Economics and Business
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.
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 conclusion provides a brief summary of the nature of the UK financial system as presented in this book. The financial crisis of 2007-8 has resulted in major changes to the whole framework of regulation and supervision of the financial system. Collateralised debt obligations and structured investment vehicles were badly designed and credit default swaps misused, with the result that they all contributed to the financial crisis. In addition, the reputation of the banks has not been enhanced by their being associated with a series of financial scandals. These include mis-selling of payment protection insurance, fraud and the rigging of LIBOR and the foreign exchange markets. Despite the malpractices it can still be contented that finance plays an important role in the economic growth of a country and the poor reputation of the banks held by the general public is only partly justified.
Three main areas of international financial activity can be distinguished: banking, bonds and similar types of securities, and equities. This chapter examines the eurosecurities markets which have developed out of the eurocurrency markets and then discusses some of the wider developments in international financing. The eurosecurities markets considered in the chapter are those of eurobonds, euronotes and euro-equities. These markets have been the subject of a great deal of financial innovation over the past 30 years. Two types of money market instruments are highlighted in the chapter: note issuance facilities and eurocommercial paper. The chapter also considers the role of swaps before a review of disintermediation. This process describes how changes in the financial environment and the changing preferences of borrowers and international banks have led to direct financing through greater use of the international capital markets.
Financial Derivatives can be categorised according to the type of trade. The first is the category of exchange-traded instruments and the second refers to those instruments bought directly from a bank or other financial institution and these are called over-the-counter derivatives. This chapter examines the main derivative contracts used in financial markets. It considers the reasons for the development and growth of trading of financial derivatives over the last 30 or so years, and examines the organisation of trading at Intercontinental Exchange Futures Europe. The chapter also examines the nature of financial futures, options, swaps, forward rate agreements, contracts for difference and credit derivatives. It includes two case studies that illustrate the dangers of derivatives trading: Metalgesellschaft and Barings bank. The chapter summarises a selection of the studies that have examined the efficiency of derivatives markets.
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.
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.
A foreign exchange market (the 'forex') is where one currency is exchanged for another. The UK is the main centre in the world for foreign currency trading. This chapter examines the nature of exchange rates which is followed by a discussion of the determination of exchange rates. There is little, if any, agreement on the factors determining the demand for and supply of currency in the foreign exchange market. Three principal relationships are discussed in the chapter: purchasing power parity, covered interest rate parity and the international Fisher relation. The chapter explores the nature of the foreign exchange market and the types of business carried out on the market. Four types of forex business are conducted: spot transactions, outright forward transactions, foreign exchange swaps and currency swaps. The chapter also briefly summarises the empirical evidence concerning the efficiency of the forex.
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.
The global financial crisis of 2007-8 was a hugely significant event that had profound implications for the regulation of banks as well as for the wider financial system. This chapter examines the causes of financial crises in general and the specific causes of the global financial crisis in 2007-8. The specific causes of the 2007-8 include the growth of macro-imbalances; inappropriate monetary policy; sub-prime mortgages and the US housing bubble; financial innovation, in particular the process of securitisation; and the failure of regulation. The 2007-8 crisis had such far-reaching consequences for our understanding of risk and the way it is managed in the financial system, as well as consequences for the regulators of the system. In examining the global crisis of 2007-8, the chapter explores whether it was different from previous crises. It also explains the immediate response to the crisis from regulators and governments.