4.4 - The Financial Sector Content Flashcards
4.4 - The Financial Sector
What is a financial market
Any place or system that provides buyers and sellers the means to exchange goods/services and trade financial instruments
- These include bonds, equities, international currencies, and derivatives
4.4 - The Financial Sector
What are the Key Roles of Financial Markets
- Facilitate savings.
- Lend to businesses and individuals.
- Facilitate payment systems.
- Provide forward markets.
- Provide a market for shares (equities).
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What regulations can be introduced to regulate the financial market?
- Banning market rigging - jail sentences
- Liquidity ratios,
- Preventing the sale of unsuitable products
- Maximum interest rates to prevent consumer exploitation and prevent excessively risky lending
- Deposit insurance to protect consumer reposits.
- Cap on bonuses
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What types of financial market are there
- Bond Market – 2021 estimated that global corporate bond market worth $10 trillion
- Stock Market – Overseas firms can list on the UK stock market
- Currency Market – Trade in currency markets traded $6.6 trillion per day in 2021
- Mortgage Market - there are 11 million outstanding mortgages in the UK as of May 2021
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How do Businesses use Financial Markets
- To finance a business start-up – hundreds of thousands per year, over a thousand per day on average
- Finance a merger or a takeover – value of M&A in 2019 amounted to $3.7 trillion
- Finance Capital investment – in 2019 business investment grew by 1.8%
4.4 - The Financial Sector
What is the money market
- The money market is a financial market for short-term, highly liquid debt securities.
- It includes instruments like Treasury bills, commercial paper, and certificates of deposit.
- Participants include banks, financial institutions, and corporations seeking short-term financing or investments.
4.4 - The Financial Sector
What is the capital market
- The capital market deals with long-term debt and equity securities.
- It encompasses the primary market (where new securities are issued – for example when a business floats on one or more stock markets) and the secondary market (where existing securities such as bonds and shares are traded).
- Securities in the capital market include stocks, bonds, and real estate investments.
4.4 - The Financial Sector
What is the Foreign Exchange Market
- The foreign exchange market is where currencies are bought and sold.
- It facilitates international trade and investment by enabling the exchange of one currency for another.
- The forex market operates 24/5 and is decentralized.
- The most heavily traded currency is the US dollar ($)
4.4 - The Financial Sector
How is the money supply measured?
Money supply measures total available money, categorized by liquidity:
- M1 (Narrow): Physical currency + checking deposits (liquid, daily transactions).
- M2/M3 (Broad): Savings/time deposits, near-money (less liquid)
Total = M1 + Broad aggregates (M2, M3, etc.).
4.4 - The Financial Sector
What is digital money
- Digital money, also known as electronic money or digital currency, refers to a form of currency that exists solely in electronic or digital form.
- It does not have a physical counterpart like paper money or coins.
- Digital money is used for various types of transactions, including online purchases, electronic fund transfers, digital payments, and peer-to-peer transfers.
- It has become increasingly prevalent with the growth of e-commerce, digital banking, and the development of new financial technologies.
4.4 - The Financial Sector
What explains the growth of digital money
- Convenience: Digital money provides unparalleled convenience for conducting transactions. Eliminating the need for physical cash or in-person visits to banks. Mobile money technologies have accelerated.
- Globalization: Digital money facilitates rapid cross-border payments.
- Security: Many digital money systems incorporate robust security measures, including encryption and authentication, to protect users’ financial information. These security features reduce the risk of fraud, theft, and counterfeiting.
- COVID-19 Pandemic: The pandemic prompted more people to embrace contactless payment methods to reduce the risk of virus transmission.
4.4 - The Financial Sector
What is Equity Finance
Finance from shareholders the issue of new shares/stocks which carry voting rights
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What is Debt Finance
Borrowing money – requires paying interest (on loans) and may also need security
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What is the difference between Debt and Equity
Debt: Debt represents borrowing by individuals or organizations.
- It involves periodic interest payments and repayment of the principal amount at maturity.
- Bondholders are creditors with a claim on the issuer’s assets but no ownership stake.
