4.5: Risk and the financial sector

Question 1

What is risk?

Answer 1

involves situations where the outcomes are known and can be calculated or quantifiable
e.g. insurance policy taking into account different possibilities

Question 2

What is uncertainty?

Answer 2

caused by factors outside business’ control and possible outcomes cannot be calculated with any degree of accuracy

Question 3

give examples of some supply-side shocks

Answer 3

costs of production - oil prices - sanctions on russia
wage levels and labour costs
taxes and subsidies
changes in technology
productivity levels
labour migration

Question 4

give examples of some demand shocks

Answer 4

anything that will affect the levels of consumption or investment
changes in unemployment
availability of credit
business confidence
changes to fiscal policy
anything that affects levels of exports

Question 5

what are exogenous shocks?

Answer 5

originate from outside AD model

Question 6

what are endogenous shocks?

Answer 6

originate from inside AD model

Question 7

what is the role of forward markets in dealing with exhange rate risk?

Answer 7

firms that need to buy and sell in foreign currencies can insure against the risk using forward markets
allow them to buy certain quantity of a currency at a exchnage rate that is agreed now and they will receive the money on a particular date in the future

Question 8

what is the role of insurance in business?

Answer 8

insurance reduces risk
pay premium now and avoid unpleasant surprise in the future
risk of making a loss is reduced

Question 9

what happened to GDP after the shock of Brexit?

Answer 9

fell by 4.5%

Question 10

what happened to GDP after the shock of covid?

Answer 10

fell by 19.4%

Question 11

why would a rise in oil prices change gdp?

Answer 11

consumers spend more on oil, less disposable income to spend, less economic growth, decreased gdp

Question 12

why would a rise in oil prices affect cpi?

Answer 12

firms have higher costs, higher prices as firms try to protect profit margins, increased cpi

Question 13

why would a rise in oil prices affect the current account deficit?

Answer 13

import oil, cost of oil increases, current account deficit increases as value of imports increases

Question 14

why would a rise in oil prices affect the fiscal deficit?

Answer 14

economic growth is slowing, tax revenue falls, less money to spend etc, fiscal deficit increases

Question 15

what are 2 examples of a derivative?

Answer 15

futures and options

Question 16

what is a future?

Answer 16

contract that is set at a time and price now for a scenario in the future - has to be bought for that price

Question 17

what is the trade-off with a future?

Answer 17

higher price in the short run
can mean smaller price in the long run and the buyer gains certainty

Question 18

what is an option

Answer 18

gives the holder the right but not the obligation to buy or sell an asset at a certain price at a certain time

Question 19

option sr vs lr

Answer 19

increased costs for buyer in sr
benefits in lr, especially if buying and market price increases

Question 20

options small vs large firms

Answer 20

small - fee of contract outweighs price/cost of ingredients
large - fee of contract smaller than cost of ingredients

Question 21

what is the ratio of saving to spending?

Answer 21

10%

Question 22

how do banks make profit?

Answer 22

sell financial services
profit from differences in interest rates from borrowers and savers (interest differentials) –> BIGGEST PROFIT

Question 23

what must money be able to do in this economy?

Answer 23

act as a medium of exchange
measure of value
store of value
deferred payment

Question 24

what are examples of financial intermediaries?

Answer 24

banks
pension funds
building societies

Question 25

what did martin sheen do?

Answer 25

bought £1m worth of debt from 900 families for £100k costs can mean debt value depreciates banking system manages risk

Question 26

how do banks provide security to savers?

Answer 26

lower risk of theft etc

Question 27

describe retail banks

Answer 27

high street banks like HSBC current accounts, savings, mortgages, provide overdrafts and loans to businesses LOW RISK, lower profits

Question 28

why do retail banks get bailed out by the govt?

Answer 28

cannot run the economy without them

Question 29

what are building societies?

Answer 29

owned by their members less risky less profit motive

Question 30

how does assessing creditor risk help bankers?

Answer 30

assess someone's risk by asking qs about their job, income etc helps to manage risk and find out who is more likely to be secure to loan to

Question 31

why would banks lend to risky businesses?

Answer 31

can charge higher interest rates - higher profits - driven by profit motive (they are a business) HOWEVER, less risky if: tied to collateral screened - due dilligence - information failure? varied portfolios - less risky and riskier investments

Question 32

how does lending help the borrowers?

Answer 32

time gap between time of costs and revenue start up costs growth DEPENDS ON CONTEXT

Question 33

how does borrowing and lending help the economy?

Answer 33

injections into the economy --> more investment increased spending - increased demand - increased AD - increased economic growth HOWEVER, can lead to Dd-pull inflation, it depends if there is spare capacity

Question 34

what is monetary policy?

