Topic 3 Flashcards
The most commonly accepted definition of sustainability is that offered by the Brundtland Commission of the United Nations in 1987:
Sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs.
In 2005, the United Nations General assembly committed, in its World Summit Outcome, to promoting:
…the integration of the three components of sustainable development - economic development, social development and environmental protection - as interdependent and mutually reinforcing pillars
Sustainability is seen to comprise three main elements (or ‘pillars’)
Environmental sustainability
Social sustainability
Economic sustainability
What is environmental sustainability
Environmental sustainability is about reducing the negative human impact on the earth’s ecosystems through good environmental management and demand management.
What are the two main ways to achieve environmental sustainability?
A:
1. Good environmental management – addressing issues like atmospheric pollution, water management, and land use.
2. Good demand management – effectively managing human consumption of resources by limiting consumption and increasing the use of renewable resources
What is good environmental management?
A: It involves taking steps to reduce harm to the environment in key areas such as air pollution, water conservation, and land use planning.
What is good demand management in environmental sustainability?
A: It refers to managing human consumption of resources by both reducing overall consumption and promoting the use of renewable resources
How is environmental sustainability linked to economic sustainability?
A: By ensuring that resources are used efficiently and responsibly, environmental sustainability supports long-term economic stability
How can food production be made environmentally sustainable?
A: Farming can be sustainable if well-managed, and consumers can reduce environmental impact by purchasing locally produced food instead of food that requires long-distance transportation
Why is buying locally produced food more sustainable?
A: It reduces the environmental impact caused by transportation, which consumes significant resources
How can financial services providers contribute to environmental sustainability?
A: They can invest in environmentally friendly companies and manage their own resource consumption, such as reducing paper use
What is economic sustainability?
A: Economic sustainability is about reducing the negative consequences of economic activity by maintaining production and consumption on a sustainable scale rather than aiming for maximum growth
How is economic performance commonly measured, and why is it problematic?
A: Economic performance is measured using Gross Domestic Product (GDP), which reflects the level of goods and services produced. However, production requires scarce resources, which can lead to environmental degradation if not managed sustainably
How can governments promote economic sustainability?
A: Governments can regulate markets to account for environmental and social effects of demand and supply, such as imposing ‘green taxes’ to limit energy consumption
What role do banks play in economic sustainability?
A: Banks contribute by lending responsibly, ensuring that people do not borrow money for products they cannot afford, thus preventing financial instability
What is social sustainability?
A: Social sustainability focuses on building communities that promote well-being, peace, security, and justice while ensuring fair resource distribution
Why is good resource management important for social sustainability?
A: Proper management of scarce resources (such as water) helps prevent conflicts and supports world peace by ensuring equitable distribution
How does financial services contribute to social sustainability?
A: Financial firms can support social sustainability by implementing corporate social responsibility (CSR) policies, such as engaging in community projects or fair trade practices
What is a sustainable financial system?
A: A sustainable financial system ensures the continued provision of essential financial services, such as bank payments, savings, and lending, without risk of collapse
Why is financial system sustainability important?
A: A failing financial system can cause widespread economic instability, as seen in the 2007-08 financial crisis and the 2009 euro sovereign debt crisis
What lessons were learned from past financial crises?
A: The near-collapse of financial systems in the past shows that sustainability cannot be taken for granted, and continuous efforts are needed to maintain stability.
What is the ‘financial services system’?
A: It is the system that emerges when individual financial institutions connect within financial markets, creating networks that ensure survival, stability, and sustainability
Why is the sustainability of financial networks important?
A: If financial systems crash, it can have severe consequences for individuals and society, such as unemployment, business failures, and economic instability
What was a key historical example of a financial crisis before 2007?
A: The Wall Street Crash of 1929 and the subsequent Great Depression
What caused the Wall Street Crash of 1929?
A:
• Excessive stock and share purchases led to an unsustainable rise in prices (a ‘bubble’).
• When the bubble burst, prices collapsed, causing bankruptcies and business failures.
• The Great Depression followed, leading to high unemployment and widespread social distress.
What was the impact of the Great Depression?
A:
• Unemployment reached unprecedented levels.
• Many businesses collapsed.
• Significant social distress and poverty spread worldwide
What was the global financial crisis of 2007-08?
A: A financial crisis caused by unsustainable levels of debt, which severely impacted global financial systems
What was a key event during the 2007-08 financial crisis?
A: The collapse of the US investment bank Lehman Brothers in 2008, which triggered a chain reaction of failures across businesses and banks
Why were some banks considered ‘too big to fail’?
A:
• These banks had large debts and owed money to many businesses.
• Their collapse could have had catastrophic effects on the economy.
• Governments intervened by injecting large sums of money into banks in exchange for shareholdings to prevent collapse
Why is financial system stability vital for a country’s economy?
A: If financial institutions fail:
• People may struggle to receive payments, borrow, or save money.
• Businesses may be unable to function properly.
• The economy could face severe disruptions
How do financial services support the modern economy?
A: They provide essential functions like:
• Enabling payments.
• Offering savings and loans.
• Providing insurance for financial risks
What is the first knock-on effect of a major bank failure?