Equity: Equity represents ownership in a business or an asset.
- Equity holders are shareholders or owners who have a residual claim on the assets and earnings of a company.
- Equity securities include common stock and preferred stock.
4.4 - The Financial Sector
What are bonds
Corporate Bonds – From a company (lending money to a firm)
Government Bonds – From a government (lending money to government)
- Bond is a loan
- Repaid when the bond matures
- Also pays annual interest
- Market trades the bond after issue
4.4 - The Financial Sector
How are bond prices affected by changes in market interest rates?
Bond prices and market interest rates are inversely related. When market interest rates rise above a bond’s coupon rate, the bond’s fixed payments become less attractive than those of newer issues, causing its price to fall. Conversely, when interest rates decline, the fixed payments become more appealing, and the bond’s price rises.
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What is a bond yield, and how is it calculated?
A bond yield is the bond’s coupon expressed as a percentage of its current market price. For example, if a bond pays a coupon of £1,000 and its current market price is £20,000, the yield is
£1,000/£20,000 x 100 = 5%
.
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Why do bond prices drop when interest rates rise?
New bonds offer higher coupons, making existing bonds with lower fixed payments less desirable, reducing their market price.
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Reasons why 10-year bond yields differ between countries
- Inflation risk: Countries with higher actual and expected inflation will have higher bond yields to compensate investors for the expected loss of real purchasing power.
- Default risk: Countries with higher national debt or and/or persistently large fiscal deficits will usually have higher bond yields as investors demand compensation for the increased risk of default.
4.4 - The Financial Sector
Likely economic effects of a rise in bond yields on government debt for a country such as the UK
- Debt service costs: The government will have to pay more in interest payments on its outstanding debt. This might reduce the financial resources available for spending on education, NHS and other priority areas.
- Currency appreciation: High bond yields might attract inflows of financial capital (hot money) from overseas which could then cause a currency appreciation. This will help control imported inflation but might worsen the price competitiveness of export sectors
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What are Investment Banks
- Role – Investment banks specialize in activities related to capital markets, such as underwriting securities, facilitating mergers and acquisitions, and providing services to corporations
- Customer Focus – Investment banks primarily serve corporations, institutional investors, and high-net-worth individuals
- Regulation - They are subject to different regulations than commercial banks, often with a focus on securities and financial market operations
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How do investment banks make a profit
- Underwriting – assist in raising capital by underwriting securities offering (such as IPO). Buy securities from issue at discount price and sell to public at higher price, profiting from price difference
- Mergers and Acquisitions (M&A) Advisory – Provide advisory services. Earn fees as a percentage of the transaction value.
- Trading and sales – Engaged in trading activities in various financial markets, including stocks, bonds, currencies, commodities and derivatives
- Asset Management – Manage investment portfolios for clients. Charge management frees as a percentage of the assets under management. Also performance fees based on investment returns.
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What are Hudge Funds
Pooling money from a group of investors and use investment strategies to generate returns. Aim to generate returns that are not correlated to overall market and often considered to be high risk, high reward investment option
Key characteristics
* Limited number of investors - Typically have a limited number of investors, often have high minimum investment amount
* Diversified investment strategies - Wide range of strategies including long and short position, derivate contracts and leverage.
* Use of leverage – Use leverage to increase potential returns, but this can also increase the risk.
* High fees - Charge high fees, typically a percentage of assets under management plus a performance fee based on returns
What are Commercial Banks
- Banks are licensed deposit-takers providing a range of savings accounts
- They are licensed to lend money and thereby create money via new bank loans, overdrafts and mortgages
- A commercial bank’s business model relies on charging a higher interest rate on loans (or other assets) than the rate it pays out on deposits (or other liabilities)
- This spread on assets and liabilities pays the operating expenses of a bank and helps them to make a profit
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What are Leveraged Loans
Leveraged loans are loans provided to companies with a high level of debt compared to their equity. These loans are typically used by companies with lower credit ratings and are issued by private equity firms or hedge funds rather than traditional banks. The key characteristics of leveraged loans are:
1. High debt-to-equity ratio: The company borrowing the loan has a high amount of debt compared to its equity, making it riskier for lenders.
