Role Of Financial Sector

Question 1

How does borrowing and lending work (3)

Answer 1

When a person saves money in bank it doesn’t just sit there
The bank uses it to earn money to pay interest to the saver
Banks lend out savers money to borrowers who pay interest

Question 2

What is the IR “spread” (2)

Answer 2

Difference in what bank pays in interest to savers and what they are payed by borrowers
Must be positive = more money in than out or bank would go bust

Question 3

What is a liability (2)

Answer 3

Savings
Money doesn’t belong to bank = bank is liable to pay saver

Question 4

What is an asset

Answer 4

Loan = money belongs to bank + expects to be repaid

Question 5

Relationship of assets and liabilities to bank

Answer 5

Must have assets to cover liabilities

Question 6

Why is it not possible for banks to match liabilities with assets (4)

Answer 6

Amount borrowed never exactly matches amount saved (deposited)
Borrowers don’t always pay money back in time for savers to get money back
Savers can take money whenever
Borrowers often fail to repay or pay interest

Question 7

How much money was written of in 2015 (2)

Answer 7

According to the latest Bank of England data
2015 Q3 = a total of £1.5bn in bad loans had to be written off by the banks

Question 8

How do banks cover liabilities (3)

Answer 8

Reserves and capital:
Shareholders capital
Cash reserves

Question 9

What is shareholders capital

Answer 9

The owners of the banks (usually shareholders) inject their own money

Question 10

What is a cash reserve

Answer 10

The managers of the banks hold back in reserve a fraction of all savers’ deposits to meet
expected withdrawals

Question 11

What happens if bank has insufficient capital and reserves (2)

Answer 11

If savers suspect that a bank is unable to pay out everybody on demand they take FRIGHT
Seek to withdraw their money all at once

Question 12

Example of insufficient capital and reserves (4)

Answer 12

Run on the bank
2007
Nor5ern rock bank
First bank run in over 100 years

Question 13

Why run on the bank (2)

Answer 13

Fractional reserve = 1% (£100 deposited by saver and £99 loaned)
2008 financial crisis = everyone wanted take money out

Question 14

How did they stop run on the bank (3)

Answer 14

Quantitative easing = monetary = £895bn gov bonds
Nationalised some banks = northern rock + royal bank of Scotland
FCA = financial conduct authority = new rules = stress test

Question 15

What is the stress test (FCA)

Answer 15

Banks assets and liabilities tested to see if run on bank may occur and if the bank could handle it

Question 16

What does the Bank of England encourage

Answer 16

Keep 6% of deposits in reserves

Question 17

In the UK how much money is represented by banknotes or coins

Answer 17

4%

Question 18

Why is money in an account better for banks

Answer 18

(Card) Money can be recycled into loans by financial institutions - “cash under the mattress” cannot

Question 19

What are savings

Answer 19

A way of transferring spending power from the present into the future

Question 20

Features of a savings account (4)

Answer 20

Cannot be overdrawn
Will not support chequebook or debit card
Interest earned at variable rate - usually quarterly
Withdrawals can be made over counter but increasingly done over phone or computer

Question 21

What are the interest rates like in savings account (2+)

Answer 21

Usually tiered = earn more interest on larger savings than on smaller ones
They also earn more interest if they agree to keep their savings in the account for a longer or fixed period of time

Question 22

How do banks make profit (2)

Answer 22

Charges
Interest rate margin

Question 23

What are the charges a banks makes (2)

Answer 23

Fee per transaction
Fee for a bank statement

Question 24

What is an interest rate margin (3++)

Answer 24

Difference between the higher interest rates that a bank charges for loans (on borrowers) and the lower interest rates that it pays people on savings accounts (savers)
o ABC Bank charges its borrowers 7% and pays its savers 2%
o The difference of 5% covers its costs (administration, staffing and premises, etc) and its profit

Question 25

Example of charges (3)

Answer 25

Bank of Scotland = part of Lloyds
Charges more than £47 in fees when someone makes ten £50 purchases and five ATM withdrawals of £50
If they use their debit card while abroad on holiday

Question 26

What districts are financial services industry divided into (2)

Answer 26

The professional sector
The retail sector

Question 27

What do investment banks do (3/3)

Answer 27

Professional sector
Provide advice and arrange finance for governments or companies who want to issue bonds
Provide advice and arrange finance for companies who want to:
Float on the stock-market
Carry out mergers and acquisitions

Question 28

Investment bank services include (4++)

Answer 28

Securities trading in equities, bonds and derivatives
Corporate finance and advisory work
Treasury dealing for corporate clients in foreign currencies = with financial engineering services to protect them from interest and exchange rate fluctuations

Question 29

What is the foreign exchange market (2+)

Answer 29

The largest financial market in the world
Often referred to as:
Forex or FX

Question 30

What does the forex market involve (2(

Answer 30

Trading one currency for another
Over the counter (OTC) market where brokers and dealers negotiate directly with each other

Question 31

What are equities (2)

Answer 31

Also known as shares and stocks
If you own shares = essential own part of business

Question 32

How can people who hold shares benefit from growth of company (2+)

Answer 32

Usually get income through distributions of the business’s profits called ‘dividends’ and paid out to shareholders regularly – usually twice a year
Have the potential for capital growth if the price of the shares goes up

Question 33

What do shares offer and why (3+)

Answer 33

The possible combination of income and capital growth = high reward with a correspondingly high risk
If the company does badly and has no profit to distribute in a year = no dividends
If the share price falls the investor may make a capital loss

Question 34

What is a derivative (2)

Answer 34

A financial instrument that’s price is derived from the price of another asset:
The asset is known as the “underlying asset” or just as “underlying”

Question 35

Purpose of derivative (3)

Answer 35

Reduce risk faced by organisations and / or individuals
Originally these tended to be farmers, or food producers
The world’s first derivatives exchange = the Chicago Board of Trade (CBOT) opened in 1848

Question 36

What is a basic forward contract (3+)

Answer 36

Way of locking in future prices
It is derivative = the value of the forward contract during its lifetime is derived from the value of something else (potatoes)
Zero sum + hedge (makes sense later)

Question 37

What is a hedge

Answer 37

From of protection against loss on a transaction by making balancing or compensating transactions

Question 38

What is a zero sum game

Answer 38

What one party gains - another party loses