A: The failure of a big bank can trigger the collapse of other banks due to loss of confidence in the financial system
How would customers be immediately impacted by a bank failure?
A:
• They would be unable to make payments using their current accounts.
• Debit card and cheque transactions would not be honored.
• Individuals would not receive their income or benefits, affecting their ability to purchase goods and services
How would businesses be affected by a banking system failure?
A:
• Businesses would struggle to pay employee salaries and purchase raw materials.
• A lack of banking services would disrupt their financial operations.
• Revenue losses could force many businesses into liquidation
What would be the impact on government finances?
A:
• The government would stop receiving tax revenues.
• Departments might be unable to pay for essential services such as hospitals, schools, and public sector wages
What happens to savings accounts in a failed bank?
A:
• Customers with savings in a failed bank could lose their money.
• Some may lose small amounts, while others may lose their entire life savings.
• Severe social distress would follow as people lose financial security
How does a bank failure impact borrowers?
A:
• Borrowers may experience uncertainty and anxiety if a new company takes over the failed bank.
• They may face new debt repayment terms, which could be unaffordable.
• This uncertainty could lead to increased financial stress.
How does a banking crisis affect financial markets?
A:
• Banks struggle to raise funds as investors and savers lose confidence.
• Investment firms hesitate to lend money, leading to fewer loans and stricter lending criteria.
• This tightening of credit is known as a credit crunch
What is a ‘credit crunch’ and how does it impact individuals and businesses?
A:
• A credit crunch occurs when banks become extremely cautious about lending due to past financial shocks.
• Individuals may struggle to access loans, limiting spending on goods and services.
• Businesses suffer from reduced revenue and restricted access to financing, which can lead to closures and job losses
What are the long-term consequences of a banking crisis?
A:
• A rise in business liquidations and unemployment.
• Economic recession due to reduced spending and investment.
• Loss of trust in financial institutions, making future recoveries more difficult
Why was government intervention necessary during the global financial crisis?
A1: Without government intervention, the financial system’s failure would have halted economic life, leading to mass unemployment and a collapse of foreign currency earnings from financial service exports
How does the Bank of England manage inflation in the UK?
A2: The Bank of England relies on cooperation from other banks to manage inflation and stabilize the financial system
How significant is the UK’s financial services sector compared to other OECD (Organisation for Economic Co-operation and Development) countries?
A4: It was the third-largest in the OECD in 2020 by its proportion of national economic output
What is the definition of a recession?
A7: A recession is defined as a sustained fall in Gross Domestic Product (GDP) over two consecutive quarters (two three-month periods)
What are the main causes of a recession?
A8:
• Fall in consumption and investment.
• Low economic activity and growth.
• Rising unemployment
How does a recession affect businesses?
A9:
• Lower demand makes it harder for firms to sell products.
• Increased risk of business failures.
• More workers made redundant
How does rising unemployment impact household spending?
A10: Unemployed people have less to spend, and those who remain employed reduce their spending, choosing to save more or pay off existing debts
How does a recession impact government tax revenues?
A11:
• Fewer people working results in less income tax.
• Reduced spending leads to lower VAT (value-added tax) collection.
• Lower business profits decrease corporation tax revenue
What additional financial pressures does a government face during a recession?
A12:
• Increased spending on unemployment benefits.
• Growing public sector deficit due to falling tax revenue and rising expenditures.
• Need to borrow more money from global markets
Why is managing public spending difficult during a recession?
A13: Governments may need to cut spending or raise taxes to manage borrowing, but this reduces economic activity when stimulation is needed most
What long-term priorities did the UK government adopt after the financial crisis?
A14:
• Improving financial sustainability and stability.
• Managing systemic risk to prevent future financial system failures
What is systemic risk in financial services?
A1: Systemic risk refers to the risk that the failure of one financial services provider could lead to the failure of other providers in the system, creating a chain reaction that threatens the stability and sustainability of the entire financial system
Why is systemic risk a serious threat to financial sustainability?
A2: Systemic risk can cause cumulative losses, where the failure of one institution triggers a series of successive failures along a chain of interconnected institutions or markets, potentially leading to the collapse of the entire financial system
Under what circumstances is systemic risk highest
Systemic risk is highest when:
• Large financial service providers dominate the system: These providers are known as Systemically Important Financial Institutions (SIFIs), and their failure would have widespread, devastating consequences (“a huge splash in the financial pool”).
• High interconnectivity between financial institutions: Providers depend on one another through large-scale transactions, borrowing, lending, and shared payment systems. This creates a web of financial relationships where the failure of one institution can quickly affect others
How does interconnectivity contribute to systemic risk
Interconnectivity makes institutions highly dependent on each other through:
• Frequent borrowing and lending among institutions.
• Buying and selling of financial securities on global markets.
• Electronic transactions that happen almost instantly, making the system more vulnerable to rapid spread of risk
Why is systemic risk not confined to a single country?
A5: Due to the global nature of modern financial operations, international transactions and multinational financial service providers create a worldwide network. This interconnectedness means that systemic risk can spread across borders, impacting global financial stability
How does systemic risk affect the financial market?
A6: Systemic risk impacts the entire financial market, not just individual participants. It’s the most serious threat to global financial stability because the failure of one institution can undermine confidence and sustainability across the entire system
What is financial contagion, and how does it relate to systemic risk?
