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4.4 Finance – useful resources
Some useful resources
 A useful booklet explaining the Global Financial Crisis:
http://www.bankofengland.co.uk/education/Pages/resources/financialsystem/fs.aspx
 The Open University ‘Open learn’ programme has an excellent range of
podcasts/videos linked to the Global Financial Crisis:
http://www.open.edu/openlearn/money-management/management/the-bankingcrisis-cause-and-effect
 The Bank of England has a selection of animated videos called ‘The role of the Bank
of England, parts 1-7’. These can be found on the Bank of England’s video You Tube
link. Other useful videos listed on the Bank of England website include titles such as
‘Why do financial markets matter’ and ‘What is stress testing’.
 Useful to look at topical articles from newspapers or journals such as The Economist
on the internet, e.g. The Economist featured an article on 4 August 2014 called
‘What macro prudential regulation is, and why it matters’ and The Guardian has an
article titled ‘This is no recovery, this is a bubble-and it will burst’ by Ha-Joon
Chang on 24 February 2014.
 Tutor2u is likely to include a range of resources on this topic area.
Knowledge, Application, Analysis and Evaluation
Knowledge
In terms of the Global Financial Crisis, there are some key points which will
aid students’ understanding of topic 4.4 in general: these are summarised in
this section.
At any point in time, only a small fraction of depositors at a bank would wish to
withdraw their money in cash. Banks must ensure that they have enough liquid
assets (those easily convertible into cash) to ensure they can meet cash
requirements from customers. Assets are money value items which a bank owns.
Loans to customers, such as a small bank loan to a business or a mortgage for a
household, will be an asset for the bank. These loans generate an income for the bank
over time, in terms of interest. However, some of these assets will be illiquid – the
bank will not be able to quickly get the cash value in the short run. Customers hold
deposits at banks. These are liabilities for the bank, since the monetary value
belongs to the customer and not the bank. Shareholder capital or equity is also a
liability since it will generate a payment to shareholders over time in the form of
dividends.
Banks create money by lending; they have an incentive to lend as much as
possible, since the interest they gain on these loans will make a profit for the bank.
However, they must ensure that they have enough liquid assets to support these
extra deposits for individuals. One of the key roles of a central bank is to act as
a lender of last resort. On a particular day, the bank may have an unexpected
number of customers who want to withdraw cash. If the bank has insufficient liquidity
that day, they can borrow from other banks; or the central bank may be needed to
step in and provide liquidity. This prevents a bank run; this is when customers,
partly linked to herd behaviour, start to panic that the bank has run into difficulty – so
everyone starts to want their money in cash. If withdrawals by a bank’s depositors are
greater than its cash and liquid assets, then the bank will fail. This can cause
contagion, if not dealt with promptly, when all banks are affected by a fall in
confidence.
4.4 Finance – useful resources
A fundamental problem kick started the Financial Crisis in 2007/08. Many bank assets
became ‘bad debts’ (never to be repaid), so the value of their assets fell. From 2007
banks began to experience liquidity problems as interbank lending froze; they were
unwilling to lend to each other since there was uncertainty about which banks were
exposed to these bad debts. Northern Rock was frozen out of the interbank lending
market, its liquidity dried up, so the Bank of England had to intervene quickly to halt a
bank run which had started. Liquidity support was provided to Northern Rock in
September 2007, but ultimately the government nationalised Northern Rock to protect
taxpayer interests.
However, it soon became clear that the scale of the bad debt exposure was significant
within the financial market as a whole, requiring the Bank of England to step in to
provide large scale liquidity support: acting as lender of last resort. The bad debt
exposure also created an insolvency crisis. Shareholder’s capital can absorb the loss
from any bad debt exposure (it acts as a shock absorber if risky loans make
unexpected losses), but if this is not sufficient, the bank becomes insolvent. It owes
more money – its liabilities (such as the value of its customer deposits) than it owns –
its assets (such as loans to others). One insolvent bank will spark insolvency shocks
for other banks, since any previous loans to the insolvent bank, part of the assets of
the bank, will have to be written off – they will not get repaid. In 2007/08 the
government/taxpayer stepped in to provide capital to some banks – recapitalisation
package for the Royal Bank of Scotland and Lloyds (the taxpayer then became a part
owner) and made loans to some insolvent banks.
The government worked with the Bank of England to support the role as lender of last
resort since the scale of the crisis was so significant.
The cost of the Financial Crisis was to plunge economies into recessions. In the UK the
scarcity of liquidity pushed up the cost of borrowing and reduced the availability of
loans for businesses and individuals. Confidence was also shattered. This meant the
Financial Crisis (both a liquidity and insolvency crisis) made a direct hit on the real
economy, causing aggregate demand to fall and unemployment to rise.
