The Financial sector Flashcards
Roles of Financial markets:
-To facilitate saving
-To lend to businesses and individuals
-To facilitate the exchange of goods and services
-To provide forward markets in currencies and commodities
-To provide a market for equities
To facilitate savings:
Financial institutions, such as banks and credit unions, provide a safe and convenient platform for individuals and businesses to save their money.
By pooling the savings of many individuals, financial institutions can allocate these funds to support loans and investments, thereby stimulating economic activity.
To lend to businesses and individuals:
They collect deposits from individuals and then lend this money to businesses and individuals in need of capital.
They lend businesses for enterprise and individuals for consumption.
To Facilitate the Exchange of Goods and Services:
Financial institutions provide a wide range of payment and transaction services that facilitate the exchange of goods and services in the economy.
By providing a secure and efficient means of transferring funds, financial institutions play a vital role in supporting everyday economic transactions.
To Provide Forward Markets in Currencies and Commodities:
Offering forward contracts for currencies and commodities. These contracts allow businesses and investors to hedge against currency exchange rate fluctuations and commodity price volatility.
Forward markets provide a mechanism for parties to lock in future prices, reducing uncertainty and risks associated with international trade and commodity markets.
To Provide a Market for Equities:
Financial institutions often serve as intermediaries in the equity market, allowing individuals and institutions to buy and sell shares of publicly traded companies. Stock exchanges and brokerage firms facilitate these transactions, enabling investors to participate in the ownership of corporations and potentially benefit from capital gains and dividends. This function supports capital formation and efficient allocation of resources.
Examples of market failure in the financial markets:
-asymmetric information
-externalities
-moral hazard
-speculation and market bubbles
-market rigging
Asymmetric information:
Asymmetric information occurs when one party in a transaction has more information than the other. In the financial sector, this can lead to adverse selection and moral hazard problems.
-Adverse selection: Occurs when individuals with hidden information about their riskiness (e.g., borrowers with poor credit history) are more likely to seek financial products (e.g., loans).
-Moral hazard: Arises when one party, typically after a transaction, has an incentive to behave differently because of incomplete information. e.g. borrowers may take on excessive risks if they believe they won’t bear the full consequences of their actions.
Externalities:
Externalities are spill over effects that affect parties not directly involved in a transaction. In finance, externalities can result from risky behaviours of financial institutions.
Financial institutions may engage in risky practices (e.g., excessive lending) that can lead to systemic risks affecting the entire economy. e.g. 2008 financial crisis.
Moral Hazards:
Moral hazard refers to the risk that one party may take on excessive risks because they believe they are protected from the full consequences of their actions.
In the financial sector, moral hazard can arise when banks and financial institutions believe they will be bailed out by the government in the event of a financial crisis.
Speculation and Market Bubbles:
Speculation involves buying assets (e.g., stocks or real estate) with the expectation of profiting from price increases, rather than from the asset’s intrinsic value.
Market bubbles occur when asset prices rise significantly above their fundamental values due to speculation and irrational exuberance. Bubbles often burst, leading to market crashes and financial instability.
Market Rigging:
Market rigging refers to the manipulation of financial markets to gain unfair advantages.
Examples include insider trading (trading based on non-public, material information), market manipulation (e.g., pump-and-dump schemes), and collusion among market participants to distort prices.
What are the key functions of central banks:
-implementation of monetary policy
-banker to the government
-banker to the banks – lender of last resort
-role in regulation of the banking industry
Implementation of Monetary Policy:
-Involves managing the money supply and interest rates to achieve specific economic objectives, such as price stability and economic growth.
-Central banks adjust these tools to influence borrowing costs, inflation rates, and overall economic activity.
Banker to the government:
Central banks act as the government’s banker by managing the government’s bank accounts, facilitating payments, and helping with debt issuance and management.
-They often oversee the issuance and redemption of government bonds and treasury bills, helping the government fund its operations and manage its debt.
Banker to the Banks – Lender of Last Resort:
Central banks serve as a lender of last resort to financial institutions, especially during times of financial crises or bank runs.
-In this role, central banks provide emergency funding to banks facing liquidity problems to prevent systemic financial instability.
-By offering short-term loans (often referred to as the discount window), central banks help maintain confidence in the banking system.
Role in Regulation of the Banking Industry:
Central banks often play a critical role in supervising and regulating the banking sector to ensure its stability and soundness.
-They set and enforce prudential regulations, including capital adequacy requirements and risk management standards, to prevent excessive risk-taking by banks.
