The Financial Sector Functions of money Medium of exchange Measure of value Store of value Method of deferred payment

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1 The Financial Sector Functions of money Medium of exchange - avoids the double coincidence of wants Measure of value - measures the relative values of different goods and services Store of value - kept for a long time without expiring Method of deferred payment - can allow for debts to be created so people pay for things later Characteristics of money: Durability: money lasts physically between transactions Divisibility: exact value can be traded Portability: easy to carry around Uniformity: value should be consisted Limited supply: should be scarce enough to have a value and be earned Acceptability: consumers and firms should have enough confidence to accept it The financial sector and financial markets The role of the financial sector: Facilitate saving through bank accounts, pension funds, bonds and other financial products Provide loans to businesses and individuals Allow equities and bonds to be issued and traded on capital markets Everyday forms of borrowing: Personal loans: leans to individuals to be paid back over a small number of years - can be secured (bank forces the sale of an asset to cover the loan s cost if not repaid) or unsecured - unsecured loans have a higher rate of interest Mortgages: loans to buy property Credit cards: allow holders to borrow money from a bank when purchasing goods or services Pay-day loans: short-term, small, unsecured loans - high rates of interest Overdrafts: loans to firms and individuals that occur when funds fall below zero Firm borrowing: Equity finance is raised by selling shares in a company - person buying shares becomes a shareholder

2 - have a share of firm s profits in the form of dividends Debt finance: borrowing money that has to be paid back, usually with interest - borrowing from banks or issuing corporate bonds Types of financial markets: Money markets: provide short-term finance to banks, companies, governments and individuals - short-term debt will have a maturity (repayment period) of up to a year Capital markets: provide medium and long-term finance to governments - governments raise finance by issuing bonds, firms raise finance by issuing shares or by borrowing from banks - capital market has a primary (new share and bond issues) and secondary market (existing securities) Foreign exchange markets: where different currencies are bought and sold - to allow international trade and investment, or as speculation - spot market is for transactions that happen now - forward market is for transactions that will happen in the future Bonds as a form of borrowing: Governments can issue bonds to raise money - a form of long-term loan - UK government bonds are called gilts Investors buy new bonds at the nominal value and become bondholders Interest is paid to the bondholder - amount of interest paid is called the coupon After the bonds are issues, they can be traded in secondary capital markets - investors can buy or sell bonds at any price - coupons would be paid to the current bondholder The bonds yield is the annual return an investor will get from the bond - the less someone pays for a bond, the higher its yield Yield = Coupon x 100 Market price When the bond matures, the current bondholder is paid the nominal value of the bond by the issuer - this means the issuer s original debt has been repaid

3 Banks and money Commercial banks: Roles of commercial banks: - to accept savings - to lend to individuals and firms - to be financial intermediaries - to allow payments from one person or firm to another Commercial banks also provide financial services, like insurance and financial advice Areas of commercial banking: - retail banking: providing services for individuals and smaller firms - wholesale banking: dealing with larger firms banking needs Investment banks: Role of investment banks: - arrange share and bond issues - offer advice on raising finance, and on mergers and acquisitions - buy and sell securities on behalf of clients - act as market makers to make trading in securities easier Investment banks also engage in higher risk activities - e.g. proprietary trading involves a bank buying and selling shares using its own money Other Financial Institutions: Pension funds: collect people s pension savings and invest them in securities - when a client retires, the pension fund pays out their savings - also provide long-term, large-scale investment in companies Insurance firms: charge customers fees to provide insurance cover Hedge funds: firms that invest pooled funds from different contributors to receive high returns Private equity: invest in businesses and then try to make the maximum return The money supply: The money supply is the stock of currency and liquid assets in an economy Any financial instrument that is portable, widely accepted, difficult to forge and durable can be classified as money and counted as part of the money supply - e.g. notes, coins, shares, bonds Liquidity refers to how easily something can be spent - e.g. notes and coins are very liquid - shares and houses are less liquid (illiquid) because they need to be converted into cash before they can be spent Narrow money: notes and coins in circulation, plus balances held at a central bank Broad money: assets that are less liquid and all of narrow money

4 Profits and liquidity: One of the aims of banks is to maximise profits for their shareholders The rate of return on illiquid assets is generally higher than on liquid assets - so banks don t want too many liquid assets However, they need to have some liquid assets to lend money over a long term and for people to withdraw their savings Banks rely on depositors not all wanting to withdraw their savings at the same time - usually there isn t a problem as it is quite unlikely However, if people thought their savings were at risk, then lots of people would withdraw their savings very quickly - known as a run on the bank It is important that people trust the banking system and is why a central bank acts as an emergency lender of last resort Risky investments will usually generate a higher return investors will want high rewards for risking their money Interest rates are charged in different money markets the more secure an investment is, the lower the interest rate that will be earned All investors must balance the security of an investment against its profitability Banking and Interest rates Loanable Funds Theory: Interest rates are determined by supply and demand Loanable funds are the total amount of money available for borrowing The loanable funds theory says the interest rate is determined by the supply of, and demand for, loanable funds At higher interest rates, the supply of loanable funds will be higher (since people save more) and demand will be lower (since people borrow less) The interest rate is the equilibrium price Liquidity Preference Theory: The demand for money curve is sometimes called the liquidity preference schedule - horizontal curve at low rates of interest because firms are prepared to hold more or less money at this low rate of interest Demand for liquid money depends on how people want to hold their wealth It assumes people either hold their wealth as liquid money or as illiquid bonds - bonds earn interest but price of bonds changes - liquid money value is stable