A7: Financial contagion is the spread of financial distress from one institution or market to others, causing a chain reaction of failures. A key example of this is the 2007–08 global financial crisis, where debt problems in one part of the system spread and threatened the entire global financial network
What visual metaphor is often used to describe systemic risk?
A8: Systemic risk is often compared to a line of falling dominoes, where the failure of one institution causes others to fall in quick succession
Why is interdependence between international banks a risk?
A2: If one large international bank is unable to pay its debts, it triggers a knock-on effect on other banks that it owes money to. These affected banks may then struggle to meet their own obligations, spreading financial instability
What is the consequence of one large bank defaulting on its debts?
A3:
• Banks owed money by the defaulting bank suffer financial losses.
• Those banks may fail to meet their own obligations, leading to more defaults.
• This chain reaction of failures can destabilize the entire financial system
What is the role of confidence in the financial system’s stability?
A4: The ability of financial markets to function depends heavily on confidence. If confidence in banks’ ability to meet obligations is undermined, the system can collapse
Why is a financial system with a realistic chance of failure unsustainable?
A5: A system where one institution’s failure can realistically lead to widespread collapse is inherently fragile and unsustainable, as seen in interconnected global banking networks
Which countries are described in the debt network?
A7:
• Major players: USA, Germany, France, Japan, Britain, Italy, Spain.
• Smaller nations: Ireland, Greece, Portugal
How does this debt network contribute to systemic risk?
A8:
• High interconnectivity: A default by one country’s banks affects multiple others.
• Global spread: Problems in one nation can rapidly spread worldwide.
• Complexity: The web of obligations creates a situation where multiple banks are vulnerable if a single player fails
What happens when a Systemically Important Financial Institution (SIFI) fails?
A: The government must take immediate action to limit damage and prevent contagion from spreading to other banks
The Northern Rock Crisis (2007)
What was the main reason for Northern Rock’s collapse in 2007?
A: A “run on the bank” – too many customers withdrew money due to a lack of confidence, worsening the situation
Which financial authorities were responsible for handling the crisis?
A: HM Treasury, the Bank of England, and the Financial Services Authority (FSA)
How did the authorities initially respond?
A: They tried to reassure the public through the media that the bank was safe and only in trouble due to the bank run
Government Hesitation and Action
Why did the government hesitate to guarantee deposits in Northern Rock?
A: They feared it would be too expensive and that other banks would demand similar support if they faced trouble
What eventually happened to Northern Rock?
A: The government was forced to take it over entirely in 2008.
Wider Banking Crisis and Bailout (2008-2009)
Which other banks were at risk of failing after Northern Rock?
A: Royal Bank of Scotland (RBS) and Lloyds Banking Group (LBG)
How did the government intervene?
A: It bailed out the banks at a cost of £94 billion to UK taxpayers
Lessons from the Northern Rock Crisis
Q: What did the Northern Rock crisis highlight about financial stability?
A: The importance of maintaining public confidence in banks to prevent bank runs
What was a major flaw in the government’s initial response? And What does this case study demonstrate about the role of governments in financial crises?
A: Delayed decision-making, which worsened the crisis
A: Governments must act decisively to prevent systemic collapse but also balance costs to taxpayers
Government Ownership of Rescued Banks
How did the UK government rescue Northern Rock, RBS, and LBG? And Why is the term ‘nationalisation’ not entirely accurate for these rescues?
A: The government injected large sums of cash in return for substantial shareholdings (e.g., 100% ownership of Northern Rock)
A: It is more accurate to say the banks were taken into temporary public ownership with the intention of selling shares back to the private sector later
What happened to Northern Rock after the rescue?
A: Part of Northern Rock was sold to Virgin Money in January 2012
What is the status of the government’s shareholding in RBS and LBG?
A: The government still owns a significant percentage of RBS but has sold all of its shares in LBG
Comparison with the US Government’s Response
How did the US government’s response differ from the UK’s?
A: The US government refused to rescue Lehman Brothers, an investment bank that had incurred heavy losses in the US mortgage market
What happened to Lehman Brothers?
A: It went into liquidation in September 2008, marking the biggest bankruptcy in US corporate history
Concept of ‘Too Big to Fail’
What does ‘too big to fail’ mean in banking?
A: It refers to the idea that some banks are so large and interconnected that their failure would severely damage the financial system, justifying government intervention
What is the argument in favor of bailing out large banks?
A: Preventing their failure protects the financial system and restores public confidence
What is the argument against bailing out banks?
A: It shifts the financial burden to taxpayers, allowing banks to keep profits in good times while relying on government support in bad times
What is the concern with bailing out very large banks?
A: The financial burden on the government and taxpayers could be too great, leading to the idea that some banks are ‘too big to save’
What is ‘moral hazard’ in the context of banking?
A: The expectation that a bank will always be bailed out may encourage riskier, less-prudent management decisions
How has the UK government addressed the issue of moral hazard?
A: Financial regulators have decided that in the future, banks must face the consequences of poor management, meaning failing banks will be allowed to fail
What steps will be taken to minimize the impact of a failing bank on the wider economy?
