Financial Markets, Institutions and Regulation
Core concepts
Financial markets channel funds from savers to borrowers. Candidates must understand money versus capital markets, primary versus secondary markets, and the roles of banks, insurance companies, pension funds, and securities exchanges. Know the functions of a central bank: monetary policy, lender of last resort, and payment-system oversight. Grasp prudential regulation, capital adequacy, deposit insurance, and the rationale for regulating systemic risk and protecting depositors and investors. Understand key instruments: treasury bills, bonds, equities, and derivatives.
Common traps
A frequent trap is confusing the primary market (new issues raising capital for the issuer) with the secondary market (trading existing securities among investors). Another is mixing monetary policy tools (open market operations, reserve requirements, policy rate) with fiscal tools (taxes, spending). Watch for asymmetry between banks and non-bank institutions and the difference between solvency (assets exceed liabilities) and liquidity (ability to meet short-term obligations). Regulation aims at market failure, not at guaranteeing profits.
Worked rule of thumb
A bank holds 100 of assets and 90 of liabilities, so capital is 10, a 10 percent capital ratio. If assets fall in value by 15 to 85, capital becomes negative 5 and the bank is insolvent, even if it still holds some liquid assets. Rule of thumb: capital absorbs losses; liquidity buys time. Regulators watch both, because a solvent bank can fail from a liquidity run.