The risk of the whole financial system collapsing from a liquidity crisis
and/or insolvency crisis is called systemic risk. The central bank will want to
reduce this risk by regulating the financial sector and acting as lender of last resort.
Regulation of financial markets (both within the UK, EU and globally) was significantly
tightened after the Financial Crisis
A key role of regulation is to ensure that a bank holds sufficient capital to protect
customer deposits at its bank and holds enough liquid assets. Even the risk of
insolvency or a liquidity crisis can cause a bank run, as depositors lose confidence.
Microprudential and macroprudential regulation aims to create financial
stability.
4.4 Finance – useful resources
Application
The market failures need to be applied to the financial sector. Some examples of
application include:
Asymmetric information
 Collateral Debt Obligations (CDOs) were complex financial products, created by
financial institutions, and then traded within the financial sector. They contained a
pool of sub-prime mortgages and other loans. The buyers often had difficulty
assessing the ‘true’ level of risk associated with these assets, due to their complex
nature.
 The PPI scandal of the 1990s and 2000s. Consumers were sold unnecessary
insurance policies, at exploitatively high prices, when they took out loans such as
mortgages and credit cards. Consumers did not understand whether they needed
the insurance, whether it was necessary to buy from the lender or they could shop
around, and what precisely they were being covered for. They were oversold
insurance which many of them didn’t need.
 Regulators often possess inadequate information to regulate banking activity
effectively, due to the complexity of the products or systems created by financial
institutions. The problem is compounded by regulatory capture
Speculation and market bubbles
These bubbles are often fueled by speculative behaviour in the financial markets that
the value of an asset will rise. In the housing market, irresponsible mortgage lending
can also fuel a housing price rise which is way beyond its objective value. Panic selling
then sets in, creating a fall in the asset value and a fall in confidence. The Swiss bank,
UBS, reported in 2014 that London property was the most overvalued in the world
with high risk that the bubble will burst. Since 2013 real London house prices have
increased by 40%; key causes are foreign investors and ‘right to buy’ schemes fueling
demand.
Moral hazard
Banks will be willing to take more risks in their banking activities, to potentially
benefit the bank and the banker, because any negative costs or consequences which
result will be felt by someone else, such as the government/ taxpayer or shareholder.
The central bank is a lender of last resort: they will usually step in with extra funding
to prevent a bank collapsing. This role of the central bank, combined with bankers’
bonuses being tied to making high short run profits with a minimum secure salary,
gives bankers a real incentive to take on unacceptable risk in their lending behavior.
This excessive risk taking was the prime cause of the 2007/08 Financial Crisis.
 Although the government is always likely to act as lender of last resort, new global
rules proposed in 2014 (and to take effect by 2019) by the Financial Stability board
(an international body – the current chairman is Mark Carney), requires ‘’globally
systemically important banks’’ to hold more reserves to cover any losses they make
(the banks will have to increase their capital: assets ratio) This would mean
shareholders will bear an increasing burden of any future banking crisis, rather than
the taxpayer. This helps to remove some of the moral hazard problem, since the
costs of unacceptable risk taking are now felt by the bank via its shareholders.
 In April 2013 the European parliament approved capping bankers’ bonuses to
double bankers pay, or triple with shareholders’ approval, to remove the incentive
of unacceptable risk taking.
 In June 2015 the Bank of England and FCA have proposed that any bank involved
in an investigation for misconduct will put the bonuses of their most senior
managers at risk of being clawed back for 10 years. This is to link pay rewards with
4.4 Finance – useful resources
responsible banking activity – ‘to discourage irresponsible risk taking and shorttermism’.
Market rigging
The LIBOR rate fixing scandal and the rigging of foreign exchange markets have been
highlighted in the press in recent years.
In June 2015 it is also reported that ‘The fair and Effective Markets Review’ proposes
new laws to make it illegal to manipulate markets, such as the foreign exchange
market. This would make individuals more personally accountable; rather than just
fines for the institutions involved.
Externalities
Market failure in the financial sector in 2007/08 imposed high external costs on the
real economy, beyond the costs to the financial markets themselves. These external
costs fall on the taxpayer and government, and firms and individuals in general as
GDP falls and unemployment rises. According to the National Audit Office, at its peak,
UK taxpayers’ direct subsidies to banks was just over £1 trillion.
Role of the Bank of England and government
The Bank of England provided liquidity support and loosened monetary policy in
response to the crisis. Quantitative easing was introduced. The Government bailed out
specific banks with state investment and relaxed fiscal policy. Regulation of the
banking industry was also tightened up. In the UK, in 2012, 3 bodies were set up to
improve financial regulation; The Financial Policy Committee, The Prudential
Regulation Authority and The Financial Conduct Authority.
