4.4 - The financial sector Flashcards
What are the roles of financial markets?
- To facilitate saving
- To lend to businesses and individuals
- To facilitate the exchange of goods and services
- To provide forward markets in currencies and
commodities - To provide a market for equities
How do financial markets facilitate saving
- Provides an opportunity for firms & individuals who need more cash
- E.g. pension funds, bank accounts
How do financial markets facilitate exchange?
- Provides an opportunity for firms & individuals to exchange
- Makes it easier for individuals to exchange
How do financial markets facilitate lending?
- Lend money to businesses & individuals who need more cash
- E.g. mortgage, loans - paid back at a later date with interest
How do financial markets provide a market for equity?
- Provide a market in which equity can be bought/sold
- Selling shares is costly - hard to track down investors so firms go to banks
- Allows firms to raise finance
What is equity?
Equity is when a firm sells a percentage of their company to investors in the form of shares. The investors can then receive a percentage of the profits.
How do financial markets provide forward markets? (define forward contracts)
- A forward contract fixes the price and date of a future transaction now, so that you know exactly how much you will pay in the future
- Useful for commodities & currencies -> price instability
What are the roles of the central bank?
- Lending to other banks
- Lending to the government
- Implementing monetary policy by manipulating the base interest rate &money supply
- Regulating the banking industry
What did the Federal Reserve do in 2011?
The strict set of financial regulations imposed on US banks by the Federal Reserve in 2011 was called Basel III
What are subprime mortgages?
A subprime mortgage is a mortgage that the borrower is unlikely to be able to pay back
Why did bankers start selling subprime mortgages at the start of the financial crisis
The bankers thought they could make a profit in two ways:
- If the borrower managed to repay their mortgage then the bank would make profit from repayments + interest
- If the borrower didn’t manage to repay then the bank would make profit by selling the house when they defaulted
- House prices were also rising - thought this was a win-win formula.
How did bankers get away with selling subprime mortgages? (Financial crisis)
- Asymmetric information - the banks knew more about the mortgages than the people borrowing
- Bankers knew they were going to increase the interest rates a lot but the people taking out the mortgage didn’t know/understand
What happened as bankers sold more subprime mortgages? (Financial crisis)
More subprime mortgages -> Increased demand for houses -> Increases house prices -> More profit from selling houses when people default -> More subprime mortgages -> Increased demand for houses -> Increases house prices -> Housing bubble
Why did the housing bubble burst?
In a market bubble, the price of an asset begins to increase -> demand for that asset increases -> increases the price of the asset further until the asset become hugely overvalued -> people realise they have paid more for the asset than it is actually worth - the bubble starts to burst
- They quickly start to sell the asset while the price is still high -> supply increases & price falls -> as the price starts to fall, more people sell & the cycle continues
What are the causes of market failure in the financial sector?
- asymmetric information
- externalities
- moral hazard
- speculation and market bubbles
- market rigging
