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

  3. Facilitate the exchange of goods and services

  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
• There are a number of costs placed on firms, individuals and the government that the financial market does not pay
• The long-term cost to the economy of the 2007-8 financial crisis due to its effects on demand and growth was even higher than the cost of bailing out the banks
• 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
• Speculation and market bubbles

  Almost all trading in financial markets is speculative and this leads to the creation of market bubbles, where the price of a particular assets rises massively and then falls
• 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 included the dot com bubble in the 1990s and the 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
• 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

  2. Acts as a banker to the government

  3. Acts as a bank to other banks

  4. Regulates the financial system
• Central bank's role as a bank to other banks

  • Banks deposit their money within the central bank and this is often used to balance the accounts of banks at the end of each day
  • The most important part of this role is the fact they are a lender of last resort
• 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)
• Fiscal policy is used when there are fluctuations in economic activity such as recessions or booms