Section 12 - The Financial Sector

Question 1

Financial sector- intro

Answer 1

> Basic purpose of banks and other financial institutions is to make money available to those who want to spend more than their income using the savings of those who don’t currently want to spend.
To do this, they:
-help people and firms save - through bank accounts, pension funds, bonds and other financial products.
-provide loans to businesses and individuals.
-allow equities and bonds to be issued and traded on capital markets.
Financial institutions and financial markets also perform various other functions in an economy:
-they make trade easier by allowing buyers to make payments quickly and easily.
-they provide insurance cover to firms and individuals.

Question 2

Everyday forms of borrowing for individuals - list

Answer 2

>Personal loans.
>Mortgages.
>Credit cards.
>Pay-day loans.
>Overdrafts.

Question 3

Everyday forms of borrowing for individuals - Personal loans

Answer 3

> Personal loans are loans to individuals to be paid back over a small number of years.
These can be secured (where a bank can force the sale of an asset, like a house, to recover the loan’s cost if it isn’t repaid) or unsecured.
Unsecured loans have a higher rate of interest than secured loans as they’re riskier.

Question 4

Everyday forms of borrowing for individuals - Mortgages

Answer 4

> Mortgages are loans to buy property.

>The bank owns the property until the loan is repaid.

Question 5

Everyday forms of borrowing for individuals - credit cards

Answer 5

> Credit cards allow their holders to borrow money from a bank when purchasing goods or services.

Question 6

Everyday forms of borrowing for individuals - pay-day loans

Answer 6

> Pay-day loans are short-term, small, unsecured loans, usually with high rates of interest.

Question 7

Everyday forms of borrowing for individuals - overdrafts

Answer 7

> Overdrafts are loans to firms and individuals that occur when the funds in their account fall below zero.
A fee might need to be paid for using an overdraft.

Question 8

Firms funding their activities - list

Answer 8

1. Equity finance

2. Debt finance

Question 9

Firms funding their activities - equity finance

Answer 9

> Equity finance is raised by selling shares in a company.
Raising funds this way means that the person providing the finance (by buying shares) becomes a shareholder in the firm and can claim some ownership of it.
This entitles the shareholder to a share of the firm’s profits in the form of dividends.

Question 10

Firms funding their activities - debt finance

Answer 10

> Debt finance is borrowing money that has to be paid back (usually with interest).
This can involve borrowing from financial institutions (e.g. banks), or issuing corporate bonds.

Question 11

Financial sector - importance

Answer 11

> Effective and efficient financial institutions and financial markets enable economic growth to occur, while unstable institutions and markets can cause major problems.
Economic growth is driven by the spending of individuals and firms, much of which relies on credit.
Businesses (small firms especially) are unlikely to grow without credit. If firms don’t grow, this means fewer new jobs and lower exports.
Firms in developing countries, where the financial sector tends to be quite weak or underdeveloped, struggle to get credit and this restricts their growth.

Question 12

Banking industry - intro

Answer 12

> Banks are private-sector organisations that aim to make profits for their shareholders. But in some ways banks are treated quite differently from most other private firms.
This is partly because problems in a bank or in the banking industry can have an impact beyond those with bank savings - they could potentially destabilise a country’s whole economy.
Greater profitability in banking is also often associated with taking bigger risks, so there are incentives for banks to take financial risks in the hope of making a large profit.
The huge economic importance of banks combined with the incentive to take risks means that banking is a regulated industry - i.e. there are rules to control the behaviour of banks, and penalties for any banks that break the rules.

Question 13

Why are financial institutions regulated?

Answer 13

> Reduce the impacts of financial market failure.
Protect consumers by policing individuals and firms to ensure that they act fairly and legally.
Ensure the integrity and stability of financial institutions and the services they provide.
Maintain confidence in the financial sector and avoid sudden panics.

Question 14

Types of financial market

Answer 14

1. Money markets
2. Capital markets
3. Foreign exchange markets

Question 15

Money markets

Answer 15

> Money markets provide short-term finance to banks (and other financial institutions), companies, governments and individuals.
The short-term debt will have a maturity (i.e. repayment period) of up to about a year (and it could be as little as 24hours).
Inter-bank lending is arranged via a money market.

