4.4 The Financial Sector

Question 1

Define financial markets

Answer 1

Where buyers and sellers can trade financial assets

Question 2

Examples of intermediaries

Answer 2

1. Commercial banks- provides services to businesses
2. Investment banks: trade in foreign exchange, commodities, bonds, shares and derivatives for speculation purposes
3. Pension funds
4. Hedge funds: engage in riskier transactions than mutual funds e.g. buy up debt in leverage deals
5. Mutual funds: less risky

Question 3

Explain the role of financial markets: Facilitate savings

Answer 3

• Storing £ in savings accounts and holding stocks/ share.
• According to the Harrod-Domar model of economic growth, sufficient saving must be undertaken in an economy to enable capital accumulation to occur
• Douglas North said a lack of institutions affects development
• Higher savings in bamks–> higher borrowing–> higher investment
• Zambia has only 17 banks & not enough Zambians have banking accounts which affects the savings gap

Question 4

Explain the role of financial markets: Lend to businesses and individuals

Answer 4

Being able to borrow £ increases consumption and investment. Allows households or firms to purchase assets and pay them off over an extended period of time e.g. mortgages on home purchases
* Allows expansion: hire more labour, export the surplus
* Buy more premium goods (hot ticket items)
* Microfinance is used in Zambia because its very hard to get a loan–> need property rights, law courts
* Zambians are ‘unbanked’

Question 5

Explain the role of financial markets: Facilitate the exchange of G/S

Answer 5

• 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 and bank transfers
• Allowing circular flow of income to flow so labour earn income and spends in shops
• Banksing system allows income to go into accounts which can be spent via contactless/ debit cards etc, bank tranfers to buy things
• Allows C to take place and workers to be paid

Question 6

Explain the role of financial markets: Provide forward markets in currencies and commodities

Answer 6

Banks either fix currency now for future transactions or set the price of the commodity today for delivery in the future
Future contracts are undertaken to hedge (decrease risk) against adverse movement in E.R. or commodity P’s
Especially important for developing countries

Question 7

Explain the role of financial markets: Provide a market for equities

Answer 7

• Equities are shares in public companies that are listed on stock exchanges around the world.
• Financial markets facilitate both long term investment and speculation by providing platforms which connect buyers and sellers e.g. E-Trade
• Positive wealth effect, QE, allows firms to expand, grow and eomply more via issueing share capital, firms can attain finance to innovate

Question 8

Financial market failure

Answer 8

Where free markets fail to allocate financial products at the socially optimum level of output

Question 9

MEAMSS

Acronym for financial market failure

Answer 9

Moral hazard
Externalities
Assymetric infomation
Market rigging
Speculation and market bubbles
Systemic risk

Question 10

Financial market failure

Define systemic risk

Answer 10

Risk in whole financial system

Question 10

Financial market failure

Define moral hazard

Answer 10

One person (bankers) make the decision about how much risk to take, while someone else (customer) bears the cost if things go badly

Question 11

Financial market failure

Define speculation and market bubbles

Answer 11

Over valued assets, as speculators take calculated risks to gain from trading assets; herding place a big part, as well as animal spirits
Positive wealth effect is rife

Question 11

Financial market failure

Define externalities

Answer 11

3rd party cost of financial sector: bail out; unemployment due to financial crash

Question 12

Financial market failure

Define asymetric infomation

Answer 12

When some parties in a transaction (financial consultants) have more information regarding the product than others

Question 13

Financial market failure

Define market rigging

Answer 13

Market rigging occurs when individuals or businesses deliberately inflate or deflate prices in order to realise profits

Question 14

Market failure in the finanical sector

Explain how speculation and market bubbles occur

Answer 14

• Speculations occur when assets are bought at a low price and sold at a high price.
• Market bubbles= P’s for a stock/ asset rise exponentially, over a period of time, well in excess of their intrinsic value
• If assets end up falling in value (P’s fall) and the deal is leveraged= borrowing to amplify the end outcome of a deal (normal deal: buy high profile, lucrative, liquid assets)
• Eventually high estimates of future price increases can create a market bubble and overpaying got assets
• Eventually D fall and P fall leading to worthless assets and huge debts
• People cannot pay back their debts, bank could go bust, commercial banks who lent lost of £ to investors looking to leverage these deals will go bust → systemic risk, potential financial collapse
• The higher the money supply in an economy, the greater the speculation and potential for market bubbles

