The Financial Sector

Question 1

Define financial markets

Answer 1

Where buyers and sellers can buy and trade a range of services or assets which are fundamentally monetary in nature

Question 2

Give the two main reasons as to why financial markets exist

Answer 2

1. To meet the demand for services, such as saving and borrowing, from individuals, businesses and the government
2. To allow for speculation and financial gains

Question 3

Name the types of financial markets

Answer 3

• The money market - provides short-term saving and lending
• The capital market which provides longer-term financing including; foreign exchange markets, commodity markets, derivative markets, and insurance markets

Question 4

Define derivative markets

Answer 4

Trading financial instruments based on the values of other financial instruments

Question 5

Name the 6 types of financial institutions

Answer 5

1. Retail banks
2. Commercial banks
3. Investment banks
4. Central bank
5. Saving vehicles
6. Insurance companies

Question 6

Role of Retail banks

Answer 6

Provide services to households including direct debit payments, saving accounts, loans, and mortgages

Question 7

Role of Commercial banks

Answer 7

Provide services to corporate and individual customers

Question 8

Role of Investment banks

Answer 8

• To trade in currencies, commodities, bonds, shares and derivatives for speculation purposes
• To offer advice on finances and mergers

Question 9

Role of the Central bank

Answer 9

• To control the money supply and monetary policy
• To manage gold, foreign currency reserves, and issuing government debt

Question 10

Role of saving vehicles and the types of them saving vehicles

Answer 10

Role: To help individuals save money

Saving vehicles include: pension schemes, trusts, hedge funds and assurance companies

Question 11

Role of insurance companies

Answer 11

To provide insurance against a range of risks

Question 12

1st role of financial markets

Answer 12

To facilitate saving

• allowing people to transfer their spending power from the present to the future.
• Savings can be done through a range of assets, such as storing money in savings accounts and holding stocks and shares.

Question 13

2nd role of financial mrkets

Answer 13

To facilitate lending to businesses and individuals.

• allowing consumption and investment, acting as a financial intermediary to transfer money from savers to investors.

Question 14

3rd role of financial marktes

Answer 14

To facilitate the exchange of goods and services.

• by providing payment systems such as paper money, cheque transactions, credit card services, and foreign currency exchange.

Question 15

4th role of financial markets

Answer 15

To provide forward markets

• For commodities and foreign exchange, allowing firms to buy and sell in the future at a set price, providing stability.

Question 16

5th role of finaniclal marktes

Answer 16

Provide a market for equities (company shares)

• making them more appealing as they can be sold in the future and facilitating companies to finance expansion through issuing shares

Question 17

Define market failure in the financial sector

Answer 17

The combination of speculation and provision of genuine services means that financial markets are prone to regular crises that cause significant damage to the real economy

Question 18

Name the 5 types of market failure in financial markets

Answer 18

1. Asymmetric information
2. Externalities
3. Moral hazard
4. Speculation and market bubbles
5. Market rigging

Question 19

Outline asymmetric information in financial markets

Answer 19

• When Financial institutions may have more knowledge compared to their customers, may also exist between financial institutions and regulators
• As a result, customers may buy products that they don’t need or are riskier than they thought
• Exam Application : The Global Financial Crisis (2007-8) was partially caused by banks selling packages of prime and subprime mortgages which were all advertised as prime mortgages. Buyers suffered from asymmetric information

Question 20

Outline externalities in financial markets

Answer 20

• Costs placed on individuals, firms and the government that the financial market does not pay
• Taxpayers were forced to pay for the bailout of banks in the 2007-8 financial crisis
• The crisis had long-term costs to the economy, harming demand and growth

Question 21

Outline moral hazards in financial markets

Answer 21

• When individuals make decisions in their own best interest knowing there are potential risks it may implicate on others

Two main ways in which it can occur:

1. Individual workers take adverse risk in order to increase their salary . Any
   problems they cause will be the problem of the company and not the problem of the
   individual, the worst that can happen is to lose their job whilst the company may lose millions of pounds. (The Global Financial Crisis was caused by moral hazard when employees sold
   mortgages to those who would not be able to pay them back. By selling more mortgages, they would see higher salaries and bonuses and wouldn’t have to see the negative effects if the
   loan was not repaid.
2. Financial institutions may take excessive risk because they know the central bank is the lender of last resort and so will not allow them to fail
   because of the impact it would have on the economy.

Question 22

Outline speculation and market bubbles in financial markets

Answer 22

• Speculation and herding behaviour lead to market bubbles
• Market bubbles cause prices to become excessively high and eventually crash
• Financial markets lending too much in mortgages causes housing market bubbles
• Global financial crisis (2007-8) was partially caused by this as the housing bubble market burst due to a rise in real interest rates which caused a fall in demand for houses, leading to negative wealth effects, a fall in Ad and leaving banks with loans that would not be repaid in full

Question 23

Outline market rigging in financial markets

Answer 23

• This is where a group of individuals or institutions collude to fix prices or exchange information that will lead to gains for themselves at the expense of other participants in
  the market.

Two examples of where market rigging occurs:

• Insider trading, where an individual or institution has
  knowledge about something that will happen in the future that others do not know and so can buy or sell shares to make a profit.
• Individuals or institutions affect the price of a commodity, currency or asset to benefit themselves, for
  example large trades in a currency will shift its value and this will make a difference to
  individuals selling or buying assets with that currency.

Question 24

Outline the role of the central bank (

Answer 24

• The central bank controls monetary policy through interest rates and money supply to keep inflation low and stable.
• Issue government debt E.g. Bank of England was responsible for managing the national debt before it was transferred to the Debt Management Office in 1998.
• They act as a bank to other banks and offer a lender of last resort facility. During the financial crisis of 2007-08, central banks across the world played an essential role in restoring financial stability by providing liquidity.
• Central banks in some countries also regulate the financial system to prevent risky activities that could harm consumers and lead to collapse. For instance, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 in the US aimed to prevent another financial crisis by increasing transparency and accountability in the financial system.

Financial Regulation

• Regulation can include banning market rigging, preventing the sale of unsuitable products, setting maximum interest rates, deposit insurance, and liquidity ratios.
• According to a report by the Bank of International Settlements, 60% of central banks worldwide have integrated financial stability into their regular operations.
• The Financial Stability Board was established in 2009 to coordinate the work of different regulatory bodies across the world to promote global financial stability.
• Some major historical events that led to increased financial regulation include the Great Depression of the 1930s, the global financial crisis in 2007-08, and the European debt crisis in 2009-12.
• In the US, the Securities and Exchange Commission and the Federal Reserve are among the regulatory bodies responsible for financial oversight.

Question 25

Define finnancial regulation and the 3 bodies for finanical regulation

Answer 25

Financial regulation:
● Regulation that can include: banning market rigging; preventing the sale of unsuitable
products; maximum interest rates to prevent consumer exploitation and prevent excessively risky lending; deposit insurance to protect consumer deposits and
increase stability; and liquidity ratios, when banks are forced to hold a certain percentage of liquid assets.

● There are three key bodies for financial regulation:

o The FPC identifies and reduces system risk and supports government
economic policy (macroprudential)

o The PRA ensures competition, ensures consumers have access to services, minimises risk should a bank fail and ensures banks take responsible action.
(microprudential)

o The FCA protects consumers, promotes competition and enhances the
integrity of the system by preventing market rigging.