BANKING & FINANCE Unit 1 The Financial Sector 9/7/20151

2 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). 9/7/2015

3 The Main Functions of the Financial System Are: The provision of financial services and liquidity. 9/7/2015

4 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. 9/7/2015

5 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. 9/7/2015

6 Banks Central (Bank of England) Retail Wholesale (Primary) (Secondary) (Commercial) (Merchant) Discount Houses Finance Houses Foreign banks Consortium banks 9/7/2015

7 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  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. 9/7/2015

8 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. 9/7/2015

9 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. 9/7/2015

10 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) 9/7/2015

11 “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. 9/7/2015

12 London Is a Global Financial Centre It holds a comparative advantage due to: Time zone Language Expertise Deregulation 9/7/2015

13 Important Themes Globalisation/Internationalisation Information Technology Freedom from Exchange Controls Regulation/Deregulation/Re-regulation Innovation Competition 9/7/2015

14 Financial Markets Widely dispersed geographically both nationally and internationally. Facilitated by: Deregulation Abolition of exchange controls Improved communications 9/7/2015

15 UK Financial Markets Comprise: The Money Markets The Capital Markets LIFFE (Euronext) Lloyds FOREX LTOM (now part of LIFFE/Euronext) 9/7/2015

16 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. 9/7/2015

17 Parallel Market Comprises: Inter-bank market Inter-company market Local Authority market Eurocurrency market Finance house market Commercial paper market Certificates of deposit market 9/7/2015

18 Capital Markets Comprise; The Stock Exchange The Main The AIM The CP The Gilts Market Market Market Market 9/7/2015

19 Financial Claims These are financial assets and liabilities of: Financial Institutions Personal Sector Industrial & Commercial Companies’ (ICCs) Sector Government Sector Represent flows of funds between these sectors, and Represent assets to the investor, liabilities to the issuer. 9/7/2015

20 Financial Institutions Liabilities Assets Deposits Loans Mortgages Reserve Assets Gilts Treasury Bills Bills of Exchange 9/7/2015

21 Personal Sector Liabilities Assets Borrowings Deposits Securities Insurance Unit Trusts Gilts National Savings 9/7/2015

22 ICCs Sector Liabilities Assets Capital: Shares Debentures ULS CULS Cash 9/7/2015

23 Government Sector Liabilities Assets Gilts Treasury Bills National Savings Cash 9/7/2015

24 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. 9/7/2015

25 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. 9/7/2015

26 Non-marketable Financial Claims Cash Investments:- Bank and Building Society accounts; National Savings Accounts, Certificates, etc. Characteristics:- Low Risk Low Return Short-term Capital Safety 9/7/2015

27 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. 9/7/2015

28 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. 9/7/2015

29 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. 9/7/2015

30 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). 9/7/2015

31 Financial Instruments – Characteristics: Risk Term to Maturity Expected Return Liquidity Real value certainty Currency denomination Divisibility 9/7/2015

32 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. 9/7/2015

33 Liquidity Spectrum Notes and coin Current account Ordinary account 7 day deposit account Time deposit Treasury Bill Commercial bill and CD Government Bond Corporate Bond Shares Buildings, land and machinery 9/7/2015

34 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. 9/7/2015

35 Equity Ownership in the UK % % % % % % Institutions Pension funds Insurance companies Unit & Investment trusts Total Personal sector Individuals Other UK organisations Overseas Total /7/2015