1. Floating interest rates: The interest rates on leveraged loans are often variable, which means they can change over time.
1. Higher risk: Leveraged loans carry a higher risk of default, which is why they often have higher interest rates and fees than traditional loans.
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What are the main functions of Commerical Banks
- Accepting Deposits: Commercial banks offer safe and easily accessible deposit accounts, including savings accounts, checking accounts, and fixed deposits.
- Providing Loans: They extend credit to individuals and businesses for various purposes, such as mortgages, business loans, and personal loans.
- Payment Services: Commercial banks facilitate payment and fund transfer services through checks, electronic funds transfers, and online banking.
- Safekeeping of Valuables: Some commercial banks offer safe deposit boxes for customers to store valuable items securely.
- Currency Exchange: They provide foreign exchange services to facilitate international trade and travel.
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What are the Assets of Commercial Banks
- Cash and Reserves - Funds held in the central bank or as cash on hand
- Loans and Advances - The money lent out to borrowers
- Investments - Securities held by the bank, such as government bonds or corporate bonds
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What are the Liabilities of Commercial Banks
- Deposits - Funds held in customer accounts
- Borrowings - Funds borrowed from other financial institutions
- Capital - The bank’s equity, including share and retained earnings
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How commercial banks create credit
- Fractional Reserve System: Banks create credit by using the fractional reserve system, where they are required to hold only a fraction of their deposits as cash / liquid reserves and can lend out the rest.
- Money Multiplier Effect: When banks lend out a portion of the funds deposited with them, these funds are deposited in other banks, creating a chain reaction of lending and increasing the money supply.
- Credit Creation Process: As banks make loans, they effectively create new money in the form of additional deposits. This process multiplies the initial deposit and contributes to economic activity measured by GDP
4.4 - The Financial Sector
Limits to credit creation by banks
- Market forces – the profitable lending opportunities to businesses and households can often fluctuate for example at different stages of the cycle
- The risks of lending including default risk from the borrower
- Regulatory policies such as minimum capital reserve requirements as part of regular bank stress tests
- Monetary policy - level of policy interest rates set by the Bank of England influences total demand for loans
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How commercial banks make profit
- Interest-rate spreads - Charging a higher interest rate on loans than the rate paid to savers
- Service Fees – Fees charged when arranging business & personal loans
- Brokerage percentages – Many banks provide currency and share-dealing services and charge a brokerage fee for doing so
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What is a Non-Performing Loan
A non-performing loan (NPL) is a loan where the borrower has stopped making payments and is in default. The loan is considered non-performing when it is more than 90 days overdue. NPLs are a major concern for commercial banks because they represent a loss of revenue and can also have negative effects on the bank’s capital and liquidity.
4.4 - The Financial Sector
Factors causing high non-performing loans
- Economic downturns: During economic downturns, businesses and individuals may struggle to repay their loans, leading to an increase in NPLs.
- Industry-specific issues: Certain industries, such as construction may be more prone to NPLs due to the cyclical nature of their business.
- Credit standards: When commercial banks loosen their credit standards, they may lend to riskier borrowers, leading to a higher probability of defaults.
- Fraud: Some borrowers may intentionally default on their loans through fraudulent behaviour, such as falsifying financial information to obtain loans they can’t repay. This is a type of financial market failure.
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Trade-off between Liquidity and Profitability
Banks must balance holding liquid assets to meet deposit withdrawals and fund operations with investing in higher-yield, often less liquid assets for profit. Higher liquidity ensures safety and quick access to funds but typically offers lower returns, while investing in less liquid assets can boost earnings yet increases risk. This trade-off is further managed by regulations, such as minimum liquidity requirements imposed by central banks, to safeguard customer deposits and maintain overall financial stability.
4.4 - The Financial Sector
Causes of Commercial Bank Failures
- Poor management: This can include taking on too much risk, making bad loans
- Lack of diversification in the bank’s loan portfolio - for example, excessive lending to the volatile property market.
