Chapter 10 - Financial Markets Flashcards
What are the 4 functions of a commercial bank?
1) Accept savings
-Allowing individuals to open up savings account
2) Lend to individuals and firms
Use funds from savers and gained from money markets to lend;
Difference between interest rate given to savers and charged to borrowers acting as banks profit margin
3) Financial Intermediaries
Moving funds from 3rd party lenders to borrowers through an individuals bank account ; also allow for payments to take place between an individuals account and a firms
4) Financial services advice
To its customers; insurance, mortgage and investment advice in return for a fee.
What are the 4 functions of an investment bank?
1) Propietary trading
Using banks funds to invest in financial assets for a better return than market interest rates. Speculators use market knowledge to….blah blah blah trading
2) Market making
The practise of holding a large quantity and variety of financial assets to be able to buy and sell whenever demanded, in this sense making a market for that asset. Whenever a client wants to sell a bond, they know an investment bank will buy it up AND if an investor wants to buy a bod, they knbow an investment bank will sell it to them. Banks make money off spread
3) Mergers and acquisitions
IBs can organise and advise on MnAs on behalf of clients; giving advice and guidance in many areas of the move.
4) New issues, IPOs
IBs can engage in new issues on behalf of clients who need to raise funds, for example a firm may be issuing shares or bonds but wants help and advice from an IB to ensure these products are actually sold.
Can also engage in underwriting; where bank buys up all shares if firms i in desperate need of funding, in return for a % fee on top
What has occured for IBs and Commercial Banks since deregulation in 1970s?
Commercial and investment banks can operate under the same name, for example Barclays has both a commercial bank and investment bank division. -> has allowed for rapid growth of IB industry as safe and stable funds from commercial bank can be used in IB practises, for this reason it is rare to see purely specialised IBs.
What is systemic risk?
Where the collapse of one firm in the financial industry can ripple through the industry leading to further banking collapses and eventual meltdown of the entire industry
How do commercial banks make money?
The traditional model is as follows, called the ‘money multiplier’:
-Accepting savings from individuals
-Keeping a fraction of savings withing bank, in case of withdrawals
-Rest used to issue loans
-Difference between interest rate offered to savers and interest rate charge to borrowers is profit for bank
It is calculated using ‘1/r’ where r = % percentage requirement of savings that must be held as reserves
Why do commercial banks fail? 2
1) Liquidity crisis
Not enough short term assetss to meet short term liabilties
Could be caused by: commercial banks run down their liquid cash assetss from savings in order to make long term loans where there is greater profit to be made OR if they borrow short term in the money markets and use this to increase less liquid assets
CONSEQUENCE : short term liabilities cannot be met -> savers come to bank to demand savings but bank cannot provide -> panic -> run on the bank -> liquidity crisis
2) Insolvency
Where commercial bank does not have anough capital to offset any losses in longer term asset values -> liabilites greater than assetts -> failure
What are the consequencs of commercial bank failure? 3
1) Systemic risk
Collapse of one bank ripples through industry -> further bank collapses -> meltdown of entire industry
Why? if one bank fails, assets held by another bank AT THE FAILED BANK will become worthless and will need to be offset by a reduction in capital -> if capital is not enough to offset this loss this bank will become insolvent
2) Recession
Given the importance of the financial industry for growth; bank failure can lead to a deep recession or depression for a nation -> increased unemployment -> reduced incomes and living standards -> banks become unwilling to lend -> reducing I and C -> limited borrowing for governments -> reducing G -> harder to stimulate economy
3) Negative externalities and moral hazard
Bank failure can have a serious negative effect on tax payers if Gov think that sytemic risk is too high and opt for bailouts; tax payer money is used to fund bailout -> usual opp cost argument
ALSO the existence of bailouts encourages moral hazard; incentivising excessive risk to be taken by commercial banks for profit seeking purposes knowing that the gov will bail them out, a 3rd party bares the risk, .
