BANKING & FINANCE

Unit 1

The Financial Sector

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UK Financial Sector

The Financial System is one of the many important systems operating within the UK and can be defined as:

“a set of markets for financial instruments, and the individuals and institutions who trade in those markets” (Howells & Bain, 1998).

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The Main Functions of the Financial System Are:

The provision of financial services and liquidity.

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A Financial System

• Channels funds from lenders (Surplus units) to borrowers (Deficit units)

• Creates liquidity and money

• Provides a payments mechanism

• Provides financial services like investment, insurance and pensions

• Offers portfolio adjustment facilities.

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The Main Types of Financial Business Are:

• Banking – Retail and Wholesale

• Insurance – Life; General and Investment

• Mortgage Finance – Home and Corporate

• Fund Management – Pensions, Insurance

• Capital Markets – IPOs and security exchanges

• Money Markets – eg Inter-bank; CD.

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BanksCentral

(Bank of England)

Retail Wholesale (Primary) (Secondary) (Commercial) (Merchant)

Discount HousesFinance HousesForeign banks

Consortium banks

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The Bank of England Implements monetary policy, and ensures there is

sufficient liquidity in the commercial banking system for it to be able to meet its daily commitments.

  Semi-independent since May 1997. Full independence gives the central bank the freedom to

choose both the goal and the steps necessary to achieve it.  The Bank of England, has had instrumental independence

since 1997 – it can take whatever steps it thinks necessary to achieve the Government’s goal. Since then, the MPC has been responsible for setting interest rates in order to meet the government’s inflation target.

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Retail Banks• Must be authorised by the FSA.• FSA exercises prudential control and enforces capital

adequacy requirements as per Basle Accord.• Operate the money transmission service.• Clearing banks, via APACS and BACS, provide the

cheque clearing service as part of that service.• Required to hold a cash ratio of 0.15% of their eligible

sterling liabilities above £400m with the Bank of England, interest free.

• Large branch network – customer convenience.• Very large in terms of market capitalisation.

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Wholesale Banks

• Includes Acceptance houses; Overseas banks; Consortium banks

• Function – To finance and facilitate trade• Provide banking and financial services to the

corporate sector• Provide advice to companies on mergers and

takeovers• Investment funds management• Dealing in Foreign Exchange Market• Syndicated lending.

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Financial Intermediaries (FIs)

Two main types of Financial Intermediary:

Deposit-taking FIs

(eg Banks and Building Societies)

Non-deposit-taking FIs

(Insurance; Pension; UTs; ITCs; OEICs)

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“The City”

The Square Mile known as “The City” attracts a range of associated professions due to the possibility of reaping the benefits of external economies of scale. For example:

• Accounting • Legal• Investment management.

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London Is a Global Financial Centre

It holds a comparative advantage due to:

Time zone

Language

Expertise

Deregulation 04/21/23

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Important Themes

Globalisation/Internationalisation

Information Technology

Freedom from Exchange Controls

Regulation/Deregulation/Re-regulation

Innovation

Competition

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Financial Markets

Widely dispersed geographically both nationally and internationally. Facilitated by:

Deregulation

Abolition of exchange controls

Improved communications

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UK Financial Markets Comprise:

The Money Markets

The Capital Markets

LIFFE (Euronext)

Lloyds

FOREX

LTOM

(now part of LIFFE/Euronext)

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Money Markets

• Match borrowers and Lenders of large short-term Sterling and currency funds

• Deal in wholesale deposits

• Deal in secured and unsecured borrowing and lending

• Secured market = Discount/Repo Market

• Unsecured market = Parallel market.

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Parallel Market Comprises:

Inter-bank market

Inter-company market

Local Authority market

Eurocurrency market

Finance house market

Commercial paper market

Certificates of deposit market

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Capital Markets Comprise;

The Stock Exchange

The Main The AIM The CP The Gilts

Market Market Market Market

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Financial Claims

These are financial assets and liabilities of:

Financial InstitutionsPersonal Sector

Industrial & Commercial Companies’ (ICCs) SectorGovernment Sector

• Represent flows of funds between these sectors, and• Represent assets to the investor, liabilities to the

issuer.

