Financial Markets | A-Level Economics Notes

These revision notes cover everything you need to know about Financial Markets for A-Level Economics. They're designed for students studying AQA A-Level Economics, Edexcel A-Level Economics, and Edexcel International A-Level Economics. Written by Jaisul Naik, UCL Economics graduate and A-Level Economics tutor since 2017.

What is the role of financial markets?

1. facilitate borrowing and saving
2. facilitate the exchange of goods and services
3. provide forward markets
   1. this allows firms to buy currencies delivered in the future
   2. at a price that is agreed in advance
4. provide a market for equities

Explain what happened in the global financial crisis

1. US mortgage companies offered risky mortgages.
2. House prices increased.
3. This led to a further increase in demand for housing.
4. US mortgage companies sold their debt to banks all around the world.
5. This allowed them to provide even more risky mortgages.
6. House prices increased rapidly and this formed a bubble
7. Over time, banks and people realised that these mortgages were high-risk.
8. This caused panic and led to a bank-run.
9. Banks ran out of liquidity.
10. This led to a fall in consumer confidence and business confidence.
11. This led to a demand-side shock across the world.

Explain the causes of financial market failure

Moral hazard

1. Mortgage companies offered 'subprime' mortgages as they targeted high profitability.
2. Moral hazard meant that banks were happy to increase risk as they new the risk could be passed on.

Asymmetric information

1. Mortgage companies were then able to bundle up the mortgages and pass them on/ sell them to banks all across the world.
2. Asymmetric information meant that mortgage companies had more information about the mortgages than the banks.

Speculation and market bubbles

1. In the background, homeowners and consumers saw huge increases in house prices.
2. This incentivised more people to buy homes.
3. This led to a bubble.

Bank run

1. Market signals eventually caused people to realise that houses and assets were over-valued, and that something was wrong.
2. We later found out that mortgages were mis-sold.
3. Consumers panicked and withdrew their money from banks as they expected people to default on payments and for banks to run out of money.

Systemic risk

1. Systemic risk is the possibility that an event in one bank/ insurance company can trigger instability across the economy.
2. This happened as mortgage companies in the US spread risk to banks across the world.
3. Additionally, financial institutions are highly interconnected, which means that a failure in one institution or market can have a knock-on effect on other institutions. For example, if a large bank fails, it can lead to a lack of confidence in the banking system and a decrease in the availability of credit.

Externalities

1. As financial market failure can be severe, it is usually the central bank that acts as a lender of last resort if there is a risk of a bank failing.
2. This means that the burden of risky lending and bad decision making gets passed onto the taxpayer.

Recession and negative multiplier effect

1. A financial market failure can cause banks to reduce liquidity but it can also reduce consumer and business confidence massively.
2. This can lead to a decrease in consumer spending and a deflationary spiral.

What is the role of the central bank?

The financial crisis caused externalities. The central bank stepped in as the lender of last resort in order to prevent the financial crisis spreading even further.

Financial market failure has huge systemic risk as so many banks are inter-linked.

1. a lender of last resort
2. in control of monetary policy
3. banker to the government
4. banker to banks
5. regulation of financial markets

What does the PRA do?

The PRA is part of the Bank of England. They help to ensure that banks do not get themselves into financial trouble by ensuring they manage their risk and capital.

What does the FPC do?

The FPC is also part of the Bank of England. It helps to control financial markets from systemic risk.

What does the FCA do?

The FCA is separate from the Bank of England. The FCA ensures consumers are treated fairly in financial markets.

What is a capital ratio?

A capital ratio is the minimum amount of capital that banks have to hold relative to their risky assets.

What is a liquidity ratio?

A liquidity ratio is the amount of liquid assets a bank has relative to its overall assets.

Summary questions

1. What is the role of financial markets?
2. Explain what happened in the global financial crisis
3. Explain the causes of financial market failure
   1. asymmetric information
   2. externalities
   3. moral hazard
   4. market bubbles
4. What is the role of central banks?
5. What does the PRA do?
6. What does the FPC do?
7. What does the FCA do?

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