Edexcel A Macroeconomics 4.4 financial markets A* revision notes.
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4.4 Financial Markets
Financial market failure- when free financial markets fail to allocate financial products and services at the socially
optimum level of output resulting in a net loss of social and economic welfare
Bank assets- assets are ‘owned’ by the bank e.g. cash, balances, loads (advances), securities (bonds), and also fixed
assets – property
Bank capital- value of the bank’s assets minus its liabilities
Bank liabilities- ‘owed’ by the bank
Bank reserves- money and liquid assets held by banks in order to meet cash withdrawals by customers
Banking credit- an arrangement with a bank for a loan, or bank lending in general
Banking system- way banks work together to handle payments, make money available
Base money- Currency (banknotes and coins) in circulation plus minimum reserves credit institutions are
required/choose to hold with a country's central bank
Base interest rate- the rate of interest set by the MPC of BOE being in effect the lowest rate that commercial lenders will
charge interest at
Bond market- market for interest-bearing securities (fixed or floating rate) and with a maturity off at least one year)
that companies and gov issue to raise capital
Bond yield-
Broad money- a measure of the money supply. Broad money is a measure of the total amount of money held by
households and companies in economy. Mainly commercial bank deposits= IOU’s from commercial banks to households
and companies and currency- IOUs from central bank
Building societies- owned by their members and not shareholders – focus on offering mortgages and savings
Crowdfunding- form of equity finance t
Debt default- failure of a debtor to make agreed payments
Equity- refers to the value of the interest of an owner or partial owner in an investors
Forward market- a market dealing in commodities, currencies and securities for future delivery at prices agreed upon in
advance.
Financial market- any exchange that facilitates the trading of financial instruments- stocks, bonds, foreign exchange, or
primary commodities such as oil and gas
,Investment bank- provides a wide range of specialised services for companies and large investors. Underwriting and
advising on securities issues and other forms of capital raising. Advice on mergers and acquisitions and corporate
restructuring; trading on capital markets; research and private equity investment
.4 Financial Markets
Leverage- the use of borrowed funds to inc profitability. One measure of leverage is the amount of l/t debt relative to
equity
Liquidity- the ease and cost with which assets can be turned into cash and used immediately as a means of exchange
Money market- market for s/t loan finance for businesses and households. Money is borrowed and lent normally for up
to 12 moths i.e. commercial banks providing liquidity for each other, also S/T gov borrowing
Money supply- total amount of money in circulation in a country or group of countries in a monetary union.
SPOT market- buy and sell currently
Asset bubble- a sustained rise in prices of assets, housing, equities which takes their values well above long run
sustainable levels
Asymmetric information- this type of market failure exists when one individual or part has more info than another and
uses that advantage to exploit the other party. Often a borrower has better info on likelihood that they will be able to
repay a loan than the lender
Moral hazard- taking excessive risk as you are insured or protective form failure. 3rd party bares the benefit of the cost
of someone else
Regulatory capture-when regulators of different industries act in favour of producers not consumers
Forward market- buying and selling a good however at fixed prices. To prevent price volatility- could cost you more-
reduce risk
SPOT markets- trade at current prices
Systemic risk - the possibility that an event at the microlevel of an individual bank could then trigger instability of the
collapse of entire of the entire industry or economy
Market rigging illegally and unfairly controlling the price of the interest-rate in order to increase their joint profits will
exploit consumers
,
, Financial markets are where buyers and sellers can buy and trade a range of goods and services or assets that are
fundamentally monetary in nature
§ Range of different financial institutions. Retail banks provide services to households- payment of direct debits,
saving accounts, loans and mortgages
§ Commercial banks provide services to businesses.
§ Investment banks trade in foreign exchange, commodities, bonds, shares and derivatives for speculation
purposes as well as giving advice to firms on how to raise finance and on mergers. Some smaller companies also
take part in speculation.
§ Savings vehicles exist to help individuals save, for example pension schemes, trusts, hedge funds and assurance
companies, whilst insurance companies insure against a range of risks.
§ The central bank is a financial institution that has direct responsibility to control the money supply and monetary
policy, to manage the country's gold and foreign currency reserves and to issue government debt.
