FINANCIAL MARKETS AND INSTITUTIONS

Transcription

1 Fifth Edition PETER HOWELLS KEITH BAIN FINANCIAL MARKETS AND INSTITUTIONS

2 Financia Markets and Institutions Visit the Financia Markets and Institutions, fifth edition Companion Website at to find vauabe student earning materia incuding: Mutipe choice questions to test your earning Written answer questions providing the opportunity to answer onger questions Annotated inks to vauabe sites of interest on the web

3 We work with eading authors to deveop the strongest educationa materias in business and finance, bringing cutting-edge thinking and best earning practice to a goba market. Under a range of we-known imprints, incuding Financia Times Prentice Ha, we craft high quaity print and eectronic pubications which hep readers to understand and appy their content, whether studying or at work. To find out more about the compete range of our pubishing, pease visit us on the Word Wide Web at:

4 FINANCIAL MARKETS AND INSTITUTIONS Fifth Edition Peter Howes and Keith Bain

5 Pearson Education Limited Edinburgh Gate Harow Essex CM20 2JE Engand and Associated Companies throughout the word Visit us on the Word Wide Web at: First pubished under the Longman imprint 1990 Fifth edition pubished 2007 Pearson Education Limited 2007 The rights of Peter Howes and Keith Bain to be identified as authors of this work have been asserted by them in accordance with the Copyright, Designs and Patents Act A rights reserved. No part of this pubication may be reproduced, stored in a retrieva system, or transmitted in any form or by any means, eectronic, mechanica, photocopying, recording or otherwise, without either the prior written permission of the pubishers or a icence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, Saffron House, 6 10 Kirby Street, London EC1N 8TS. A trademarks used herein are the property of their respective owners. The use of any trademark in this text does not vest in the author or pubisher any trademark ownership rights in such trademarks, nor does the use of such trademarks impy any affiiation with or endorsement of this book by such owners. ISBN-13: British Library Cataoguing-in-Pubication Data A cataogue record for this book is avaiabe from the British Library Library of Congress Cataoging-in-Pubication Data Howes, P.G.A., 1947 Financia markets and institutions / Peter Howes and Keith Bain. 5th ed. p. cm. Incudes bibiographica references and index. ISBN-13: ISBN-10: Financia institutions Great Britain. 2. Finance Great Britain. I. Bain, K., 1942 II. Tite. HG186.G7H dc Typeset in 9.5/13pt Stone Serif by 35 Printed by bound by Ashford Coour Press, Gosport The pubisher s poicy is to use paper manufactured from sustainabe forests.

6 Contents Preface to the fifth edition Guided tour Acknowedgements Terms used in equations xi xii xiv xv 1 2 Introduction: the financia system Financia institutions Financia institutions as firms Financia institutions as intermediaries The creation of assets and iabiities Portfoio equiibrium Financia markets Types of product The suppy of financia instruments The demand for financia instruments Stocks and fows in financia markets Lenders and borrowers Saving and ending Borrowing Lending, borrowing and weath Summary 27 Questions for discussion 28 Further reading 28 The financia system and the rea economy Lending, borrowing and nationa income Financia activity and the eve of aggregate demand Money and spending Liquid assets and spending Financia weath and spending The composition of aggregate demand The financia system and resource aocation Summary 47 Questions for discussion 48 Further reading 48 v

7 Contents Deposit-taking institutions The Bank of Engand The conduct of monetary poicy Banker to the commercia banking system Banker to the government Supervisor of the banking system Management of the nationa debt Manager of the foreign exchange reserves Currency issue Banks Banks and the creation of money Why banks create money How banks create money Constraints on bank ending The demand for bank ending The demand for money The monetary base Buiding societies Liabiity management 85 Questions for discussion 88 Further reading 88 Answers to exercises 89 Appendix to Chapter 3: A history of UK monetary aggregates 90 Non-deposit-taking institutions Insurance companies Pension funds Unit trusts Investment trusts NDTIs and the fow of funds Summary 115 Questions for discussion 115 Further reading 116 The money markets The discount market The parae markets The interbank market The market for certificates of deposit 130 vi

