4.4 - The Financial Sector Flashcards
1
Q
4.4.1 - Role of Financial markets
To facilitate saving:
A
- banks connect savers with borrowers
- financial institutions give return on savings in the form of interest, then lens out the deposit at a higher interest rate to make profit
- allows wealth accumulation = large purchases can be made eg mortgage on a house or for firms = capital expenditure
2
Q
4.4.1 - Role of Financial markets
To lend to businesses and individuals:
A
- banks connect savers with borrowers
- households can use borrowing to finance large purchases - credit cards, mortgages, loans and overdrafts
- firms can use finance to purchase capital expenditure = increase capacity and shift LRAS
3
Q
4.4.1 - Role of Financial markets
To facilitate the exchange of goods and services:
A
- create payment system for g+s
- facilitate transfer of money - one bank to another (in order to pay for g or s)
- removes need for face-to-face transactions and can facilitate international purchases, trade and globalisation
4
Q
4.4.1 - Role of Financial markets
To provide forward markets in currencies and commodities:
A
- parties agree to buy/sell an asset for a price agreed today (forward price), with delivery and payment occurring at a future point, with delivery date
- good for firms as they can be certain of their future costs (increase confidence) and future costs could be higher than agreed price
- forward buying is similar to hedging = agreed price between firm and supplier for all purchases of a particular good for a fixed amount of time
5
Q
4.4.1 - Role of Financial markets
To provide a market for equities (stocks and shares)
A
- issuing shares can be way companies finance expansion
- firms can either issue shares for the first time (go public - becoming a PLC) or existing PLC can issue more shares
- shareholders will get a share of profits made by the company (known as a dividend) - their wealth can change if share prices rise/fall
6
Q
4.4.1 - Role of Financial markets
Different types of financial institutions:
x6
A
- retail banks - banks that provide services to individuals
- commercial banks - banks that provide services to businesses
- investment banks - banks that engage in a variety of activities in different financial markets, eg foreign exchange market, money market, capital market and derivative markets
- saving vehicles - help individuals to make a return on their savings eg pension funds
- speculators - speculate on financial markets
- insurance companies - provide insurance against risks by charging customers a premium
7
Q
4.4.1 - Role of Financial markets
Different types of markets:
A
- money markets - financial market that provides short-term borrowing and lending (up to 1yr)
- capital markets - financial markets which provide long-term borrowing and lending (1yr+)
- foreign exchange markets - where different currencies are traded
- commodity markets - where commodities are traded eg London Metal Exchange
- derivatives markets - markets which trade financial instruments based on the values of other financial instruments
- insurance markets - where individuals, firms and government can by insurance
8
Q
Market Failure
asymmetric information:
A
- difference in info available to buyers and sellers
- banks can hide info from the regulators/gov = can take excessive risk can be taken knowing that if things go bad they will be bailed out - but regulators wont know they are doing it
- securitisation is the process of bundling together various types of contractual debt - creating CDO
- E.g = financial institutions sold mortgage-backed securities as ‘low risk products’ despite knowing there were problems with some of the mortgages (sub-prime mortgages)
9
Q
Market Failure
moral hazard
A
- when economic agents (eg bank) make decisions in their best interest knowing their are potential adverse risks - costs that will be partly borne by other economic agents
- eg sub-prime lending, banks then sold as CDOs knowing there was a high change of the borrower defaulting
10
Q
Market Failure
externalities:
A
- neg externalities from irresponsible lending by banks (taking excessive risk)
- cost to tax payers of bailouts
- loss of savings loss of jobs, incomes and growth
11
Q
Market Failure
speculation and market bubbles:
A
- speculation - investors try to make profit by buying low and selling high
- market bubble occurs when the price of a particular asset is driven to an excessive high and then collapses (bursts) - herding behaviour
- UK housing market is prone to bubbles
12
Q
Market Failure
market rigging:
A
- where a group collude (cartel) to fix prices or exchange info that lead to gains for themselves at the expense of others in the market
- to increase profits
- LIBOR scandal - fixing IR and ER
- heavy fines and regulation but can still occur if punishment and enforcement is weak
13
Q
Role of central banks
implementation of monetary policy
A
demand side policies
14
Q
Role of central banks
banker to the government
A
- most central banks act as a banker to their gov
- central banks may handle the accounts of the government departments and make short term advances to gov
- UK - BoE was responsible for managing national debt but this role was transferred to in 1998 to UK Debt Management Office
15
Q
Role of central banks
banker to the banks – lender of last resort
A
- key role is to act as lender of last resort
- short term liquidity problem - banks may borrow money or sell the central bank some of the illiquid assets
- bank may face problems when too many assets fall in value eg many loans turn into bad debt - never repaid eg 2008 FC (too many mortgage assets in default) - central bank is then the lender of last resort as it can lend banks money to stop them collapsing
- may lead to moral hazard
