4.4 The Financial Sector

Question 1

What are financial markets?

Answer 1

Where buyers and sellers can buy and trade a range of services or assets that are fundamentally monetary in nature

Question 2

What are the two main reasons of financial markets?

Answer 2

• To meet demand for services (such as savings and borrowing from individuals, firms and the state)
• To allow speculation and financial gain (Gambling in the hope of making profit)

Question 3

What are the roles of the financial market?

Answer 3

• To facilitate savings
• To lend to businesses and individuals
• To facilitate the exchange of goods and services
• To provide forward markets
• To provide a market for equities

Question 4

Explain the role of facilitating savings in a financial market

Answer 4

• Allows people to transfer their spending power from the present to the future.
• It can be done through a range of assets, such as storing money in savings account and holding stocks and shares.

Question 5

Explain the role of lending to businesses and individuals in a financial market?

Answer 5

• Allows consumption and investment.
• They are sometimes referred to as a financial intermediary, the step between taking money from one person to give to another since money from savings is used for investment.

Question 6

Explain the role of facilitating the exchange of goods and services in a financial market?

Answer 6

• Creating a payment system.
• Central banks print paper money, institutions process cheque transactions, companies offer credit card services and banks and bureau de changes buy and sell foreign currencies.

Question 7

Explain the role of providing forward markets in a financial market

Answer 7

• Where firms are able to buy and sell in the future at a set price
• For example if a farmer wants to sell the crop they are growing at guaranteed price in a month’s time
• The forward market exists for commodities and in foreign exchange and helps to provide stability.

Question 8

Explain the role of providing market equities in a financial market?

Answer 8

• Issuing shares is an important way for companies to finance expansion but people would be unlikely to buy shares if they were unable to sell them on in the future
• Financial markets provide the ability for shares to be sold on in the future, making assets more appealing

Question 9

What are the five reasons of Market Failure in the Financial Sector?

Answer 9

• Asymmetric information
• Externalities
• Moral Hazard
• Speculation and Market bubbles
• Market rigging

Question 10

Explain Asymmetric information as a market failure in the financial sector

Answer 10

• Financial institutions often have more knowledge compared to their customers
• This means they can sell them products that they do not need, are cheaper elsewhere or are riskier than the buyer realises
• There can also be asymmetric information between financial institutions and regulators
• The institutions have little incentive to help regulators understand their business and this causes difficulties for the regulators so may allow institutions to undertake harmful activities.

Question 11

Link Asymmetric information to the Financial Crisis

Answer 11

• The Global Financial Crisis was partially caused by banks selling packages of prime and subprime mortgages, but advertising them as all prime mortgages.
• Those buying these packages suffered from asymmetric information and it is unlikely they would have bought them if they knew the risk involved.

Question 12

Explain Externalities as a market failure in the financial sector

Answer 12

• There are a number of costs placed on firms, individuals and the government that the financial market does not pay

Question 13

Link Externalities to the Financial Crisis

Answer 13

• The cost to the taxpayer of bailing
  out the banks after the 2007-8 financial crisis.
• Even higher than this, was the long-term cost to the economy of the crisis due to its effects on demand and growth.
• Significant falls in GDP, rising unemployment, falling income across the world economy

Question 14

Explain Moral Hazard as a market failure in the financial market

Answer 14

• This is where individuals make decisions in their own best interests knowing there are potential risks.
• Occurs when individual workers take adverse risk in order to increase their salary
• Any problems caused will be the problem of the company and not the problem of the individual, the worst that can happen is to lose their job whilst the company may lose millions of pounds
• Financial institutions may take excessive risk because they know the central bank is the lender of last resort and so will not allow them to fail because of the impact it will have on the economy

Question 15

Link Moral Hazard with the financial crisis

Answer 15

• The Global Financial Crisis was caused by moral hazard, when employees sold mortgages to those who would not be unable to pay them back.
• By selling more mortgages, they would see higher salaries and bonuses but would not see the negative effects if the loan was not repaid

Question 16

Explain Speculation and market bubbles as a market failure in the financial sector

Answer 16

• A lot of trading in financial markets is speculative and this leads to the creation of market bubbles, where the price of a particular assets rises massively and then falls.
• Occur because investors see the price of an asset is rising and so decide to purchase this asset as they believe the price will continue to rise and will profit them in the future.
• This leads to prices becoming excessively high and eventually enough investors decide that the
  price will fall, so they sell their assets and panic sets in, causing mass selling. (Known as Herding Behaviour)
• Also caused also caused market bubbles in the housing market by lending too much in mortgages and increasing demand for houses.
• When this bubble bursts, for example due to a rise in real interest rates, there is a fall in
  demand for houses and a negative wealth effect, reducing AD, and banks are left with loans that will not be repaid in full. Other bubbles included the dot com bubble in the 1990s and the Wall Street Crash in 1929.

Question 17

Explain Market Rigging as a market failure in the financial sector

Answer 17

NEETEN UP

This is where a group of individuals or institutions collude to fix prices or exchange
information that will lead to gains for themselves at the expense of other participants in
the market. One example of this is insider trading, where an individual or institution has
knowledge about something that will happen in the future that others do not know and so
can buy or sell shares to make a profit. Another example is where individuals or
institutions affect the price of a commodity, currency or asset to benefit themselves, for
example large trades in a currency will shift its value and this will make a difference to
individuals selling or buying assets with that currency. In the Libor scandal of 2008, financial
institutions were accused of fixing the London Interbank Lending Rate (LIBOR), one of the
most important rates in the world.

Question 18

What do Central Banks do?

Answer 18

Control monetary policy through interest rates and controlling money supply in order to keep inflation low and stable

Question 19

Discuss the central bank act as a banker to the government

Question 20

Discuss the central bank act as a bank to other banks?

Question 21

Discuss the central bank in regulating the financial system