1. Financial Markets

3.
(from the Bank of England)

4. Fiat

6. Market Failure Asymmetric Information
regulators may have insufficient information, relative to the bankers, to ensure the stability of the banking system.
PPI
Sub-prime mortgages
Market Failure

8. Market Failure Externalities
decisions by the financial sector could cause external costs.
For example, in 2009, the UK government had to spend over $45bn of taxpayers’ money to prevent the collapse of RBS.
Market Failure

9. Market Failure Moral hazard
by rescuing banks from collapse, there is a danger that they will follow inappropriate policies in the future because they know that the government will rescue them.
Investment bankers, traders etc. are encouraged to take short term risks to generate profit
Market Failure

11. Speculation and market bubbles
poor lending decisions by bankers can lead to market bubbles.
For example, excessive lending to home buyers who have no deposit and/or poor credit records can result in a housing bubble.
As house prices rise, investors look to buy which causes the price to become too high (“Herding Behaviour” or the “Greater Fool Theory”
…Also look up “Irrational Exuberance” who said it, why was it famous?

12. Market Failure Market rigging Insider trading
it has been alleged that some bankers have been involved in rigging key interest rates and exchange rates.
Market Failure
See for a very clear summary on what LIBOR (London Interbank Offered Rate) is and why it matters, linked to the LIBOR rate-fixing scandal which led to large fines and a tightening of regulation.

15. Central banks and financial market regulation

16. 1 2 3 6 5 4 9 7 8

18. Acting as banker to other banks
If banks get into liquidity shortages then the Central Bank is able to lend the commercial bank sufficient funds to avoid the bank running short.
This is a very important function as it helps maintain confidence in the banking system.
But does this result in moral hazard  market failure?
Acting as banker to other banks

19. Acting as banker to the government
Lender of Last Resort to Government.
Handle the accounts of government departments
Acting as banker to the government

20. Regulator of the financial system
Ensure stability of financial system, e.g. regulate bank lending and financial derivatives
Correct market failures that might occur in financial markets
One example is that the central bank may increase the reserve requirements that the banks need to have at the central bank and therefore reduce the amount of money in circulation. Following the financial crisis, regulations are being changed and new ones introduced.
Students will not be expected to know details of regulations but would be expected to examine the possible consequences of those mentioned in, for example, a data response question.
Regulator of the financial system

21. Stress Testing https://www.youtube.com/watch?v=b75qgqHqV98
In March 2013, the FPC of the Bank of England recommended that regular stress testing of the UK banking system should be developed to assess the system’s capital adequacy.
Research these stress tests from newspaper articles and identify what their objectives are and what risks they can assess. ‘What is a Bank Stress Test?’, an IMF Survey magazine article (29 July 2010 – see is a good article explaining the key threats to financial health which a stress test normally includes.
Review the results of the Bank of England’s 2016 stress tests here: stest.aspx
Stress Testing

22. Banking Regulation – recently enhanced
Banking Regulations – how they have changed
Banking Regulation – recently enhanced