Financial Sector

Question 1

What is a financial market?

Answer 1

A financial market covers any marketplace where buyers and sellers participate in the trade of assets such as equities, bonds, currencies and derivatives. Therefore, the financial sector provides the means of channelling funds to households, firms and governments.

Question 2

What are the four most important types of financial market?

Answer 2

1) Capital market
2) Foreign exchange market
3) Money market
4) Derivatives market

Question 3

What is a capital market?

Give two different types of capital market.

Answer 3

Capital market – These enable individuals and institutions to trade financial securities, so enabling organisations and firms in both the public and private sectors to gain long-term finance.

Two examples are stock markets and bond markets:
Stock markets allow investors to buy and sell in limited companies.
Bond markets are for loans to companies or governments.

Question 4

What is a foreign exchange market?

Answer 4

Foreign exchange market - this is the market in which currencies are traded.

Question 5

What is a money market?

Answer 5

Money market – These are markets for short-term loans such as treasury bills and certificates of deposit.

Question 6

What is a derivatives market?

Answer 6

Derivatives market – Derivatives are financial instruments, e.g. futures contracts whose price depends on the value of the underlying asset.

Question 7

What are the five main roles of financial markets?

Answer 7

1) To facilitate saving
2) To lend to businesses and individuals
3) To facilitate the exchange of goods and services.
4) To provide forward markets in currencies and commodities
5) To provided a market for equities

Question 8

Explain the role of the financial market in facilitating saving.

Answer 8

Financial institutions enable households and businesses to save money by providing a range of accounts with varying degrees of risk and rates of interest.

Question 9

Explain the role of the financial market in lending to businesses and individuals.

Answer 9

Financial institutions enable the connection between households and businesses which have savings with those which need to borrow.

Question 10

Explain the role of the financial market in facilitating the exchange of goods and services.

Answer 10

The financial system handles millions of transactions everyday. These allow people to:

1. Make payments in shops and online.
2. Receive wages, welfare payments from the government and other incomes.
3. Settle debts

Question 11

Explain the role of the financial market in providing a forward market in currencies and commodities.

Answer 11

Essentially, forward markets set the price of an asset, e.g. a commodity such as wheat, or of a financial instrument, e.g. a foreign currency for future delivery.
Forward contracts may be used for both hedging and speculation. A hedge is an investment to reduce the risk of adverse price movements in an asset.

Question 12

Explain the role of the financial market in providing a market for equities.

Answer 12

An equities or stock market is one in which stocks and shares are issued and traded. A stock market gives companies access to capital and investors, a share of ownership in the company.

Question 13

What are the possible reasons for market failure in the financial sector? (5)

Answer 13

1) Asymmetric information
2) Moral hazard
3) Speculation and market bubbles
4) Externalities
5) Market rigging

Question 14

What is asymmetric information and how does it occur in the financial sector?

Give examples. (3)

Answer 14

This is a situation in which one party involved in a financial contract has less information than the other party.
Examples of this include:
The market for health insurance relies heavily on accurate information but those seeking insurance generally have better information about their health than the health insurance providers.
In the banking industry – relatively few investors understood the risks associated with derivatives traded prior to the 2008 financial crisis.
In the stock market – there will be differences in knowledge between buyers and sellers about productivity and profitability of companies.

Question 15

Explain how moral hazard may lead to market failure in the financial sector?

Answer 15

Before the financial crisis some bankers engaged in trading highly risky securities to enhance their bonuses. In the event, these risky loans resulted in huge losses that were so great that some of the banks, for example RBS had to be rescued by the UK government. This could create a further moral hazard (and government failure) because banks might continue to engage in risky behaviour in the knowledge that will be bailed out by the government if they were in danger of going bankrupt.

Question 16

Explain how speculation and market bubbles could lead to market failure in the financial sector.

Answer 16

The period between 2000 and 2007 were years in which interest rates were low, credit was easy to obtain and asset prices were increasing. This period saw banks creating £1 trillion of new money, accompanied by a doubling of debt. Indeed, there was a ‘hard effect’, which resulted in people buying assets in the hope of future capital gains even though these were unjustified in terms of their real worth.

Question 17

Explain how externalities could cause market failure in the financial sector?

Answer 17

The activities of the agents in financial markets could cause asset bubbles, for example, in the housing market. This could be an external benefit to people who own houses but would be an external cost to those wishing to get onto the property ladder.

Question 18

What are the main roles of Central banks? (4)

Answer 18

1) Implementation of monetary policy.
2) Banker to the government.
3) Banker to the banks
4) Regulation in he banking industry

Question 19

Explain the role of the Central bank in the implementation of monetary policy.

Answer 19

Central banks are responsible for implementing the monetary policy of governments, which may involve inflation targeting with the use of interest rate policy and quantitative easing.

Question 20

Explain the role of the Central bank as being banker to the government?

Answer 20

From the beginning, the Bank of England was the government’s banker which means that it manages the government’s accounts and arranges loans to the government. However, with the decision to grant the bank operational independence in 1997, responsibility for government debt management was transferred to the new UK Debt Management Office in 1998.

Question 21

Explain the role of the Central bank in being banker to the banks.

Answer 21

A central bank is usually willing to offer loans to financial institutions which are experiencing financial difficulties and which are unable to obtain the necessary funds elsewhere, so helping to maintain the stability of the banking and financial system.
The scale of the 2008 financial crisis meant that a number of governments including those in the UK and Ireland had to bail out banks and keep them afloat.

Question 22

Explain the role of regulation in the banking industry.

What are the new financial regulators in the UK?

What is the main objective of the FPC?

Answer 22

Since April 2013, the UK has had two new financial regulators:

1) The Prudential Regulation Authority (PRA), whose main function is to ensure the stability of firms involved in financial services such as banks, building societies, credit unions and insurers.
2) The Financial Conduct Authority (FCA), which is the city’s behavioural watchdog and is designed to protect consumers, to promote competition and to maintain stability in the financial services sector.

The Bank of England has also gained direct supervision of the whole of the banking system though its Financial Policy Committee (FPC). The main objective of this committee is to identify risks and weaknesses across the UK financial system. If risks are increasing, it might ask banks to raise more money from shareholders as a buffer in case of a liquidity problem.

Question 23

Give three facts about regulation in the UK.

Answer 23

Some aspects of regulation
• By 2019, Britain’s biggest banks must separate their retail operations from their investment banking and overseas operations.
• The Bank of England subjects the UK’s biggest banks to tests to measure whether they would survive a financial shock.
• Regulators in the UK, USA and the European Union have fined banks more than $9 billion for rigging Libor, which underpins over $300 trillion worth of loans worldwide.