8 Contents The commercia paper market The oca authority market Repurchase agreements The euromarkets The significance of the parae markets Monetary poicy and the money markets Summary 146 Questions for discussion 147 Further reading 147 Answers to exercises The capita markets The importance of capita markets Characteristics of bonds and equities Bonds Equities The trading of bonds and equities Bonds: suppy, demand and price Equities: suppy, demand and price The behaviour of security prices Reading the financia press Summary 198 Questions for discussion 199 Further reading 199 Answers to exercises 200 Interest rates The rate of interest The oanabe funds theory of rea interest rates Loanabe funds and nomina interest rates Probems with the oanabe funds theory Loanabe funds in an uncertain economy The iquidity preference theory of interest rates Loanabe funds and iquidity preference The monetary authorities and the rate of interest The structure of interest rates The term structure of interest rates The pure expectations theory of interest rate structure Term premiums 224 vii

9 Contents Market segmentation Preferred habitat A summary of views on maturity substitutabiity The significance of term structure theories Summary 232 Questions for discussion 233 Further reading 233 Answer to exercise Foreign exchange markets The nature of forex markets Interest rate parity Other foreign exchange market rues Differences in interest rates among countries the Fisher effect The determinants of spot exchange rates purchasing power parity Equiibrium in the forex markets Aternative views of forex markets Fixed exchange rate systems Monetary union in Europe The singe currency in practice The UK and the euro Summary 258 Questions for discussion 259 Further reading 260 Answers to exercises 260 Exchange rate risk, derivatives markets and specuation Forms of exposure to exchange rate risk Exchange rate risk management techniques Derivatives markets Financia futures Options Exotic options Other reated products Comparing different types of derivatives Exchange-traded versus OTC products Forward versus futures contracts Forward and futures contracts versus options 280 viii

10 Contents 9.5 The use and abuse of derivatives Summary 285 Questions for discussion 286 Further reading 287 Answers to exercises Internationa capita markets The word capita market Eurocurrencies The growth of the eurocurrency markets The nature of the market Issues reating to eurocurrency markets Techniques and instruments in the eurobond and euronote markets Summary 305 Questions for discussion 306 Further reading 307 Answers to exercises 307 Government borrowing and financia markets The measurement of pubic deficits and debt Financing the PSNCR The PSNCR and interest rates The sae of bonds to banks The sae of bonds overseas PSNCR, interest rates and the money suppy a concusion Attitudes to pubic debt in the European Union The pubic debt and open market operations Debt management and interest rate structure Summary 329 Questions for discussion 330 Further reading 331 Answers to exercise 331 Financia market faiure and financia crises Borrowing and ending probems in financia intermediation The financing needs of firms and attempted remedies Financia market excusion The financia system and ong-term saving The financia system and househod indebtedness Financia instabiity: bubbes and crises 347 ix

11 Contents 12.3 Frauduent behaviour and scandas in financia markets The damaging effects of internationa markets? Summary 358 Questions for discussion 359 Further reading The reguation of financia markets The theory of reguation Financia reguation in the UK Reguatory changes in the 1980s Supervision of the banking system The 1998 reforms The Financia Services Authority (FSA) The European Union and financia reguation Reguation of the banking industry in the EU Reguation of the securities markets in the EU Reguation of insurance services in the EU The probems of gobaisation and the growing compexity of derivatives markets Summary 398 Questions for discussion 399 Further reading 399 Appendix I: Portfoio theory 401 Appendix II: Present and future vaue tabes 419 Index 425 x