A: While failing banks may not be rescued, measures will be in place to reduce systemic risks and limit economic damage
What is ‘bank resolution’?
A: It is the procedure for handling a failing bank, where financial authorities save viable parts of the bank and close down the remainder in an orderly manner
What is the role of the Prudential Regulation Authority (PRA) in bank resolution?
A: The PRA ensures that banks can fail in an orderly way without harming financial stability
The Principle of Bank Failure
Why does the PRA argue that banks should be allowed to fail?
A: Business failure is a natural feature of a market economy, and financial institutions should be subject to market discipline like other businesses
Does the PRA see bank failure as a regulatory failure?
A: No, it considers failure a normal part of a properly functioning market
The Banking Act 2009 and Special Resolution Regime (SRR)
What law gave the Bank of England the power to manage failing banks?
A: The Banking Act 2009, which created the Special Resolution Regime (SRR)
What powers does the SRR give to the Bank of England?
A: The Bank of England can handle failing institutions in several ways
Methods of Bank Resolution Under the SRR
What are the four ways the Bank of England can deal with a failing institution?
- Selling the institution to a private sector buyer.
- Transferring property to a ‘bridge bank’, temporarily controlled by the Bank of England until a sale is arranged.
- Placing the bank under temporary public ownership, where the government buys it if the HM Treasury decides.
- Applying for insolvency and winding up its affairs
What are the key objectives the Bank of England considers when handling a failing bank
• Maintaining critical banking services for the economy.
• Ensuring financial stability in the UK.
• Protecting public confidence in the banking system.
• Safeguarding depositors’ money.
• Protecting public funds to prevent excessive taxpayer costs.
• Avoiding interference with property rights
Bank Resolution and Moral Hazard
How does the PRA approach moral hazard in bank resolution?
A: By ensuring failing banks are not automatically bailed out, reducing the expectation that risky decisions will be rescued by the government
What is the long-term goal of regulators regarding financial stability?
A: To manage moral hazard and eliminate the risk of future financial instability
The 2007-08 Financial Crisis and Systemic Failure
How did the UK financial system avoid collapse during the 2007-08 financial crisis?
A: The public sector bailed out the worst-hit banks to prevent systemic failure
What was the economic impact of the crisis?
A: The UK experienced its deepest economic recession in decades, leading to a public deficit that will take years to pay off
The Importance of Prevention in Financial Stability
What did the financial crisis expose about the banking system?
A: Fundamental weaknesses that made the system unsustainable
Why is financial stability important for the UK and other countries like the US, Greece, and Ireland?
A: These countries were severely affected by the crisis and cannot afford another similar collapse
What proactive steps must be taken to prevent future crises?
A: Strengthening regulations and monitoring financial institutions more closely.
The Role of the Prudential Regulation Authority (PRA)
Q: What stance has the PRA taken on bank failures since 2008?
A: Banks will be allowed to fail in the future rather than being bailed out
How do regulatory bodies help prevent bank failures?
A: By enforcing stricter rules and controls over financial service providers
What is prudential regulation?
A: A form of financial regulation that ensures banks operate sustainably and maintain safe balance sheets
Why is prudential regulation important?
A: It helps prevent banks from collapsing by ensuring they have adequate capital and liquidity
Capital Requirements Under Prudential Regulation
How are banks required to increase their capital?
A: By issuing more shares to shareholders
Who bears the loss if a bank fails?
A: Shareholders suffer the loss first, while depositors and creditors have priority in receiving remaining funds
Why are banks encouraged to build up capital during good times?
A: So they have reserves to rely on in bad times
Liquidity Requirements Under Prudential Regulation
What must banks do to maintain liquidity?
A: Hold more liquid assets such as loans and debts that will be repaid soon
What is the most liquid asset a bank holds?
A: Its account at the Bank of England
Why is liquidity crucial for a bank?
A: It allows the bank to meet short-term financial obligations
What does the Basel III regulation require banks to do?
A: Maintain enough cash and liquid assets to cover short-term debts for the next 30 days at any time
Why must banks rely more on customer deposits rather than short-term loans from financial markets?
Answer:
• Customer deposits are a safer source of funding because customers are more likely to keep their money in the bank for long periods.
• Short-term loans must be repaid within a few months, creating financial instability.
What is financial leverage, and why must banks reduce it?
Answer:
• Leverage is the amount of credit a bank creates based on its deposits.
• The more credit a bank creates, the higher the risk of financial instability.
• If things go wrong, the bank may struggle to repay its debts
Why must banks adopt a responsible lending policy?
Answer:
• Ensures that loans are given only to customers who can afford to repay.
• Reduces the risk of high default rates.
• Prevents banks from writing off large amounts in bad debts
What are the objectives of the Financial Policy Committee (FPC)?
Answer:
1. Identify, monitor, and take action to remove or reduce systemic risks in the UK financial system.
2. Enhance financial resilience by protecting the financial system from risks.
3. Support the economic policy of the government
What are the objectives of the Prudential Regulation Authority (PRA)?
Answer:
1. Promote the safety and soundness of the firms it regulates.
2. Ensure appropriate protection for insurance policyholders.
3. Facilitate effective competition between firms
What are the objectives of the Financial Conduct Authority (FCA)?
