financial markets Flashcards
Role of financial markets?
Facilitate saving
-Provides safe and convenient platform for individuals and businesses to save their money
-Transfer spending power from present to future
-Done through range of assets such as storing money in a savings account and holding stocks and shares
-Often pay interest to encourage saving
-By pooling savings, institutions can use these funds for loans and investments - stimulating economic activity
Role of financial markets: To lend to businesses and individuals
-Lend to businesses and individuals in need of capital
-Assess creditworthiness of borrowers and determine terms and conditions of loans
-Intermediation process directs funds to productive uses (e.g. business expansion) allowing for economic growth
-Funds for consumption and investment
Roles: Facilitate exchange of goods and services
-Provide a wide range of payment and transaction services
-Debit, credit cards
-Online payment systems
-Support everyday economic transactions by providing secure and efficient means of transferring funds
Roles: provide forward markets in currencies and commodities
-Offer contracts for currencies and commodities
-Allow businesses and investors to buy and sell in future at set price
-Currencies are prone to speculative attacks
-Stability provided
Roles: To provide a market for equities
-Involve the trade of shares
-Investors can participate in ownership of corporations
-They can possibly benefit from capital gains and dividends
-Supports capital formation and efficient allocation of resources
-Shares are an important way to finance expansion
-Shares can be sold on in future making the asset more appealing
Market failure: asymmetric info
-One party in a transaction has more info than another leading to adverse selection and moral hazard
-Individuals may hide their poor credit history so their may be higher default rates for lenders - most likely to seek financial products
-Financial institutions can sell products with higher risk than the buyer knows
-Sellers of subprime mortgages had more info on risk profile - also understant implication of interest rate changes to repayments
Global financial crisis
-Banks began lending to subprime borrowers after speculative bubble in US housing market
-People defaulted on their mortgages
-House prices fell
-Banks now have large stocks of assets with no income from mortgages
-Confidence lost
-People stop buying houses
-Further decrease in house prices
-Stuck with fixed assets - liquidity crisis
-Credit crunch - no money to lend
-Decreased growth to the negative levels
-Gov bailouts
-Banks have become more risk averse
Market failure: externalities
-Pecuniary externality leads to under provision of liquidity
-Risky practices lead to systematic risks triggering instability and collapse of entire economy
-Could be positive - well functioning financial market can benefit wider economy by efficiently allocating capital and promoting economic growth
Market failure: moral hazard
-Banks may feel they can be bailed out by government - taxpayers money
-Leads to reckless behaviour and excessive risk-taking
-Make decisions in own best interest
-E.g. during GFC - sold mortgages to sub-prime borrowers
-Banks seemed to be ‘too big to fail’
Market failure: speculation and market bubbles
-Speculation involves buying assets due to the expectation of price increases rather than from its intrinsic value - animal spirits
-demand exceeds supply - price rises too high above value
-When confidence is lost they sell their assets - mass selling - herding behaviour
-Price of asset decreases sharply
-Negative wealth effect
-Market bubble may also burst due rise in interest rates
Market failure: market rigging
-Collusion to gain unfair advantages
-e.g. invest billions into a stock so the price increases
-People notice so buy into the stock which further increases the price
-When the price reaches its target
-Price plummets so people lose out
-Pump-and-dump schemes
-e.g. Libor scandal - institutions accused of fixing london interbank lending rate to make a profit and seem more financially reliable
role of central banks: implementing monetary policy
-Manage money supply
-influence interest rates (set base rate)
-Quantitative easing
Role of central banks: banker to the gov
-Helps government to manage national debt
-Issues gov bonds on behalf of gov
-Financial advice on economic matters and international negotiations to ensure economic stability
Role of CBs - lender of last resort - banker to the banks
-Lend to banks to deal with liquidity crisis - access to liquidity through discount window
-Bank must be solvent - assets>liabilities
-Emergency scheme
Role of CB: role of regulation in banking industry
-Regulations ensure stability
-Capital adequacy requirements
-Risk management standards
-Regular examinations to assess financial health
