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The early part of the twenty-first century has witnessed a sea-change in regulation of the financial system following the financial crisis of 2007-2008. Prior to that financial crisis, the official policy was directed to deregulating the financial system, whereas after 2008 the move is towards increased regulation. This book begins the study of the UK financial system with an introduction to the role of a financial system in an economy, and a very simple model of an economy. In this model the economy is divided into two distinct groups or sectors. The first is the household sector and the second is the firms sector. The book describes the process of financial intermediation, and in doing so, it examines the arguments as to why we need financial institutions. It highlights the nature of financial intermediation, and examines the various roles of financial intermediaries: banks as transformers, undertaking of transformation process, and providers of liquidity insurance. The nature of banking, the operations carried out by banks, and the categories of banking operations are discussed next. The book also examines the investment institutions and other investment vehicles. It examines the role of central banks in the financial system in principle, particularly, the role of the Bank of England. Primary market for equity issues, secondary market, the global stock market crash of October 1987 and efficient markets hypothesis are also covered. The book also looks at the trading of financial derivatives, risk management, bank regulation, and the regulation of life insurance companies, pension funds.
This chapter provides an introduction to the role of a financial system in an economy. It presents a very simple model of an economy and establishes some of the basic financial concepts which will be drawn upon throughout this book. In this model the economy is divided into two distinct groups or sectors. The first is the household sector and the second is the firms sector. The chapter examines the nature of the financial claims which underlie the transfer of funds from those with surplus funds to those who wish to borrow. It also provides a sectoral analysis of the financial system, focusing on households, non-financial corporations, financial corporations, general government and rest of the world. The chapter discusses three sets of national accounts that are relevant to the analysis of the financial sector: national wealth, financial wealth and flow-offunds accounts.
This chapter describes the process of financial intermediation, and in doing so, it examines the arguments as to why we need financial institutions. It discusses the reasons why we need financial intermediaries and hence the benefits of the financial sector. The chapter highlights the nature of financial intermediation, examining the various roles of financial intermediaries: banks as transformers, undertaking of transformation process, and providers of liquidity insurance. Banks reduce the problems arising out of asymmetric information. The chapter also examines the implications of the existence of financial intermediaries for individual lenders and borrowers using the Hirshleifer model and provides an overview of the tremendous changes that have taken place in the UK financial system over the last 20 years.
Banks are the most important category of financial institution, which provide intermediation services to the economy. This chapter focuses on the nature of banking and the operations carried out by banks. It examines the different categories of banking operations. For expository purposes, the chapter divides discussion of banking into six categories: retail banking, wholesale/investment banking, international banking, universal banking, Islamic banking and narrow banking. The process of financial intermediation can be deconstructed into four constituent parts: loan origination, loan funding, loan servicing, and loan warehousing. The process of securitisation separates loan origination to loan servicing from function loan warehousing so that after the loan is arranged, it is transferred to a third party. The chapter examines the risks faced by banks and how they are managed. The risks include: liquidity risk, market risk, payments risk/settlement risk, operational risk, credit risk, sovereign risk and legal risk.
This chapter examines the investment institutions and other investment vehicles (i.e. funds which finance investment). It discusses the types of investment institutions: pension funds, long-term insurance companies, investment trusts, unit trusts, open-ended investment companies, property trusts, and exchange-traded funds. The portfolio investment of both long-term insurance companies and pension funds is determined by the nature of their liabilities and the return on and availability of the various types of financial asset. The chapter also examines the role played by the new funds: hedge funds, private equity, sovereign wealth funds (including central bank reserves) and money market funds. The importance of these new funds can be gauged by the fact that McKinsey & Company designated the first three the 'new power brokers'. The main types of alternative finance funding includes peer-to-peer lending, invoice funding, and crowd-funding.
Central banks have achieved greater prominence since 2008 as a result of their role in bailing out banks following the financial crisis. This chapter examines the role of central banks in the financial system in principle and discusses whether, in fact, this role is necessary for the smooth running of such systems. It addresses the question of why it should be necessary for the financial system to have a 'super-bank' responsible for the operation of the financial system. This includes consideration of the objectives of central banks, their role in the operation of monetary policy and their function as a lender of last resort. The chapter also examines the part they may play in the regulation of the financial system and whether they should be independent of the government. Against this background it looks in more detail at the role of the Bank of England.
This chapter looks at the main financial markets making up the UK financial system. It considers some general issues relating to the nature and role of financial markets, including types of trading system and types of trading activity. The chapter discusses the nature of an efficient financial market and examines the behavioural theory of finance. The emergence of London as an international financial centre can be explained with reference to a number of factors. The first is the time zone factor, with London occupying a position mid-way between the western and eastern time zones, which allows financial trading to take place 24 hours a day, with business switching between the major financial centres. The chapter outlines the role of markets in the completion of deals. It also considers the opportunities offered by financial markets to engage in three specialist activities, namely hedging, speculation and arbitrage.
The market for equities is part of the capital market, which refers to the market for long-term finance. This chapter deals with equity markets and examines some general issues relating to the raising of long-term finance by private firms. It focuses on the primary market for equity issues, which is followed by a discussion of the secondary market, where equity securities are traded. The chapter also examines the nature of and causes of the global stock market crash of October 1987 and the 'technology bubble' in the late 1990s that led to global stock market falls from 2000. It considers the degree to which stock markets conform to the efficient markets hypothesis. Two markets exist in London. The main market is the London Stock Exchange (LSE), which deals in the securities of established companies. The second market is the Alternative Investments Market, which is owned and operated by the LSE.
This chapter mainly focuses on the bond market and the term structure of interest rates. The two are linked because the discussion of the term structure of interest rates is mainly conducted in the context of government securities. The chapter briefly discusses the reasons why different securities have different interest rates (i.e. the general structure of interest rates) and surveys the differing theories of the level of interest rates. It examines the general nature and valuation of bonds by highlighting the standard bonds and the Sukuk Islamic bonds. The chapter looks at the market for UK government securities (the gilt-edged market) in terms of new issues, secondary market trading and the innovation of gilt strips. It also examines the nature of corporate bonds and credit ratings.
The sterling money market located in London is a wholesale market for short-term funds and consequently provides facilities for economic units to adjust their cash position quickly. This chapter discusses the nature of the London money markets. It reviews the assets traded in the money markets and their valuation, and examines the supply of central bank money. The chapter also reviews the Bank of England's (BofE) and Debt Management Office's (DMO) operation in the money markets. The BofE is the price setter in the money market, as the Monetary Policy Committee (MPC) sets the bank rate, but, on the other hand the DMO is a price taker. The primary object of BofE's intervention is to ensure that short-term interest rates are consistent with the bank rate set by the MPC. This objective also includes the objective that day-to-day and intra-day volatility be limited.