Answer:
1. Protect consumers by ensuring an appropriate degree of protection.
2. Enhance the integrity of the UK financial system.
3. Promote effective competition in the interest of consumers
What does “provider sustainability” mean in the financial services system?
Answer:
• Provider sustainability does not mean that individual firms will always survive.
• Individual banks must assume they will not be bailed out if things go wrong, encouraging better risk management.
• Sustainability focuses on the overall effectiveness of the financial system, even if some firms fail
Why is a sustainable business model important for financial providers?
Answer:
• Ensures prudent management decisions.
• Avoids excessive risks that could lead to financial failure.
• Leads to long-term survival, stable income, and continued services.
• Designs financial products that meet long-term customer needs
What are the key financial regulations providers must comply with to operate sustainably?
Answer:
1. Prudential management of balance sheets – Ensuring financial stability by managing assets and liabilities carefully.
2. Customer treatment and conduct rules – Treating customers fairly and following business regulations on marketing and selling financial products
What are stakeholder groups in financial services, and why are they important?
Answer:
• A financial provider (e.g., a bank) consists of multiple stakeholder groups with different interests and claims.
• Sustainability must be considered for all stakeholders.
• The same principles apply to banks, building societies, and insurance companies.
Shareholders in the Financial Services Sector
Who are the shareholders of a bank, and what are their interests?
Answer:
• Shareholders can be companies, individuals, or the UK government.
• They want the bank to make good profits to receive dividends.
• They also want the share price to rise and stay high.
What are the two types of shareholders in financial services companies (name them)
Long-term shareholders (e.g., pension funds)
Speculators
What are the two types of shareholders in financial services companies?
Answer:
1. Long-term shareholders (e.g., pension funds):
• Invest in shares for long-term income.
• Rely on pension schemes for retirement income.
• Need a sustainable financial system (investments must last 70+ years).
2. Speculators:
• Buy and sell shares quickly for short-term profits.
• They do not care about individual companies but need a stable stock market.
• If the market crashes, they lose money, so they also want sustainability
Directors Responsibility in Financial Sustainability
What is the role of directors in a bank?
Answer:
Directors are at the head of the organisation and make strategic decisions.
• Their position includes high salaries, bonuses, and prestige.
• Their interests align with the bank’s success since they want continued employment and pay
Why must directors incorporate sustainability in decision-making?
Answer:
• Directors decide the business model and company culture.
• They should not encourage excessive risk-taking for short-term profits.
• High short-term profits may lead to long-term failure if the bank becomes unprofitable or unable to meet obligations
How can directors’ decisions on mortgage lending impact a bank’s sustainability?
Answer:
• Short-term impact:
• Relaxing lending criteria increases business and immediate profits.
• Higher sales make the bank look more successful.
• Long-term risks:
• If interest rates rise or the economy goes into recession, customers may default on mortgages.
• The bank will suffer bad debts and losses.
• Sustainability approach:
• Directors should prioritize long-term profits over short-term gains
What legal accountability do directors have under the Financial Services (Banking Reform) Act 2013?
Answer:
• Directors are held accountable for their decisions.
• It is an offence for a director or senior employee to take a reckless risk that could lead to the bank’s failure.
• Consequences: Imprisonment, fines, or both
Consumers in the Financial Services Sector
Question: Who are consumers in the financial services sector, and what do they want
Answer:
• Consumers include: Individuals and businesses that use financial services.
• They use payment mechanisms, save money, borrow, and purchase products like insurance.
• Key consumer expectations:
• High-quality financial products.
• Fair treatment from financial service providers
Why is financial sustainability critical for consumers?
Answer:
• If a bank fails:
• Businesses cannot make millions of daily transactions.
• Shoppers cannot pay for goods.
• Workers may not receive wages.
• Firms cannot pay suppliers, rent, or materials.
• If an insurer fails:
• Consumers and companies lose risk coverage.
• They become exposed to large financial losses.
• If savers’ deposits are lost:
• They may need state guarantees, which burdens taxpayers
How should consumers manage their finances sustainably?
Answer:
• Avoid becoming overindebted.
• Carefully choose financial products and providers.
• Savers must check if deposits are covered under the Financial Services Compensation Scheme (FSCS)
Employees in the Financial Services Sector
Who are considered employees in the context of financial services, and what do they want from their jobs?
A: Employees include managers, administrative staff, and other workers. They seek good salaries, job security, interesting work, promotion prospects, and training. They need ongoing jobs to earn a living and build a career
How can employees encourage sustainable behavior in financial services?
A: Employees advise and help individuals and businesses make sustainable saving and borrowing decisions. For example, a mortgage manager should guide customers toward affordable loans rather than large, unaffordable ones
Why is the role of employees important in managing financial risk for insurance companies?
A: Employees help prevent financial service failures. If an insurance company fails, customers face uninsured risks and the potential for large financial losses
Sustainable Financial Products
What defines a ‘sustainable financial product’?
A: A sustainable financial product meets the long-term needs of customers while remaining profitable for the provider. It must comply with basic rules like affordability (for loans) and return on investment (for savings), ensuring long-term operation
Why is a mortgage considered a sustainable financial product?
