Financial Markets and Banking

AQA A-level Economics 7136 · specification section 3.2.4 (parts 1, 2 and 4)

Why this topic matters

Specification section 3.2.4 is "Financial markets and monetary policy". Monetary policy itself is covered in [9.2](/aqa-economics/9-2-monetary-policy). This page covers the other three quarters of that section, which are examined and are easy to lose marks on because they are the least like the rest of the course: the structure of financial markets, what banks actually do, and why the system is regulated.

The role of financial markets

Financial markets exist to move funds from those with a surplus to those who want to spend more than they have. Their functions:

• Facilitate saving, giving households somewhere to store purchasing power.
• Lend to businesses and individuals, funding investment and consumption.
• Allow the exchange of goods and services, by operating the payments system.
• Provide forward markets in currencies and commodities, letting firms fix a future price and so reduce risk.
• Provide a market for equities, so that ownership of firms can be bought and sold, which is what makes investing in a company attractive in the first place.

Money markets, capital markets and foreign exchange markets

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• Money markets deal in short-term debt, typically under a year. Treasury bills, commercial paper, interbank lending. This is where institutions manage day-to-day liquidity.
• Capital markets deal in long-term finance: shares (equity) and longer-dated bonds. This is where firms and governments raise money for investment.
• Foreign exchange markets trade currencies, used both by traders needing foreign currency and by speculators.

The primary market is where a security is first issued and the money actually reaches the firm or government. The secondary market is where existing securities are traded between investors; the issuer receives nothing, but the secondary market is what makes the primary market work, because few would buy an asset they could never sell.

Bond prices and yields

This relationship is examined directly and is counter-intuitive the first time.

A bond pays a fixed coupon. If you buy a bond paying £5 a year for £100, the yield is 5 per cent. If market interest rates rise and new bonds pay £10, nobody will pay £100 for yours. Its price falls until the fixed £5 represents a competitive return: at £50, the £5 coupon is a 10 per cent yield.

Bond prices and yields move in opposite directions.

Approximately: yield = coupon ÷ market price.

So a rise in interest rates lowers bond prices, which is why monetary tightening reduces the value of bond portfolios, and why long-dated bonds move most.

Commercial banks and investment banks

Commercial banks take deposits from the public and lend to households and firms. Their balance sheet:

• Assets, what is owed to the bank: loans and mortgages, reserves at the central bank, securities.
• Liabilities, what the bank owes: customer deposits, mostly.

They pursue three objectives that pull against each other:

• Liquidity: holding enough cash to meet withdrawals.
• Security: lending only where the risk of default is acceptable.
• Profitability: lending long at higher rates than they pay on deposits.

The conflict is the examinable point. The most profitable assets are illiquid long-term loans; the most liquid assets earn least. A bank that maximises profitability holds too little liquidity and cannot meet a surge of withdrawals. That is a bank run, and it can destroy a solvent bank, because the assets are real but cannot be turned into cash fast enough.

Investment banks do not take retail deposits. They arrange share and bond issues, advise on mergers and acquisitions, and trade securities on their own account and for clients.

The distinction matters because investment banking is higher risk. Where the two are combined, retail depositors' money can be exposed to trading losses, which is the argument for separating them.

The regulation of the financial system

Financial markets fail in ways that justify intervention, and the exam rewards naming the failure rather than just asserting that regulation is needed.

• Asymmetric information: borrowers know their own riskiness better than lenders, giving adverse selection and moral hazard.
• Externalities: a bank failure imposes costs far beyond its own shareholders, because the payments system and credit supply are shared infrastructure.
• Moral hazard from implicit guarantees: a bank believed too big to fail can take risks knowing losses may be socialised.
• Speculative bubbles and herding, where asset prices detach from fundamentals.
• Market rigging, such as manipulation of benchmark rates.

Regulatory responses:

• Capital ratios, requiring banks to fund a minimum share of assets with equity so shareholders absorb losses first.
• Liquidity ratios, requiring enough readily saleable assets to survive a withdrawal surge.
• Stress testing against hypothetical downturns.
• Deposit insurance, guaranteeing retail deposits up to a limit, which stops runs but itself creates moral hazard.
• Ring-fencing retail banking from investment banking.
• Conduct regulation, on mis-selling and market manipulation.

Evaluation: regulation has costs. Higher capital ratios mean less lending for a given deposit base, which can restrain growth. Rules invite regulatory arbitrage into less regulated shadow banking. And regulators face the same information problem as everyone else, so government failure is possible here too.

Common exam mistakes

• Saying a rise in interest rates raises bond prices. It lowers them.
• Confusing money markets (short-term) with capital markets (long-term).
• Treating a bank run as proof a bank was insolvent, when illiquidity alone is enough.
• Describing the liquidity, security and profitability objectives without explaining that they conflict.
• Arguing for regulation without naming the market failure it addresses.
• Forgetting that deposit insurance both prevents runs and creates moral hazard.

Quick revision

• Financial markets channel funds from savers to borrowers, run payments, allow hedging and make equity tradable.
• Money markets are short-term; capital markets are long-term; primary issues raise money, secondary trades do not.
• Bond prices and yields move in opposite directions; yield is roughly coupon ÷ price.
• Commercial banks balance liquidity, security and profitability, and the three conflict.
• Investment banks arrange issues and trade; they take no retail deposits.
• Regulation answers asymmetric information, externalities and moral hazard, using capital and liquidity ratios, stress tests, deposit insurance and ring-fencing.