The financial sector

The financial sector is part of an economy that provides financial services to economic agents, which involves a wide range of institutions to fulfill certain objectives. The financial sector can become important in achieving economic growth, providing price stability, and increasing employment and the individual financial markets within the financial sector work together to achieve this.

Role of financial markets

Credit provision: The financial sector can provide loans and credit to businesses, individuals, and governments who want to undergo economic transactions, but do not have the resources to do so in the current moment. This enables more capital to be effectively used around the economy, potentially contributing to economic growth.

Provision of equity markets: The financial sector allows for firms to sell their shares to raise capital, and allows for investors to buy their shares to earn dividends or create valuation returns. The financial sector does this primarily through stock exchanges, so a platform can exist for the buying and selling of publicly traded companies' shares.

Savings facilitator: The financial sector can gather savings from individuals, businesses, and governments. This is important because economic agents want a place to store their money, to transfer spending power into the future. This can be done by purchasing assets or storing money in bank accounts.

Risk management and insurance: Insurance companies can help individuals and businesses manage risks including those of health, property, or damage. By spreading risk among operations, it may increase confidence in the economy, thus leading to more investment and hence more economic growth.

Facilitating trade and commerce: The financial sector allows for smooth transactions between buyers and sellers, using systems such as banks, credit cards, and online transaction platforms. The financial sector can help these smooth transactions to occur both domestically and internationally.

Creating liquidity: Financial markets, such as stock exchanges provide liquidity to assets, which allows individuals to be able to quickly turn their assets into cash without losing value. This allows investors to quickly access funds, making investing more attractive to outsiders.

Financial sector market failure

Externalities: Externalities are consequences to third parties that are not reflected in the original price of the economic transaction. Negative externalities can occur in finance and may lead to severe economic harm if they are not dealt with or accounted for. For example, the collapse of one major bank can lead to severe effects on other financial institutions and individuals around a country.

Moral hazard: Moral hazard occurs when an entity takes on too much risk to earn a higher return, however, normally this entity does not bear the consequences of the risk. In the financial sector, this can happen if parties believe they will be bailed out if things go wrong, allowing them to generate as many short-term returns as possible and allowing them to take excessive risk.

Asset bubbles: Financial markets can sometimes lead to asset bubbles, where the price of assets increases so quickly due to vast quantities of market speculation at once. This can make the asset overvalued and can lead to severe consequences when investors believe they should sell this overvalued asset in return for an undervalued asset that will rise in value. If large amounts of investors commit to mass selling due to anxiety and herding behaviour, the bubble "pops" and the asset falls sharply in price. An example of this was the dot-com bubble in the early 2000s in the USA.

Asymmetric information: Asymmetric information can lead to market failure when one economic agent has more knowledge about an economic transaction than another agent. This can lead to exploitation of agents and can occur in the financial sector when consumers purchase products that are cheaper elsewhere or are riskier than the consumer originally thought.

Financial regulation

Financial regulation pertains to the rules, laws, and regulations that govern the financial sector. It protects the economy from fraud, makes the financial sector more efficient, and ensures protection for financial institutions and consumers.

Types of financial regulation:

Prudential regulation: This regulation ensures that financial institutions are stable, and have enough capital to cover risks. If used, this means that no financial institution should theoretically go out of business due to financial troubles.

Market regulation: This is the overseeing of financial markets to prevent price manipulation and insider trading. This ensures a fair financial market where entities are unable to benefit at the purposeful cost of other entities.

Consumer protection: Consumer protection aims to protect the welfare of consumers by encouraging the sale of financial products to include fair marketing and to be properly explained. This reduces market failure of asymmetric information.

UK financial regulators:

Financial Conduct Authority (FCA): The FCA is an independent body that is responsible for the protection of consumers and overseeing the conduct of financial firms. It oversees firms such as investment firms, banks, mortgage brokers and insurance companies and may take action against a firm for failing to treat their customers fairly.

Prudential Regulation Authority (PRA): The PRA is part of the Bank of England and focuses on the financial stability of firms to ensure that they can be resilient to external shocks and remain in business. They can do this by making sure these firms hold adequate capital and have enough liquidity in their assets.

Financial Policy Committee (FPC): The FPC is also a part of the Bank of England and is used to monitor systemic risks to the stability of the UK financial system. This body focuses on the broader financial environment and ensures that risks to the entire system are mitigated. They can do this by recommending specific policies to the government or altering capital requirements held by financial firms.

Central Banks

A central bank is an authority that oversees the monetary policy of a country or monetary union. Some examples of central banks include:

Bank of England: The central bank of the UK.

Federal Reserve: The central bank of the USA.

European Central Bank: The central bank of the EU.

Bank of Japan: The central bank of Japan

People's Bank of China: The central bank of China

The role of central banks

Oversees monetary policy: Central banks are in control of monetary policy, which means they can control the interest rates at which banks borrow from them. This can affect the whole economy, by affecting the number of borrowers and lenders in the economy, thus stimulating or slowing aggregate demand.

Ensuring price stability: Central banks aim for a stable and low rate of inflation, which will help create a predictable economic environment, allowing businesses and individuals to make long-term financial decisions.

Banking for the government: The extent to which this occurs can vary from country to country, but in the UK, the Bank of England typically holds the UK's gold reserves and government debt

Acting as a lender of last resort: When large institutions are on the verge of collapse, such as in 2008, they may look to the central bank to bail them out. This is because allowing the collapse of these institutions could lead to catastrophic events, thus the central bank uses unconventional monetary policies to bail these institutions out of debt.

Financial regulation: In some countries, the central bank can have a role in regulating the financial market, to ensure the financial market is stable and economic agents are protected. In the UK, the PRA and FPC are both bodies that are part of the Bank of England that oversee financial regulation.

Issuing currency: Typically, a central bank has control over the money supply in an economy. This control means that they have to issue currency and maintain an efficient amount of money in the economy.

Banking for other banks: Banks can deposit their money within a central bank, sell their illiquid assets to a central bank or receive loans from a central bank. This keeps the banking system afloat and prevents it from collapsing.