What are the objectives of a commercial bank? 3
1) Profitability
Shareholders seek dividends as a reward for their investment -> profitability is core objective to satisfy shareholders -> EASIEST WAY; borrowing short term at low interest rates from money markets and lending long term for example mortgages or business loans
EVAL = Overriding search for profit is extremely dangerous as methods of maximising profit increases the chances of both insolency and a liquidity crisis and thus bank failure -> given consequences of bank failure then it is not in commercial banks best interest to flirt too closesly with this occurence
2) Liquidity
To avoid liquidity crisis and a run on the banks, maintaining sufficient levels of short-term liquid assets is a key objective; cash, reserves at the central bank or short term investments
3) Security
To avoid insolvency, security must be considered and thus offer loans that are less likely to default; safer borrowers OR loans backed with collateral…this does involve sacrificing profit as such loans do not command the highest interest rates that can be charged
What is the role of the central bank? 4
1) To implement monetary policy
Interest rates, money supply and exchange rate in order to meet key macroeconomic objectives
2) To act as a banker to the government
Gov bonds can be bought and sold on behalf of GOv and debt interest can be managed, central bank can also offer advice to Gov on various economic matters
3) Lender of last resort to banks
Commercial banks suffer liquidity problems -> do not have enough short term liquidt assets to meet short term liablities -> central bank can step in and provide liquidity; emergency or non-emergency -> preventing a full blown liquidity crisis and bank failure
——-Conditions need to be met for banks to be eligible for these funds AND strict regulations will be imposed once liquidity hasbeen transferred, with money being paid back with higher than market interst rates
4) Regulator of the financial system
The Financial Policy Committee (FPC) and the Prudential Regulation Authority (PRA) are; regulatory bodies within the BoE whos job is to look out for risks to financial stability, prevent bank failure and thus reduce systemic risk
What are the Pros of the Central Bank acting as a Lender of Last Resort? 2
1) Prevent a liquidity crisis
Prevents liquidity crisis -> bank failure -> systemic risk -> full financial sector collapse
Individuals know their money is safe and panic does not surface -> crucial for confidence in banking sector -> otherwise growth and living standards would suffer due to deep recession
2) BoE can advise the Gov where a bailout may be necessary
Can identify where serious concerns in banking sector lay -> where state intervention may be necessary -> preventing systemic risk and sector collapse
What are the cons of the Central Bank acting as a Lender of Last Resort? 3
1) Promote further exessive risk, MORAL HAZARD
Commercial banks know that if they are ever short of liquidity, central bank will be there to provide emergency funds -> MORAL HAZARD, excessive risk is taken due to third parties bearing the consequences
2) WHy should banks be treated different to any other business in economy?
In a market economy losses and failure signal shut down and a transfer of factors of production to other areas of activity -> true for any private business without emergency liquidity -> why shouldnt banks be allowed to close and bailout funds instead be sued to protect individuals savings
3) Risk of regulatory capture
Managers of commercial bank form close relationships with central bank regulators, influencing decision making over liquidity provision and conditions imposed thereafter to favour the commercial bank rather than doing what is in the best interests of society -> significant Gov failure -> risk of future liquidity crisis could be high -> problem worsens if regulators used to WORK at commercial banks they are meant to be regulating
What is a financial market failure?
