Financial Markets Flashcards
Money Supply
the total amount of money in circulation in a country
Narrow Money
part of the money stock made up of cash and liquid bank/building society projects
Broad Money
Includes narrow money and illiquid assets, deposits that are harder/take more time to turn into cash
Liabilities
The debts owned by the individual or firm, main type is bank overdrafts or loans
Equity (finance)
A measure of wealth; the difference between the value of assets and the costs of liabilities. An assets : liabilities ratio. Positive equity is when the value of an asset is rising while liabilities are falling, opposite for negative
Systematic Risk
failure of the entire banking system caused by the linkages in the financial system, rather than the failure of one individual bank
Commercial Banks
They provide a service to individuals and businesses which involves deposits, withdrawals, overdrafts, loans. Banks make profit by borrowing at one rate of interest and lending at a higher rate. They are businesses to make money
Creating credit and deposits
Deposits are just a number and aren’t tangible. When cash is deposited in a bank an asset is created, but since the bank is now liable to honour any cash withdrawals, it is also a liability
Cash ratio
The amount of capital as a proportion of loans, an indicator to financial health e.g. 10%, meaning that 10% of any liabilities are backed with cash. Since the financial crisis the central bank has raised the minimum cash ratio so banks are less likely to become insolvent
Assets of a bank
Cash, Balance, Bills, Advances, Investments, Fixed assets (building or equipment)
Liabilities of a bank
Share capital, Reserves, Long-term borrowing, Short-term borrowing from money markets, Customer deposits
Investment Banks
Do not generally accept deposits from ordinary members of public. Offer financial advisory, such as advising private companies on how to become public by floating on the stock market, or public companies on how to buy up another company
Central Bank
Macroeconomic stability- MPC in charge of monetary control, meet once a month to decide interest rates for stability, inflation target of 2% but MPC will not put stability at risk for the target i.e. 2011 when inflation was 5% but MPC didn’t raise rates as low growth, manage gold and foreign currency reserves on behalf of treasury.
Financial Stability- Lender of last resort to banking system providing to solvent banks, regulator over whole financial system to ensure banking standards like no excessive lending or ensuring consumers are not sold products which provide no benefit,
Money Markets
A means for lenders and borrowers to satisfy short-term financial needs. Can range from overnight to many months, rate will be higher for longer term borrowing as level of risk rises. Pay back date of a year or less. Most liquid
Capital markets
Issuing of securities for medium to long term financing. Debt capital in the buying and selling of government bonds and equity capital through the transaction of shares , pay back in more than a year. Can create secondary markets, middle liquidity
Foreign Exchange Market
Currency trading where traders can move money around the globe to take advantage of changes in interest rates by depositing funds in banks. In addition traders will look to take advantage of currency movements i.e. buy low, sell high. Spot and futures
Banking crisis and moral hazard
If a bank has insufficient liquidity it may be in danger of collapse. This is when too many customers demand cash and the bank is unable to meet these requests. Banks may engage in risky behaviour for higher profits since they believe the BoE will bail them out. Can create moral hazards, financial crisis of 07/08.
Asymmetric Information
When financial institutions have greater knowledge than their customers
Payment Protection Insurance (PPI)- Bank customers taking out a loan were sold insurance on these products.
Payday Lenders- charge high rates of interest on short term loans to consumers that are financially vulnerable and uneducated, lenders knew but customers confused
Speculative bubbles
Almost all trading in financial products is speculative. Much of it is based on the hope that the value of a financial product will rise, and that an income will be paid. Purchasing of assets can create ‘herd mentality’- as the price starts to rise, other investors pile into the market and buy up the asset. Further momentum may create a market bubble where an asset is greatly overvalued then people sell and there is a price collapse an example is the UK Housing Market in early-mid 2000s
UK Housing Market (speculative bubble)
Houses rose at unsustainable rates and there was a bubble in early-mid 2000s. Lending was too high and supply of housing was restricted, prices increased dramatically. There was a rise in interest rates reducing demand for mortgages. This forced house prices down causing negative equity where the value of a house is lower than a mortgage. Banks will sell defaults at lower prices causing household wealth to fall, lower consumption, negative house price spiral could result
Market Rigging
Participants in financial markets collude to fix prices or share info to gain at the expense of others.
Insider Trading- trader knows classified info that is likely to affect the share price in the near future
Externalities
Financial markets can create significant negative externalities for example: Nationalisation of UK banks, gov bought sizeable stake in Lloyds and RBS during financial crisis as bailout and cost to taxpayer was £133bn. Impact on the economy, financial crisis had a major cost to real economy in terms of lower incomes, rising unemployment and falling GDP
The Turner Review of 2009
A more coordinated international banking regulation. Banks to hold more assets- higher capital ratios. Improved regulation of liquidity- capital reserves will improve bank’s liquidity but remove money in circulation in economy. Separation of retail banking activities and riskier investment banking activities. Review of banks accounting practices.
Importance of liquidity and capital ratios
To remain viable a financial institution must hold enough liquid assets to meet its short-term obligations such as cash withdrawals. Problems will occur if they do not hold sufficient cash.