Question 16

Capital markets

Answer 16

> Capital markets provide governments and firms with medium and long-term finance.
Governments and firms can raise finance by issuing bonds.
Firms can also raise finance by issuing shares or by borrowing from banks.
A capital market has a primary market and a secondary market:
-The primary market is for new share and bond issues.
-The secondary market is where existing securities are traded (e.g. a stock exchange). This increases their liquidity (i.e. being able to sell them means it’s easier to ‘convert them to spendable cash’).

Question 17

Security - definition

Answer 17

> A security is basically a certificate with some kind of financial value which can be bought and sold (e.g. shares and bonds).

Question 18

Foreign exchange markets

Answer 18

> Foreign exchange markets are where different currencies are bought and sold.
This is usually done to allow international trade and investment, or as speculation (to make money on fluctuations in currency prices).
A foreign exchange market is split into what’s known as the spot market and the forward market:
-The spot market is for transactions happening now.
-The forward market is for transactions that will happen at an agreed time in the future.

Question 19

Foreign exchange markets - Forward markets

Answer 19

> On a forward market, contracts (called futures) are made at a price agreed today but for delivery later.
Futures are useful for firms who export and import goods, as they ‘lock in’ an agreed exchange rate between the buyer’s and seller’s currencies. The certainty allows both firms to be more confident about their future plans.
Either firm could lose out if the exchange rate changes, but this ‘risk sharing’ encourages more trade.
Forward markets also exist for commodities - e.g. a price for a future trade in coffee can be agreed in advance.

Question 20

Bonds

Answer 20

> Bonds are a form of borrowing.
Governments and large firms can issue bonds to raise money (e.g. a government might need to finance a budget deficit, while a firm might want to invest in new machinery).
Investors buy new bonds at their ‘face value’ (called the nominal value) and become bondholders.
Interest is paid to the bondholder - the amount of interest paid is called the coupon.
After they’ve been issued, bonds can be traded in secondary capital markets.
Investors can buy or sell bonds at any price - this ‘market price’ may be bigger or smaller than the bond’s nominal value. Coupons are paid to the current bond holder.
The bond’s yield is the annual return an investor will get from the bond. The less someone pays for a bond, the higher its yield.
When the bond matures, the current bondholder is paid the nominal value of the bond by the issuer. This means the issuer’s original debt has been repaid.

Question 21

Bond’s yield

Answer 21

> Yield = (Coupon/Market price) x 100.
The coupon might be described as a percentage of the nominal value (e.g. a coupon of 6% per year on a bond with a nominal value of £100 would pay £6 per year).

Question 22

Types of bank

Answer 22

1. Commercial bank

2. Investment bank

Question 23

Commercial banks

Answer 23

> Commercial banks have these main roles:
1. To accept savings
2. To lend to firms and individuals
3. To be financial intermediaries (i.e. move funds from lenders to borrowers)
4. To allow payments from one person or firm to another.
Commercial banks also provide other financial services to customers, such as insurance and financial advice.
Commercial banking is split into 2 areas:
-retail banking and wholesale banking.
Commercial banks help firms grow by providing loans, financial advice, and by facilitating overseas trade.

Question 24

Commercial banking is split into 2 areas…

Answer 24

1. Retail banking - providing services for individuals and smaller firms (e.g. savings accounts and mortgages). Retail banks are often called ‘high street banks’.
2. Wholesale banking - dealing with larger firms’ banking needs,
   >The term ‘commercial banking’ is sometimes used to mean just wholesale banking.

Question 25

Investment banks

Answer 25

> Investment banks don’t take deposits from customers. Instead, their role is to:
1. Arrange share and bond issues
2. Offer advice on raising finance, and on mergers and acquisitions
3. Buy and sell securities on behalf of their clients
4. Act as market makers to make trading in securities easier.
Investment banks also engage in higher risk (but potentially very profitable) activities. For example, proprietary trading involves a bank buying and selling shares using its own money.

Question 26

Market maker

Answer 26

> A market maker for a security allows companies and individuals to buy and sell that security without the need to use a stock exchange.

Question 27

Commercial banks can also operate investment banks

Answer 27

> Many large banks operate as both commercial and investment banks (e.g. Barclays and HSBC).
Allowing banks to operate as both commercial and investment banks creates a systemic risk (i.e. a risk that a whole market or even the whole financial system might collapse), because banks may wish to use deposits from the commercial banking side of their business to fund investment banking activities. If they lose money in bad investments then their depositor’s money could be at risk.

