4.4.1 Role of financial markets

Question 1

Most basic purpose of banks and other financial institutions

Answer 1

To make money available to those who want to spend more than their income (e.g. a business wanting to expand) using the savings of those who don’t currently want to spend (e.g. someone with savings in a bank account or a pensions fund).

Question 2

How can banks make money available to those who want to spend more than their income?

Answer 2

• Help people and firms save – through bank accounts, pension funds, bonds and other financial products.
• Provide loans to businesses and individuals.
• Allow equities and bonds to be issued and traded on capital markets.

Question 3

Everyday forms of borrowing for individuals

Answer 3

• Personal loans are loans to individuals to be paid back over a small number of years. These can be secured (where a bank can force the sale of an asset, like a house, to recover the loan’s cost if it isn’t repaid) or unsecured. Unsecured loans have a higher rate of interest than secured loans because they’re riskier.
• Mortgages are loans to buy property. The bank owns the property until the loan is repaid.
• Credit cards allow their holders to borrow money from a bank when purchasing goods or services.
• Pay-day loans are short term, small, unsecured loans, usually with high rates of interest.
• Overdrafts are loans to firms and individuals that occur when the funds in their account fall below zero. A fee might need to be paid for using an overdraft, and interest may need to be paid on the money borrowed.

Question 4

Functions of financial institutions and financial markets

Answer 4

• They make trade easier by allowing buyers to make payments quickly and easily.
• They provide insurance cover to firms and individuals.
• They allow currency exchange.
• They make money available to those who want to spend more than their income.
• They allow individuals and firms to save money they do not currently want to spend.

Question 5

How do firms raise money?

Answer 5

• Equity finance is raised by selling shares in a company. Raising funds in this way means that the person providing the finance (by buying shares) becomes a shareholder in the firm and can claim some ownership of it. This entitles the shareholder to a share of the firm’s profits in the form of dividends.
• Debt finance is borrowing money that has to be paid back (usually with interest). This can involve borrowing from financial institutions (e.g. banks) or issuing corporate bonds.

Question 6

The financial sector and economic growth

Answer 6

• Effective and efficient financial institutions and financial markets enable economic growth, while unstable institutions and markets can cause major problems.
• Economic growth is driven by the spending of individuals and firms, much of which relies on credit and loans.
• Businesses (small firms especially) are unlikely to grow without credit. If firms don’t grow, this means fewer new jobs and lower exports.
• Firms in developing countries - where the financial sector tends to be quite weak or underdeveloped – struggle to get credit and this restricts their growth.

Question 7

Types of financial market

Answer 7

• Money Markets
• Capital Markets
• Foreign Exchange Markets
• Equities Market
• Derivatives Market

Question 8

Money Markets

Question 9

Money Markets

Answer 9

Money markets provide short-term finance to banks (and other financial institutions), companies, governments and individuals.

This short-term debt will have a maturity (i.e. a repayment period) of up to about a year (it could be as little as 24 hours).

Question 10

Capital Markets

Answer 10

Capital markets provide governments and firms with medium and long term finance. Governments and firms can raise finance by issuing bonds. Firms can also raise finance by issuing shares or by borrowing from banks.

A capital markets has a primary market and a secondary market:
- The primary market is for new share and bond issues
- The secondary market is where existing securities are traded (e.g. a stock exchange). This increases their liquidity (i.e. being able to sell them means it’s easier to convert them to spendable cash).

Question 11

Foreign Exchange Markets

Answer 11

Foreign exchange markets are where different currencies are bought and sold. This is usually done to allow international trade and investment, or as speculation (to make money on fluctuations in currency prices).

A foreign exchange market is split into what’s known as the spot market and the forward market:
- The spot market is for transactions that happen now.
- The forward market is for transactions that will happen at an agreed time in the future.

Question 12

How does the forward (or futures) market work?

Answer 12

Question 13

Equities Market

Answer 13

Where shares are sold to raise equity for firms.

• Shares are known as Stocks in the USA.

Question 14

Derivatives Market

Answer 14

Where shares are re-sold.

• This includes the trading of capital, mortgages, insurance and loans.

Question 15

Bonds

Answer 15

• Governments and large firms can issue bonds to raise money (e.g. a government might need to finance a budget deficit, while a firm might want to invest in new machinery).
• Investors buy new bonds at their ‘face value’ (or nominal value).
• After they’ve been issued, bonds can be traded in secondary capital markets. Investors can buy or sell bonds at any price – this ‘market price’ may be bigger or smaller than the bond’s nominal value.
• The bond’s yield is the annual return an investor will get from the bond. The less someone pays for a bond, the higher it’s yield.
• When the bond matures, the current bondholder is paid the nominal value of the bond by the issuer. This means the issuer’s original debt has been repaid.

Question 16

What are the main types of banks?

Answer 16

• Commercial banks
• Investment banks

Question 17

What are the main types of financial institutions?

Answer 17

• Banks (commercial and investment)
• Pension funds
• Insurance firms
• Hedge funds
• Private equity firms

Question 18

Pension funds

Answer 18

These firms collect people’s pension savings and invest them in securities. When a client retires, the pension fund pays out their savings and the returns they’ve generated. Pension funds also provide long-term, large-scale investment in companies.