If banks don’t have enough capital, they are vulnerable if their assets fall in value. Assets may fall due to customers defaulting on loans made so a bank with insufficient capital may be unable to operate and technically bankrupt- happened during banking crisis.
Financial Services Act
A new regulatory structure governing financial services provision came into effect in April 2013. Regulation was increased at both a micro and macro level
Micro prudential regulation (examples)
Financial Conduct Authority- ensures that financial institutions provide customers with appropriate products and services, and treat customers fairly. FCA has the power to fine financial institutions for any misconduct.
Prudential Regulation Authority- supervising banks, building societies, credit unions, insurers and major investment firms to ensure stability
Measures that can be adopted to regulate at a micro level
Ensuring staff are trained to understand risk, and are competent. Deciding which assets can be held by institutions. Setting rules relating the trade of assets
Macro prudential regulation (examples)
Financial Policy Committee- run by BoE. Responsible for making sure the financial system doesn’t collapse, conduct regular ‘stress tests’ which look how’s banks and financial system as a whole would cope with particular scenarios. If they fail they must raise levels of reserves. The FPC can direct regulators and make recommendations to reduce risks to financial stability
Role of Financial Markets in Wider Economy
Lending and borrowing- enables the economy to function (consumption and investment) and grow. Stock market- enables businesses to finance their growth. Forex- enables currency transactions and trade to occur. Lender of last resort
Benefits of financial markets
Creates jobs- helps grow businesses, creates more jobs
Generates gov revenue- lending and borrowing brings more available income into the economy raising tax rev
Contributes to trade- forex markets
Quantitative Easing
Monetary authorities buy back government bonds ( e.g. from domestic banks) using newly printed money. This money goes into the economy whilst the gov receives previously sold bonds. Main aim is to boost the economy
Two intended effects of quantitative easing
An increase in the amount of money in circulation will hopefully lead to more lending to consumers and businesses which should result in higher levels of consumption, investment, causing more AD.
Since bonds are out of circulation, supply will fall. Results in higher bond prices but lower yields. These lowers yields will affects other interest rates in economy and generally the cost of borrowing will fall. Opportunity cost of holding bonds rise while cost of spending falls, encouraging more borrowing further stimulating AD. Decreased investment in bonds but greater investment in other assets e.g. property or shares. If prices of these rise there will be a wealth effect further stimulating demand in economy
Reverse QE
Involves central bank releasing gov bonds back onto the market, following the asset-purchasing that took place during QE. Increases supply of gov bonds which banks will buy back. This reduces the money in circulation but also reduces price of bonds and raising yields and interest rates. Both should help reduce AD
Limitations of QE
Bonds may be held by foreign investors and may not directly stimulate the UK economy.
Can cause a liquidity trap where interest rates are so low that consumers and businesses may hoard cash in savings expecting rates to rise rather than buying government bonds or other debt instruments due to little profit from little interest. This will cut consumption and investment and stunt growth, going against the intention of QE
Financial Markets
Any place where buyers and sellers meet to trade financial assets or securities. Lenders meet borrowers through intermediates such as banks
Types of Regulation
Ban market rigging, Prevent sale of unsuitable products to consumers, Maximum interest rates, Deregulation to encourage competition, Set limits on bank lending, Liquidity assurance quotas, Deposit insurance
Adverse Selection
When the most likely buyers of a financial asset are those buyers that the institution would prefer not to sell do. Happens due to asymmetric info. Excessive risk is taken and can cause potential collapse
Shares
Undated financial assets, sold initially by a company to raise financial capital. Owning a share signifies owning part of the enterprise, you get paid dividends based on enterprise porifts
Bonds
Financial securities sold by companies or by governments which are a form of long-term borrowing. Purchasing earns through fixed interest payments each year until maturity
Securities
Secured loans, such as mortgage loans secured against the value of property, less risky for banks
Conflicts between liquidity, profitability and security
Higher liquidity often means lower profitability which is why cash ratios were sub 5% causing financial crisis. Between these two, banks must also consider security, non-secured loans are more risky and thus provide more profits. To remain safe banks must remain liquid and secure to a degree but greed for profit can lead to incorrect decisions and moral hazard
Monetary policy
Part of the economic policy that attempts to achieve the government’s macroeconomic objectives using monetary instruments such as controls over bank lending and the rate of interest
Bank Rate
The rate of interest that the Bank of England pays to commercial banks on their deposits held, influences the interest rates which banks set
Contractionary Monetary Policy
Raising interest rates to decrease aggregate demand which would most likely decrease inflation, higher interest reduces consumption as they save more, reduces business investment as cost of borrowing rises, higher interest raises demand for pound, raising strength in world markets, exports reduce and imports raise reducing AD.
Expansionary Monetary Policy
Uses lower interest rates to increase AD, cost of borrowing reduces and incentive to save falls therefore raising consumption and investment, exchange rate weakens making exports more competitive, exports rise and imports fall, raising AD.
Time lags in monetary policy
The Bank of England estimates a time lag of up to 2 years between an initial change in Bank Rate and the resulting change in inflation
Forward guidance
A policy which attempts to send signals to financial markets, businesses and individuals, about the Bank of England’s interest rate policy in the months and years ahead, so that economic agents are not surprised by a sudden change in policy