- Insufficient reserves to cover bad loans: Banks must set aside a certain amount of money to cover the possibility of loan defaults
- Run on the bank: A bank can fail if too many depositors withdraw their money at the same time, this is called a run on the bank.
- Economic downturns: Recessions can lead to an increase in loan defaults and a decrease in the value of the bank’s assets
- Regulatory failure: Inadequate regulatory oversight can lead to risky practices, fraud and corruption, and ultimately bank failure.
4.4 - The Financial Sector
Examples of Commerical Bank Failures
- Northern Rock: This bank failed in 2007. The government had to step in and nationalize the bank in 2008. It was eventually sold to other investors including Virgin Money.
- RBS (Royal Bank of Scotland): RBS required a government bailout in 2008 due to its exposure to bad loans and toxic assets. The government took a majority stake in the bank, and it eventually returned to private ownership.
4.4 - The Financial Sector
What is a Credit Crunch
- A credit crunch, also known as a credit squeeze, is a period when the availability of credit from banks decreases, making it harder for individuals and businesses to borrow money.
- During a credit crunch, lending institutions may become more risk-averse and increase their lending standards, making it more difficult for borrowers such as households and businesses to qualify for new loans or to extend their existing debts.
- Banks may also call back loans or reduce credit lines for existing borrowers. This can lead to a decrease in consumer spending and capital investment, which can slow down AD and perhaps cause a recession.
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What occured during the Credit Crunch of 2007-2009
The crisis was triggered by the collapse of the subprime mortgage market in the United States, which led to a decline in the value of mortgage-backed securities held by banks and other financial institutions around the world. This caused a decrease in the availability of credit and shortly after, an economic recession. Commercial banks became more risk-averse and tightened their lending standards, making it harder for individuals and businesses to borrow money. Credit supply contracted
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Arguments for allowing banks to fail
- Encourages Market Discipline: Creates an incentive for financial institutions to adopt sound lending models and avoid high leverage
- Promotes Competition: Challenger banks can step in whereas bail outs make financial markets less contestable – which is bad for customers in long run
- Avoids Moral Hazard: Government bailouts create a moral hazard by providing a safety net for banks, which may encourage them to take on excessive risk, knowing that they will be rescued in the event of failure.
- Protects Taxpayers: Bailing out failing banks can be costly to taxpayers. Allowing banks to fail means that losses are absorbed by shareholders and creditors of the bank, not taxpayers.
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Justifications for Bank Bail-outs
- Preventing Systemic Risk: A bailout of a failing bank can prevent a bank run, which can trigger a domino effect leading to the failure of other banks in the financial system, creating a systemic risk
- Protecting Depositors: Bailing out a bank can protect depositors’ savings and reduce the risk of them losing their money. Deposits in UK banks are insured up to a certain amount.
- Externalities from financial market failure: There are negative externalities from allowing a systemic banking failure – justifies intervention and regulatory reforms
4.4 - The Financial Sector
What is Market Failure
Market failure happens when the price mechanism fails to allocate scarce resources efficiently or when the operation of market forces lead to a net social welfare loss.
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What are the main causes of financial market failure
- Externalities from financial instability
- Monopoly power in financial markets
- Market rigging
- Speculative bubbles/irrational behaviour
- Moral hazard and attitudes to risk
- Asymmetric information and complexity
4.4 - The Financial Sector
What are Speculative Bubbles
A bubble exists when the market price of a financial asset is driven above what it should be such as a speculative boom in housing, crypto, NFTs, commodities or share prices. Speculation can be amplified by herd behaviour where many people take the same decision.