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Financial Institutions

Liabilities Assets

Deposits Loans

Mortgages

Reserve Assets

Gilts

Treasury Bills

Bills of Exchange04/21/23

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Personal Sector

Liabilities Assets

Borrowings Deposits

Securities

Insurance

Unit Trusts

Gilts

National Savings04/21/23

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ICCs Sector

Liabilities Assets

Capital:

Shares

Debentures

ULS

CULS Cash

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Government Sector

Liabilities Assets

Gilts

Treasury Bills

National Savings Cash

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Financial Claims Are Either:

Marketable or Non-Marketable Marketable are Company or Government

securities.

Non-Marketable are Cash Investments such as bank, building society, Insurance, Pensions and National Savings products.

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Marketable Financial Claims

• Company (Corporate):- Equities (Shares); Corporate Bonds (eg Debentures & ULS); Warrants; CDs (Banks); Commercial Paper.

Higher risk; higher potential returns.

• Government:- Government Bonds (Gilts); Treasury Bills; Gilt Repos.

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Non-marketable Financial Claims

• Cash Investments:- Bank and Building Society accounts; National Savings Accounts, Certificates, etc.

• Characteristics:-Low Risk

Low ReturnShort-term

Capital Safety

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Financial Claims Are Represented By:

Financial Instruments

These are a means of holding surplus wealth by depositors and investors which can be traded in the financial markets.

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Financial Instruments – General:

• Bills: Short-term instruments issued at a discount to their par value

• Bonds: Longer-term, fixed interest/income instruments

• Equities: Ordinary shares of companies. They pay a variable return – dividend.

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Financial Instruments –Specific:• Treasury Bills:- Short-term Promissory Notes of HM

Treasury; Issued at discount to par. Return = capital gain.

• Commercial Bills:- Short-term bearer securities issued by companies at a discount to par. The market prefers to deal in denominations of £500,000. Variants are Bank Bills, Trade Bills and Acceptance Credits. Self-liquidating.

• Commercial Paper:- Short-term securities issued at a discount by companies (with assets of £25m) in need of short-term funds (7 days – 1 year). Similar to commercial bills of exchange except that they are not self-liquidating.

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• Certificates of Deposit (CDs):- Short-term, fixed interest securities issued by banks and building societies. Usual term is up to one year, but can be up to five years. (“NCDs” in Hong Kong)

• Gilt-edged securities:- Government Bonds issued to cover the PSNCR (previously the PSBR). Known as Funded Debt, it is long-term borrowing by the Government.

• Debentures:- Loan stock issued by companies to cover long-term borrowing needs. Debentures are secured borrowing with a fixed and/or a floating charge against the company’s assets. Other loan stock:- ULS; CULS is unsecured.

• Shares:- These are mainly ordinary (variable dividend) and preference (fixed dividend).

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Financial Instruments – Characteristics:

• Risk

• Term to Maturity

• Expected Return

• Liquidity

• Real value certainty

• Currency denomination

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Risk, Term and Return

• There is a direct relationship between these 3 variables.

• Generally, the longer the term the greater the risk. Therefore, greater expected return.

• Marketable securities are inherently riskier than non-marketable.

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Liquidity SpectrumNotes and coinCurrent account

Ordinary account7 day deposit account

Time depositTreasury Bill

Commercial bill and CDGovernment BondCorporate Bond

SharesBuildings , land and machinery

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Corporate Bonds and Shares Compared

• Bond interest paid from profits before tax• Share dividend paid from profits after tax• Interest and dividend liable to income tax• Capital gains on Bonds not liable to CGT• Capital gains on shares are liable to CGT• Bond-holders are creditors of the company• Shareholders are owners of the company• Corporate bonds susceptible to inflation• Shares have tended historically to beat inflation.

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Equity Ownership in the UK 

1963 1975 1981 1989 1999 2006 % % % % % % Institutions  Pension funds 6.4 16.8 26.7 30.6 19.6 12.7 Insurance companies 10.0 15.9 20.5 18.6 21.6 14.7 Unit & Investment trusts 1.3 4.1 3.6 5.9 2.7 1.6  Total 17.7 36.8 50.8 55.1 48.2 29.0  Personal sector  Individuals 54.0 37.5 28.2 20.6 15.3 12.8 Other UK organisations 21.3 20.1 17.4 11.5 11.6 18.2 Overseas 7.0 5.6 3.6 12.8 29.3 40.0  Total 82.3 63.2 49.2 44.9 56.2 71.0

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