4.4 The Financial Sector Flashcards
What are financial markets?
Where buyers and sellers can buy and trade a range of services or assets that are fundamentally monetary in nature
Why do financial markets exist?
- to meet the demand for services, such as saving and borrowing, from individuals, businesses and the government
- to allow speculation and financial gains
What are retail banks?
- provide services to households
- payment of direct debts
- saving accounts
- loans and mortgages
What are commercial banks?
- provide services to businesses
What do investment banks do?
- trade in foreign exchange, commodities, bonds and shares for speculation purposes
- gives advice to firms on how to raise finance and on mergers
What are examples of savings vehicles?
- pension schemes
- trusts
- hedge funds
- assurance companies
Role of the central bank?
- control the money supply of a country
- monetary policy
- manage country’s gold and foreign currency reserves
- issue government debt
Roles of the financial market?
- facilitate savings
- lend to businesses and individuals
- facilitate exchange of goods and services
- provide forward markets
- provide a market for equities
Reasons for market failure in the financial sector
- asymmetric information
- externalities
- moral hazard
- speculation and market bubbles
- market rigging
Asymmetric information in the financial sector
- financial institutions often have more knowledge than customers
- therefore they can sell them products that they do not need, are cheaper elsewhere or are risky
- can be AI between financial institutions and regulators since institutions causing difficulties for regulators, allowing institutions to undertake harmful activities
Externalities in the financial sector
- costs placed on firms, individuals and the government that the financial market does not pay for
What is moral hazard?
- when investors are protected from the consequences of their actions, they engage in riskier behaviour than usual
- leads to misallocation of resources
- build up of risk in financial system
Two methods of moral hazard?
- when individual workers take adverse risk in order to increase their salary (i.e. GFC caused by moral hazard as employees sold mortgages to those who would not be able to pay them back, cost to firms)
- financial institutions take excessive risk because they know central bank is lender of last resort and will not allow them to fail
Speculation and market bubbles in financial markets?
Speculation => buying assets (eg stocks or real estates) with the expectation of profiting from price increases, rather than from the assets intrinsic
Market bubbles => when asset prices rise significantly above their fundamental values due to speculation and irrational exuberance. When they burst, they lead to market crashes and financial instability
Positive externalities?
A well-functioning financial sector can benefit the broader economy by efficiently allocating capital and promoting economic growth
Negative externalities?
Financial institutions may engage in risky practices (excessive lending) that lead to systemic risks affecting the entire economy, such as the 2008 financial crisis
What is market rigging in the financial sector?
Refers to the manipulation of financial markets to gain unfair advantages
Examples of market rigging
Insider trading, market manipulation and collusion among market participants to distort prices
What is insider trading?
Trading based on non-public material information
Examples of market manipulation?
Pump and dump schemes, insider trading, bull raids
What is a pump and dump scheme?
Artificially inflating the price of an owned stock through false and misleading positive statements in order to sell the cheaply purchased stock at a profit
Causes a loss of income for other shareholders as the prices of their stocks decrease
What are forward markets?
Financial institutions offer forwarding contracts for currencies and commodities, which let businesses and investors lock in future prices, reducing uncertainty and risks associated with international trade.
What are commodities?
Raw materials used in the production of goods
What are equities?
Shares in public companies that are listed on stock exchanges