A: A mortgage is long-term and low-interest, secured by the property being purchased. It enables customers to own a home and avoid renting while providing banks with a steady return through interest and secured repayment
How does a mortgage protect the lending bank’s interests?
A: If a customer defaults, the bank can repossess and sell the property, ensuring the recovery of its funds. This makes the loan sustainable and low-risk for the lender
What can cause mortgages to become unsustainable?
Answer: Mortgages become unsustainable when lenders fail to adhere to the principles of lending. This happens when:
• Too much money is loaned to people who cannot afford repayments.
• Loans are approved based only on property value rather than borrower affordability.
• High numbers of borrowers default on their loans.
• Falling house prices worsen the situation
What was the ‘subprime market’ and how did it contribute to the financial crisis
• The ‘subprime market’ referred to loans given to borrowers with very low incomes before 2007.
• These borrowers were enticed with large discounts on interest rates, which were only temporary.
• When interest rates increased, borrowers could no longer afford repayments, leading to high default rates.
• Banks suffered massive debt write-offs and struggled to meet their own financial obligations.
• This triggered a systemic crisis, leading to the global economic recession of 2007–2008
How did the 2007–2008 financial crisis unfold?
Answer:
1. Irresponsible mortgage lending led to high numbers of borrower defaults.
2. Banks suffered financial losses as they had to write off debts.
3. This caused a systemic crisis, first affecting the United States.
4. The crisis spread to the UK and other countries.
5. A global economic recession followed
What makes a financial product sustainable?
Answer:
A financial product is sustainable if:
• It is well-designed.
• It is not abused (e.g., overuse of overdrafts).
• It offers fair terms that borrowers can meet.
• It does not encourage excessive debt accumulation
How can personal current accounts be sustainable or unsustainable?
Answer:
• Sustainable: A current account is the most fundamental financial product and remains sustainable if used responsibly (e.g., avoiding excessive overdrafts).
• Unsustainable: Some accounts include expensive ‘add-ons’ like travel and breakdown insurance, making them costlier and potentially unsustainable
How do credit cards function as a financial product?
Answer:
• Function: Credit cards are a well-established method of rollover borrowing to finance short-term purchases.
• Sustainability: They work well if used responsibly, but become unsustainable if abused.
• Example of unsustainable use: A customer maxes out multiple cards and makes only the minimum payments each month, leading to mounting debt
Why is it important to consider sustainable product portfolios?
Answer:
• People often use multiple financial products simultaneously.
• The sustainability of an individual’s overall financial position depends on how these products interact.
• A balanced and sustainable mix of financial products ensures long-term financial stability
Why is balance important in a product portfolio?
A: Balance ensures sustainability, as individuals must manage saving and borrowing effectively to meet their financial goals, such as retirement or homeownership.
What are the two extremes of financial behaviour in relation to saving and borrowing? Name them
Extreme savers
Extreme avoiders of debt
What are the two extremes of financial behaviour in relation to saving and borrowing?
- Extreme savers – Consume very little, save aggressively, may use credit cards but pay off balances monthly, missing out on benefits of borrowing.
- Extreme avoiders of debt – May refuse long-term commitments like mortgages, preferring to rent but risking financial instability in later life
Why might taking a mortgage be beneficial?
A: Mortgage holders aim to pay off their debt before retirement, ensuring financial security when relying on pensions or investments instead of rent payments
How do rising property prices affect mortgage sustainability?
A: They make it harder to pay off mortgages before retirement, increasing financial pressure on homeowners
What was the average age of first-time buyers in 2020/21, and how did it change over time?
A: The average age was 32 years (34 in London), up from 31 years in 2007/08
How did the proportion of first-time buyers aged 16-24 change from 1994/95 to 2014/15?
A: It dropped from 23% to 10% due to rising property prices and economic challenges
Q: What was the impact of the financial crisis on first-time buyer mortgage loans?
A: Mortgage loans declined significantly from 2007 onwards, reaching their lowest levels between 2008-2011 before a slow recovery
Who are extreme borrowers, and what financial risks do they face?
A: Extreme borrowers consume a lot of goods and services, financing everything with credit (mortgages, loans, credit cards, overdrafts). They have no savings and may not contribute to pensions. Risks include job loss, reliance on state benefits, rising interest rates, higher repayments, and potential bankruptcy
Why is extreme borrowing unsustainable?
A: Without savings, borrowers are vulnerable to financial shocks like job loss or increased interest rates, which may force them into debt repayment struggles or bankruptcy
What is the sustainable approach to balancing saving and borrowing?
A: Borrowing should be for essential or valuable purchases (e.g., a car for work), within a person’s repayment ability. Saving is also important, but it should not completely prevent borrowing for beneficial investments
Why is insurance an important part of financial planning?
A: Some assets, like cars, must be insured by law (e.g., third-party insurance). Mortgage lenders usually require building insurance. Other policies are optional, and individuals must decide whether to buy insurance or accept financial risk
What is self-insurance, and how does it apply to pet insurance?
A: Self-insurance is setting aside savings instead of buying insurance. For example, some pet owners choose to save money for vet bills rather than buying pet insurance, which may not cover all treatments
Why is it important to use a range of financial providers?