Financial markets: Different financial institutions:
1. Forex- exchanging currencies Retail banks- provides services to households, direct debits,
2. Money market- lending for s/t (less than a year) savings accounts, loans and mortgagets
3. Capital market- longer time financing
4. Commodity markets Commercial banks – provides services to businesses
5. Derivatives markets- trading financial Investment banks (JP Morgan, Goldman Sachs)
instruments
§ Trade in foreign exchange, commodities, bonds, shares,
Equity Finance- sell a portion of the business and derivatives for speculation
§ Raise finance and on mergers and acquisitions
Debt Finance- loans § mergers and acquisitions
§ IPO’s
Primary markets- issuing of new shares
Secondary markets- dealing with share that have already been
issued
Role of the financial market:
§ Facilitate savings, which allows people to transfer their spending power from the present to the future. It can be
done through a range of assets, such as storing money in savings account and holding stocks and shares.
§ Lend to businesses and individuals which allows consumption and investment- financial intermediary, the step
between taking money from one person to give to another since money from savings is used for investment.
§ Facilitate the exchange of goods and services by creating a payment system. Central banks print paper money,
institutions process cheque transactions, companies offer credit card services and banks and bureau de changes buy
and sell foreign currencies.
§ They provide forward markets . This is where firms are able to buy and sell in the future at a set price - exists for
commodities and in foreign exchange and helps to provide stability.
§ Provide a market for equities company’s shares. Issuing shares is an important way for companies to finance
expansion but people would be unlikely to buy shares if they were unable to sell them on in the future. Financial
markets provide the ability for shares to be sold on in the future, making the asset more appealing.
,Functions of a commercial bank:
§ Commercial banks accept savings by allowing individuals to open up savings accounts to keep their money safe
and to provide a rate of return on money assets in the form of an interest rate
§ As profitable organisations, commercial banks will use funds from savers and funds gained from the money
markets to lend to individuals and firms. Individuals who need loans to buy houses, cars etc and firms who need
loans to finance investment expenditure can receive such finance from a commercial Bank. Savings put Into a
commercial bank can be used to offer loans with the difference between the interest rate offered to savers and
charged to borrowers acting as the banks profit margin
§ Commercial banks can also be financial intermediaries. In this sense they can move funds from 3rd party lenders
to borrowers through an individual’s bank account and they can also allow for payments to take place between
an individual with a bank account to a given firm
§ Commercial banks can provide financial services advice to its customers in the form of insurance, mortgage and
investment advice i.e. individuals can at a fee, receive guidance on where best to save their money, how to
budget sustainably and also how to achieve the best mortgage deals. Businesses can gain advice on credit
worthiness and safer strategies for future growth.
Functions of an investment bank:
1. A key role of an investment bank engage in proprietary trading. Banks own funds to invest in financial assets
for a better return than market I/R. those who work on the trading floor use market knowledge and skills to buy
shares, bonds and financial market derivatives they think will rise significantly in value before selling them on
to make significant profit.
2. The majority of investment banking activity is focused in market making. practise of holding a large quantity
and variety of financial assets to be able to buy and sell whenever demanded, in this sense a market for that
asset. Whenever a client wants to sell a bond, they know an Investment bank will buy it up, furthermore if an
investor wants to buy a bond. they know an investment bank will sell to them. Investment banks make profit from
this activity by offering a spread difference between their prices/offers and market prices
3. Investment banks can organise and advise on mergers and acquisitions on behalf of a client. The firm, known as
the predator, looking to merge with or takeover a rival firm, the target, can sees advice for an Investment over
many areas to do with the move, for example, how to structure the deal (cash sale, share acquisition etc.),
overcome regulatory hurdles, ensure competition policy will not halt the deal, perform due diligence on the
target, best timing of the deal, dealing with necessary paperwork and deal with publicity in the media all for a fee
4. investment banks be issues share new issues on behalf of a client who needs to raise funds. For example a firm
may be issuing, shares, or bonds but wants help and advice from an investment bank to ensure these products are
actually sold. In which case investment banks can contact prospective buyers, create the products and market the
shares/bonds all for a fee. Furthermore, if the client is in need of urgent finance through the sale of shares for
example, the investment bank can buy up all the shares charging a percentage fee on top, a practise known as
underwriting.