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What are some examples of financial bubbles
- Gold rushes in the late 19th century
- Real estate bubbles
- Dot com boom from 1997-2000
- Crypto-currencies
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What are the 5 stages of a financial bubble
- Displacement stage - excitement grows about a new product/emerging technology
- Prices boom as demand surges + limited (inelastic) supply causing market prices to spike higher
- Euphoria as more investors look to take advantage (Robert Shiller calls this “irrational exuberance”)
- Profit taking stage – some investors sell as they realise prices are out of line with fundamentals
- Panic - the herd mentality switches to desperate selling and prices fall fast inflicting big losses
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Explain Herd Behaviour during a bubble
Herd behaviour is where individuals act in a certain way because they believe that others are acting in the same way, even if it may not be the most rational decision.
* Fear of missing out (FOMO) - investors may feel a sense of urgency to participate in the rally, even if it is not based on sound analysis.
* Availability bias - investors may place too much emphasis on recent information and ignore longer-term trends.
* Overconfidence - investors may overestimate their ability to predict the market and make riskier investments.
* Social influence - investors may be influenced by the actions of others in their social network or by media coverage
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What is Hot-Hand Fallacy during a Bubble
- The hot-hand fallacy is a cognitive bias that leads investors to believe that a series of successful investments is indicative of future success, even if it may be due to luck or randomness.
- During a financial bubble, investors may become overconfident and continue to make investments based on the assumption that their previous success will continue. This can lead to over-investment in a particular asset, creating a bubble that is not sustainable in the long run.
- The hot-hand fallacy can lead to irrational decision-making, as investors fail to recognize that their previous successes may not be predictive of future outcomes. This can result in significant losses when the bubble eventually bursts and the underlying asset’s value plummets.
4.4 - The Financial Sector
What is Irrational Exuberance
- In his book “Irrational Exuberance,” Robert Shiller coined the term to describe the tendency of investors to become overly optimistic during economic booms, leading to a financial bubble.
- Shiller argues that this exuberance can cause investors to ignore risks and make irrational investment decisions, leading to a bubble that eventually bursts, causing significant losses.
- The concept of irrational exuberance is particularly relevant during periods of rapid economic growth, where investors can become overly confident and lose their ability to accurately assess the risks involved in investments.
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What is Prospect Theory
Prospect Theory (Kahneman & Tversky) argues investors make irrational choices during financial bubbles by:
* Framing decisions around gains vs. losses: They overvalue potential profits (e.g., “This stock could double!”) and downplay risks (overweighting gains).
* Loss aversion: Fear of losses outweighs desire for gains, leading to:
* Risk-taking: Chasing high returns (e.g., buying overvalued assets).
* Holding too long: Refusing to sell declining assets to avoid “locking in” losses.
* Result: Overconfidence and herd behavior inflate bubbles. When the bubble bursts, loss-averse investors panic, deepening crashes (e.g., 2008 housing crisis).
Key insight: Emotions distort rational risk assessment, fueling instability.
4.4 - The Financial Sector
What is Market Rigging
- Manipulating the market to make a gain at the expense of others.
- Eg. Insider trading - using confidential information to buy or sell shares to your advantage. Causes misallocation of resources
- For example if high profits of a firm are about to be announced, those with inside information can buy the shares first before the information is public
- Banks can also collude to fix interest rates. (RBS and Barclays)
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What is Asymmetric Information
Occurs when there is imbalance in information between agents. For example, financial markets often use complex information – a borrower (such as a small business) has better information on whether they can afford to repay a loan than the lender.
4.4 - The Financial Sector
What is Insider Information
Insider information is confidential, non-public data (e.g., mergers, earnings) that unfairly benefits traders. Using it (insider trading) is illegal, as it distorts market fairness, leading to fines, jail, or reputational harm. Laws prohibit exploiting undisclosed info to protect equal investor access.
Key: Unethical advantage → legal penalties.
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Where does Asymmetric Information appear in the Banking System
- Credit risk: Banks may have incomplete information about the creditworthiness of borrowers, which can lead to risky lending decisions. This can result in loan defaults and financial losses for the bank.
- Rating agencies: Banks rely on rating agencies to assess the creditworthiness of borrowers and investments, but these agencies may not always have complete or accurate information. This can lead to inaccurate ratings and further misinformation in the market.
