theme 4- 4.4 the financial sector

Question 1

financial market definition

Answer 1

any marketplace where buyers and sellers participate in the trade of assets such as:
- equities
- bonds
- currencies
- derivatives
provides means of channelling funds to households, firms and govts

Question 2

key financial markets

Answer 2

1. capital markets- enable individuals and orgs in both the private and public sectors to trade financial securities to gain long term finance e.g. stock markets
2. money markets- for short-term loans e.g. treasury bills
3. derivatives markets- = financial instruments e.g. futures contracts
4. foreign exchange (FOREX) markets- trade currencies

Question 3

role of financial markets- to facilitate saving

Answer 3

provide a range of accounts with varying degrees of risk and interest to enable households and businesses to save money

Question 4

role of financial markets- to lend to businesses and individuals

Answer 4

enable the connection between households and businesses which have the savings with those that need to borrow

Question 5

role of financial markets- to facilitate the exchange of goods and services

Answer 5

the financial system handles millions of transactions everyday that allow people to:
- make payments in shops and online
- receive wages, welfare payments from the govt and other incomes
- settle debts

Question 6

role of financial markets- to provide forward markets in commodities and contracts

Answer 6

forward markets set the price of an asset e.g. a commodity such as wheat, or a financial instrument e.g. a foreign currency for future delivery
may be used for both hedging and speculation
hedge = an investment to reduce the risk of adverse price movements in an asset

Question 7

role of financial markets- to provide a market for equities

Answer 7

equities/stock market= where stocks and shares are issued and traded
-> gives companies access to capital and investors a share of ownership in a company

Question 8

market failure in the financial sector- asymmetric information example

Answer 8

financial market for health insurance relies heavily on accurate info, but those seeking insurance generally have better info about their own health than the health insurance provides

Question 9

market failure in the financial sector- moral hazard examples

Answer 9

before the 2008 GFC some bankers engaged in trading highly risky securities to enhance their bonuses
in the even, these resulted in huge losses, so great the govt had to bail some banks out e.g. RBS
could create a further moral hazard as banks may continue risky behaviour with the knowledge govt will bail them out

Question 10

market failure in the financial sector- speculation and market bubbles example

Answer 10

between 2000 and 2007 interest rates were low, credit was easy to obtain and asset prices = increasing
also saw banks create £1 trillion of new money, accompanied with a doubling of debt
was a ‘herd effect’ which resulted in people buying assets in the hope of future capital gains, even though these were unjustified in terms of their real worth

Question 11

market bubbles definition

Answer 11

market bubbles occur when an asset e.g. shares or houses are traded at prices considerably higher than their intrinsic value, usually followed by a crash when prices fall

Question 12

market failure in the financial sector- externalities

Answer 12

activities of agents in the financial market could cause asset bubbles e.g. in the housing market
could be an external benefit to people who own houses but would be an external cost to those wishing to get onto the property ladder

Question 13

market failure in the financial sector- market rigging example

Answer 13

the Libor rate- benchmark interest rate based on the rates at which banks lend unsecured funds to each other in the London interbank market

Question 14

the role of central banks- implementation of monetary policy

Answer 14

are responsible for implementing governmental monetary policy, which may involve inflation targeting with the use of interest rate policy and quantitative easing

Question 15

the role of central banks- lender of last resort (banker to the banks)

Answer 15

usually willing to offer loans to financial institutions that are experiencing financial difficulties and are unable to obtain the necessary funds elsewhere, helping to maintain the stability of the banking and financial system e.g. 2008 GFC

Question 16

the role of the central banks- banker to the government

Answer 16

from its founding, the Bank of England was the government’s banker- manages the govt’s accounts and arranges loans to the government
however, with the decision to grant the bank operational independence in 1997, responsibility for govt debt management -> UK debt management office

Question 17

financial regulators

Answer 17

from 2013- 2 financial regulators in the UK
1. Prudential Regulation Authority (PRA) to ensure stability of firms involved in financial services
2. Financial Conduct Authority (FCA)- behavioural watchdog to protect consumers and promote competition

Question 18

the role of the central banks- role of regulation in the banking industry

Answer 18

BoE gained direct supervision of the whole of the banking system through the Financial Policy Committee (FPC)
main objective = identify risks and weaknesses across the financial system
if risks = increasing, may ask banks to raise more money from shareholders as a buffer in case of a liquidity problem