What financial markets are for

The spec gives you five functions. Learn them as a list — they are directly examinable.

• To facilitate saving — offering households a safe place to store purchasing power and earn a return.
• To lend to businesses and individuals — channelling those savings into investment and consumption. This is the core of it: without lending, only those who already have money could ever invest.
• To facilitate the exchange of goods and services — the payments system: current accounts, debit cards, clearing. Without it, trade collapses to barter.
• To provide forward markets in currencies and commodities — allowing a firm to hedge: an airline can fix the price of jet fuel a year ahead, or an exporter can lock in an exchange rate, removing risk from its planning.
• To provide a market for equities — companies raise capital by issuing shares, and the stock market gives those shares liquidity (you can sell them), which is precisely what makes people willing to buy them in the first place.

The distinction to keep straight: a share (equity) is a slice of ownership — it pays a variable dividend and has no maturity. A bond is a loan to a company or government — it pays a fixed coupon and is repaid at maturity. Note also the inverse relationship: when bond prices rise, bond yields fall.

Which function is this?

The banker's dilemma: liquidity vs profitability

A commercial bank takes in deposits (which are its liabilities — it owes you the money, repayable on demand) and makes loans (its assets). It profits from the gap between the interest it pays savers and the interest it charges borrowers.

Every bank runs on fractional reserve banking: it keeps only a fraction of deposits as cash, and lends the rest out. That is what makes it profitable — and what makes it fragile. If every depositor demanded their money at once, no bank on earth could pay. That is a bank run: a self-fulfilling panic in which a solvent bank can be destroyed simply because people believe it might fail.

Why capital matters: a bank's capital (shareholders' equity) is the buffer that absorbs losses. In 2007 some banks were leveraged 30 or 40 to 1 — meaning a fall of just 3% in the value of their assets would have wiped out all their capital and left them insolvent. That is why post-crisis regulation is obsessed with capital ratios.

A bank's capital ratio

Credit creation

Asymmetric information

Finance is the market in which asymmetric information does the most damage, because what is being traded is a promise about the future — and only one side really knows how likely it is to be kept.

• The borrower knows more than the lender about their own riskiness. This produces adverse selection: if the bank cannot tell good borrowers from bad, it charges an average interest rate — which is too high for the safe borrowers (who leave the market) and too cheap for the reckless ones (who pile in). The pool of borrowers gets worse, precisely the opposite of what the bank wants.
• The seller of a financial product knows more than the buyer. Sub-prime mortgages were repackaged into complex securities that almost nobody — including, it turned out, the credit rating agencies who stamped them AAA — actually understood. Buyers could not price the risk they were taking.
• Mis-selling — PPI, endowment mortgages, unsuitable pension transfers: consumers cannot judge a product whose consequences appear decades later.

Why this justifies regulation: asymmetric information means the market cannot price risk correctly on its own. Hence disclosure rules, the licensing of advisers, deposit insurance, and the regulation of rating agencies.

Moral hazard

Moral hazard — when someone takes more risk because they know they will not bear the full cost if it goes wrong.

• "Too big to fail." A bank whose collapse would destroy the payments system knows the government cannot allow it to fail. So it takes on more risk than it otherwise would: profits are private, losses are socialised. The implicit guarantee is a subsidy that also lets it borrow more cheaply than a smaller rival.
• Bonus structures. A trader paid a bonus on this year's profits, with no clawback if the trade blows up in three years, has a powerful incentive to take enormous risks with other people's money. Their downside is capped (they can be sacked); their upside is not.
• Deposit insurance — necessary to stop bank runs, but it means savers have no incentive to check whether their bank is prudent, which removes market discipline. A textbook trade-off.

Distinguish it precisely: adverse selection happens before the transaction (hidden characteristics — you cannot tell who is risky). Moral hazard happens after (hidden actions — behaviour changes once you are insured). Examiners test this distinction constantly.

Which failure?

Speculation and market bubbles

An asset's price should reflect the discounted value of the income it will generate. In a bubble, it stops doing so: people buy purely because they expect the price to keep rising, so they can sell to someone else at more — the "greater fool".

