4.4 The financial sector

Question 1

The role of financial markets

Answer 1

1) To facilitate (allow) saving 2) To lend to businesses and individuals (business loans, mortgages). 3) To allow the exchange of goods and services. 4) To provide forward markets in currencies and commodities 5) To provide a market for equities (shares).

Question 2

Asymmetric information

Answer 2

Some players in financial markets have a lot more information than others. This allows markets to be rigged easily or some people to be exploited . It can lead to financial products being mis-sold (sold to people who do not need them).

Question 3

Externalities

Answer 3

Major costs that fall on third parties. When a bank fails, its savers could lose all their money, sparking a financial panic or recession.

Question 4

Moral Hazard

Answer 4

When you have an incentive to take too many risks or behave poorly. Because of the major externalities, banks have become ‘too big to fail’. Governments will bail them out if they get into trouble. This increases their incentive to take big risks.

Question 5

Speculation

Answer 5

Buying or selling assets because you believe their prices will rise/fall in order to make a profit.

Question 6

Market bubbles

Answer 6

Caused by speculation – the price of assets can rocket far above what they are worth. The market is a ‘bubble’ which could burst at any moment causing a massive price fall.

Question 7

Market rigging

Answer 7

Using your inside information to ‘fix’ or rig a market to make money for yourself. Illegal.

Question 8

The role of central banks

Answer 8

1) Implement monetary policy (inflation targeting through interest rates / QE). 2) Banker to the Government – issue new bonds / manage the national debt. 3) Banker to the Banking system – the lender of last resort 4) Prudential regulation – regulating the banking system to manage risks

Question 9

The Federal Reserve

Answer 9

The US Central Bank. Known as ‘the Fed’.

Question 10

The ECB

Answer 10

European Central Bank. Central Bank for countries that use the Euro.

Question 11

Liquidity

Answer 11

Cash or assets which are easy to turn into cash. Banks need liquidity from day-to-day to meet their commitments.

Question 12

Capital (banking def)

Answer 12

The money or assets a bank holds to support its long-term position. The Central Bank must ensure that banks have enough long-term capital and day-to-day liquidity.

Question 13

Capital requirements

Answer 13

When Central Bank demands that an individual bank holds a certain amount of assets.

Question 14

Stress testing

Answer 14

Scenarios created by the central bank to test whether individual banks could survive crises, unexpected events or external shocks, like big recessions, wars or Brexit.

Question 15

Financial Conduct Authority

Answer 15

UK regulator which policies the behaviour of banks to prevent/punish mis-selling.

Question 16

Prudential regulation

Answer 16

Regulating the Banks to ensure overall macroeconomic stability – preventing another credit crunch/Great Recession.