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LE Paper 7 · Topic 1
Topic 1 of Paper 7 explains how savings reach borrowers, what money and central banks do, how markets and intermediaries are organised and regulated, and what moves global markets. Expect short cause-and-effect questions: what a rate rise or an open market purchase does, whether a deal is direct finance or intermediated, which international body does what, which indicator leads the cycle, and what went wrong in 1997, 1998 and 2007-09. Learn the mechanisms and the few figures that matter (Basel III ratios, the 10% direct investment test, 2% inflation targets, the deposit multiplier) and most questions answer themselves.
17 min read9 sections
Checked 11 October 2026 against: BCBS Basel III summary table, transitional arrangements 2017-2028 and Finalising Basel III in brief (bis.org); BIS, About the BIS; FSB, History of the FSB and OTC derivatives reforms (fsb.org); IOSCO, About IOSCO; IMF, Articles of Agreement (imf.org); World Bank, IBRD and IDA; WTO, What is the WTO?; Federal Reserve FAQ on monetary policy goals, Open Market Operations and Reserve Requirements (federalreserve.gov); ECB, Monetary policy (ecb.europa.eu); HKMA, Guide to Hong Kong Monetary, Banking and Financial Terms: Money supply (hkma.gov.hk); US BEA glossary: Direct investment; The Conference Board, US Leading Indicators and Business Cycle Indicators; Federal Reserve History essays on the Asian Financial Crisis, LTCM, the Subprime Mortgage Crisis and the Great Recession. Syllabus: LE Paper 7 v3.5 (effective 1 March 2026), Topic 1. As at October 2026. Independent prep, not endorsed by HKSI Institute or the SFC.
Prices in financial markets are set by supply and demand, as in any market. The interest rate is the price of loanable funds: more saving lowers it, more borrowing raises it. For bonds, price and yield move in opposite directions, so a bigger supply of bonds with unchanged demand means lower prices and higher yields. When a government borrows heavily at home, it competes with private borrowers for savings, pushing rates up and crowding out some private investment.
The flow of funds groups the economy into sectors. Surplus units save more than they invest; deficit units invest more than they save. Funds move from one to the other directly or through intermediaries.
| Sector | Usual position | How it supplies or raises funds |
|---|---|---|
| Households | Net surplus (saver) | Bank deposits, pension and insurance savings, funds, direct holdings of shares and bonds |
| Businesses (corporate) | Net deficit (borrower) | Bank loans, bonds, commercial paper, new shares |
| Government | Often net deficit | Treasury bills and government bonds |
| Overseas (external) | Either, depending on the current account | Capital flows into and out of the economy |
| Financial institutions |
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| Channel funds |
| Banks, insurers and funds intermediate between the other sectors |
Trap: calling a bond deal arranged by a bank 'indirect finance'. If the investor ends up holding the issuer's own security, it is direct finance.
Takeaway: Households save, firms and governments borrow. Direct finance means holding the issuer's paper; indirect finance means holding a bank's claim.
The balance of payments records all transactions between residents and non-residents in a double-entry system. The current account covers goods, services and income; the financial account covers direct investment, portfolio investment, financial derivatives, other investment (such as loans and deposits) and reserve assets (ECB, balance of payments statistics). A current account deficit must be financed by net financial account inflows or by running down official reserves.
Direct investment gives a resident of one economy a lasting interest in, and a degree of influence over, an enterprise in another. The US Bureau of Economic Analysis applies the international test of at least 10% of the voting securities. Smaller, passive stakes are portfolio investment. Short-term portfolio holdings and short-term bank loans can be withdrawn quickly; across East Asia in 1997 capital inflows slowed or reversed (Federal Reserve History).
| Body | Origin | What it does |
|---|---|---|
| International Monetary Fund (IMF) | Articles adopted at Bretton Woods, 22 July 1944; 190 members | Surveillance of the international monetary system and members' policies; resources for members in need (balance of payments problems); technical assistance |
| World Bank (IBRD and IDA) | IBRD created 1944 | Development finance: IBRD lends to middle-income and creditworthy low-income countries; IDA gives grants and concessional loans to the poorest |
| Bank for International Settlements (BIS) | Established 1930, Basel; owned by 63 central banks | Supports central banks' pursuit of monetary and financial stability; acts as a bank for central banks; hosts the Basel Committee |
| Basel Committee on Banking Supervision (BCBS) | Hosted at the BIS | Primary global standard setter for the prudential regulation of banks (the Basel Framework, including Basel III) |
| Financial Stability Board (FSB) | April 2009, successor to the Financial Stability Forum (1999) | Coordinates international financial regulatory reform for the G20 and monitors implementation |
| IOSCO | Headquartered in Madrid | Brings together securities and derivatives regulators; its Objectives and Principles of Securities Regulation are used in IMF and World Bank FSAPs |
| World Trade Organization (WTO) | Successor to the GATT | Rules of trade between nations |
IOSCO's three objectives: protecting investors; ensuring that markets are fair, efficient and transparent; and reducing systemic risk.
Trap: mixing up the two Bretton Woods institutions and the Basel bodies. The IMF watches policies and lends for payments problems; the World Bank finances development; bank capital standards come from the Basel Committee, not IOSCO.
Takeaway: IMF stabilises, World Bank develops, BIS banks for central banks, BCBS sets bank rules, IOSCO sets securities principles, FSB coordinates.