Question 15

Market failure in the finanical sector

Explain how asymmetric infomation occurs

Answer 15

• When one party has more information that the other party
• Many financial products are complex and difficult for consumers to understand
• Sellers often have a significant information advantages over the buyers
• E.g. Borrowers may not reveal their previous borrowing history, lenders many not clarify all the details and clauses attached to a loan

Question 16

Market failure in the finanical sector

Explain how moral hazard occurs

Answer 16

• Banks seems to be considered ‘too big to fail’ and governments bear the consequences of their risky behavior
• Risks or decisions is taken by a bank→ if decision goes bad, 3rd party will bear the risk → bank goes insolvent
• Encourages excessive risk and bad loans to be issued out
• Believe central bank or government will bail them out
• Moral hazard has increased in the financial sector since 2008 as governments have stepped in to save individuals from failure (e.g. RBS)

Question 17

Market failure in the finanical sector

Explain how externalities occur

Answer 17

• Cost to the taxpayer of bailouts
• Loss of savings
• Loss jobs, incomes, growth (due to commercial/ investment bankers who take excessive risks→overproduce risky financial assets)
• Negative externalities of production and consumption exist in financial market
• E.g. When investors speculate on property prices, a negative consumption externality occurs ar young buyers end up payer more (or being forced out of the market) due to higher prices caused my speculation (AirBnB effect)
• In developing countries, individuals may prefer to keep their savings at home rather than lend to banks, thus depriving the economy of valuable flow of funds

Question 18

Market failure in the finanical sector

Explain how market rigging occurs

Answer 18

• Where traders/ bankers/ intermediaries collude to manipulate markets and make huge profits
• E.g. rigging LIBOR & FOREX markets
• Heavy fines and regulation but can still occur is punishment and enforcement is weak
• LIBER (London Interbank Offered Rate) is used to set I.R. on a wide array of loans to individuals, firms and governments including mortgages, credit cards and student loans. In 2012, banks were fixing I.R. above or below their ‘true’ rate to benefit their own financial positions

Question 19

Market failure in the finanical sector

Explain how adverse selection occurs

Answer 19

• When most likely buyers are those who are those the seller would prefer not to sell to due to imperfect information (between buyer and sellers)
• Excessive risk is then taken e.g. with health insurance
  1. Premium issues on who it believes will buy
  2. Healthy consumers- premium too high (good, profitable buyers). Poor health consumers- good value (bad buyers→ more costly given the amount of claims these people will make)
  3. Result in selling only to unprofitable consumers making riskier loans and collapse
  4. Increase premiums only makes this worse

Question 20

Roles of the central bank

Answer 20

• To implement monetray policy (M.S, I.R, E.R.)
• Act as a banker to the govt: buying and selling govt bonds & decreasing I.R. paid on govt bond, the govt sets the annual budget but the central bank manages the tax receipts and payments
• Act as a banker to the banks (‘Lender of the last resort’): Commercial banks are able to borrow from the Central Bank if they run into short-term liquidity issues. W/o this help, –> might go bankrupt –> instability in the financial system + a potential loss of savings for many households
• Regulate the financial system

Question 21

When will the Central Bank NOT intervene to other banks

Answer 21

• Wont intervene if a bank goes insolvent
• Make risky decisions
• Issue to many risky loans
• Not enough capital to offset the loss in loan value

Question 22

Why is financial stability crucial for confidence in the financial system to remain high

Answer 22

1. Prevent panic and a run on the banks
2. Reduce financial instability and systemic risk (entire financial system collapses)
3. Advise the govt of bank bailouts

Question 23

Evaluate the role of central banks acting as a banker to other banks

Answer 23

• Moral hazard–> risk is taken so cost is borne by a 3rd party (Central Bank)
• Banks may not hold sufficient liquidity–> banks may take greater risks= make more profits= not hold many short term liquid assets and lend out long term liquid assets instead. If they need to fulfill short term liabilities, they will just go to the central bank
• Regulatory capture
• Why should banks have this luxury and not other firms?