4.4: The financial sector Flashcards
what even is a bond
5 Role of financial markets
-Facilitate Saving —> To provide an opportunity for individuals and firms to save money
-Facilitate Lending —> To individuals and businesses and individuals who need more cash
-Facilitate Exchange
-To provide a market for equity —> To provide a market in which equity can be sold
-Provide Forward markets —> Provide forward contracts
What do Forward contracts do?
Fix the price and date of a future transaction, now so that you know exactly how much you will pay or receive and when.
This prevents both parties having to anxiously monitor the price, especially with price volatile commodities or currencies
Types of financial market failure
-Speculation and market bubbles
-Negative externalities
-Moral hazard
-Asymmetric information
-Market rigging
Explain how asymmetric information leads to market failure
Asymmetric information is when one party knows more than another in a transaction.
- Bankers knew much more about their adjustable rate subprime mortgages than the people they were selling them to
- Bankers knew far more about banking than the financial regulators who were meant to be monitoring their behaviour.
APPLICATION
How much money did global banks lose in the 2008 financial crisis?
$2.8 trillion
Explain how speculation and market bubbles lead to market failure
-When people speculate that the price of something will increase, they demand more of it, pushing up the price further. This inflates the price so high that people realise it is becoming over-valued and begin to sell it, causing the price to decrease
-E.g. 2008 financial crisis was due to housing bubble. House prices would rise - so they sold subprime mortgages, which caused a housing bubble.
-In the late 1990s there was a dotcom bubble where the price of shares in new online companies speculated to increase until they came crashing down when the dotcom bubble burst
Application
How did the price of bitcoin increase due to speculation?
Investors were buying Bitcoin speculatively. This means that most people who bought it weren’t actually wanting to have Bitcoin - they just bought it because they thought it would go up in price and so they would be able to make money. More and more people kept buying it as the price increased further and further. Eventually, people begin to realise that they had paid $16000 for a Bitcoin and they don’t even really know what a Bitcoin is! The price was probably overvalued. This created a market bubble.
How are negative externalities a market failure?
Refer to 2008 financial crisis
After the financial crisis, banks stopped lending money to people or businesses. Firms couldn’t borrow money, so they had to make cutbacks, which meant that millions of people became unemployed. This decreased the amount of peoples real disposable incomes, so consumption decreased, AD decreased. There was therefore a decrease in real GDP. This is a negative externality because the people who lost their jobs were outside the price mechanism in the financial sector
Explain how a moral hazard leads to market failure
-Moral hazard occurs when you take more risk because somebody else is bearing the consequences of that risk
-Banks dont feel the consequences of their mistakes as they are likely to get bailed out by their governments as they did in 2008
-After the 2008 financial crisis, the US spent about $700 billion of taxpayers’ money to stop banks from going bankrupt
Explain how market rigging is a form of market failure
Market rigging is when banks collude to fix the interest rate
Banks dont leave interest rates down to supply and demand and fix the numbers to suit themselves. As a result the price mechanism becomes distorted
APP
Market rigging examples
-The LIBOR (London Interbank Offered Rate) fixing scandal was a financial scandal that was uncovered in 2012
-Evidence emerged that some of the banks were artificially lowering or raising the LIBOR to benefit their own financial positions, such as by making their own borrowing costs appear lower than they actually were
-Barclays, Royal Bank of Scotland and three other banks are being sued by investors for at least £1bn over rigging of the foreign exchange market in a test case for US-style class actions in the UK.
Definition of quantitative easing
When the central bank buys financial assets from highstreet banks in order to encourage them to lend
Aim of quantitative easing
Central bank buys financial assets from highstreet banks. This means that these banks have more cash which they can use to lend. This increases borrowing, which increases investment. There is then a positive multiplier effect, which leads to economic growth.
4 roles of central banks
- Lending to other banks
- Lending to the government
- Implementing monetary policy by manipulating the base interest rate and the money supply.
- Regulate the banking industry e.g. through stress tests
What happens if the central bank decreases interest rates?
Highstreet banks have lower interest rate repayments. This means they keep more money themselves and can lend it out to people. This increases the supply of money, potentially increasing consumption and therefore and increase in AD
Explain the shape of the supply of money curve
Supply of money is perfectly inelastic as there is only a specific quantity of money at any given point
Define the reserve requirement
Minimum percentage of money that banks must hold in reserve from the deposits they receive from their customers.
Factors affecting the supply of money
-Reserve requirement - Lower interest rate decreases reserve requirement and higher reserve requirement increases interest rate
-Discount rate/ Repo rate / Bank rate. Higher interest rate decreases bank rate
-Open market operations (the purchase and sale of securities in the open market by a central bank) - Lower interest rate, buy bonds
Role of the financial conduct authority (FCA)
Protect consumers and increase confidence in banks and financial institutions / products by:
-Supervising conduct of firms / markets to ensure legal business (Prevent market rigging)
-Promote competition so consumers get better deals (Deregulation)
-Banning financial products against interest of consumers (Mis-selling)
-Banning or changing mis-leading adverts for financial products (Loan sharks)
Role of the Central bank
-To implement monetary policy to help manage inflation —> interest rates, quantitative easing and money supply (QE + Reserve requirement)
-Act as banker to the government —> Buying and selling of government bonds
-Act as a banker to banks —> Prevent a bank run. Central bank can provide emergency or non-emergency liquidity to banks to prevent systematic risk
-Regulate the financial system alongside FCA—> Test how risky a bank’s assets are, decide reserve rate and regulate the LIBOR
ANALYSIS
Role of the central bank
-Leads to less panic and bank runs —> Increases consumer confidence, potentially causing and increase in consumption, increasing AD
-Less chance of systemic risk
-Better banking decisions made by bankers —> Less chance of bank failure due to moral hazard
Evaluation
Role of the central bank
-Moral hazard —> Banks may take more risk if they know BofE will bail them out —>Banks wont have enough enough liquidity and rely on BofE
-Regulatory capture —> Lower interest rate on emergency liquidity for banks
-FCA potentially over-regulate the banking industry
Definition of systemic risk
When one banks instability can decrease confidence in the whole banking industry, potentially causing a bank run