Where free financial markets fail to allocate financial products and services at the socially optimum level of output resulting in a net loss of social and economic welfare
What are the causes of financial market failure? 4
Excessive risk 1; Speculation) Speculastors look to buy financial assetss low and sell them high, most times leveraging the transaction -> when excessively high prices are paid for assets that are overvalued -> market bubble forms -> overproduction of assets that carry excessive risk of collapsing in price -> eventually, investors realise market has peaked -> stop buyiung, stop demand -> lowering price of assetts -> panic sets in and investors in possesion of assets begin to sell to mitigate losses -> price collapses further ->lack of buyside liquidity -> assets becomes worthless but borrowed money to buy them needs paying back, resulting in damage to investor -> damage to brokers who lent money -> banks -> insolvency
Excessive risk 2; Aysmmetric information) Can lead to adverse selection and moral hazard. -> emergence liquidity promotes moral hazard -> central banks can impose regulation post bailout HOWEVER asymmetric info will limit effectiveness as banks can always conceal new risky deals or loans being issued -> incentivised to do so given the safety of intervnetion if under threat of failure -> increases sytemic risk in banking sector
Excessive risk 3; Tax payer burdens) Baiouts -> gov funds -> tax payer money ->OPP COST ARGUMENT
ALSO if there is no assurance scheme for individuals savings -> lead to large recession throigh loss of savings -> reduced AD -> also widespread unemployment in banking sector -> negative externalities are ignored by banks due to self interest -> overproduction of risky financial products such as laons -> increasing future risk of bank failure
4) Collusion and price fixing; Market Rigging
This occurs when traders, banks and/or intermediaries collude to manipulate markets away from equilibrium levels and make huge profits -> for example FOREX fixing scandals where heavy fines and regulatonis were clearly not strong enough to detract such behaviour -> society suffer drastically through extra charges dependant on the nature of the fix
Who are the 3 UK financial market regulators?
1) Financial Policy Committee (FPC)
Macro prudential regulator, part of the Bank of England, with its main objective to monitor and protect against systemic risk within the financial sector -> can advise the PRA and FCA and the Gov
2) Prudential Regulation Authority (PRA)
Micro prudential regulator, part of BoE -> role to maintain stability of banks and banking sector as a whole -> supervising management of risk and set industry standards for management and conduct within the banking industry
3) Financial Conduct Authority (FCA)
Gov regulatory body reporting to the treasury ->main role to protect the public interest and consumers, thus promoting confidence in the financial products and institutions
What are the types of Financial Market Regulation? 8
1) Ban Market Rigging
To monitor and enforce a ban on market rigging -> interest rates and exchange rates will be determined yb free market without undue harm to consumers, businesses and other financial institutions
2) Prevent the sale of unsuitable financial products
For example poroducts where consumers lack information or the information is unclear such as a payment protection insurance (PPI) and banning sale of financial products that are not in consumers best interest
3) IMposing maximum interst rates
Proitects borrowers and reduces incentive for banks to issue loans and make investments with excessive risk -> reduces chance of bank failure
4) Deregulate financial markets
Reducing paper work and red tape, making it easier to start up and close down a bank, reducing limits on bank lending ETC ETC -> competition in banking sector increases -> reducing interest rates on borrowing -> increasing interest rates for savers -> through natural competitive forces
5) Deposit Insurance Schemes
Goverment backed deposit insurance schemes protecting individual savers,as seen in UK, promoting confidence in banking sector
6) Ring fence commercial banking from investment banking
Reducing risk of commercial bank failure as safe commercial finds stay within the bank rather than being used in more risky uncertain activities of investment banking, in which losses can be accrued leading to collapse of both sides of the bank
7) The central bank can provide emeregency liquidity
Lender of Last resort, preventing liquidity crisis, systemic risk and financial sector collapse -> individual savers know their money is sfae and panic does not set in
8) Basel III recomendations
The Basel agreement is regulation agreed ad recommended by world experts to reduce chance of bank failure and systemic risk, they are only recommendations and is up to individual gov whether they’re followed:
- Cash Ratio (total assets / total liabilities) -> imposing or increasing this ratio will reduce chances of bank run
-Liquidity ratio (current assets / current liabilities)
- Reserve requirement
- Capital ratio (total capital / loans issued) -> not including safer loans -> by imposing or increasing, reduced risk of systemic risk
- Leverage ratio (total capital / total loans), including mortages and ‘safer’ loans, unlike capital ratio
