The financial sector

Question 1

What are the 5 key roles of the financial sector?

Answer 1

• facilitating saving
• facilitating borrowing
• facilitating exchange of goods and services
• forward markets
• equity market

Question 2

What are financial intermediaries?

Answer 2

institutions such as banks and building societies that channel funds from lenders to borrowers

Question 3

What’s the difference between retail banks and wholesale banks?

Answer 3

Retail banks provide high-street (and online) services to depositors.
Wholesale banks deal with companies and other banks on a large scale.

Question 4

What is a universal bank?

Answer 4

a bank that operates in both retail and wholesale markets

Question 5

define the liquidity ratio

Answer 5

ratio of liquid assets to total assets

Question 6

What is LIBOR?

Answer 6

average rate of interest on interbank lending in London interbank market

Question 7

What is a repo?

Answer 7

sale and repurchase agreement where one financial institution sells financial asset to anotherh with agreement to buy it back at a future date

Question 8

Why might a bank take part in a repo?

Answer 8

to make money (if buying) or to help with short-term liquidity problem if selling

Question 9

Why do mortgages have lower interest rates than just a loan of same amount?

Answer 9

Loan secured against house, so if borrower defaults the lender owns the house.

Question 10

Why do interest rates vary?

Answer 10

depends on risk, which will depend on eg if secured against collateral (eg house, car), duration of loan, income/expenses of borrower

Question 11

What is a bond?

Answer 11

financial asset that pays fixed amount each year and fixed amount at fixed date in future when it matures

Question 12

What is a certificate of deposit (CD)?

Answer 12

certificate issued by bank in return for deposit for fixed term, and CDs can be bought and sold

Question 13

What is securitisation?

Answer 13

process where cash flows are converted to marketable securities

Question 14

What were some key reasons for the financial crisis of late 2000s?

Answer 14

• more securitisation meant banks held more in bonds and less in equities, and bond interest has to be paid, unlike dividends on equities
• securitisation of less secure / more risky assets eg sub-prime mortgages
• reduced liquidity ratios
• government debt rose to government reduced spending

Question 15

What is the capital adequacy ratio?

Answer 15

ratio of bank’s capital to its current liabilities and risk-weighted assets

Question 16

What is asymmetric information?

Answer 16

when some market participants have better information about market conditions than others

Question 17

How did asymmetric information contribute to the financial crisis in late 2000s?

Answer 17

banks accumulated assets about which they had incomplete knowledge, particularly sub-prime mortgages that they securitised

Question 18

How did moral hazard contribute to the financial crisis in late 2000s?

Answer 18

banks knew that if they failed, government would be likely to bail them out as they were “too big to fail”

Question 19

How did externalities contribute to the financial crisis in late 2000s?

Answer 19

Once one bank seen to be failing, reputation of all banks questioned and people started withdrawing their money.

Question 20

How did market rigging contribute to the financial crisis in late 2000s?

Answer 20

Some bankers operated to distort interest or exchange rates to make illegal profits, eg rigging of LIBOR.