12 Preface to the fifth edition The principa objective of this book is to hep students make sense of the financia activity which these days is so prominenty reported in the media. Making sense of anything requires some grasp of theory and principes. We have done what we can to minimise the use of theory, but because we want the book to be particuary usefu to students on A-eve and first degree courses, we have fet it necessary to expain some basic ideas in finance and economics. Much of this is in Appendix 1: Portfoio theory. We try to make sense of financia activity from the economist s perspective. Thus, we go to some engths to show how financia activity has its origins in the rea economy and in the need to end and to borrow to enabe rea investment to take pace. Simiary, when we tak about the shortcomings of financia markets and institutions, we are concerned with the effects that these shortcomings have on the functioning of the rea economy. We have not produced a consumers guide to financia products and services. Financia advisers, both actua and potentia, shoud find much of interest here, but it is not a guide to financia products and services. Because we want students to understand the events which they wi come across, we have made frequent use of materia from the Financia Times and from readiy avaiabe statistica sources. We have gone to some pains to expain how to interpret the data from such sources. We hope this wi encourage some students to update the evidence we have provided. In preparing this atest edition, we have taken the opportunity to update figures and tabes and to repace oder with more recent iustrations. In response to readers comments we have aso added a new chapter on the mafunctioning of the financia system (Chapter 12) and we have restructured Chapter 6 in order to treat the pricing of bonds and equities separatey. PGAH KB xi