Evaluation. Since deregulation of financial markets in the 1970s, commercial and investment banks can operate
under the same business name, for example Barclays has both an investment banking division and a commercial
banking arm- allowed for rapid growth of investment banking industry where safe and stable funds made in the
commercial banking part of the business can be used in riskier but more lucrative investment banking activities
where huge profits can be made and in a short period of time. It’s rare to see purely specialised investment banks for
this reason.
§ Whilst this has allowed the industry to grow, creating jobs and contributing strongly to economic growth and
services exports, it does increase systemic risk in the economy where the collapse of one firm in the financial
industry can ripple through the industry leading to further banking collapses and eventual meltdown of the
entire industry.
, Commercial Banks and Credit Creation
§ The traditional model of profit making for commercial banks involves accepting savings from individuals
keeping a fraction of these savings within the bank or in their bank account at the Bank of England in case
savers return for some of their money.
§ The rest can be used to issue loans to those who need to borrow and spend.
§ The difference between the interest rate given to savers and the interest rate charged to borrowers is the profit
for the commercial bank. Once spent, it will end up in a savings account back at the commercial bank and the
process will start over. This process is known as the money multiplier indicates how much the money supply will
increase from the initial savings deposit.
Reasons for Commercial Bank Failure
§ Liquidity Crisis. A commercial bank does not have enough S/T liquid assets to meet its S/T liabilities. This could
happen if commercial banks run down their liquid cash assets from savings to make l/t loans where there’s
greater profit to be made or if they borrow s/t in the money markets and use this to increase less liquid assets,
lending long term- consequence is that if S/T liabilities need to be met e.g. if savers come to the bank and
demand their savings- commercial bank won’t be able to meet this obligation causing panic and a run on the
bank, known as a liquidity crisis.
§ Insolvency. This is where a commercial bank does not have enough capital (shareholder's funds or retained
profit) to offset any losses in longer term asset values. For example if excessive risk is taken by banks and any
mortgages or other loans default they will be underwritten, cancelled out by a reduction in capital. However if
the level of capital is large enough, the bank will owe more than it owns - not a long run sustainable position.
Overall liabilities will be greater than assets, an unbalanced balance sheet, culminating in the failure of the
commercial bank.
Consequences of Bank Failure
§ Systemic Risk. Bank failure can increase systemic risk in the economy where the collapse of one commercial bank
can ripple through the industry leading to further banking collapses and eventual meltdown of the entire
industry. This is because as one bank fails, assets held by another bank may become worthless and will need to
be offset by a reduction in capital. If capital is not enough to offset this loss this bank = insolvent and fail causing
problems for other banks in the same way.
§ Recession. Given imp of financial industry for growth- bank failure/ systemic risk = lead to deep recession or
depression = increases U/E and reduces incomes and SOL not just for those who work in industry but negative
multiplier effects occur - create job losses throughout entire economy. Businesses, individuals and governments =
reliant on commercial banks and financial markets to borrow and spend. Businesses and individuals = directly
affected - risk averse banks = unwilling to lend, reducing borrowing for investment and consumption hampering
AD significantly. Financial sector collapse= limit borrowing by GOV for GOV spending to stimulate recovery
deepening crisis, heightening U/E.
§ Negative Externalities and Moral Hazard. Bank failure -significant impact on tax payers if GOV feel systemic risk
is too great a possibility and thus agree on bank bailouts. Tax payers money used to fund bailout BUT if funds do
not currently exist at level required to cover the bailout, gov =substantially increase borrowing, creating a L/T
burden of debt repayment and debt interest servicing, impacting current/ future gens with higher tax rates.
§ The deeper consequence of bank bailouts is that it incentivises further excessive risk to be taken by commercial
banks either by not holding enough liquid assets, deciding instead to convert cash assets into loans or by a bank
deciding to offer more risky loans for profit seeking purposes. Banks take such risks knowing that if they fail as a
result, either becoming insolvent or suffering a liquidity crisis, the gov will bail them out to continue operating=
moral hazard, where excessive risk is taken due to third parties paying the consequences of decisions going
wrong as banks believe there are too big to fail. Despite the gov being able to regulate bank decisions and
operations after a bail out, if a bail out is expected, this will not stop excessive risk taking with the tax payer
suffering the most as a result of more likely bank failure.
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