Question 28

List of financial institutions

Answer 28

> There are other financial institutions operating global financial markets - not just banks. For example:

1. Pension funds
2. Insurance firms
3. Hedge funds
4. Private equity firms

Question 29

Pension funds

Answer 29

> These collect people’s savings and invest them in securities.
When a client retires, the pension fund pays out their savings and the returns they’ve generated.
Pension funds also provide long-term, large-scale investment in companies.

Question 30

Insurance firms

Answer 30

> Insurance firms charge customers fees to provide insurance cover against all kinds of risk.
This is important for the economy - e.g. a business can insure against the risk of customers not paying (which encourages trade).

Question 31

Hedge funds

Answer 31

> Firms that invest in pooled funds from different contributors in the hope of receiving high returns.
They usually invest in a number of different markets, but the desire for high returns (and the fact that they’re only lightly regulates) can lead to risks for the contributors, and the wider economy.

Question 32

Private equity firms

Answer 32

> These invest in businesses (e.g. by buying equity) and then try to make the maximum return.
This could mean helping a business become successful so that it can be sold for profit.
However, they’re often criticised for asset-stripping (selling a firm’s assets) and cutting jobs.

Question 33

Shadow banking system

Answer 33

> The shadow banking system includes unregulated financial intermediaries and the unregulated activities of otherwise regulated financial institutions.
The shadow banking system has become much larger in recent years (but since it’s not regulated, it’s hard to tell exactly how large).
Hedge funds and private equity firms are often considered part of the shadow banking system.
The shadow banking system supplies an increasing amount of credit.
But the lack of regulation, the absence of the sort of emergency support available to normal banks and its large (but unknown) size add to the risk of the shadow banking system helping to cause a financial crisis.

Question 34

Money - definition

Answer 34

> Any financial instrument that satisfies the four main functions of money, and that’s also portable, widely accepted, difficult to forge and durable can be classified as money and counted as part of the money supply.

Question 35

Money - general

Answer 35

> Different types of money have different levels of liquidity.
Liquidity refers to how easily something can be spent.
Economists have ‘narrow’ and ‘broad’ definitions of money, based on the liquidity of different forms.

Question 36

Narrow money

Answer 36

> Narrow money refers to the notes and coins in circulation, plus balances held at a central bank.
In other words, narrow money consist of financial instruments that are very liquid.

Question 37

Broad money

Answer 37

> Broad money includes assets that are less liquid, as well as all of the things that make up narrow money.

Question 38

Banks - conflicts

Answer 38

> Banks have to balance profitability and liquidity.
Risk is profitable but risky.
Security of an investment vs profitability.

Question 39

Banks - profit and liquidity

Answer 39

> Banks are businesses, and one of their aims is to maximise profits for the benefit of their shareholders.
The rate of return on illiquid assets (e.g. corporate bonds) is generally higher than that on more liquid assets (e.g. deposits at the BoE). So banks don’t want to have too many liquid assets.
However, banks need to have a certain amount of liquid assets available. This is because banks tend to lend money over a long term but depositors who give their money to banks expect to be able to withdraw their savings immediately.
So banks need enough liquidity to be able to repay depositors when asked, but not too much liquidity, or they might become unprofitable. This means they have to calculate very carefully the amount of liquid reserves they hold.
Banks actually rely on depositors not all wanting to withdraw their savings at the dame time. If too many depositors want to withdraw their money at short notice, a bank may not have the liquidity to be able to repay them.
This usually won’t be a problem, as it’s very unlikely everyone would suddenly decide to withdraw their savings at the same time.
However, if people thought their savings were at risk for any reason, then lots of people probably would withdraw their savings very quickly (run on the bank), and the bank could quite quickly run out of liquid assets.
This is why it is really important that people trust the banking system with their savings. It’s also why a central bank is needed to act as an emergency lender of last resort.

Question 40

Banks - risk and profit

Answer 40

> Risk is a key idea in finance.
All other things being equal, risky investments will usually generate a higher return than less risky ones.
Investors will want high rewards for risking their money.
This is why different interest rates are charged in different money markets - the more secure an investment is, the lower the rate of interest that will be earned.
All investors must balance the security of an investment against its profitability.
This is especially important if an investor is using someone else’s money, or if the firm they’re working for is particularly important to the stability of the financial system.

