Financial stability

Question 1

The extent to which the UK financial sector is beneficial to the UK economy

Answer 1

• Job creation, creation of highly paid job for those with the relavent skills and qualfiicantions.
• Tax revenues, higher wages are a important source of tax revenue.
• Export earnings, an important source of export earnings and economic growth.
• Balance of payments, creates many credit flows on the current account, when foreigner pay for UK financial services, help to reduce the iverall UK current account deficit driven by the UK deficit on goods.
• Comparative advantage, we cannot be competitive in many labour instensive industries such as manafacturing but we can be in high skilled service sector.
• Credit (loan) creation, financial sector plays a crucial role in providing loans to buisness which enable economic expansion.

Question 2

Disadvantages of the UK financial sector

Answer 2

• Wage inequality, wages in the finance sector have risen faster than the non-finance sector
• Focusing on finance can be detriment to investment in real goods and industry.
• London centred, Uk economy dominates london and less in other regions, more inequality.
• Short-termism, A focus on returns from finance rather than long-term investment and wider social factors.
• High wages in the finance sector, attract skilled graduates, especially with maths and science degrees – taking these graduates away from jobs in the real economy which are more productive.
• Bank losses. When banks lost money in the 2008 financial crisis, the wider economy was adversely affected. Banks became short of cash and reduced lending to households and firms. The lack of credit helped contribute to a deep recession.

Question 3

Asset Bubbles

Answer 3

• Financial sector bubbles occur when assets such as houses or shares rise rapidly, become overvalued and eventually burst, meaning prices fall rapidly.

Question 4

How do asset bubbles arise

Answer 4

• Overconfidence, if an asset such as housing rises in price, people think it is a good investemnt and therefore buy it. Due to overall overconfidence, the price of the asset can become inflated above the true value quickly.
• Short term profit means people are incetivised to buy assets rising in price for short term profits, the price rise from the demand for the asset becomes self-fulfilling.
• Moral hazard, bankers gain bonuses from investing in rising asset prices, if the assets implode in price, banks know they are likely to be bailed out by the government.

Question 5

2008 financial crisis

Answer 5

• The financial crisis of 2008 was partially caused by speculative bubble in the US housing market.
• Growth in the sub-prime morgage markets caused house prices to rise, as demand increased.
• Rising house prices led to more and more people invesiting in property, pushing prices up more and more.
• Some people who had taken on mortgages they couldnt afford began to default, the house prices began to fall.
• This meant that banks levels of capital fell, so banks reduced their lending, creating a ‘credit crunch’. This triggered a loss in confidence in their wider economy and a fall in aggregate demand and deep reccession.

THIS MEANS THAT THE BANKS SHOULD BE REGULATED.

Question 6

What is a asset bubble?

Answer 6

• People buy assests and hope to sell them on for profits later, this is called speculation. Speculators often assume than an increase in the price of an asset means that its price will continue to increase in the future, this prompts further buying of the good and further increases leading to further buying as the price increases.
• This behaviour leads to asset price bubbles, where price increase way beyond the assets ‘true value’.
• Eventually the bubble will burst (due to a fall in confidence from investors) and this leads to a fall in asset prices, confidence will fall and people may start to sell assets to avoid losing money, leading to further price falls and further selling.
• Property and shares can easily been effected by assest price bubbles and the effects of a sudden fall in the UK house prices, for example can be dramatic. As people less wealthy and less confident, they start to save instead of spend, this can lead to downward spiral in the economy.

Question 7

Why is there a need for regulation?

Answer 7

• Some economists argue that the banks have a huge influence in the economy; if they failed it would have huge consequences. Therefore, it is important to regulate the banking industry.
• Financial crash of 2008, importance of monitooring asset bubbles.

Question 8

Possible regulation focus

Answer 8

• Competition, making financial markets competitive to benefit consumers.
• The structure of firms and risk management, ensuring firms are stable. This could be achieved through.

Question 9

Capital and liquidity ratios

Answer 9

• A capital ratios measures the ratio of a banks capital to loans, it gives a measure of the risks associated with the bank lending and of their stability.
• A liquidity ratio measures the ratio of higly liquid assets to the expected short term need for cash, it also gives an idea of the banks stability.

Question 10

FPC and the PRA

Answer 10

• Financial policy committee.
• Identifies, monitors and protects against systemic risks in the financial system.
• Prudential regulation authority
• Maintaining stability and promoting competition.
• Supervising firms making sure they manage risks, and specify capital and liquidity ratios.