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Asymmetric Information in Insurance
- Adverse selection: Insurers may not have complete information about the riskiness of policyholders, which can lead to higher premiums or lower coverage. Policyholders may also have an incentive to conceal information about their risk level, leading to more adverse selection.
- Moral hazard: Insurance may lead to increased risk-taking by policyholders, since they are shielded from the full costs of their actions. For example, a driver with collision insurance may drive more recklessly than one without insurance.
4.4 - The Financial Sector
What is a Moral Hazard
Moral hazard exists in a market where an individual or organisation takes greater risks than they should do because they know that they are either covered by insurance, or that a government will protect them from any damage incurred as a result of those risks. For example, creditors might be insured from risk by prospects of a government (state) bail-out.
Bail-outs may encourage risker behaviour
4.4 - The Financial Sector
What is Financial Crisis
A financial crisis is a major disturbance / shock to financial markets, associated typically with falling asset prices and insolvency amongst debtors and intermediaries, which ramifies throughout the financial system, disrupting the market’s capacity to allocate financial capital.
4.4 - The Financial Sector
What are the 5 types of Financial Crisis
- Currency crisis when a fixed exchange rate regime collapses, or a currency goes into a free-fall (depreciating rapidly)
- External debt crisis – when a country cannot attract the capital needed to finance a current account deficit
- Sovereign debt crisis – when a government cannot afford to pay the interest on their existing debts
- Banking crisis – when stability of banking system is low leading to a sharp rise in savings deposits and possible run-on banks
- Broad financial crisis – which combines elements of all the above
4.4 - The Financial Sector
What are some examples of recent financial crisis
- The Venezuelan crisis (ongoing) - an economic collapse characterized by hyperinflation, food and medicine shortages, and political instability.
- The Turkish currency crisis (2018) - a sharp decline in the value of the Turkish lira, caused by economic mismanagement and political tensions with the United States.
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What are some examples of recent banking crisis
- USA financial crisis (2007-2008) - known as the “global financial crisis,” was caused by a collapse in the housing market and a wave of mortgage defaults.
- Greek banking crisis (2012-2015) - caused by the country’s debt crisis and the imposition of strict austerity measures, leading to a run on the banks and a loss of confidence in the Greek banking system.
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What are the Main Causes of Financial Crises
- Financial market failures / behavioural finance
- “Irrational exuberance” among investors – see the work of Robert Shiller
- Increased complexity arising from financial innovation – such as mortgage bonds
- The Minsky Hypothesis – where “financial stability breeds instability”
- Macroeconomic and financial policy failures
- Unintended consequences of financial deregulation as a supply-side policy
- Banks too big to fail? Ever-riskier behaviour due to moral hazard
- Failures of credit ratings agencies in pricing risk accurately
- Structural changes in the global economy including economic imbalances including global savings glut and extended period of low /negative real interest rates
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What triggered the USA Subprime Mortgage Crisis in the early 2000s?
US Financial crisis
Many US banks began offering mortgages to subprime borrowers by relaxing lending standards. This led to a rapid rise in housing prices followed by mass defaults as the market collapsed.
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How did the issuance of subprime mortgages affect housing prices?
US Financial crisis
The increased issuance of subprime mortgages drove housing prices up rapidly; however, when the market reversed, the high prices and defaults contributed to a major financial collapse.
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What were the key contributing factors to the subprime crisis?
US Financial crisis
The crisis was fueled by:
* Relaxed lending standards and packaging risky mortgages into securities.
* Speculation in the housing market, leading to overvaluation of properties.
* The use of complex financial instruments paired with a lack of transparency in financial markets.
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What deregulation event contributed to the Global Financial Crisis of 2007–2010?
US Financial crisis
The repeal of the Glass-Steagall Act, which allowed banks to engage in riskier behaviors by mixing commercial and investment banking, was a significant factor.
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How did easy credit help trigger the Global Financial Crisis
US Financial crisis
Low interest rates and loose lending standards created an environment rich in easy credit, which led to a flood of subprime mortgages and toxic loans, ultimately fueling a housing bubble.
