4.5.2 Role of the financial sector

Question 1

key roles of banks

Answer 1

1.Using savings to led to firms and individuals
2. Lending to businesses for investment in working capital
3. Lending to individuals
4. Facilitating the exchange of goods and services
5. Assessing creditor risk
6. Providing forward markets in currencies and commodities
7. Providing a market for equities

Question 2

banks and the creation of credit

Answer 2

1. Banks invest majority of the savings of consumers, generating credit in the economy
   - Can use savings not taken out to invest into economies
   - Can give loans to businesses, government projects so they can invest and generate AD
   - allow more borrowing, spending and invetsment
   - increases AD
   - however can cause demand pull inflation due to time lag between increase in credit and AD but lack of goos to supply this increased demand
2. Banks can store money and minimise risk
   - if robbed, can freeze account and money safe in secure place
3. they can determine rates of interest dependent on the risk of the borrower
   - can have safer lending and lessen risk of crisis eg 2008-09
   - Banks make profit by charging higher interest on loans, than the interest they pay to savers

Question 3

money and the financial sector

Answer 3

Money is a generally acceptable means of exchange

it must
1. act as a medium of exchange and enable buyers and sellers to interact and sell goods/services in the marketplace
- Offer payment mechanisms that are safe and reliable
- without this, market failure
- This is why banks were bailed out in financial crisis as markets would not occur
2. measure of value: relative value of goods and services can be shown —> freedom of information needed for this
3. a store of value —> asset can be stored and used later
- both of these can be impacted by inflation
4. deferred payment: way to spread payments over a period of time and goods to be purchased on credit

martin sheen:bought debt of S wales families and paid it off

Question 4

borrowing

Answer 4

1. Firms
   - To pay for costs → eg working capital, input costs, must be enough working capital to cover wages and salaries that must be paid each month
   - Companies that sell to other businesses need much more working capital than retailers

Individuals
- Need to borrow for major purchases such as housing and vehicles
- Bank trusts them for having good credit rating, can have loan/overdraft to cover current spending
- Interest rates may be high due to individual financial history and poor credit rating

Question 5

retail banks

Answer 5

• current accounts savings mortgages insurance and and foreign exchange
• Provide overdrafts and loans —> firms can have working capital that business need to cover costs until revenue is collected

Question 6

investment banks

Answer 6

• arranging loans for big projects like the channel tunnel
• advising and organising takeovers, mergers and acquisitions
• selling shares and debentures
• trading in foreign currency, commodities
• high risk, some banks have separate retail and investment arms —> HSBC in Canary Wharf for investment but in Birmingham for retail

Question 7

building societies

Answer 7

• lower risk as they do not lend out
• no shareholders, surplus used to keep business afloat, or to give members higher rates of interest

Question 8

stock exchanges and share capital

Answer 8

• trump: unpredictability and increased risk decrease stock market values
• Can sell shares for finance in exchange for parts of the business

Question 9

socially responsible creditor risk/ways to access risk

Answer 9

• Factors like income and job security are used to assess reliability of borrower
• can not be socially responsible —> lower income individuals can be socially excluded, cannot access significant loans
• TSB flee fund —> fund for women in domestic abuse situations who wish to escape
• Banks use credit reference agencies like Experian
• Can utilise information from courts, and bankruptcy proceedings, hire purchase firms, and professional debt collectors
• Banks can check the probability of if a loan will be paid back and can plan for the level of reserves they need to allow for losses

Question 10

summary of banks role in the economy

Answer 10

• Banks lend to risky businesses
• Driven by profit motive
• Increased risk in firms increases loans at higher interest rates
• Banks can make a higher profit
• Will spread this risk by having a portfolio of risk → range of loans with different risk rates
• Banks lending helps borrowers
• Firms gain working capital for everyday expenses
• Investment for growth, start up costs and reduces cash flow problems
• Need lower interest borrowing for long term profitability
• Borrowing and lending helps the economy
• Growth and demand pull inflation → tradeoff