4.4 The financial sector

Question 1

money market

Answer 1

short term loan finance for businesses and households

up to 12 months

inter-bank lending

short term government borrowing e.g. 3-12 months Treasury Bills

Question 2

capital market

Answer 2

medium & longer-term loan finance

shares and bonds are issued

long-term government bonds for example 10 year and 20-year bonds

Question 3

key roles of financial markets

Answer 3

facilitate saving by businesses and households - secure place to earn interest

lend to businesses and individuals - intermediary between savers and borrowers

allocate funds to productive uses - allocate capital to where the risk-adjusted rate of return is highest

facilitate the final exchange of goods and services: provide payments mechanisms e.g. contactless
payments

provide forward markets in currencies and commodities: Forward markets allow agents to insure against price volatility

provide a market for equities: Allowing businesses to raise fresh equity to fund investment and growth

Question 4

money characteristics

Answer 4

durability - needs to last
portable - easy to carry around
divisible - can be broken down to smaller denominations
hard to counterfeit
must be generally accepted by population
limited in supply - so holds value over time

Question 5

money supply

Answer 5

stock of currency and other liquid financial instruments circulating in the economy of the country at the particular point in time

Question 6

how banks fail

Answer 6

run on the bank: depositors panic and withdraw their savings fearing that the bank may collapse, liquidity crisis

credit crunch: unable to borrow money from other banks even on an overnight basis, Heavy losses and collapsing capital threaten their commercial viability

high losses from bad debts: loan default rate might rise e.g. in a recession as borrower struggle to make loan repayments,credit rating of bank declines and their share price falls making it harder to raise new finance

Question 7

limits to credit creation

Answer 7

market forces

regulatory policies - high capital reserve requirements

behaviour of consumers and firms - decisions about how much debt to repay

monetary policy - interest rates influences the demand for loans

Question 8

bond yield

Answer 8

coupon/market price

coupon = interest rate over fixed period of time

therefore, if price of gov bond increases, yield decreases

Question 9

systemic risk

Answer 9

possibility that an event at the micro level of an individual bank / insurance company could then trigger instability or the collapse an entire industry or economy

Question 10

mkt failure in financial sector

Answer 10

asymmetric info - borrower has better info on likelihood of repaying loan than lender

externalities - contagion effects (loss of trust and confidence between lenders and savers)

moral hazard - individual or organisation takes more risks because they know that they are covered by insurance e.g. bank bailouts will encourage riskier behaviour

market rigging - Illegally and unfairly controlling the price or the interest rate in order to increase their joint profits or exploit consumers

Question 11

external costs from financial crises

Answer 11

taxpayers bearing costs of bank bailouts (through austerity)

depositors face risk of losing savings

creditors face a rise in unpaid debts

shareholders lose equity from falling bank share price
employees lose jobs in finance and wider economy if it results in recession

government (increased fiscal deficit and debt)
businesses face reduced demand and higher borrowing costs

Question 12

speculative bubble

Answer 12

sharp and steep rise in asset prices, fuelled by high levels of speculative demand

due to exaggerated expectations of future price rises
irrational exuberance of investors
period of low interest rates - encouraging risky investments

Question 13

barriers to entry to commercial banking

Answer 13

regulatory barriers - licence needed by central bank

intrinsic barriers - marketing costs, reliable secure IT systems

high brand loyalty (oligopoly)

Question 14

functions of central bank

Answer 14

monetary policy: interest rate, QE, x rate

financial stability and regulatory function: supervision of stability of financial system and prudential policies to maintain financial stability during times of crisis

policy operation functions: lender of last resort to banking system during liquidity crisis

Question 15

problems with QE

Answer 15

ultra low IR can distort allocation of capital and keep alive companies who might not have survived with normal levels of interest rates

surge in property values, reducing affordability

bad for people who rely on interest from savings (real interest rates for savers has been negative for over 10 years)

Question 16

regulators of financial markets

Answer 16

Financial Policy Committee:

identify, monitor, and take actions to remove or reduce risks that threaten the resilience of the UK financial system

can instruct commercial banks to change their capital reserve ratios

“macro-prudential policy” - increase capital buffers

UK Prudential Regulation Authority:

microprudential regulators, maintains stability of banks and sets industry standards

FCA:

protects consumers by ensuring no market rigging by supervising behaviour of firms, promotes competition (deregulation), bans financial products against consumer interest, change mis-leading adverts for financial products

Question 17

liquidity ratio

Answer 17

ratio of liquid assets held by a bank on their balance sheet to their overall assets

Question 18

capital ratio

Answer 18

funds it has in reserve against the riskier assets it holds that could be vulnerable in the event of a crisis

Question 19

forward markets

Answer 19

Firms agree a fixed price for purchase of
foreign currency in the future