13 Guided tour 5.2 The parae markets CHAPTER 5 The money markets Objectives What you wi earn in this chapter: Who uses the money markets and for what purpose What the various money markets are How different money market instruments are priced Why money market operations are important to centra banks How to read, interpret and anayse data reating to the money market Box 5.4 London money market rates UK INTEREST RATES May 31 Over- 7 days One Three Six One night notice month months months year Interbank Stering BBA Stering Stering CDs Treasury Bis Bank Bis Loca authority deps Discount Market deps Av. tndr rate of discount May 26, pc. ECGD fixed rate Stg. Export Finance. make up day Apr 29, Reference rate for period Apr 29, 2006 to May 31, 2005, Scheme V 4.701%. Finance House Base Rate 5pc for Apr 2006 UK cearing bank base ending rate per cent from Aug 4, 2005 Up to month months months months months Certs of Tax dep. ( 100,000) Certs of Tax dep. under 100,000 is 1pc. Deposits withdrawn for cash 1 2 pc. In Chapters 3 and 4 we have been ooking at the major groups of institutions that participate in the financia system. In this chapter, and in Chapters 6, 8 and 9, we sha ook at the markets in which these institutions operate. Financia institutions are not the ony participants, of course. A financia markets (not just the money markets) invove brokers, market-makers, specuators, as we as the utimate borrowers and enders firms, governments and occasionay househods. Box 5.1 provides a ist of the major market participants and their functions. The box makes it cear why financia markets tend to be dominated by institutions (DTIs and NDTIs) rather than individuas. It is common to tak of two groups of domestic financia markets: the money markets and the capita markets. In one sense this is miseading. In both markets what is offered for sae is debts or caims, in exchange for money. In both markets it is money that is being borrowed. The difference which justifies the abes is the period to maturity of the debts or, more simpy, the ength of time for which the funds are borrowed. In the money markets, funds are borrowed for a short period, i.e. ess than one year; in the capita markets, funds are borrowed for ong-term use, in some cases indeed with no promise of ever being repaid. Athough the distinction is usefu and we recognised, it does not of course constrain peope s behaviour. Some institutions banks and buiding societies, for exampe are accustomed to working in money markets, whie others, ike pension funds, are accustomed to capita markets, but these boundaries are occasionay crossed when commercia circumstances require. Certainy, utimate borrowers and enders are free to switch as the advantage of doing so presents itsef. Firms may, as a rue, prefer to raise capita by issuing ong-term bonds, Source: Reuters, RBS, Tradition (UK) Ltd. FT 5.2 The parae markets The parae markets are aso markets for short-term money. They therefore share many of the characteristics of the traditiona, discount, market. Deas are done for very arge sums at very sma rates of profit. Most of the participants, banks and discount houses, are common to both the traditiona and parae markets. In this section we sha provide a brief description of each of the markets and foow that with a discussion of the significance of the parae markets as a group The interbank market As its name suggests, the interbank market is a market through which banks end to each other. Like the discount market this provides individua banks with an outet for surpus funds and a source of borrowing when their reserves are ow. It is a whoesae market. Deas are usuay measured in ms. The market deveoped in the 1960s, invoving firsty overseas banks, and ater merchant banks and discount houses. Now it is used by a types of banks and it is not uncommon for NDTIs as we to end surpus funds through this market. The oans are normay for very short periods, from overnight to fourteen days, though some ending for three, six months and one year occurs. Naturay, given Chapter Objectives buet points at the start of each chapter show what you can expect to earn from that chapter, and highight the core coverage. Boxes provide different ways of iustrating and consoidating key points in the chapter. For exampe, Box 5.4 above provides information from the FT about seected instruments in the London money markets. Chapter 5 The money markets security and a secondary market, as though they were somehow different in ocation, design and rues. Primary market: A market for newy issued securities. Secondary market: The market for existing securities. Whie the way in which a market fufis its primary roe is obviousy very important to borrowers, every market is dominated by secondary trading. In section 5.1 we sha ook at the characteristics of the discount market. We ook at this in some detai for two reasons. Firsty, unti very recenty the discount market was the money market in which the Bank of Engand carried out its interest-setting activities, and it remains important from that point of view. Secondy, much of what we earn about the discount market can be carried forward, without repetition, to our discussion of the parae money markets in section 5.2. In section 5.3 we ook at the way in which centra banks, and the Bank of Engand in particuar, can expoit their power in the money markets to set short-term interest rates. 6.3 Bonds: suppy, demand and price Thus it foows that the vaue of the whoe stream of payments is the sum of this progression. If P is the present vaue or price of the bond, then n 1 P = C (6.3) (1 + i) t t=1 In the case of an irredeemabe bond, the payments go on for ever and t tends to infinity. This means that the series 1 C (6.4) (1 + i) t is converging on zero and the present vaue P of the sum of the series can be more convenienty written as P = C/i (6.5) This can be confirmed by taking the coupon of any undated government bond from the Financia Times and dividing it by the current ong-term rate of interest. 5.1 The discount market In the discount market funds are raised by issuing bis, at a discount to their eventua redemption or maturity vaue. We sha ook at the characteristics of bis more carefuy in a moment. Transactions in the discount market are normay very arge, enabing profits to be made from deas invoving differentias in discount rates of sma fractions of 1 per cent. The market has no physica ocation, reying amost excusivey on teephone contact between operators and, therefore, on verba contracts. As with any market, we can think in terms of a source of suppy and a source of demand. In theory, bis can be issued by anyone, but in practice they are issued mainy by arge corporations (commercia bis) and by the government (treasury bis). The main buyers and hoders of bis used to be a highy speciaised group of banks known as discount houses. Their centra roe came about because traditionay the Bank of Engand deat ony with the discount houses (rather than with the banks or financia institutions as a whoe). In 1997, when the Bank began deaing directy with a wide range of banks, retai and whoesae, the discount houses ost their specia position and were generay absorbed into the banks that we described in Chapter 3 as investment banks. This means that treasury and other eigibe bis are now widey hed throughout the banking system. As we said in section 3.3, this is one of the reasons why banks can manage with such a ow ratio of primary reserves. The existence of an active discount market, together with the distinctive characteristics of bis (we ook at these in a moment), means that these assets are highy iquid. In the event of a shortage of primary reserves (cash and deposits with the centra bank) banks can se bis very quicky and for a price which is virtuay certain. Bis are certificates containing a promise to pay a specified sum of money to the hoder at a specified time in the future. After issue they can be traded (they are thus Exercise 6.1 (a) On 6 May 2006, ong-term interest rates were about 4.6 per cent. Cacuate a price for the undated bonds Treasury 2 1 /2% on that day. (b) What woud the price have been if ong-term interest rates had been 1.6 per cent? Answers at end of chapter However, most bonds in fact mature and so our formua has to incude a vauation of the payment received on maturity. In this case P is found as foows: n 1 G 1 J P = C + M (6.6) (1 + i) t I (1 + i) n L t=1 where M is the maturity vaue of the bond. Or, more compacty, C M P = + (6.7) (1 + i) t (1 + i) n Remember that in cacuating P we have assumed that the next coupon payment is one year away. This is a way of saying that the ast coupon payment has just been made. In practice, however, we sha often want to price bonds at dates which ie between two coupon payments. We might want to price a bond, for exampe, where three months have eapsed since the ast coupon payment (and there are three months to run to the next haf-coupon payment, or nine months to the next fu payment). If we continue with our assumption of singe, annua coupon payments, it is cear that if we buy a bond three months after its ast coupon payment, we have to wait ony nine months to get the next coupon, and waiting nine months for a given payment Key terms provide cear definitions of key concepts in each chapter, highighted in coour where first introduced. Exercises boxed in coour and interspersed throughout every chapter, providing an opportunity to practise the new cacuations you wi earn in each chapter. Answers to the exercises are provided at the end of each chapter.