A: Using multiple providers reduces risk. The Financial Services Compensation Scheme (FSCS) guarantees deposits up to £85,000 per provider, so individuals with more than this should spread funds across different providers to ensure full protection
How does FSCS protection work, and why should individuals check banking groups?
A: FSCS guarantees up to £85,000 per provider, but providers within the same banking group count as one. To maximize protection, individuals should place funds in different providers outside the same group
Trends in (un) sustainability
Why is sustainability important in the financial services system?
A: Sustainability ensures the long-term stability of the financial sector by addressing, mitigating, and reversing unsustainable trends. This helps banks and financial institutions maintain strong financial positions and treat customers fairly
What is responsible borrowing and lending?
A: It is when individuals or businesses borrow only as much as they can afford to repay within the agreed timeframe, considering their income and expected future financial position
How did the culture of high lending contribute to the 2007-08 financial crisis?
A:
• Banks could easily borrow money and had large amounts to lend.
• Interest rates were low, encouraging aggressive lending.
• Consumers were encouraged to take on high levels of debt through mortgages, personal loans, and credit cards.
• A ‘consumer culture’ developed, leading many people to become over-indebted, borrowing more than they could afford to repay
What happened to the financial markets after the 2007-08 crisis?
A:
• Banks collapsed and required government bailouts.
• Economic activity declined sharply as people became cautious with money.
• Businesses and individuals reduced spending.
• Banks became hesitant to lend, tightening loan criteria.
How were businesses affected by the financial crisis?
A:
• Banks called in overdrafts, making it harder for businesses to cover short-term expenses.
• Many businesses went into liquidation.
• Unemployment rose as businesses could not sustain operations
How were personal borrowers affected after the crisis?
A:
• Borrowers with large outstanding debts feared job loss, making repayment difficult.
• People stopped spending as much and started saving instead.
• This shift in behavior is known as ‘deleveraging’ – reducing spending to pay off existing debts
The mortgage market review
What is perilous debt?
A: Perilous debt is when someone spends more than half of their monthly income on debt repayments. It becomes particularly problematic when interest rates rise, increasing financial strain on households
What percentage of UK households had significant debt between April 2016 and March 2018?
A: 4% of households had debt amounting to at least 25% of their disposable income, even when interest rates were low (ONS, 2019)
Why is payday lending a problem for over-indebted individuals?
A:
• Payday loans are short-term, high-interest loans meant to cover shortfalls before payday.
• Some borrowers struggle to repay, leading to extremely high interest rates (e.g., 1,333%).
• Default fees can be as high as £15.
• This type of borrowing is highly expensive and unsustainable
How has the FCA regulated payday lending?
A:
• The Financial Services (Banking Reform) Act 2013 introduced stricter controls.
• The FCA capped the cost of credit at 100%, meaning no borrower can repay more than twice the amount they originally borrowed
The Mortgage Market Review (MMR)
Q: What is the Mortgage Market Review (MMR)?
A:
• Published by the FCA in October 2013 to reform the mortgage market and make it sustainable.
• By 2007, it became clear that ineffective regulations had led to high-risk lending and borrowing, causing hardship for many.
• The MMR aimed to ensure mortgages remained accessible for those who could afford them while preventing past poor practices
What were the key changes introduced by the MMR in April 2014?
A:
• Lenders are fully responsible for assessing whether a borrower can afford a mortgage.
• Income verification is mandatory to ensure borrowers can sustain repayments.
• Lenders are accountable for failures in this process, even if they use a mortgage broker
What are interest-only mortgages?
A: A type of mortgage where the borrower only pays interest during the term, with the full loan capital due at the end
Why did interest-only mortgages become risky before the financial crisis?
A:
• Borrowers took them out without a repayment plan to pay off the capital.
• Many assumed they could refinance or use other means to pay later.
• The number of such mortgages increased significantly before 2008
What requirements must lenders check before approving interest-only mortgages?
A:
1. Borrowers must show a credible repayment strategy (e.g., endowment policy).
2. Lenders must ensure borrowers have a plan to repay the full capital at the end of the term
What factors do lenders assess when determining if a borrower can repay a loan?
✔️ Income verification (checking with employer or financial records for self-employed).
✔️ Committed expenditure (e.g., food, utilities, existing debts).
✔️ Interest rate stress test (ensuring the borrower can afford repayments if rates rise).
✔️ Risk assessment (avoiding lending to high-risk borrowers with poor credit or unstable income)
Competition in Financial Services
Why is competition important in the financial services sector?
A: Competition ensures consumers have a wider choice and prevents providers from having too much power. It encourages sustainable pricing and responsible lending practices
What example is given of how consumers can stimulate competition?
A: Current account switching is an example of how consumers can encourage competition among providers
What risks remain even with increased competition?
A: Bad practices, such as irresponsible lending and mis-selling, can still emerge despite competition
The Role of the FCA in Competition
How does the FCA regulate competition in financial services?
A: The FCA enforces rules on business conduct to ensure competition is fair and sustainable
What obligation does competition place on financial providers?
A: Providers must offer sustainable products at fair prices and avoid irresponsible lending or mis-selling
What are the three key factors the FCA considers when protecting consumers?
- Different degrees of risk in various transactions.
- Consumers’ varying levels of experience and expertise.