Answer 34

changing the interest rate to control and manage AD in the economy

Question 35

what is the bofe?

Answer 35

central bank, govts bank, banks bank

Question 36

what is the mpc?

Answer 36

set the interest rates, 9 members 4 bofe 4 non 1 governor

Question 37

what is the base rate?

Answer 37

base interest rate set by the mpc

Question 38

what is inflation?

Answer 38

general and consistent rise in price level across economy

Question 39

how did the financial crisis come about?

Answer 39

banks like issuing loans - most of their profit from interest give out risky loans to low-income families for lowerend housing stock as it is only way to increase bank's market share mortgage advisers get commission so will give out lots of mortgages SUB-PRIME MORTGAGES in recession first ones to lose jobs, cant pay mortgage market segment can no longer afford to buy a house collateral becomes worthless debt bundled togehter - banks dont know what is risky

Question 40

what do central banks do?

Answer 40

determine monetary policy provide banking services to govt, managing govt debt and ex rate bankers to the banking system regulate and control banking system

Question 41

what does the bofe do when fiscal deficit occurs?

Answer 41

sells govt bonds for them

Question 42

why was setting the interest rate given to the bofe by gordon brown?

Answer 42

cutting interest rates was often used as a way to gain political favour by the governing party, leading to huge inflation after

Question 43

describe the mpc

Answer 43

has 9 members meets for 2 day each month to set base rate minutes published to ensure transparency - no info failure, can see all the evidence, helps increase certainty sets interest rate to meet 2% inflation target set by govt

Question 44

what are key indicators for increasing the rate of interest?

Answer 44

buoyant economic growth low unemployment AD growing faster than AS inflation is accelerating

Question 45

what are key indicators for decreasing interest rate?

Answer 45

high unemployment low inflation slow economic growth

Question 46

what happens if the interest rate target is not met?

Answer 46

governor writes an open letter to chancellor to explain the reasons - banks and financial institutions are aware, information given to prevent info failure

Question 47

what happens when there is a fiscal deficit?

Answer 47

govt spends more than they collect in tax - have to borrow - adding to national debt - more interest - less spending on public services and goods

Question 48

decribe the cor for qe

Answer 48

bofe creates money - spends this money to get into economy - money spent in City buying govt bonds from financial institutions - 1. gets money into economy as city has money to invest - 2. makes it cheaper for govt to borrow, bofe pushes up demand for treasury bonds, raising their price, lowering interest - long term interest rates lower - cheaper for everyone to borrow - consumer spending and investment should increase - ad increases so faster growth

Question 49

what are the howevers for qe?

Answer 49

conflicting objectives... inflation v growth increasing money supply - dd pull inflation context... depends on level of spare capacity/unemployment

Question 50

what type of market structure is the banking sector?

Answer 50

oligopoly

Question 51

what was the new banking regulation that was put in place from the mid 1990s?

Answer 51

banks must: have more equity or capital from shareholders hold larger cash reserves rely less on short term loans accept limits bonuses and incentives retail banking separated from investment banking big banks have been broken up to avoid them being too big to fail

Question 52

what are the 2 banking regulatory bodies within the bofe?

Answer 52

financial policy committee prudential regulation authority

Question 53

what does the fpc do?

Answer 53

meets every quarter to look at wider economic picture maintains stability and oversees the financial system organises stress tests to reveal potential problems and threats identifies risks and changes regulation if necessary

Question 54

what does the pra do?

Answer 54

regulates every organisation that offers banking services, enforcing regulation

Question 55

what did the us govt do in response to the 2008 fc?

Answer 55

implemented emergency economic stabilisation act - troubled asset relief program provided $700 billion in bailout relief to failing financial institutions dodd-frank wall street reform and cpa regulated financial sector and protect consumers

Question 56

what was the name of the first financial institution to collapse in 2008 fc?

Answer 56

lehman brothers

Question 57

what were the root causes of the 2008 fc?

Answer 57

years of low interest rates regulatory failure excessive risk taking and leverage of banks global current account imbalances and global savings glut animal spirits leading to financial bubbles distorted incentives of credit rating agencies

Question 58

what is minsky's financial instability hypothesis?

Answer 58

financial system is inherently unstable over periods of long economic prosperity, financial institutions invest more in risky assets, looking for high returns bad economic news happens system is too highly leveraged

Question 59

what is a speculative bubble

Answer 59

a spike in the value of an asset

Question 60

how does a speculative bubble usually form?

Answer 60

by exaggerated expectations of future growth in the value of an asset

Question 61

what was the uk govts response to the 2008 fc?

Answer 61

nationalised major banks like lloyds and royal bank of scotland financial services act 2013: large banks have to separate their retail and investment banks inceased govt spending and tax cuts swap mortgage-backed assets for qe