4.4.1 Role Of Financial Markets

Question 1

Roles of financial system

Answer 1

• payment systems
• facilitate saving
• Facilitate borrowing by firms both short term and long term
• Facilitate lending to individuals
• To provide spot and forward markets in currencies & commodities
• Raise finance for firms. Issue equity (shares)

Question 2

Role of financial system (payment system)

Answer 2

Systems to settle financial transactions through the transfer money/monetary value
- E.g BACS UK, SWIFT transfers (international)

Question 3

Role of financial system (facilitate saving)

Answer 3

Retain incomes that is not spent
- E.g savings account (Barclays)

Question 4

Role of financial system (facilitate borrowing by firms both short term and long term)

Answer 4

Business lending) Borrowing loans to be paid back in a short period or after a long period
- Short term loan: over draft
- Long term loan: bank loans (normally over a year)
E.g corporate bonds (long term loan)

Question 5

Role of financial system (Facilitate lending to individuals)

Answer 5

• secured loans (collateral/security): if the individual cannot pay it back, they can take an asset e.g house
• insecure loan
• E.g mortgage (secure loan)

Question 6

Role of financial system (To provide spot and forward markets in currencies & commodities)

Answer 6

• Spot market: exchange of commodities and currencies for immediate cash
• Forward market: a marketplace that offers financial instruments that are priced in advance for future delivery

Question 7

Role of financial system (Raise finance for firms. Issue equity (shares))

Answer 7

The sale of an equity or stock by a firm to investors. Shares represent part-ownership of a company.

Question 8

Key purposes of a central bank

Answer 8

• implementing monetary policy (using interest rates & money supply to affect AD e.g quantitative easing)
• managing the currency of a country
• regulating money supply

Question 9

Why are central banks independent from governments?

Answer 9

• to prevent political influence central bank can’t be used for political motivated targets)

Question 10

Explain one role of financial markets

Answer 10

One role of financial markets is to facilitate long term borrowing by firms. These loans can help small firms survive downturns in the economy, especially when aggregate demand is low. The extract says that in May 2020, small firms could borrow up to £50,000 at an interest rate of 2.5% for up to 6 years. The loans borrowed by firms from the government would be paid back after a long period when the firm is generating enough allowing them to stay in business.

Question 11

Roles of the Banks of England

Answer 11

• MPC (monetary policy committee)
• FPC (financial policy committee)
• PRA (prudential regulation authority)
• FCA (financial conduct authority)

Question 12

MPC(monetary policy committee)

Answer 12

• Inflation targeting Bank of England
• Set interest rate
• Monitor economy
• Maintain price stability - 2%
• Inflation report published every three months

Question 13

FPC(financial policy committee)

Answer 13

• Policy guidance
• Assess risks facing the financial system and actions needed to tackle
• Meets at least 4 times a year
• Financial stability report twice yearly
• 10 members - 5 within the bank 4 external members 1 chief executive
• Give directions to the PRA and the FCA
• Make recommendation to other bodies
• Lending increases fast —> FPC wants banks to raise more capital as an extra buffer

Question 14

PRA(prudential regulation authority)

Answer 14

• micro potential regulator
• Regulate individual financial institution to improve safety

Question 15

FCA(financial conduct authority)

Answer 15

• independent regulator
• Protecting consumers
• Promoting confidence in financial product and services
• Not part of the bank

Question 16

Market failures in financial system

Answer 16

• Information gaps / asymmetries
• Moral Hazard
• Adverse selection
• Externalities (negative)
• Market rigging / fixing
• Speculation and market bubbles
• Excessive price volatility

Question 17

Asymmetric information in financial system

Answer 17

Regulators may have insufficient information, relative to the bankers, to ensure the stability of the banking system.

Question 18

Example of asymmetric information/information gaps in financial markets

Answer 18

• The emergence of new types of security before the financial crash = new types of risk.
• Low interest rates & poor yields from ‘safe’ government bonds = global investors were looking for new assets to invest in = this demand triggered the expansion of securitised debt = encouraged the introduction of new derivatives =holders of debt become increasingly unaware of the risks they were exposed to = they remained ignorant of the possible impact on them.
  • In this case, risks tended to be under-estimated and asset values over-estimated

Question 19

Moral hazard in financial markets

Answer 19

Central bank will always lend = moral hazard
- The assumption by many financial institutions that they were ‘too big or too important’ to fail and would be bailed out if the need arises = failure to understand the level of risk associated with securitised assets = encouraged further risk above a rational level.
- The central bank was seen as an ‘insurance policy’ should the financial institutions suffer excessive losses form imprudent lending.

