Macro Pack 9: The Financial Sector

Question 1

what are liabilities, capital and assets?

Answer 1

liabilities + capital = assets
Liabilities and capital:
- customer deposits from savings: main source of finance
- borrowing from other banks (or central bank as last resort)
- capital: selling shares/retained profit: security to write off bad loans

Assets:
- holds cash for liquidity
- invest in securities (tradable financial assets) to earn profit/be sold for liquidity
- greatest profit from loans (most of their assets)

Question 2

how are banks profitable?

Answer 2

• by earning higher returns on their loans/securities than they pay to savers
• so to maximise profits: hold as little cash as possible and instead earn interest on loans/securities

HOWEVER:
- liquidity issues: not holding enough cash/other liquid assets to meet demands from depositors, if run out = insolvent
- security issues: insufficient capital to cover losses from bad loans = will fail, but holding more capital relative to assets = less profits per share

Question 3

role of banks

Answer 3

• facilitate saving: save money securely/earn interest on it
• facilitate exchange of goods/services: consumers/businesses can take cash out to do this
• lend to businesses/individuals:
• fund consumption/investment

Question 4

role of financial markets

Answer 4

1. to facilitate savings:
   - securely save money
   - important source of finance for banks, who can lend out/invest to make profits
2. to lend to businesses and individuals:
   - help facilitate consumption/investment and so AD and growth
3. facilitate exchange in goods/services:
   - coins/printed money
   - debit/credit cards
   - medium of exchange
4. provide a market for equities:
   - equities = shares of a company
   - important finance for a company without need of a loan
   - stock markets enable these to be bought/sold
   - give shareholders both income (dividends) and wealth
5. provide forward markets in currencies and commodities
   - forward market: price of asset is set today but transaction will take place at future date - reduce risk for traders and uncertainty (can plan)
   for commodities:
   - e.g fixing price of wheat means producer certain of their costs even if price increases
   for currnecy:
   - lock in exchange rate for the purchase/sale of currency on a future date, reducing exchange rate risk for importers/exporters

Question 5

market failures in the financial sector

Answer 5

1. moral hazard:
   - one person takes more risks because someone else bears the cost of those risks
   e.g
   - banking bail outs: if bank too big to fail, failure borne by taxpayers
   - securitisation: if can sell loans they have made to other financial institutions may lend more recklessly
   - banker bonuses: encourage risk taking and unlikely to suffer any consequences if goes wrong
2. asymmetric information:
   - one party more info than the other
   - consumers: e.g insurers overcharging/providing unneeded cover
   - banks: may not know full risk of lending to client/risk of complex securities: too risky lending could threaten security
3. Market rigging:
   - group collude to fix prices/exchange info that will benefit themselves at expense of others
   - e.g collusion to fix prices: e.g interest rates/exchange rates to gain higher profit
   - e.g use of hidden information: insider trading, e.g aware of upcoming takeover which could affect share price and so selling shares to take advantage of this
4. Speculation and Market bubbles:
   - speculative bubble = spike in value of an asset caused by speculation
   - normally caused by exaggerated expectations of furute growth in asset = belief of rise in value = invest = driving up demand/price
   - herding behaviour
   - once belief its reached peak value, investors quickly try to sell to make profit, herding behaviour causes price to drop dramatically: bubble has burst
5. Externalities:
   - financial cost to taxpayer if need bailing out
   - will maximise profits by setting MPC=MPB so lead to over-production of loans compared to social optimum and so welfare loss of ABC
   however:
   - external benefits: loans = increased investment/more access to finance for small firms = increase competition = lower prices = improved consumer welfare

Question 6

explain speculation and market bubbles

Answer 6

• speculative bubble = spike in value of an asset caused by speculation
• normally caused by exaggerated expectations of furute growth in asset = belief of rise in value = invest = driving up demand/price
• herding behaviour
• once belief its reached peak value, investors quickly try to sell to make profit, herding behaviour causes price to drop dramatically: bubble has burst

Question 7

causes of high risk taking prior to global financial crisis

Answer 7

• riskier lending due to moral hazard:
• securitisation: more risky loans given as these mortgages/mortgage backed securities were sold onto other banks - not their problem
• future bailouts: believed they would be so act in risky manner to maximise profits
• asymmetric information:
• collateralised debt obligations (CDOs) involve mortgage backed securities packaged together with more complex investment making them harder to understand
• credit default swaps: complex derivatives allowing financial institutions to bet on whether complex CDOs would pay or not

Question 8

external costs of global financial crisis

Answer 8

• bank bailouts: funded by taxpayers to provide capital for banks to cover their toxic debt to continue operating
• reduced availability of credit: banks less willing/able to lend to businesses/individuals, particular issue of banks not wanting to lend from one another as unsure if near failure meant inter-bank lending market failed to function/provide usual funds for lending
• recession and unemployment: and loss of tax revenue

Question 9

was global financial crisis a market or regulatory failure?

Answer 9

Market:
- moral hazard = risky lending
- asymmetric information of CDOs
- resulted in externalities

Failure from regulators:
- did not get banks to hold enough capita;
- allowed banks to get “too big to fail”
- failures by rating agencies to rate securities as risky due to imperfect information/attempts to keep clients against rivals rating agencies

Question 10

role of central banks

Answer 10

1. banker to government:
   could include managing national debt, handling accounts of gov departments, making short-term advances to gov

2.Implementation of monetary policy:
e.g
- interest rates: alter base rate to meet 2% target, communicate future interest rate using forward guidance
- quantitative easing: electronically increase money supply to purchase gov bonds
- exchange rates: using interest rates
- regulating money supply and credit availability: alter how much cash/liquid assets banks hold in economy

3. Bankers to the Banks (Lend of last resort)
   - commercial banks tend to try not to as indicates bank is experiencing financial crisis
   - reduce chance of bank run (where en masse withdraw funds)
   - issues of moral hazard
4. Regulation of the Banking Industry:
   - protect consumers and maintain financial stability

Question 11

Regulations in individual financial market by central banks

Answer 11

• intervene against asymmetric information, e.g FCA cap on interest charged on payday loans in UK
• intervene in cases of market rigging: found guilty = fined/face jail time

Question 12

Regulations in Banking industry by central banks

Answer 12

1. improve bank liquidity:
- get banks to hold more cash/other liquid assets
- reduce chance of banks failing due to liquidity issues

2. improve bank security:
- regulate banks to raise more capital, such as when failing a stress test (how much might lose in scenarios/if have enough to cover potential losses)
- reduce chance of failing due to security issues
- can get banks to change amount of capital over the financial cycle: countercyclical capital buffers: requires banks to hold more capital when credit growing rapidly so that buffer can be reduced when market turns

3. reduce chance of risky lending and market bubbles:
- e.g limit placed on amount house buyers can borrow compared with cost of their house or their income
- can be used to cool housing market with rapidly increasing house prices

EVALUATION:
- operating with asymmetric information
- time/costs of regulations
- regulatory capture is policy makers continue to regulate same institutions over time and so become too lenient towards them
- conflict between regulating banks to make them safe and providing enough credit for the economy - long term may become too relaxed and so under regulate to boost growth