- The need for accurate and timely information
What is the general principle of consumer responsibility?
A: Consumers should take responsibility for their decisions, but financial firms must also ensure their advice considers consumer knowledge and product risks
What are the FCA’s main responsibilities
• Supervising all financial firms.
• Enforcing compliance with regulations.
• Maintaining high standards in the industry.
• Monitoring and intervening when firms act unfairly or pose risks to market integrity.
• Responding to industry problems and ensuring consumer compensation
How does the FCA ensure consumers receive suitable financial products?
• Ensures providers offer products tailored to personal circumstances.
• Sets independent standards for financial advisers (IFAs) to provide unbiased advice.
• Requires firms to train staff well to give knowledgeable and ethical advice
How does the FCA help prevent financial crime?
• Works with UK and international firms to fight financial crime.
• Detects and prevents money laundering.
• Takes action against corrupt or unethical practices
What penalties can the FCA impose on firms that break regulations?
- Withdrawing a firm’s authorization.
- Prohibiting individuals from regulated activities.
- Suspending firms.
- Imposing fines.
- Applying for court injunctions and restitution orders.
- Bringing criminal prosecutions to tackle financial crime
What does the FCA do to identify potential financial problems?
• Detects and addresses risks early.
• Works with the Financial Ombudsman Service (FOS) and Financial Services Compensation Scheme (FSCS) for consumer protection
What was a major consumer protection case handled by the FCA?
• The PPI mis-selling scandal, where lenders sold Payment Protection Insurance to borrowers who either couldn’t afford it or weren’t eligible to claim.
• The FOS forced firms to pay large compensation sums to victims of PPI mis-selling
Consumer education
Why is financial literacy low among the population?
• Finance has not historically been taught in schools.
• Many people buy financial products they don’t fully understand
Why is financial education important?
• People are now more responsible for managing their own finances.
• Financial decisions (e.g., borrowing, saving) can be complex.
• It helps consumers make informed choices
What independent body educates consumers about financial products?
• MoneyHelper, part of the Money and Pensions Service
What has the government done to improve financial education?
• Money management and financial education have been added to the school curriculum
Ethical lending
What is ethical lending?
• A practice where financial institutions consider sustainability, fairness, and ethical responsibility when lending money
How do financial organizations influence sustainability?
• By factoring sustainability into products:
• Banks can lend money to companies investing in green technology.
• Insurance firms can charge lower premiums for low-carbon vehicles
What ethical benchmarks guide banks in sustainable finance?
• The Equator Principles, which provide ethical guidelines for financing infrastructure projects
What is the business case for sustainable lending?
• Sustainable companies perform better in the long run, making ethical lending financially viable
Financial sustainability levels
What are the four levels of financial sustainability?
- Sustainability of the financial system (overall economic stability).
- Sustainability of financial providers (banks, investment firms).
- Sustainability of financial products (loans, insurance, investments).
- Sustainability of individual customers (consumer financial well-being)
How are these levels interconnected?
• If customers act sustainably (choosing ethical products),
• And providers behave ethically,
• It reduces the risk of financial crises
What are the benefits of financial sustainability?
• Prevents bank failures.
• Protects consumer savings.
• Avoids government bailouts of firms deemed “too big to fail.”
• Reduces risk of economic recessions
The three pillars of sustainability are:
A. Environmental, social economic
B. Ecology, social and economic
C. Environmental, psychological and economic
D. Environmental, society, technology
A
Systematic risk is highest when financial providers are:
A. Tiny companies
B. Small computers
C. Medium sized companies
D. Large companies
D
When the government purchased the failed banks in 2007/08, the banks were placed in:
A. Temporary public ownership
B. permanent public ownership
C. Temporary private ownership
D. Permanent private ownership
A
The procedure that takes place when a bank is in trouble is known as bank:
Recuperation
Resolution
Revival
Redundancy
Resolution
As a result of regulations put in place since the banking crisis a failing bank:
A. May receive help from the gov and the BOE and will not be allowed to fail
B. May receive help from the gov and the BOE but may be allowed to fail
C. Will not receive any help from the gov or BOE and will be allowed to fail
B
Directors are:
A. Those who make the company’s strategic decisions
B. The owners of a company
C. Those who buy goods and services produced by a company
D. Those that solely line manage others
A
A sustainable financial product is one that is designed to meet the:
A. Long term requirements of consumers
B. Medium term requirements if consumers
C. Median term requirements of consumers
D. Short term requirements of consumers
A
Regularly setting aside a sum of money to cover unexpected expenses such as vet bills, instead of paying insurance premiums, is known as:
Compulsory insurance
Voluntary insurance
Regulatory insurance
Self insurance
Self insurance
Deleveraging is when:
A. People start spending and stop paying off existing debts
B. people start spending and increase their existing debts.
C. People stop spending and starting saving to pay off existing debts
C
As a result of the mortgage market review who is now fully responsible for assessing whether a potential mortgage customer can afford the loan and for verifying the customer’s income?
The borrower
The estate agent
The mortgage broker
The lender
The lender
Sustainable development is ‘development that means the needs of the present without compromising the ability of future generations to meet their own needs
True
False
T
It is not necessary to address unsustainable trends as they will die out by themselves
False
True
F