Why bubbles happen: herding and irrational exuberance (behavioural economics); extrapolative expectations ("house prices always go up"); cheap credit fuelling leveraged buying; and moral hazard among traders. When the bubble bursts, the fall is amplified by fire sales — leveraged holders must sell to repay debt, which pushes prices down further, forcing more selling.

Is speculation always harmful? No. Speculators add liquidity and help prices adjust quickly to news. The problem is destabilising speculation — buying because the price is rising rather than because the asset is undervalued. The same activity, opposite effect.

Dividend yield

Externalities and market rigging

• Negative externalities — this is the one that makes finance different from every other industry. When a bakery fails, its customers buy bread elsewhere. When a bank fails, it can bring down the entire payments system, freeze lending to healthy firms, and tip the whole economy into recession. The social cost of a bank failure vastly exceeds the private cost to its shareholders. In 2008–09 the UK bailouts cost taxpayers tens of billions and the ensuing recession destroyed output and jobs across every sector — none of which the bankers bore. That externality is the fundamental economic justification for regulating banks far more heavily than other firms.
• Market rigging — collusion and manipulation. The LIBOR scandal: traders at several major banks colluded to submit false estimates of their borrowing costs, distorting an interest rate benchmark used to price hundreds of trillions of dollars of contracts worldwide. Also insider dealing (trading on private information) and foreign exchange rigging. All are forms of market abuse — they destroy trust, deter honest participants, and misallocate capital.

Systemic risk is the technical name for this externality: the risk that the failure of one institution cascades through the interconnected system and brings down the rest. It cannot be seen by looking at any single bank — which is why regulators now supervise the system as a whole (macroprudential regulation), not just individual firms.

Why regulate banks more than bakeries?

The four functions of a central bank

The spec names exactly four. Learn them.

• 1. Implementation of monetary policy. The Bank of England's Monetary Policy Committee sets Bank Rate to hit the government's 2% CPI inflation target, and conducts quantitative easing (buying government bonds to raise their price, push down long-term yields and expand the money supply). Its operational independence since 1997 is designed to make the inflation target credible — a politician facing an election has an incentive to cut rates; an independent technocrat does not.
• 2. Banker to the government. It holds the government's account, manages the issue of gilts (government debt), and holds the foreign exchange reserves.
• 3. Banker to the banks — lender of last resort. When a solvent bank cannot borrow in a panic, the central bank lends to it against good collateral. This stops a liquidity crisis becoming a bank run and then a systemic collapse. But note the tension: the very existence of this backstop creates moral hazard — the classic answer, Bagehot's rule, is to lend freely, against good collateral, at a penalty rate, so that it is a rescue, not a subsidy.
• 4. Regulation of the banking industry. Setting and enforcing prudential rules — capital, liquidity, stress tests — and maintaining financial stability.

Lender of last resort

Regulation after the crisis

Every post-2008 reform maps directly onto one of the market failures above.

• Higher capital requirements (Basel III) — a thicker equity cushion to absorb losses. Directly attacks the externality of failure and reduces the chance a bailout is ever needed.
• Liquidity requirements — banks must hold enough high-quality liquid assets to survive a 30-day stress. Attacks the bank run problem.
• Stress tests — the Bank of England simulates a severe recession and checks that each bank would survive. Attacks asymmetric information: it forces the true risk into the open.
• Ring-fencing — separating ordinary retail deposit-taking from risky investment banking, so that a trading loss cannot destroy people's current accounts. Attacks moral hazard and "too big to fail".
• Bonus rules and clawback — deferring bonuses and reclaiming them if trades later sour. Attacks the incentive problem directly.
• The UK architecture: the Financial Policy Committee (macroprudential — the system as a whole), the Prudential Regulation Authority (the safety of individual firms), and the Financial Conduct Authority (conduct, consumer protection, market abuse).

Evaluate the regulation too. Higher capital ratios make banks safer but mean they lend less, which can slow growth and investment. Compliance costs are heavy and fall hardest on small banks, reducing competition. Activity may migrate to the lightly regulated shadow banking sector, where the risk becomes invisible. And regulators face regulatory capture and asymmetric information of their own — they are always fighting the last crisis.

Which market failure?

Tap a situation, then tap the failure it illustrates.

Match the term to its meaning

Tap a definition on the left, then its term on the right.

The cost of safer banks

The big ideas to know

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