What does the financial sector do, and why does it sometimes fail?
The role of financial markets, market failure in the financial sector, the role of central banks, and the regulation of the financial system.
An Edexcel A-Level Economics A answer to the financial sector, covering the role of financial markets in the wider economy, the causes of market failure in the financial sector such as asymmetric information and moral hazard, the role of central banks, and the regulation of the financial system after the 2008 crisis.
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What this dot point is asking
Edexcel wants you to explain the role of financial markets, explain why the financial sector can fail, explain the functions of a central bank, and explain how the financial system is regulated.
The role of financial markets
By channelling savings into investment, a healthy financial sector raises potential output; when it malfunctions, the whole economy suffers, which is why financial-sector failure is a Theme 4 priority.
Market failure in the financial sector
Central banks and regulation
After the 2008 financial crisis, the UK strengthened regulation: the Financial Policy Committee monitors system-wide (macroprudential) risk, the Prudential Regulation Authority supervises the safety of individual banks, and the Financial Conduct Authority protects consumers and market integrity. Higher capital requirements (Basel III) and ring-fencing of retail banking aim to reduce moral hazard and contagion.
Examples in context
- Northern Rock (2007). A bank run that forced the Bank of England to act as lender of last resort, a real systemic-risk and liquidity case.
- RBS bailout (2008). Taxpayer rescue illustrating moral hazard and the externalities of bank failure.
- LIBOR rigging. The manipulation of the interest-rate benchmark, a textbook example of market rigging.
- Basel III and ring-fencing. Post-crisis UK reforms raising capital requirements and separating retail from investment banking.
Try this
Q1. Explain what is meant by moral hazard in the financial sector. [3 marks]
- Cue. Banks take on excessive risk because they expect to be bailed out, so others bear the cost of their decisions.
Q2. Explain one function of a central bank. [3 marks]
- Cue. For example, acting as lender of last resort to banks facing a short-term liquidity crisis to prevent a wider collapse.
Exam-style practice questions
Practice questions written in the style of Pearson Edexcel exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
Edexcel 20194 marksA bank holds bn of risk-weighted assets and bn of capital. Calculate its capital ratio, and state whether it meets a minimum requirement.Show worked answer →
A short calculate question on prudential regulation.
Capital ratio .
At the bank fails the minimum, so it would need to raise more capital or cut risky lending. Higher capital ratios reduce moral hazard by making banks absorb their own losses.
Markers reward (1) the capital-ratio formula, (2) , (3) the conclusion that it falls short of the requirement and the link to financial stability.
Edexcel 202212 marksAssess the view that tighter regulation of the financial sector does more harm than good.Show worked answer →
A 12 mark question (around 8 KAA, 4 evaluation).
KAA: explain that regulation (higher capital ratios, ring-fencing, FCA conduct rules) corrects market failures, asymmetric information, moral hazard and systemic externalities, reducing the chance and cost of a crisis like 2008.
Evaluation: tighter rules raise compliance costs, can reduce lending and growth, may push activity into a shadow banking sector and risk regulatory capture. Reach a judgement weighing stability against efficiency.
Markers reward the market-failure analysis, the costs of regulation and balance.
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Sources & how we know this
- Pearson Edexcel A-Level Economics A (9EC0) specification — Pearson Edexcel (2015)