securities or gilts
Asymmetric information defintion
The underlying cause of market failure in the financial sector. Exists in any transaction where one part has less information than the other
Asymmetric info explanation
If depositors could perfectly observe and evaluate what the banks was doing with its money, then the moment it did something that may put the depositors money at risk, depositors would presumably withdraw their money + exercise discipline over banks. However usually depositors are unaware of what is going on with their money as banks know that they have considerable discretion.
Asymmetric info can give rise to both moral hazard and adverse selection.
Exp of asymmetric info in financial market
Subprime mortgages - a lender does not know how likely borrower is to repay their loan
Insurance - an car insurance company cannot tell the true level of risk associated with each driver
The buyer of a financial product is unaware of true level of risk (CDO)
Externalities (financial crisis)
Bankers in their lending behaviour did not fully take into account the external costs of not managing risk. The financial sector imposed negative externalities on the real economy as the financial crisis triggered falls in GDP, increased unemployment and falling incomes.
There was also the external cost of the sacrifice of taxpayers money.
Banks needed to be bailed out by go and this led to a sacrifice of other public services
Moral hazard
A situation where a person or business is willing to take more risks to benefit themselves because any negative consequences which result from a course of action will be felt by someone else. This happens due to asymmetric info so risk taker has superior info over the other and can therefore get away with the risky behaviour
Moral Hazard Exp
To ensure financial and economic stability, Govs offer banks extra funding to prevent collapse of banks. However, this creates moral hazards as banks gain incentive to take on riskier lending as they know they will be bailed out. Banks enjoy the upsides while taxpayers suffer
Speculation and market bubbles
A speculative bubble is a spike in the value of an asset (house p or stock market values).
Poor lending decisions by bankers can help fuel a market bubble e.g through irresponsible mortgage lending
Speculative bubble cause
Caused by exaggerated expectations of future growth in the value of an asset. Investors believe that the value will rise and so with heightened expectation, this causes value to further inflate beyond an objective assessment would suggest.
How does the bubble burst?
Once belief sets in that the asset has reached its peak value, investors will quickly try to sell, causing the artificially high value to fall. As the bubble bursts there’s usually a fall in confidence and AD leading to the wealth effect on consumption (e.g the housing bubble in the financial crisis)
Market rigging
The illegal practice of manipulating financial markets for personal gain. Illegal as it prevents fair working of the market. Responsibility falls not Financial Conduct Authority as they regulate how financial institutions do business with their customers
