4.4 - The financial sector

• Financial markets

  Where buyers and sellers can buy and trade a range of services or assets that are fundamentally monetary in nature
• Reasons financial markets exist

  • To meet the demand for services, such as saving and borrowing, from individuals, businesses and the government
  • To allow speculation and financial gains
• Role of the financial market

  1. Facilitate savings

  2. Lend to businesses and individuals which allows consumption and investment

  3. Facilitate the exchange of goods and services by creating a payment system

  4. Provide forward markets

  5. Provide a market for equities
• The combination of speculation and provision of genuine services means that financial markets are prone to regular crises that cause significant damage to the real economy
• Asymmetric information


  Financial institutions often have more knowledge compared to their customers, both consumers and other institutions
• The Global Financial Crisis was partially caused by

  Banks selling packages of prime and subprime mortgages, but advertising them as all prime mortgages
• Asymmetric information between financial institutions and regulators


  Institutions have little incentive to help regulators understand their business and this causes difficulties for the regulators so may allow institutions to undertake harmful activities
• The financial market does not pay the costs placed on firms, individuals and the government
• The long-term cost to the economy of the 2007-8 financial crisis

  Due to its effects on demand and growth
• Moral hazard

  Individuals make decisions in their own best interests knowing there are potential risks
• The Global Financial Crisis was caused by moral hazard, when


  Employees sold mortgages to those who would not be unable to pay them back
• Financial institutions may take excessive risk because

  They know the central bank is the lender of last resort and so will not allow them to fail because of the impact it would have on the economy
• Creation of market bubbles

  1. Investors see the price of an asset is rising and so decide to purchase this asset as they believe the price will continue to rise and will profit them in the future

  2. Prices becoming excessively high and eventually enough investors decide that the price will fall, so they sell their assets and panic sets in, causing mass selling
• The financial market has also caused market bubbles in the housing market by lending too much in mortgages and increasing demand for houses
• Other bubbles

  • Dot com bubble in the 1990s
  • Wall Street Crash in 1929
• Market rigging

  A group of individuals or institutions collude to fix prices or exchange information that will lead to gains for themselves at the expense of other participants in the market
• Examples of market rigging

  • Insider trading
  • Individuals or institutions affect the price of a commodity, currency or asset to benefit themselves
• In the Libor scandal of 2008, financial institutions were accused of fixing the London Interbank Lending Rate (LIBOR), one of the most important rates in the world
• Role of the central bank

  1. Controls monetary policy through interest rates and controlling money supply in order to keep inflation low and stable

  2. Acts as a banker to the government

  3. Acts as a bank to other banks, including being a lender of last resort

  4. Regulates the financial system
• Importance of central bank's role as lender of last resort

  • Allows the bank to ensure financial stability
• Key bodies for financial regulation

  • FPC (identifies and reduces system risk and supports government economic policy)
  • PRA (ensures competition, ensures consumers have access to services, minimises risk should a bank fail and ensures banks take responsible action)
  • FCA (protects consumers, promotes competition and enhances the integrity of the system by preventing market rigging)
• Regulation can include: banning market rigging; preventing the sale of unsuitable products; maximum interest rates to prevent consumer exploitation and prevent excessively risky lending; deposit insurance to protect consumer deposits and increase stability; and liquidity ratios, when banks are forced to hold a certain percentage of liquid assets
• Lender of last resort

  The role of the central bank to act as a backstop for the financial system in times of crisis. It provides funding to financial institutions that are unable to obtain it from other sources.
• Implicit guarantee


  The signal sent to the market by the central bank when it acts as a lender of last resort. This can create an expectation that the central bank will step in to prevent a collapse, even if the institution is taking excessive risks.
• Moral hazard


  The tendency for people to take more risks when they are protected from the consequences. In the context of financial institutions, the knowledge that the central bank will step in as a lender of last resort can create moral hazard, as institutions may be more likely to take excessive risks because they believe they will be bailed out.
• Impact on the economy

  The potential for a large financial institution's failure to have a significant impact on the economy as a whole. Financial institutions play a critical role in the flow of credit and the allocation of capital. If one were to fail, it could disrupt these processes and lead to a slowdown in economic activity.