4.7 The finaancial sector Flashcards
What are the 3 kinds of market in the financial sector? What are the other 3 types?
Money market:
- Short term loan finance for businesses and households
- Usually only up to a term of a year
- Includes inter-bank lending of banks lending to eachother and short term government borrowing
Capital market:
- Medium to long term loan finances in securities such as shares and bonds
- Includes raising of finance by the government through the issue and sale of medium to long term bonds
Foreign exchange markets:
Market where currencies are traded. There is no single currency market but instead made up of thousands of trading floors - run by speculation
- Commodity markets
- Derivatives market
- Insurance market
What are the key roles of financial markets?
- Facilitate saving by businesses and households by offering a secure place to store money and earn interest, allowing households to smooth consumption over time and build up deposits and funds for large purchases
- To lend out to individuals and firms, creating an intermediatary between savers and borrowers as money saved goes to borrowers.
- Allocate funds to productive use - allocating capital to where return is highest
- Facilitate exchange of goods and services - money essential for market economies and allows a more efficient operation of an economy
- Provide forward markets in currencies and commodities allowing agents to insure against price volatility
- Provide a market for equities - loans, bonds, stocks and shares
What are the characteristics and functions of money?
Characteristics:
- Durable
- Portable
- Divisible
- Hard to counterfeit
- Accepted
- Valuable
Functions:
- Medium of exchange
- Store of value
- Unit of account
- Standard of deferred payment
What are some examples of long, medium and short term loan givers?
Long term:
- Share capital
- Retained profits
- Venture capital
- Mortgages
- Long term bank loans
Medium: Bank loans -Leasing -Hire -Government grants
Short:
- Bank overdraft
- Trade creditors
- Short term loans
- Factoring
What are the features and types of loans?
Features:
- Over fixed period
- Interest either fixed or variable
- Timing and amount set by lender
- Non performing loans occur when borrowing unable to pay
Types:
-Unsecured - only supported by credit instead of collateral
Secured: secured against assets you own.
What are some examples of equity finance?
- Business start up investment
- Venture apital
- Stock market listings
- Crowd funding - raising capital from large number of investors
What are the types of financial institution?
- Retail bank
- Commercial bank
- Investment bank
- Savings vehicle
- Insurance companies
- Speculators
Split into two:
Direct finance: borrowing directly from investors
Indirect finance: borrowing from an intermediary e.g. a bank
What are the main functions of a commercial bank? How do they profit?
- Retail banks to household and business customers
- Licensed deposit takers - savings accounts
- Lend money and create money via bank loans, overdrafts and mortgages
- Create credit by extending loans to businesses and households
- Profit by charging higher interest on loans than paid on deposits - this is interest rate spreads
- Service fees - fees charge by bank to borrowers when arranging loans
- Brokerage percentages and fees
How can banks fail?
-Depositors panic and withdraw in fear of collapse creating a liquidity crisis and so need emergency funding
Credit crunch - unable to borrow from other banks and so heavy losses and collapsing capital threaten viability
-Also, high losses from bad debts and loans as borrowers cannot repay and so credit rating declines and share prices fail
What limits credit creation by banks?
- Market forces
- Regulatory policies - higher capital reserve requirements
- Behavior of consumers and businesses
- Monetary policy
What is liquidity and credit risk?
Liquduity risk:
-Tend to attract short term deposits and lend for longer periods of time so may not have the liquid cash to repay all deposits if savers wish to withdraw funds and so try to attract long term deposits and hold some liquid assets
Credit risk:
-Lending to borrowers who cannot repay their loans - sufficient capital in reserves. Minimum capital reserves imposed by financial authorities
What are investment banks?
Provide specialized services for companies and large investors
- Securities and capital raising
- Advice on M&As
- Trading on capital markets
- Corporate research and private equity investments
- Trades and invests on own account
Commercial banks provide investment banking services
Why does asymmetric information cause market failure in financial markets?
1.Asymmetric information: individual or party has more information than another using the advantage to exploit the other.
Finance is the market in information - often a borrower has better information on the likelihood they can repay a loan
Why do externalities cause market failure in financial markets?
- Externalities: transactions may have negative or positive consequences for a third party.
They often have contagion effects as if there is a loss of confidence between lenders there is also a loss between savers and financial institutions. It is hard to asses the risks accurately and understand the markets
Examples may be from the GFC which left everyone around £20,000, the costs were on:
- Taxpayers
- Depositors (loss of savings)
- Creditors (rise in unpaid debts)
- Shareholders (lost equity from falling share prices)
- Employees
- Government - fiscal deficit and national debt
- businesses reduced demand for goods and services.
What is moral hazard?
An organisation takes more risk as they know they are covered by insurance or the government will bail them out.
- Individuals with large insurance policies
- Government bailouts of banks
- Sub prime mortgage lenders prior to 2008 could repackage loans
What is a speculative bubble?
-Sharp and steep rise in asset prices such as shares, bonds, housing, commodities or crypto usually fuelled by speculative demand taking prices above the value.
causes:
- Behavioural factors (herd effect)
- Exaggerated expectations of future prices
- Irrational investment
- Low monetary policy interest rates encourages risky investment
What is market rigging and monopoly power in financial markets?
-Collusion or abuse can occur when companies work together to gain an unfair advantage and join profits
Monopony power: market failure arises when a market is not competitive - UK market dominated by few large banks who own significant amounts of the business - oligopolistic. There are high barriers to entry into the market marking it hard for new entrants and this is therfore a competitive market
Barriers:
- Regulation costs and licencing
- Natural costs - building and infrastrucutre
- Larger banks have strategic advantage
- First mover advantages - brand loyalty - hard to make switch
What caused the financial crisis in 2008?
- Information gaps - buyers of debt didn’t understand risks as people were packaged loans which knew were bad debts that couldn’t be paid off
- Speculation - securitization created new market and bonuses for sales for risky practices - firms began to bet on markets so banks stopped lending but speculated on stocks and shares
- Externalities - failure of one big bank - RBS - contagion
- Moral hazard - seen too big to fail, government will bail out as too important
- Monopolies, collusion and market rigging - UK market ran by several few major old banks so potential for collusion clear and lacks contestability and competition - can raise interest rates
All these factors contributed to loss of confidence pushing banks into major debt and bankruptcy
What is the relationship between financial intermediataries?
- Lenders and savers such as houses, firms and governments deposit their money into financial markets (money/capital market) and financial intermediatairres (credit, financial institutions,etc.)
- Funds go to borrowers and net spenders (firms, states and houses) for investment
What is the money multiplier theory?
-Growth in money resulting from an injection multiplied by credit creation
Calculated by 1/reserve percentage
If reserve was 3%, 1/0.03 is 33.3 so every 1 pound makes 33 pounds
- Deposits are made
- Banks take part of the deposit
- Loans are sent out
- Investment - money generated and growth
- Money returns to firms as such
- Incomes made return to banks through saving and deposits + interest so lend more, money generated.
- Cycle continues
What were the responses of the financial crisis?
Monetary policy bank rate from 5% to 0.5%
£700bn in QE
-VAT reduced from 17.5% to 15%
Money did not arrive at expected rates and growth of public debt led to austerity programmes
Debt made banks nervous to lend, leading to credit crunch
