Role of financial Markets

Question 1

Role of the financial market

Answer 1

-facilitate saving
-facilitate borrowing
-facilitate exchange of goods and services
-forward markets
-market for equity

Question 2

Causes of market failure in the financial market

Answer 2

-Asymmetric info
-Externality
-Moral hazard
-speculation and market bubble
-market rigging

Question 3

Asymmetric info

Answer 3

-financial institution have more info than consumers
-sell stuff they don’t need, expensive or risky
-Economic crisis : banks sold subprime and prime mortgages saying they were prime mortgages
+ don’t wanna help regulators so won’t provide info

Question 4

Externality

Answer 4

-cost of taxpayers to bail out banks after financial crisis

Question 5

Moral Hazard

Answer 5

-when a firm or individual pursues profit and takes on too much risk in the knowledge that if things go wrong, someone else would bear a significant amount of the cost
-employees sold mortgages to those who couldn’t pay it back in hopes of better salary and bonuses
-financial institutions take risk as they know central bank is lender of last resort

Question 6

Speculation and market bubbles

Answer 6

-investors (financial institutions)buy an asset that’s rising in price
-this cause a market bubble as the value of the assets exceeds its expected value
-housing market bubble due to excess mortgages and increase demand
-they sell when they make a profit and this causes mass selling : herding behaviour
-bubble bursts and causes negative wealth effect, mortgages weren’t paid back and SD decreases

Question 7

Market rigging

Answer 7

-collude to fix prices or exchange info
Eg insider trading : knowledge of something that happens in the future and buy shares
-large trades in currency to affect the price of the commodity : Libor scandal of 2008 : FI accused of fixing London interbank Lending rate (LIBOR)

Question 8

Role of the Central Bank

Answer 8

-controls monetary policy and money supply to keep inflation stable
-banker to the government
-bank to other banks
-regulate financial system :prevent systemic risk

Question 9

Financial regulation

Answer 9

-banning market rigging, maximum interest rate, liquidity ratio

Question 10

3 key bodies of financial regulation

Answer 10

-FPC : identify and reduce systemic risk and support government economic policy (macroprudential)
-PRA : ensure competition, consumers have access to services and reduce bank failure (microprudential)
-FCA :protect consumers, promote competition and promote integrity by preventing market rigging