Question 41

Commercial banks and credit

Answer 41

> Most of the money in the economy is created by commercial banks when they make loans.
When a loan is granted, the bank creates a deposit in the customer’s account - this is new money, so it increases the money supply.
The customer becomes a debtor of the bank - they need to repay the loan, plus interest.
The loan is an asset for the bank.
The customer’s deposit is a liability for the bank.

Question 42

Bank asset - definition

Answer 42

> Anything that’s owned by or owed to the bank is an asset.

Question 43

Bank liability - definiton

Answer 43

> Anything that the bank owes is a liability.

Question 44

Inter-bank lending

Answer 44

> Inter-bank lending is lending between banks and occurs on the inter-bank lending market (a money market).
The loans given between the banks are very short-term - usually less than one week, and often only overnight.
On any day, some banks will have excess liquidity and others will have a shortage.
Inter-bank lending means that banks with a temporary shortage of liquidity can borrow to meet their customers’ needs. Banks with excess liquidity earn interest on what they lend.
The rate charged is called the inter-bank lending rate, or the overnight rate.

Question 45

Banks’ balance sheets

Answer 45

> Like all businesses, banks have balance sheets.
A bank’s balance sheet is a snapshot of its assets and liabilities on a particular date.
On a balance sheet, total assets should always equal total liabilities.

Question 46

Banks and capital

Answer 46

> A bank’s capital is the total of its share capital (the money raised when its shares were first issued) and its reserves (made up from retained profits).
The amount of credit a bank can create depends on how much capital the bank holds. This is because banks will usually want to keep the ratio of loans to capital with a certain limit (and central banks sometimes insist on it).
If the value of one of the bank’s assets falls, the bank’s capital is reduced by the same amount (so that total assets still equal total liabilities).
If the total value of a bank’s assets falls by a large amount, the bank could ‘run out’ of capital (i.e. if the banks capital is less than the amount lost).
The value of the bank’s assets would be less than the value of its liabilities and the bank would be insolvent.
An insolvent bank would normally have to close down - central banks don’t usually lend to insolvent banks.

Question 47

A bank’s capital - liability or asset?

Answer 47

> A bank’s capital is a liability, because if the bank ceased trading, this money would be returned to shareholders (once all the bank’s outstanding debts had been paid).

Question 48

Banks - what do they need to achieve?

Answer 48

> Banks need to achieve a balance of liquidity, security and profitability.
A bank will aim to hold a variety of different types of asset to achieve a suitable balance of liquidity, security and profitability.
For example, unsecured loans are more profitable (but riskier) than secured loans (e.g. mortgages).
If someone defaults on a secured loan (e.g. a mortgage), the bank can repossess the house (or other asset) that’s been used as security (and the value of the bank’s assets doesn’t fall too much).
If someone defaults on an unsecured loan, that asset is removed from the bank’s balance sheet.

Question 49

Market interest rates and bond prices

Answer 49

> Market interest rates and bond prices have an inverse relationship.
The yield of a bond will approximately match the rate of interest on other investments with similar risk levels.
This means that as interest rates rise, bond prices fall, and vice versa.
Market price = (coupon/yield(IR))x 100

Question 50

Implications of a financial crisis

Answer 50

> There are various kinds of financial crisis - e.g. a sudden sharp fall in the price of assets (e.g. shares or houses), or a government defaulting on its loans.
Financial crises often seem to happen after a long period or prosperity (e.g. because of low interest rates, easy credit, excessive speculation and overconfidence), and often lead to a recession.
It usually takes longer for an economy to recover after a recession accompanied by a financial crises than it would from a ‘normal’ recession.
Problems in the financial sector also involve systemic risk - the risk that a problem in one part (e.g. a single bank) can lead to the breakdown of a whole market or perhaps even the whole financial system.
Problems in one country’s financial sector can also quickly spread around the world. What looks like a fairly minor local problem can quickly become a much more serious international situation.

Question 51

Systemic risk - definition

Answer 51

> The risk that a problem in one part (e.g. a single bank) can lead to the breakdown of a whole market or perhaps even the whole financial system.

Question 52

Speculation - definition

Answer 52

> Speculation means aiming to make a profit by buying assets relatively cheaply and selling them at a higher price.
Speculation always carries some risk (because if asset prices fall, a speculator will lose money).