5 If interest rates are high, bonds are more attractive - reward of interest outweighs the risk of a price fall If interest rates are low, bonds are less attractive - risk of a price fall outweighs the reward of interest When interest rates are high, people may expect them to fall soon, which will lead to a bond-price increase - speculators will want to hold their wealth as bonds and will demand less liquid money High interest rates mean demand for money is low The interest rate is at the equilibrium between supply and demand Different markets, different rates of interest: It has been assumed that there is one market for money and one equilibrium rate of interest in the economy - useful simplification in macro-economic theory In reality, there are many markets for money and many rates of interest in an economy Time the longer the period of the loan, the interest rate tends to be higher - lender has complete flexibility to either stop lending or to witch money to another market - higher interest is necessary to compensate lenders as the length of the term of a loan increases Expectations if the market expects interest rates to fall in the near future, then longer term loans could attract a lower rate of interest than shorter term loans Risk the greater the risk of default on the loan, the higher the interest rate will be - lending money to an unemployed worker is likely to be far more risky than lending it to the HSBC Administrative cost the higher the administration cost, the higher the rate of interest - lending out 100 million in lots of 100 at a time is more expensive than lending out 100 million to one customer Imperfect knowledge borrowers and lender may have imperfect knowledge - credit card holders may be unaware they could cut their interest payments by changing their credit card provider

6 Relationship between inflation rate and nominal interest rate: A nominal interest rate is one that hasn t been adjusted to allow for inflation Real rates of interest have been adjusted to show changes in the purchasing power of money that s been saved Real rate of interest = nominal rate of interest rate of inflation Higher inflation will push up nominal interest rates Commercial banks balance sheet: A bank s balance sheet is a snapshot of its assets and liabilities on a particular date Liabilities are things which must be paid, it is a claim on assets An asset is something that can be sold for value Equity is what is left over when assets have been sold and liabilities have been paid On a balance sheet, total assets should always equal total liabilities - total assets = total liabilities A bank s capital is the total of its share capital and its reserves (retained profits) ASSETS LIABILITIES Cash Balances at the Bank of England Money at call and short notice Commercial and Treasury Bills Investments Advances Fixed assets Deposits from savers Short-term borrowing Long-term borrowing Reserves Share capital Most liquid Least liquid

7 The Role of the Central Bank Functions of the central bank Banker to the government: Helps government manage its national debt, for example by trying to reduce the interest paid Offers advice to the government on economic matters and helps in negotiations with other international financial organisations Collects payments to the governments and makes payments on behalf of the government Implementation of monetary policy: Manages the money supply by controlling interest rates or quantitative easing inflation targeting Can set capital requirements which affects the amount of loans banks make Controls the issuing of bank notes and ensures confidence in the currency (by preventing counterfeiting) Influences the exchange rate by buying and selling currencies and changing interest rates Lender of last resort: Banks borrow short-term but lend long-term so can have a shortage of liquidity The central bank will lend money to increase the supply of liquidity The central bank charges a higher interest rate for emergency funds to create an incentive for the bank to behave more carefully in the future If an institution is close to collapsing, the central bank will lend to them to ensure banking stability It prevents runs on the bank and reduces the impact of financial instability However, it can lead to moral hazard and banks may take big risks and it could lead to banks not holding enough liquidity Regulators of the financial sector: A central bank can impose rules to prevent financial market failure and instability Financial stability means an efficient flow of funds in the economy and confidence in UK financial institutions Independent and state-controlled banks Advantages of independent central banks: For example, the Bank of England Decisions (e.g. interest rates) are made for economic, not political reasons The public may have more confidence in independent central banks managing issues like inflation have more expertise Frees up the government to concentrate on other policies

8 Advantages of state-controlled central banks: Found in planned economies Governments can ensure the central bank fully concentrates on the government s objectives Easier to coordinate the actions of the central bank with the actions of the government Independent central banks are usually run by bankers or academics who may lack the real-world experience that politicians may have State-controlled central bank might have more democratic accountability (if the government is democratically elected) Independent Central Banks: Most major economies have independent central banks as they mostly manage to achieve lower levels of inflation Since the Bank of England became independent in 1997, it has been successful in keeping inflation close to the target of 2% set by the government After the 2008 financial crisis, inflation increased sharply, but the Bank of England decided raising interest rates would further harm economic recovery The Bank of England instead carried out quantitative easing and Funding for Lending In contrast, the European Central Bank has been criticised for being inflexible and focusing too much on inflation

