Financial Markets

• What is a commercial bank?

  A financial institution that aims to make profits by selling banking services to customers
• What is the primary business model of commercial banks?

  To earn a higher interest rate on loans than the rate paid on deposits
• What are commercial banks also known as?

  Retail banks and high-street banks
• What is the 'spread' in banking terms?

  The difference between the interest earned on loans and that paid on deposits
• What is an investment bank?

  A bank that does not generally accept deposits from the public and deals mainly with corporate customers
• What activities do investment banks engage in?

  Helping firms issue shares, raise finance, and assisting with mergers and acquisitions
• Why are regulations being introduced to separate commercial and investment banking activities?

  To protect customers from losing money due to riskier investment banking activities
• What does 'ring-fencing' refer to in banking?

  Separating retail banking divisions from investment banking arms
• What is the aim of ring-fencing?

  To reduce systemic risk in the financial system
• What is systemic risk?

  The risk of a breakdown of the entire financial system due to inter-linkages
• What power did the 2013 Banking Reform Act give to the Prudential Regulation Authority (PRU)?

  The power to enforce full separation on banks if necessary
• How do banks traditionally create credit?

  By taking deposits from savers and lending them to borrowers
• How do modern commercial banks create credit?

  By giving a loan to a customer and creating an equivalent deposit in their accounts
• What are some constraints that limit the amount of money banks can create?

  Market forces, regulatory policies, consumer behavior, and monetary policy
• What are reserve assets in a bank?

  Liquid assets other than cash deposits, such as balances at the Bank of England
• Why is cash considered the most important reserve asset?

  It allows banks to maintain liquidity and meet customer demands for cash
• What risk do commercial banks face if they reduce liquid assets to a minimum?

  Illiquidity and loss of confidence from customers
• What can lead to a 'run on the bank'?

  Loss of confidence from customers due to illiquidity
• How do banks manage their portfolio of assets?

  To meet customer demands for cash while aiming to make a profit
• What is the inherent risk of banks borrowing short term and lending long term?

  Depositors may withdraw money while loans cannot be repaid immediately
• What happens if a bank invests in assets that fall in value?

  It results in losses and reduces the bank's capital
• What is the role of a central bank in maintaining financial market stability?

  To provide liquidity insurance and act as a lender of last resort
• What is the liquidity-profitability trade-off?

  The balance between maintaining sufficient cash and generating profits
• What happens if banks create too many profitable advances?

  They may possess insufficient cash to meet customer withdrawals
• What is the significance of cash ratios in retail banking?

  They maintain customer confidence while generating acceptable profits
• Why are non-secured loans considered risky?

  If a customer defaults, the bank cannot recover any money
• What are secured loans?

  Loans backed by collateral, such as mortgage loans
• What is interbank lending?

  Borrowing cash from other banks to meet short-term liquidity needs
• What are treasury bills?

  Short-term government securities with a life of three months before maturity
• Why do retail banks hold a portfolio of commercial and treasury bills?

  To maintain liquidity while also being profitable
• What typically happens during a bank run?

  People withdraw funds due to fears of insolvency, leading to liquidity issues
• What are the two fundamental reasons for bank failure?

  Insolvency due to falling asset values and insufficient liquidity
• What types of institutions operate in financial markets besides commercial and investment banks?

  Insurance companies, pension funds, hedge funds, and private equity companies
• What is the shadow banking sector?

  A system that supplies credit but is not subject to regulatory oversight
• Why is the growth of the shadow banking system concerning to authorities?

  It adds to systemic risk in the financial system
• What role does the financial sector play in the Circular Flow of Income?

  It intermediates between savings and investment.
• How do household savings flow into the financial system?

  They flow into various products and firms.
• What is the fundamental purpose of the financial market?

  To channel funds from surplus to deficit units.
• How might individuals use the financial market for retirement savings?

  By saving through a pension fund.
• What is the purpose of the Money Market?

  To satisfy short-term financial needs.