Question 53

Speculation and market bubbles

Answer 53

> Excessively high estimates of future asset price rises can lead to market bubbles (or ‘asset price bubbles’). For example:
-Investors expecting the price of an asset to continue to rise can overpay, creating a market bubble (where prices in a market are much greater than the assets’ true worth).
-When investors eventually lose confidence, the bubble will ‘burst’ and investors will rush to sell their assets to avoid large losses. This leads to prices plummeting, leaving investors with large debts (if they borrowed the money they invested) and worthless assets.
Banks can help to create market bubbles if they give out credit too easily. (Speculators often borrow the money to fund their purchases).

Question 54

Credit crunch

Answer 54

> The financial crisis of 2008 was partially caused by a speculative housing bubble in the US housing market.
The growth in the ‘sub-prime’ mortgage market caused house prices to rise, as demand increased.
Rising house prices led to more and more people investing in property, pushing prices up further.
The bubble burst when people who’d taken on mortgages they couldn’t afford began to default, and 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 of confidence in the wider economy, a fall in AD, and a deep recession.

Question 55

Financial markets - externalities

Answer 55

> There are negative externalities in financial markets. Some of these come about because of the importance of banks and the financial sector to the wider economy.
In the financial sector, mismanagement of risk is one cause of externalities.
For example, the risks financial institutions took that eventually led to the 2008 financial crises were ‘paid for’ through taxpayers - government money was used to prevent the collapse of major banks.
Other negative externalities of the 2008 financial crises included large drops in GDP, falling salary levels for many workers, and a significant rise in unemployment.

Question 56

Too big to fail

Answer 56

> The need for a bailout of the banks was partly because some were considered to be ‘too big to fail’ - they had become so big that a system risk was created.
If one or two of these large banks collapsed, it could have led to panic and a run on other banks, causing them (and possibly the whole financial sector) to collapse.
The UK government felt it had to rescue these banks, even though it cost billions of pounds.

Question 57

Asymmetric information

Answer 57

> Asymmetric information occurs when one party to a contract has less information than the other party.
For example, borrowers often know better than lenders how likely it is that they’ll be able to repay a loan.
Asymmetric information can lead to adverse selection and moral hazard.

Question 58

Asymmetric information - Adverse selection

Answer 58

> Adverse selection occurs when the most likely buyers of a product are those that the seller would probably prefer not to sell to (and the seller may not be able to tell the difference between a ‘good buyer’ and a ‘bad one’ at the time of the sale.
Adverse selection leads to a firm unknowingly taking greater risks than it intended.
Adverse selection can be a problem in some insurance markets.

Question 59

Why can adverse selection be a problem in some insurance markets?

Answer 59

> For example, suppose a company sells medical insurance. It will calculate the insurance premiums (the cost of buying a policy) based on who it believes is likely to buy it.
However, the premiums might be too high for people to be willing to pay if they’re in good health (these people would be very profitable for the insurance company, as they’ll need less medical treatment).
But it might e good value for those in poor health (who will require more medical treatment and who could therefore cost the company large amounts of money).
This results in the insurance company selling only to the most unprofitable customers - i.e. the company risks making a huge financial loss that could lead to it collapsing.
And if the insurance company increases its premiums to try and solve the problem, the result is that the problem will just get worse (since the only people willing to pay these even higher insurance premiums would be those in the worst health).

Question 60

Asymmetric information - moral hazard

Answer 60

> Moral hazard occurs when someone is more willing to take risks because they know that someone else will have to pay the consequences if anything goes wrong.
For example, a bank might provide risky loans (to chase higher profits) if it knows that it’ll be bailed out by taxpayers if things go wrong.

Question 61

Market rigging

Answer 61

> Market rigging occurs when traders on financial markets, or others working in the financial sector, collude to deliberately manipulate markets and make huge profits for themselves and the firms they work for.
E.g. they may make the demand for securities appear higher than it really is to artificially ‘inflate’ their price. This prevents the market from working as it should.
There are laws and regulations designed to stop market rigging and punish those that engage in it, but if the penalties aren’t tough enough, or the laws aren’t strictly enforces, then they won’t be a deterrent.
In recent years many banks have been fined billions of pounds by regulators for market rigging.
Some of the biggest fines have been as a result of rigging the foreign exchange markets as banks colluded on the buying and selling of currencies.
Illegal and leads to market failure.