Question 20

Adverse selection in financial markets

Answer 20

E.g when a company takes advantage of the buyer’s ignorance to the demerits of a financial asset = they succeed in selling

Question 21

Negative externalities of financial market failures

Answer 21

• Falling real output
• Rising unemployment
• Falling real wages
• Rising poverty levels
• Falling profits and bankruptcies

Question 22

Market rigging/fixing in financial markets

Answer 22

A small number of financial institutions dominating particular financial markets = encourage market players to collude and undertake cartel-like behaviour = can extent to market rigging where asset prices are fixed by the dominant firms
• E.g the Libor scandal, 2007, which involved fixing interest and exchange rates.

Question 23

Speculation and market bubbles in financial markets

Answer 23

poor lending decisions by bankers can lead to market bubbles.
- e.g excessive lending to home buyers who have no deposit and/or poor credit records can result in a housing bubble.

Question 24

Example of externalities in financial system

Answer 24

in 2009, the UK government had to spend over $45bn of taxpayers’ money to prevent the collapse of RBS.

Question 25

What has been put in place to prevent market failure in financial systems?

Answer 25

• legislation (banking reform act 2013)
• stress tests
• capital adequacy requirement: base III

Question 26

Micro policy to correct financial market failure in UK

Answer 26

• provide more licences to encourage smaller challenger banks to enter the industry.
• increase the contestability of retail banking = reduce the monopoly power of established banks e.g HSBC & Barclays.
• More competition = better outcomes for consumers including lower charges on overdrafts and improved interest rates for savers.

Question 27

Financial market failure

Answer 27

• when money, equity and bond markets failure to achieve an efficient and/or equitable outcome = economic & social costs including macro instability and loss of trust and confidence in financial institutions.
• e.g market rigging, speculative bubbles, information failures and low levels of market competition between suppliers.

Question 28

Evaluation of providing licences to correct financial market failure

Answer 28

• behavioural economics suggests consumers have strong default choices when deciding which bank to use
• the inconvenience involved in switching = challenger banks often find it hard to achieve the economies of scale needed to compete effectively

Question 29

Macro policy to correct financial market failure in UK

Answer 29

• the Bank of England to impose a higher liquidity ratio.
• If banks are required to hold more liquid reserves,= will have a stronger capital base to help them withstand a future downturn in the economy= a rise in loan defaults and bad debts
• help to promote financial and macroeconomic stability for the UK in the long term.

Question 30

Higher liquidity ratio

Answer 30

This is the ratio of liquid assets held by a bank to their total assets.

Question 31

Role of IMF in financial crisises

Answer 31

• defaults (Money enables Argentinian government to continue
  repayments on its debt)
• Enabling growth/prevent recession
  • Providing temporary loans/credit
• Money helps to stabilise currency
• Countries such as Argentina relied on IMF as it would
  be too risky for financial markets to lend to them

Question 32

Capital flight out causes

Answer 32

An depreciation of the currency

Question 33

How to solve negative output gap?

Answer 33

Improve transportation

Question 34

Why is providing support to banks important?

Answer 34

Economy is dependent on financial system working smoothly
• People could have lost their savings if banks had been allowed to fail, leading to massive drop in confidence
• Potential for risk of depression had government not intervened
• Government has recouped much of the money invested into bailing out the banks anyway- Government ‘recovered every penny of its investment in Lloyds’

Question 35

Arguments against providing support to banks

Answer 35

Huge expenditure for government that, for example in the case of the UK, already has a significant national debt- £65bn bailout of RBS and LBG. Will have to be repaid by future generations of taxpayers.
• Moral hazard: will encourage reckless behaviour from the banks in the future, expecting a bailout again
• Government looking unlikely to recoup losses from RBS for some time (in contrast to Lloyds)
• Other policies, e.g. expansionary fiscal policy, may have been more effective