The Financial Sector

Question 1

List to me the roles of financial markets

Answer 1

To facilitate saving

To lend to businesses and individuals

To facilitate exchange

To provide forward markets in currencies and commodities

To provide a market for equities

Question 2

How do the financial markets facilitate saving

Answer 2

A traditional role of the banks and other financial institutions, eg insurance companies and pension funds, is to provide facilities for individuals and firms to save, so enabling them to purchase goods at a later date.

Question 3

How do the financial markets lend to businesses and individuals

Answer 3

A function of banks and other financial institutions is to provide credit. Without this facility, individuals and businesses may have cash flow problems.

Question 4

How do the financial markets facilitates exchange

Answer 4

Transfers of money can be arranged easily when there is a fully developed banking and financial system. With the growth of online banking and smart debit cards, most such transfers now occur electronically.

Question 5

How do the financial markets provide forward markets in currencies and commodities

Answer 5

The foreign currency and commodity markets provide forward markets for currencies and commodities so that traders can buy in advance, thereby reducing risks associated with the price volatility that often characterises such markets.

Question 6

How do the financial markets provide a market for equities

Answer 6

Stock exchange enable stocks and shares to be traded. This enables companies to raise money and provides an opportunity for investors to purchase shares.

Question 7

List to me the market failures in the financial sector

Answer 7

Asymmetric information

Externalities

Moral hazard

Speculation and market bubbles

Market rigging

Question 8

How is asymmetric information a form of market failure in the financial sector

Answer 8

Financial markets and the products they deal with have become increasingly complex over recent years.

Question 9

How is externalities a form of market failure in the financial sector

Answer 9

Failure of financial institutions may have undesirable spillover effects (external costs) on third parties who are not directly involved in the financial sector. For example, the failure of a bank might result in bankruptcies for other businesses if the bank customers lose their deposits and can no longer pay bills to other businesses or of the bank failure results in a fall in sales of other businesses.

Question 10

Define externalities

Answer 10

Costs or benefits to third parties not part of the transaction. If externalities exist, there would be a divergence between social costs/benefits and private costs/benefits

Question 11

Tell me how moral hazard is a form of market failure in the financial sector

Answer 11

Before the financial crisis some bankers engaged in trading highly risk securities to enhance their bonuses, thinking that any risk would be borne to shareholders. In the event, the losses made were so great that some banks, such as RBS, had to be rescued by the uk government. This could create a further moral hazard (and government failure) because banks might continue to engage in risky behaviour, knowing that they would be bailed out by the government if they were in danger of going bankrupt.

Question 12

How is speculation and market bubbles a form of market failure in the financial sector

Answer 12

Between 2000 and 2007, UK banks created £1 trillion, doubling the amount of money and debt in the economy, but only 8% of this went to business. Over half went to residential and commercial property and 32% to the financial sector. This extra money in the economy helped to fuel bubbles in the property markets and eventually debts related to those bubbles became unplayable.

Question 13

How is market rigging a form of market failure in the financial sector

Answer 13

In 2015, several major banks around the world were fined for manipulation of Libor, the global benchmark interest rate. For example, Deutsche bank, Germany’s largest bank, was fined a record $2.5 billion for rigging Libor and was ordered to sack 7 employees.

Also, Barclays were fined £1.5 billion after rogue traders were caught manipulating foreign currency rates.

Question 14

List the roles of central banks

Answer 14

Implementation of monetary policy

Banker to the government

Banks go the banks

Role of regulation in the banking industry

Question 15

Tell me about the implementation of monetary policy as a role of central banks

Answer 15

Central banks are usually responsible for controlling the cost and supply of money. In this role they set interest rates, and are responsible for asset purchases (quantitative easing) and sales.

Many central banks are now independent of their governments but may be required to make such decisions in relation to an inflation target.

Question 16

Tell me about being a banker to the government as a role of central banks

Answer 16

Most governments keep their accounts with the central bank of the country.

Question 17

Tell me about being a banker to the banks as a role of central banks

Answer 17

Central banks also provide banking facilities to the high street banks. In the uk all banks must keep an account with the Bank of England.

Question 18

Tell me about the role of regulation In the banking industry as a role of central banks

Answer 18

Following the financial crisis, many central banks are responsible for enforcing new regulations designed to prevent the risk of banks requiring a bailout from their government. These regulations are incredibly complex. For example, the Basel III regulations are over 200 pages long.

Question 19

What are some key regulations in the EU

Answer 19

The requirement for banks to split their retail banking businesses from their investment banking activities

An increase in the amount of capital

Question 20

What role does the financial sector play in the economy

Answer 20

It plays a crucial role in any economy, not least in facilitating savings and making credit available.

Question 21

Market failures may be associated with…

Answer 21

The financial sector.

The financial crisis illustrated that market failures may be associated with the financial sector.

Question 22

What role does a central bank play

Answer 22

A central bank plays a pivotal role in implementing monetary policy and overseeing the whole financial sector.

Question 23

Outline the external costs which could result from the failure of a bank

Answer 23

A bank failure could cause problems for consumers and businesses that are not customers of the bank. For example, firms (which do not have accounts at the bank) may face a loss of trade because customers of the bank may have lost all their deposits.