9 Financial market failure Ways financial market failure can occur Financial market failure: where free financial markets fail to allocate financial products at the socially optimum level of output so there is a misallocation of resources 1. Excessive risk leading to overall collapse of the financial system Consequences: i) Systemic risk loss of confidence in banks ii) Recession lost incomes, jobs and output iii) Bank bailouts negative externalities 2. Collusion and fixing of interest/exchange rates - monopoly pricing - loss of welfare in financial markets Types of financial market failure 1. Speculation and market bubbles Speculation is buying assets cheaply and selling at a higher price - there is risk that asset prices will fall, so speculators would lose money Excessively high estimates of future price increases can create a market bubble and overpaying for assets Eventually investors will lose confidence (D ) so the bubble will burst and investors will rush to sell their assets - leads to P so assets are worthless and it creates huge debts 2. Asymmetric information Moral hazard and Adverse selection Asymmetric information occurs when the seller has less information than the borrower Adverse selection is when the most likely buyers are those that the seller would prefer not to sell to due to imperfect information - firm unknowingly takes greater risks than it intended - e.g. selling health insurance to people in poor health Moral hazard is when people take excessive risks because they know other people will have to pay the consequences 3. Negative externalities These are the costs to the taxpayer of bailouts of banks - can be caused by mismanagement of risk - in the financial crisis, there was a need for bailout because some banks were considered too big to fail so systemic risk would be created 4. Market rigging Market rigging is when traders/ bankers/ intermediaries collude to manipulate markets and make huge profits They may make the demand for securities appear higher than it really is to artificially inflate their price There are heavy fines and regulations to stop and punish market rigging, but it can still occur

10 Regulation of Financial Markets Financial markets in the past Up until the 2008 financial crisis, regulation in financial markets wasn t very strict - due to deregulation in the 1980s known as the Big Bang Less regulation helped the markets to be more profitable However, a lack of regulation in the financial sector also led to market failure which contributed to instability: - excessive risk-taking by financial institutions - commercial banks acting as investment banks - fraud and other illegal activity such as market rigging - growth of market bubbles in the housing market Aims of regulation Make financial markets more competitive to benefit consumers Ensure firms are stable - requiring banks to meet capital and liquidity ratios - preventing banks from taking excessive risks Strengthen rules and principles that financial institutions must abide by, otherwise face tough punishments Identify systemic risks in the financial markets and finding ways to manage or remove them Capital ratio: ratio of a bank s capital to loans - gives a measure of the risks associated with the bank s lending, and of the bank s stability Liquidity ratio: measure the ratio of highly liquid assets to the expected short term need for cash - gives an idea of bank s stability, as well as its ability to meet its short-term liabilities The Basal Committee (committee of global banking authorities) makes recommendations on minimum liquidity and capital levels for banks - should increase financial stability by making sure they have e buffer in case of a bank run or a fall in asset values Problems with financial regulation: Regulatory capture where banks can influence the decisions of the regulator to ensure the outcomes favour the firm, not the consumers There are administration and enforcement costs of regulation If regulation of financial markets is too strict it can lead to restrictions on credit which can harm economic growth - may lead to growth of the shadow banking system, which isn t regulated Regulation in the UK Financial Policy Committee (FPC): Macro prudential regulation financial regulation intended to mitigate the risk of the financial system as a whole Part of Bank of England The FPC identifies, monitors and protects against systemic risk

11 It instructs the PRA and FCA in tackling financial stability issues Advises the government on shocks and bailouts Prudential Regulation Authority (PRA): Micro prudential regulation financial regulation intended to set standards and supervise financial institutions at the level of the individual firm Part of Bank of England The PRA maintains the stability of banks It supervises the management of risk Set industry standards for conduct and management with enforcement Specifying ratios (capital, liquidity, leverage ratios and reserve requirements) Financial Conduct Authority (FCA): This is a government body which reports to the treasury Micro prudential regulator It aims to protect consumers and increase confidence in financial institutions and products by: 1. Supervising conduct of firms/ markets to ensure legal business activity and no market rigging 2. Promoting competition so consumers get better deals (e.g. by deregulation) 3. Banning financial products against interests of consumers 4. Banning or changing misleading adverts for financial products (e.g. loan sharks) Global Financial System The World Bank and the International Monetary Fund (IMF) aim to ensure the global financial system is well regulated and resilient to crises Through the Financial Sector Assessment Program (FSAP), the IMF and World Bank evaluate the strengths and weaknesses of a country s financial markets - they recommend policies to help reduce the chance of a future crisis Decision making in the IMF and World Bank are dominated by the richest countries who often put the interests of developed countries first During the 2008 financial crisis, the IMF and World Bank were criticised because their help required the countries to impose austerity measures that reduce public spending - this affected the poorest people the most