The Financial Sector

Question 1

What are the 5 main functions of a financial market?

Answer 1

1. Facilitate savings – People invest in stocks, bonds, and pensions.
2. Lend to businesses and individuals – Loans for capital investment and mortgages.
3. Exchange goods and services – Enables transactions through financial systems.
4. Provide forward markets – Hedging against future price changes (e.g. commodities, currencies).
5. Provide a market for equities – Allows firms to raise capital through shares.

Question 2

What are the 3 different types of financial markets?

Answer 2

1. Money markets – Short-term borrowing/lending (less than 12 months).
2. Capital markets – Long-term borrowing/lending (over 12 months, e.g. bonds).
3. Currency markets – Foreign exchange trading, highly volatile.

Question 3

What are the 4 roles of a central bank?

Answer 3

1. Monetary policy – Controls inflation and interest rates.
2. Regulation – Supervises banks to prevent crises.
3. Lender of last resort – Provides emergency funding to banks in crises.
4. Acts as banker to the government – Manages national debt and currency reserves.

Question 4

What is the Monetary Policy Committee (MPC)? (Give 3 facts and then 4 factors)

Answer 4

• The MPC is part of the Bank of England, responsible for achieving price stability.
• It meets every six weeks to decide on interest rates.
• Inflation target: 2% (±1%).

Factors influencing decisions:
✅ Inflation expectations
✅ Consumer spending & confidence
✅ GDP growth rate
✅ Exchange rate & trade balance

Question 5

How did market failure contribute to the 2007-08 financial crisis? (Give 4 ways)

Answer 5

1. Moral hazard – Banks took excessive risks, knowing they’d be bailed out.
2. Asymmetric information – Banks issued risky mortgages without full knowledge.
3. Speculation – Housing and asset bubbles were driven by speculative investments.
4. Market rigging – LIBOR scandal involved banks manipulating interest rates.

Question 6

What is moral hazard in the financial sector? (Give 3 points)

Answer 6

• Moral hazard occurs when people take higher risks because they are protected from consequences.
• In finance, banks expect government bailouts (e.g. “Too big to fail”).
• Insurance also creates moral hazard – people drive riskier knowing they’re covered.

Question 7

What is asymmetric information in financial markets? (Give 3 points)

Answer 7

• Occurs when one party has more information than another in a transaction.
• Banks knew mortgages were risky but sold them as safe investments.
• Insider trading is another example – traders use non-public information for profit.

Question 8

What is market rigging? (Give 2 example too)

Answer 8

• Market rigging happens when firms or individuals manipulate markets to gain unfair advantage.
• Example: LIBOR scandal – Banks manipulated interest rates, affecting global lending rates.
• Tom Hayes (UBS) was jailed for 14 years for LIBOR rigging.

Question 9

What are the 3 roles of stock markets in an economy?

Answer 9

✅ Provides businesses with capital – Companies issue shares for investment.
✅ Encourages investment and savings – Investors earn returns on assets.
✅ Facilitates economic growth – Efficient capital allocation boosts productivity.

Question 10

How can central banks prevent financial crises? (Give 4 ways)

Answer 10

1. Stress testing banks – Ensuring they have enough liquidity for economic shocks.
2. Regulation – Limiting risky lending practices.
3. Setting capital requirements – Banks must hold sufficient reserves.
4. Acting as lender of last resort – Providing emergency liquidity in crises.