Question 62

Central banks - intro

Answer 62

> Central banks play an important role in a country’s economy. Two key roles are to:
1. Act as a banker to the government.
2. Help to support banks by acting as a lender of last resort.
A lender of last resort is crucial for a country’s financial stability.
Central banks can also take action at times of systemic crisis. This more widespread type of emergency intervention happened during the 2008 financial crises - central banks in various countries provided ‘emergency liquidity assistance’ to ensure banking stability.

Question 63

Central bank - lender of last resort

Answer 63

> A lender of last resort is crucial for a country’s financial stability:

• Because banks borrow short-term but lend long-term, they can sometimes face a shortage of liquidity.
• If an individual bank that’s solvent (i.e. it has enough assets to meet all its liabilities) faces a temporary shortage of liquidity, the central bank can ‘provide liquidity’ by lending the bank money.
• The BoE has a number of different schemes to provide liquidity to banks (a predictable and ‘routine’ need for liquidity is dealt with under one scheme, while ‘emergency’ liquidity problems are dealt with under another).
• The central bank charges a higher rate of interest for emergency funds to create an incentive for the bank to behave more carefully in the future.

Question 64

Advantages of central banks acting as a lender of last resort

Answer 64

> It helps to prevent panic and a run on the banks.

>It helps to reduce the impact of financial instability.

Question 65

Disadvantages of central banks acting as a lender of last resort

Answer 65

> It can lead to moral hazard and encourage forms to take excessive risks.
It can lead to banks not holding sufficient liquidity.
It can seem unfair that the central bank will try to save financial institutions, but not non-financial firms.

Question 66

Other functions of the central bank - list

Answer 66

1. They act as ‘banker to the government’.
2. They can help regulate the financial sector.
3. They can implement monetary policy.

Question 67

Other functions of the central bank - ‘banker to the government’

Answer 67

> A central bank can help the government manage its national debt - e.g. by trying to reduce interest paid. This might involve issuing government bonds.
It can also offer advice to the government on economic matters, and help them in their negotiations with other international financial organisations.

Question 68

Other functions of the central bank - regulating the financial sector

Answer 68

> A central bank can impose rules to prevent financial market failure and instability.
Macroeconomic stability in an economy is unlikely without financial stability.

Question 69

Other functions of the central bank - implement monetary policy

Answer 69

> A central bank can manage the money supply by affecting the availability of credit or its cost. This mainly done through controlling interest rates, but it can also be done through other methods, such as QE.
It can also affect the amount loans banks make by setting capital requirements - i.e. the reserves of capital a bank must keep.
It can influence the exchange rate through buying and selling currencies and changing interest rates.
It’s also usually responsible for controlling the issuing of banknotes and ensuring that confidence in the currency is maintained (e.g. by working to prevent the counterfeiting of banknotes).

Question 70

Other functions of the central bank - depend

Answer 70

> What a central bank actually does varies from country to country - some governments will give certain tasks to particular government departments or to other organisations instead.
E.g. in the UK, it’s the Debt Management Office (not the BoE) that issues ‘gilts’ (government bonds).

Question 71

Financial markets and regulation in the past

Answer 71

> From the mid-1980s until the 2008 financial crisis, regulation in many financial markets across the world wasn’t very strict. This was partly due to a process of deregulating financial markets in the 1980s known as the Big Bang.
Less regulation in the financial markets helped them to be more profitable.
But a lack of regulation in the financial sector also led to market failure and other problems which contributed to instability:
-Excessive risk-taking
-Commercial banks acting as investment banks
-fraud and other illegal activity
-the growth of market bubbles.
In the UK, deregulation has been a key factor in helping London to become a major financial centre.

Question 72

Lack of regulation leading to market failure and instability - excessive risk-taking by financial institutions

Answer 72

> E.g. many financial institutions, especially investment banks, made very risky investments in the hope of making large profits.

Question 73

Lack of regulation leading to market failure and instability - commercial banks acting as investment banks

Answer 73

> The deregulation of investment banking in the 1980s led to many commercial banks getting involved in investment banking activities.
When some of those banks made massive losses in their investment banking activities during the 2008 financial crises, it also affected their commercial banking.

Question 74

Lack of regulation leading to market failure and instability - fraud/illegal activities

Answer 74

> E.g. several major banks have been involved in market rigging.

Question 75

Lack of regulation leading to market failure and instability - growth of market bubbles

Answer 75

> Speculative bubbles, e.g. in the housing market, were allowed to develop, and were made worse by the over-provision of credit.

