4.2.4.1 The Structure of Financial Markets and Financial Assets
Money is a medium of exchange, store of value, measure of value, and a standard of deferred payment.
Money is acceptable, portable, durable and divisible.
Money supply is the total amount of money circulating in an economy.
Narrow money (M0) includes physical currency (notes and coins), as well as deposits and other liquid assets.
Broad money (M4) refers to the entire money supply, including liquid and non-liquid assets.
Financial markets are markets in which financial assets or securities are traded.
Money markets provide a means for lenders and borrowers to satisfy their short-term financial needs. Assets are short-term, with maturity dates of a year or less, and they are liquid assets.
Capital markets are where securities such as bonds and shares are issued to raise medium to long-term finance.
Currency markets are global, decentralised markets where currencies are traded, often by large international banks.
Financial markets facilitate saving, lend money, facilitate the exchange of goods and services, and provide forward markets such as the currency futures market.
Equity is wealth/ shares. It is a stock or security that represents interest in owning.
Debt is the money people owe. Money which has been borrowed from a lender.
Bonds are financial securities sold by companies (corporate) or by governments (government bonds), which are a form of long-term borrowing.
Maturity is the time a financial asset is outstanding for.
Coupon is the interest payments that must be made to the bond holder each year between the date of issue and the maturity.
Yield = 100% x coupon/ market price.
There is an inverse relationship between market interest rates and bond prices. If interest rates are lower now, the value of the bond rises because, at the time the bond was issued, interest rates were fixed higher.
Firms raise finance by issuing shares, corporate bonds, or by borrowing from a bank.
4.2.4.2 Commercial Banks
Commercial banks are financial institutions that aim to make profits by selling banking services to its customers. They are also known as retail or high-street banks.
Commercial banks accept and create deposits.
Investment banks don’t accept deposits from the general public. They help companies and other financial institutions to raise finance by selling shares or bonds.
A commercial bank’s balance sheet compares assets and liabilities.
Assets include cash, near money, bills, investments, advances and fixed assets such as buildings.
Liabilities include share capital, reserves, short-term borrowing, and customer deposits.
The main objectives of a commercial bank are liquidity, profitability and security.
Profitability: the state of yielding a financial profit or gain.
Liquidity: measures the ease at which an asset can be converted into cash without a loss of value.
Security: secured loans, such as mortgage loans secured against the value of property, are less risky than unsecured loans.
Security and liquidity conflict with, and are prioritised against profitability.
Security means that a bank must take less risks, less profitable loans and deposits, and liquidity means that a bank has cash and deposits held. Both of these objectives limit how much credit is available for profit. Banks find a balance between its objectives.
A bank creates credit when it makes a loan. The loan results in the creation of an advance, which is an asset in the bank’s balance sheet, and a deposit which is a liability.
Money multiplier = 1/ Reserve Ratio.
4.2.4.3 Central Banks and Monetary Policy
A central bank is a national bank that provides financial and banking services for its country’s government and banking system. It also implements the country’s monetary policy, issues currency, and acts as a lender of last resort. It is a banker to the government, and a banker to banks.
The Bank of England is our central bank, and always aims to make decisions that will help meet UK macroeconomic objectives, such as a 2% inflation rate.
The Monetary Policy Committee consists of nine economists, chaired by the governor of the Bank of England, who meet once a month to set the Bank Rate and other aspects of monetary policy.
Exchange rate can affect aggregate demand and monetary policy objectives. If the pound appreciates, imports become cheaper and AD falls. Likewise, the demand for UK exports fall, and the interest rate will have to increase to attract investors.
The monetary policy transmission mechanism shows that a change in the bank rate can lead to changes in market interest rates, asset prices and expectations/ confidence, which can influence domestic demand. Also, changes in the bank rate can affect the exchange rate value of the pound, which can affect import prices and also aggregate demand. Overall, these changes will affect inflation rates.
The MPC of the Bank of England can use changes in the bank rate to try to achieve the objectives for monetary policy, including the government’s target rate of inflation.
For example, the BoE can adjust the bank (discount) rate. If they lower the bank rate, commercial banks can borrow money cheaper, and then lend to consumers at cheaper interest rates, lowering the cost of borrowing. This will cause aggregate demand to increase and inflation to rise.
Central banks can also alter the reserve requirement for commercial banks. If commercial banks don’t have to hold as much money, they are able to lend out more, increasing the money supply. If the supply of money increases, the interest rate will fall.
Open market transactions are less common in the UK, but they allow the central bank to sell bonds to raise finance. This can then be lent out to commercial banks, and then consumers.
Other than increasing the money supply, there are some other current and recent instruments of monetary policy:
Quantitative Easing: the central bank creates new money electronically, used to buy financial assets such as government bonds.
Funding for Lending: this scheme incentivises banks and building societies to boost lending to UK real economy.
Forward Guidance: attempts to send signals to financial markets, businesses and individuals, about future interest rate policy.
4.2.4.4 The Regulation of the Financial System
The Prudential Regulation Authority is responsible for the micro-prudential regulation and supervision of banks, building societies, credit unions, insurers and major investment firms.
The Financial Policy Committee is responsible for identifying, monitoring and taking action to remove or reduce systemic risks with a view to protecting and enhancing the resilience of the UK financial system, and also support the government’s economic policy.
The Financial Conduct Authority is responsible for macro-prudential regulation, aiming to ensure financial markets work well, an in the best interest of consumers.
Liquidity ratio: ratio of a bank’s cash and other liquid assets to its deposits.
Capital ratio: the amount of capital on a bank’s balance sheet as a proportion of its loans.
Financial market failure can be caused by
a bank run: when a bank does not have enough liquid assets to meet its current liabilities, causing panic amongst lenders, or by
insolvency:when a bank does not have enough capital assets to offset losses in asset values.
Moral hazard: the tendency of individuals and firms, once protected against some contingency, to behave so as to make that contingency more likely.
Systemic risk is the breakdown of the entire financial system, caused by inter-linkages within the financial system, rather than the failure of individual banks.
Regulation failure can occur as a result of regulatory capture, moral hazard, imperfect information or unintended consequences.