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What role did credit rating agencies play in the Global Financial Crisis?
US Financial crisis
Credit rating agencies, such as Moody’s and S&P, gave high ratings to junk securities—often backed by subprime mortgages—misleading investors about their safety.
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What is the primary function of credit rating agencies
US Financial crisis
They assess the creditworthiness of companies, governments, and other entities by assigning ratings (from AAA to D) that indicate the likelihood of debt repayment, which investors use to gauge risk.
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What are the main criticisms levied against credit rating agencies during the Global Financial Crisis?
US Financial crisis
They were criticized for:
* Overrating subprime mortgage-backed securities, which later were downgraded.
* Conflicts of interest due to payment by the banks issuing the securities.
* A slow reaction in downgrading risky securities as the housing market deteriorated.
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Why is the method of payment for credit rating agencies considered problematic?
US Financial crisis
Because the agencies are paid by the entities they rate, this can create a conflict of interest and may incentivize inflated ratings to preserve business relationships.
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Reasons why commercial banks such as Northern Rock can fail
- Losses: If people default on loans, a bank will suffer losses that erodes capital reserves and reduces its ability to lend. Investors may be unwilling to cover losses.
- Liquidity: If a bank sees a sudden loss of confidence from depositors and investors, they may struggle to obtain fresh funding in the interbank market and face liquidity problems. This can cause a run on the bank.
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In the context of financial markets, what is meant by “systemic risk”?
Systemic risk is when the failure of a single financial institution leads to a contagion effect that spreads throughout the financial system and beyond, affecting the stability of the system perhaps creating a wider crisis.
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Possible consequences for the economy of bank failures
- Credit crunch - where businesses and households find it difficult to obtain loans, which can in turn lead to a decline in capital investment by businesses and consumption causing weaker real economic growth.
- Fiscal effects - Rising national debt if commercial banks are wholly or partially bailed-out by the government. This can lead to higher interest rates on bonds & more expensive mortgages and a medium-term rise in taxes
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One argument for bailing out commercial banks who fail + One argument for letting banks fail
For
* A bail-out can limit wider systemic risks and mitigate the negative consequences for the real economy. It can prevent negative externalities.
Against
* Letting banks fail can promote market discipline and prevent moral hazard. It encourages creative destruction as new banks and banking models replace failed institutions.
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Distinguish between credit risk and liquidity risk for a bank
- Credit risk is the risk that a borrower will fail to repay their debt (bad debts)
- Liquidity risk is when a bank does not have enough cash or liquid assets to repay depositors and other creditors if they want their money back.
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What is the definition of a central bank
A central bank is the monetary authority and major regulatory bank in a country. A central bank is responsible for monetary policy and maintaining financial stability.
Examples of central banks
- Bank of England (UK)
- European Central Bank (ECB) for all member nations of the Euro Area
- United States Federal Reserve (The Fed)
- Bank of Japan (BOJ)
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What are the main roles of Central Banks
- Setting interest rates: Central banks adjust interest rates to control inflation and promote economic growth.
- Regulating banks: They regulate banks to ensure they are financially sound and to protect depositors.
- Maintaining financial stability: They act as a lender of last resort, providing liquidity to financial institutions in times of crisis.
- Issuing currency: They are responsible for issuing and managing the country’s currency. This might involve operating with a managed floating exchange rate.
- Conducting research: They conduct research and provide advice to policymakers
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What is the Base interest rate
The main interest rate set by a nation’s central bank. This is the rate of interest charged to commercial banks if they must borrow from the central bank when short of liquidity. Market interest rates often take their cue from changes in the Base Interest Rate.
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What are some factors considered when setting Base Rate
- Rate of growth of real GDP and the estimated size of the output gap
- Forecasts for price inflation
- Rate of growth of wages and other business costs
- Movements in a country’s exchange rate
- Rate of growth of asset prices such as house prices
- Movements in consumer and business confidence
- External factors such as global energy prices and inflation in other countries
- Financial market conditions including the rate of growth of credit / money
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What is the Lender of Last Resort Function
Lender of last resort is a role central banks play in times of financial distress. When other financial institutions are unable to provide loans, the central bank steps in to lend money to banks and other financial institutions. This prevents liquidity crises and helps to maintain financial stability.