Question 76

Regulation of financial markets

Answer 76

> Since the financial crises, governments have tried to improve the regulation of financial markets.
As well as regulation introduced by individual governments, there have been international agreements to regulate financial markets. E.g. the Basel Committee (a committee of global banking authorities), have made recommendations on minimum liquidity and capital levels for banks. These should help to increase financial stability of banks by making sure they have a buffer in case of a fall in asset values or bank run.
Several countries have brought in (or will soon) a policy of ‘ring fencing’ commercial banking activity. This means keeping the commercial banking side of a bank separate from the investment banking side. From 2019, UK banks with a large commercial side won’t be able to use the deposits of retail customers and small firms for their investment banking activities.

Question 77

What does regulation of the financial sector focus on?

Answer 77

1. Competition - making financial markets competitive to benefit consumers.
2. The structure of firms and risk management - ensuring firms are stable. This might be achieved by requiring banks to meet capital and liquidity ratios, or by preventing them from taking excessive risks (and making senior officials within the bank personally accountable if they do).
3. Strengthening rules and principles that financial institutions must abide by, or face tough punishments if they don’t.
4. Systemic risks - identifying systemic risks in the financial markets and finding ways to manage or remove the. E.g. plans are now made to allow banks to ‘fail safely’ if necessary. The hope is that this will encourage safer banking practices because banks will know they won’t be bailed out.

Question 78

Capital and liquidity ratios

Answer 78

> A capital ratio measures the ratio of a bank’s capital to loans. It gives a measure of the risks associated with the bank’s lending, and of the bank’s stability.
A liquidity ration measures the ratio of highly liquid assets to the expected short-term need for cash. It also gives an idea of the bank’s stability, as well as its ability to meet its short-term liabilities.
Using these two ratios together gives a better understanding of the bank’s overall stability.

Question 79

Bank’s capital - defintion

Answer 79

> A bank’s capital is the funds it holds from profits and issuing shares.

Question 80

Types of financial regulation

Answer 80

1. Microprudential regulation

2. Macroprudential regulation

Question 81

Microprudential regulation

Answer 81

> To ensure that individual firms act fairly towards their customers and don’t tale excessive risks or break the law.

Question 82

Macroprudential regulation

Answer 82

> To tackle systemic risks in financial markets and avoid large-scale financial crises that can hurt a country’s economy.

Question 83

Drawbacks of reguation

Answer 83

> Regulators can be vulnerable to regulatory capture.
If the regulation of the financial markets is too strict it can lead to restrictions on credit which harm economic growth.
It may also lead to the growth of the shadow banking sector, which isn’t regulated.

Question 84

Regulation of financial markets in the UK - intro

Answer 84

> In the UK, the BoE and the Financial Conduct Authority (FCA) are responsible for regulating financial markets.

Question 85

Regulation of financial markets in the UK - bank of england

Answer 85

> The BoE regulates the financial markets through the work of two bodies under its control - the Financial Policy Committee (FPC) and the Prudential Regulation Authority (PRA).
The FPC is a macroprudential regulator and the PRA is a microprudential regulator, but they work together to ensure stability of financial markets.

Question 86

Regulation of financial markets in the UK - FPC

Answer 86

> The work of the Financial Policy Committee involves:

• Identifying, monitoring and protecting against systemic risks in the financial system.
• Issuing instructions to the FCA and PRA to tackle problems that threaten the financial system.
• Advising the government on managing the financial markets.

Question 87

Regulation of financial markets in the UK - PRA

Answer 87

> The work of the Prudential Regulation Authority involves maintaining the stability of banks and promoting effective competition by:

• Supervising firms and financial institutions to ensure that they successfully manage risk.
• Setting industry standards for conduct and management and making sure they’re followed.
• Specifying capital and liquidity ratios for financial institutions.

Question 88

Regulation of financial markets in the UK - FCA

Answer 88

> The Financial Conduct Authority is a microprudential regulator which aims to protect consumers and increase confidence in financial institutions and products. It does this by:

1. Supervising the conduct of firms and markets to ensure that things are done legally and fairly.
2. Promoting competition in financial markets so that better deals are provided for consumers.
3. Banning financial products that don’t benefit consumers.
4. Banning, or forcing firms to change, misleading adverts for financial products and services.