Theme 4.4 Flashcards
What are financial markets?
Financial markets are where buyers and sellers can buy and trade a range of services or assets that are fundamentally monetary in nature.
They act as an allocation mechanism, channelling money from those with excess and savings, to those with too little who need to borrow.
They also perform a maturity transaction, where short-term savings are allowed to be used for much longer maturity loans.
What are the two reasons financial markets are needed?
-To meet the demand for services, such as saving and borrowing from individuals, businesses and governments (e.g households spending using credit cards, or govs borrowing money)
-To allow speculation and financial gains (e.g foreign exchange traders betting on which way a currency may move in hope of making a profit.
What are the different types of financial institutions?
-Retail banks: Provide services to households, such as the payment of direct debits, savings accounts, loans and mortgages.
-Investment banks: Trade in foreign exchange, commodities, bonds, shares, as well as derivatives for speculation as well as advising firms on raising finance and mergers.
-Universal banks: Due to financial deregulation, many banks now operate as both investment and retail banks, which increases risk for the economy.
-Pension schemes, trusts and hedge firms help people save long term.
-Insurance companies insure against a range of risks.
-Central bank is a financial institution that has direct responsibility to control the money supply and monetary policy, as well as to manage the country’s gold and foreign reserves, as well as issuing gov debt.
What are the roles of the financial market?
-Facilitate savings
-Lend to businesses and individuals
-Facilitate exchange of goods and services
-Provide forward markets
-Provide a market for equities
How do financial markets facilitate savings?
One role of the financial market is to facilitate savings, which allows people to transfer their spending power from the present to the future. It can be done through a range of assets, such as storing money in savings account and holding stocks and shares.
-Savings may be short term (e.g in banks), or long term (e.g in pension schemes).
How do financial markets allow for lending to businesses and individuals?
Lending to businesses and individuals allows consumption and investment. They are sometimes referred to as a financial intermediary, the step between taking money from one person to give to another since money from savings is used for investment.
How do financial markets facilitate the exchange of goods and services?
They facilitate the exchange of goods and services by creating a payment system. Central banks print paper money, institutions process cheque transactions, companies offer credit card services and banks and bureau de changes buy and sell foreign currencies.
How do financial markets provide forward markets?
This is where firms are able to buy and sell in the future at a set price, for example if a farmer wants to sell the crop they are growing at a guaranteed price in a month’s time. The forward market exists for commodities and in foreign exchange and helps to provide stability.
How do financial markets provide a market for equities?
They provide a market for equities, company’s shares. Issuing shares is an important way for companies to finance expansion but people would be unlikely to buy shares if they were unable to sell them on in the future. Financial markets provide the ability for shares to be sold on in the future, making the asset more appealing.
How do banks operate?
-They take deposits and make loans, then making profits from interest on loans they make.
-However banks must also have enough liquid assets to meet the withdrawals demanded from those with deposits.
-Interbank lending occurs so that banks loan to other banks so that their liquidity ratio for short term funds can be maintained.
-Banks can also sell assets to the central bank or other banks, with agreements to buy back at a later date, these are known as repos.
How do firms and governments borrow?
-Firms will generate finance by selling shares in their company, of which shareholders may receive profits of the firm’s revenue. Large shareholders may gain from having a say in the firm’s operation.
-When the gov needs to borrow, it can do so through issuing bonds. This is a financial asset which pays a fixed amount each year, and then can be payable at a fixed value in the future when the bond matures. The price of the bond with vary with market valuation, as well as interest rates.
What were the causes of the 2008 financial crisis?
-Due to the lending of ‘sub-prime’ mortgages which weren’t paid back, many banks held lower liquidity ratios, causing the interbank lending system to come under pressure. The gov had to bail out banks such as the Bank of Scotland.
-This caused the gov to have to cut back public spending, at the same time banks were lending less, leading to a recession.
-Speculation also caused stock prices to fall, which put pressure on investment and pension funds. As loans were not paid back, banks couldn’t afford to pay depositors who wanted to withdraw (e.g at Northern Rock), causing the crisis.
What are the market failures in the financial sector we need to know?
-Asymmetric information
-Externalities
-Moral hazard
-Speculation and market bubbles
-Market rigging
How does asymmetric information cause market failure in the financial market?
-When banks make a loan, they will often have less information about the assets they are acquiring than the original lender. (E.g they were unaware subprime mortgages were being grouped with prime mortgages).
-This meant that they were unable to accurately estimate the risk they were exposed to.
-This can also occur when regulators have insufficient knowledge of how banks behave, and cannot effectively regulate the market.
How do moral hazards occur in the financial market?
-Due to the securitisation banks felt they had, they would often want to expand by lending out more than was reasonable. The Global Financial Crisis was caused by moral hazard, when employees sold mortgages to those who would not be unable to pay them back. By selling more mortgages, they would see higher salaries and bonuses but would not see the negative effects if the loan was not repaid.
-Banks also took this moral hazard at the knowledge if they were to lose out due to sub-prime mortgages not being repaid, they would be bailed out by the government as the banks were ‘too big to fail’ due to the effect their collapse would have on the economy.
How can externalities occur in the financial market?
-The externalities are felt not only instantly by third parties, but also into the future.
-Taxes were increased and gov spending on welfare was reduced in the financial crisis to fund the bailing out of banks.
-Unemployment increased, and GDP growth fell
-Still today, individuals and small firms especially face much higher interest rates on loans due to the fear the loan will not be repaid.
-Those who purchased insufficient insurance on their pensions before the crisis may have lost savings, and will suffer the consequences in retirement.