Analysis
Students will need to be able to analyze why some types of market failure are a
feature of financial markets. Detailed knowledge of new regulations will not be
required; but recognition of why they are necessary (how in principle they target the
market failure) is important. The impact of the market failure, in terms of the effect
on individuals and the economy as a whole, is also important. Some examples:
Asymmetric information
The asymmetric information, between the original lenders of subprime mortgages, the
financial institutions who then packaged up the CDO’s and the subsequent buyers,
combined with the US housing bubble bursting, meant that interbank lending froze.
Banks were unwilling to lend to each other, since no one knew to what extent another
bank was exposed to what could be worthless assets (bad debts). This caused a
liquidity crisis 2007/08, where credit in general became scarce and also sparked an
insolvency crisis. The consequences were a collapse in aggregate demand and
confidence.
Asymmetric information in general, such as in the PPI scandal, means that consumers
are exploited and there is over supply of certain types of financial products. Resources
will be inefficiently allocated.
Externalities
Bankers only take into account the private costs and benefits of a ‘risky’ trading
activity. Private costs might include the cost to the bank of a default, the cost to the
banker of losing his job. Private benefits might include the high return if the activity is
successful – both for the bank and the individual banker. The external cost of
managing risk is not considered: the real cost to the economy if the whole system
4.4 Finance – useful resources
starts to collapse e.g. chance of crisis triggering a fall in confidence, fall in aggregate
demand, rise in unemployment, opportunity cost of taxpayer’s bail out etc. These
external costs need to be internalized, for example, a bank levy and/or regulation
needs to be more effective to ensure banking activity is at the ‘optimum level’
Moral hazard
The central bank’s role as lender of last resort is likely to always create some moral
hazard. However, regulation requiring banks to hold more reserves/capital so that
they and their shareholders can survive big losses without resorting to the taxpayer,
will reduce this market failure. Individual bankers may also be less willing to take
risks if their asymmetric compensation structures are reformed through regulation. In
good times, bankers stood to gain large bonuses if their risky behaviour proved
successful, but if it failed, they still earnt a high salary. The bonus cap should reduce
the personal incentive for bankers to take unacceptable high risk.
Speculation and market bubbles
The causes of speculative bubbles can be linked to herding behaviour by consumers,
unsustainable lending by financial markets which fuel the boom and exaggerated
expectations of growth in the price of the asset. However, something happens to burst
the bubble. The impact on aggregate demand can be discussed with reference to the
wealth effect on consumption and the impact of confidence on consumption.
Market rigging
The link to collusive behaviour can be made. Market rigging will distort the fair
working of the market; the market is being manipulated to send out wrong signals
about the market e.g. Barclays, in the Libor scandal, wanted to look like it had more
liquid assets than it actually had. Manipulating the key lending rate between banks
then affects the ‘price of money’ for millions of home loans and mortgages.
Consequences of market failure in the financial sector
Students need to be aware that the impact on the real economy in terms of real GDP,
unemployment, inflation will be significant if there is a financial crisis caused by
market failure; this is because banks underpin the functioning of the modern economy
and the availability and cost of loans will affect most households and firms; hence the
strong link with spending in an economy. This means effective regulation is
particularly important.
Evaluation
 The 2007/08 Financial Crisis had a massively negative impact on economies
globally. The size of the market failure was large, but this must be balanced with
the contribution of the financial sector to an economy i.e. link to the role of
financial markets and the contribution of the financial sector to the UK’s GDP.
 The issue of government failure. Any regulation may never be wholly effective;
perhaps particularly for financial markets. Due to the complexity of products
created, there may always be asymmetric information, making it hard for
regulators to have perfect information. It is, perhaps, also a market where there is
greater scope for ‘regulatory capture’ since the financial sector has high rewards for
any regulator, in the future, choosing to work in the sector. It is also fast moving,
so any regulation may be ‘out of date’ very quickly and financial institutions may
quickly find a way round the regulations e.g. growth of shadow banking.
 Regulation to reduce market failure may cause some negative consequences, which
are minimized if they are adopted globally, rather than just within a single country
or group of countries, such as the EU. For example, in 2014 the UK bank levy cost
4.4 Finance – useful resources
HSBC £720m: this prompted them to threaten to move out of the UK where it is
cheaper. A fall in foreign direct investment would have a significant negative impact
on the UK’s GDP.
 In theory a tax on banks, such as a bank levy, if set correctly, could internalize the
external costs and reduce ‘risky’ trading to its optimum level. However, regulators
will have difficulty putting a monetary measure on the external cost of banking
activities.
 Much of the unacceptable risky banking activity, which contributed heavily to the
2007/08 Financial Crisis, was linked to moral hazard. For this to change, it may be
important to let more banks fail; although the short run external costs would be
extremely high. That way the culture of banking may change, so the size of market
failure in this sector falls over time.
 The UK is particularly prone to housing bubbles, because a high proportion of
householders own houses and because there is scarcity of new housing with a
growing population.