Question 19

Insurance firms

Answer 19

Insurance firms charge customers fees to provide insurance cover against all kinds of risk. This is important for the economy – e.g. business can insure against the risk of customers not paying (which encourages trade).

Question 20

Hedge funds

Answer 20

These are firms that invest pooled funds from different contributors in the hope of receiving high returns. They usually invest in a number of different markets, but the desire for high returns (and the fact that are only lightly regulated) can lead to risks for the contributors, and for the wider economy.

Question 21

Private equity firms

Answer 21

These firms invest in businesses (e.g. by buying equity) and then try to make the maximum return. This could mean helping a business become successful so that it can be sold for a profit. However, they’re often criticised for asset-stripping (selling a firm’s assets) and cutting jobs.

Question 22

What is the shadow banking system?

Answer 22

Question 23

Role of investment banks

Answer 23

Investment banks don’t take deposits from customers and instead, there role is to:
* Arrange shares and bond issues
* Offer advice on raising finance, and on mergers and acquisitions
* Buy and sell securities (e.g. shares and bonds) on behalf of their clients.
* Act as market makers to make trading in securities easier.

Investment banks also engage in higher risk (but potentially very profitable) activities. For example, proprietary trading involves a bank buying and selling shares using its own money.

Question 24

Are commercial banks and investment banks always seperate institutions?

Answer 24

No.

Question 25

What are the two parts of commercial banking?

Answer 25

• Retail banking – providing services for individuals and smaller firms (e.g. savings accounts and mortgages). Retail banks are often called ‘High Street Banks’
• Commercial banking (wholesale) – dealing with larger firms’ banking needs.

In the UK, they are often the same institution. For example, HSBC provides banking services for both individuals and firms.

Additionally, there can also be specialist commercial banks, such as Building Societies – who specialise in providing mortgages.

Question 26

Main roles of commercial banks

Answer 26

Commercial banks (e.g. Halifax or NatWest) have these main roles:
- To accept savings
- To lend to individuals and firms
- To be financial intermediaries (i.e. move funds from lenders to borrowers).
- To allow payments from one person or firm to another.

Commercial banks also provide other financial services to customers, such as insurance and financial advice.

Question 27

The idea of risk in finance

Answer 27

Ceteris paribus, risky investments will usually generate a higher return (i.e. be more profitable) than less risky ones. Investors will want high rewards for risking their money. This is why different interest rates are charged in different money markets – the more secure an investment is, the lower the rate of interest that will be earned.

• All investors (including banks) must balance the security of an investment against its profitability.
• This is especially important if an investor is using someone else’s money, or if the firm they’re working for it particularly important to the stability of the financial system.

Question 28

Inter-bank lending

Answer 28

Lending between banks and occurs on the inter-bank lending market (a money market). The loans given between the banks are very short-term – usually less than one week, and often only overnight.

On any day, some banks will have excess liquidity and others will have a shortage (e.g. because they’ve received more or less than they expected in payments). Inter-bank lending means that banks with a temporary shortage of liquidity can borrow to meet the customers’ needs. Banks with excess liquidity earn interest on what they lend.

The rate charged is called the inter-bank lending rate, or the overnight rate.

Question 29

Balance sheets

Answer 29

Banks have balance sheets, which show a snapshot of its assets and liabilities on a particular date.

On a balance sheet, total assets should always equal total liabilities.

Question 30

Liquidity, security and profitability of banks

Answer 30

A bank will aim to hold a variety of different types of assets to achieve a suitable balance of liquidity, security and profitability. For example, unsecured loans are more profitable (but riskier) than secured loans.
- If some defaults on a secured loan (e.g. a mortgage), the bank can repossess the house that’s been used as security (and the value of the banks’ assets doesn’t fall too much).

• If someone defaults on an unsecured loan, that asset is removed from the bank’s balance sheet.

Question 31

Bank’s level of capital

Answer 31

A bank’s capital is the total of its share capital and its reserves.

The amount of credit a bank can create depends on how much capital the bank holds. This is because banks will usually want to keep the ratio of loans to capital within a certain limit.

If the value of one of the bank’s assets falls, the bank’s capital is reduced by the same amount (so that total assets equal total liabilities).

If the total value of a bank’s assets falls by a large amount, the bank could ‘run out’ of capital (i.e. if the bank’s capital is less than the amount lost). The value of the bank’s assets would be less than the value of its liabilities and the bank would be insolvent. An insolvent bank would normally have to close down – central banks don’t usually lend to insolvent banks.

Question 32

Banks are regulated to…

Answer 32

• Reduce the impacts of financial market failure.
• Protect consumers by policing individuals and firms to ensure that they act fairly and legally.
• Ensure the integrity and stability of the financial institutions and the services they provide.
• Maintain confidence in the financial sector and avoid sudden panics.

Question 33

Why are banks heavily regulated?

Answer 33

Banks are private sector organisations that aim to make profits for their shareholders.

This is partly because problems in a bank or the banking industry can have an impact beyond those with bank savings – they could potentially destabilise a country’s whole economy.