- Emergency lending: Central banks provide emergency loans to financial institutions in times of crisis to prevent their collapse and limit systemic risk.
- Discount window: They also provide short-term loans to banks at a slightly higher interest rate than the market rate. This is known as the discount window.
- Collateral requirements: Central banks require collateral from financial institutions as a condition for lending. This helps to mitigate the risk of default.
- Reputation: Central banks are known as the lender of last resort due to their ability to provide loans in times of crisis, which can help to prevent financial panics.
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What are two examples of Lender of Last Resort
- In 2012, the European Central Bank (ECB) provided emergency loans to banks in the eurozone to help stabilize the region’s financial system.
- In 2020, during the COVID-19 pandemic, central banks around the world acted as lenders of last resort to support their economies. For example, the Bank of England provided emergency loans to UK businesses and the Reserve Bank of India provided liquidity to Indian banks.
4.4 - The Financial Sector
What roles does the central bank have as banker to the government
- Issuing government bonds: Central banks can issue and sell government bonds on behalf of the government to finance its budget and borrow money.
- Managing government debt: Central banks can help governments manage their debt by buying and selling government bonds in the market, helping to stabilize prices and maintain liquidity.
- Providing advice: Central banks often provide economic and financial advice to governments, helping them to make informed decisions about fiscal policy and other issues.
4.4 - The Financial Sector
Two roles of the Central Bank in the United Kingdom
- Operation of monetary policy – setting base interest rates to meet the inflation target (2%). No direct intervention in the exchange rate – the UK operates a free-floating currency
- Lender of last resort to the financial system during a liquidity crisis / credit crunch.
4.4 - The Financial Sector
Two possible consequences for financial markets of a large increase in the size of quantitative easing (QE) by the UK central bank.
- Lower interest rates: By purchasing large amounts of government bonds, the central bank increases demand for these assets, which pushes up their prices and reduces their yields. This can lead to a fall in mortgage interest rates and corporate bond interest rates
- Currency depreciation: Another effect of a large increase in QE by the UK central bank might be a depreciation of the currency. QE increases the money supply and some of this extra liquidity will leave the UK economy – sterling is sold – causing the pound to fall
4.4 - The Financial Sector
What is the Financial Conduct Authority (FCA)
- Regulation and Supervision: The FCA is responsible for regulating commercial banks, investment firms, insurance companies, asset managers, and consumer credit providers. It sets regulatory rules and standards for these firms, conducts prudential supervision, and ensures that they comply with applicable regulations.
- Consumer Protection: The FCA focuses on protecting consumers by ensuring that financial products and services are fair, transparent, and not misleading. It enforces rules on consumer protection, including those related to the sale of financial products, conduct of business, and treating customers fairly.
- Market Supervision: The FCA actively monitors financial markets to identify risks and emerging issues
4.4 - The Financial Sector
What is the Prudential Regulation Authority (PRA)
- Prudential Supervision: The PRA is responsible for prudential supervision of banks, building societies, credit unions, insurers, and designated investment firms. Prudential supervision involves assessing and ensuring the financial soundness of these institutions to prevent financial instability.
- Setting and Enforcing Prudential Standards: The PRA establishes prudential standards and requirements that financial institutions must adhere to. These standards encompass capital adequacy, liquidity, risk management, governance, and other aspects of an institution’s financial stability. The PRA enforces these standards to ensure that financial firms maintain appropriate levels of financial resources to withstand economic and financial shocks.
4.4 - The Financial Sector
Ways in which financial regulators can reduce the risk of commercial bank failures in a country such as the UK
- Prudential regulation: Require banks to maintain adequate capital to absorb potential losses and withstand adverse economic conditions. Use of stress tests.
- Direct interventions: Setting maximum loan to valuation ratios in the mortgage market. Increasing the cash-to-deposits ratio for a commercial bank.