14 Guided Tour Chapter 4 Non-deposit-taking institutions 5.3 Monetary poicy and the money markets were persuaded to switch to private provision. It was aways unikey that persona pension products coud provide arger benefits than occupationa schemes, since an empoyee in an occupationa scheme benefited from the fact that the empoyer aso contributed. Furthermore, using the terms that we have expained above, these private pensions were a funded schemes based on defined contributions. Inevitaby, therefore, some of those who switched to a private pension scheme gave up not ony their empoyer s contribution to their retirement income but aso his wiingness to bear the risk that the fund might not be arge enough to pay the target income. Fortunatey, it is possibe to estabish retrospectivey those cases where persona pensions were missod. In 1995, the Persona Investment Authority (see Chapter 13) insisted that pension funds shoud do precisey that and it estimated that there were more than 300,000 priority cases where compensation was urgenty required. As with other intermediaries, the nature of pension fund iabiities infuences the composition of the asset portfoio. If the purpose of the fund is to coect ifetime contributions in order to pay a pension that is reated to fina saary or earnings, it is obviousy a fundamenta requirement that an empoyee s contributions be invested in a manner which keeps their vaue at east in ine with rising rea earnings. As we saw with ong-term insurance funds, this inevitaby means an emphasis upon company securities. Figure 4.2 shows the composition of pension funds portfoios in Notice firsty that at 761bn the market vaue of pension fund assets at the end of 2004 was second ony to that of ong-term insurance funds. Of this tota, UK company securities accounted for over 29 per cent, and overseas securities, by far the greater part of which are aso company shares, accounted for neary 23 per cent. UK government Figure 4.2 Pension fund asset hodings at end 2004 ( bn) Source: Adapted from ONS, Financia Statistics, Apri Tabe 5.1B Figures offer graphica representation of, for exampe, data and instruments discussed in each chapter. Figure 5.2 To understand the difference invoved in choosing between these instruments, consider Figure 5.2. At one end of the spectrum, the centra bank can set the quantity of reserves and refuse to adjust it in response to any changes in demand. In this case, the suppy of reserves is shown by the vertica suppy curve S 1 in the diagram and the quantity of reserves is R*. Banks demand for these reserves is shown by the demand curve, D 1. Notice that the demand curve is drawn steepy. Provided that banks offer free convertibiity between deposits and notes and coin (and we saw in Chapter 3 that their abiity to do this is crucia to confidence in the system), their demand for reserves is very ineastic. To begin with, we have an equiibrium position at a (short-term nomina) rate of interest at i*. Suppose now that banks demand more reserves. Remember: this coud be because their cients are making net payments to government or it coud simpy be that they have increased their ending (for commercia reasons) and now need additiona reserves to hod against the extra deposits. The demand curve shifts outwards to D 2. Given the ineasticity of demand, interest rates coud rise very quicky indeed and to very high eves. i is the exampe in the diagram. Demand is ineastic because banks must be abe to ensure convertibiity. And since their iquidity position is cacuated when interbank settements take pace at the end of each day, they need the reserves instanty. Faced with a shortage of reserves, banks wi bid aggressivey for short-term funds. For every 1 gained in customer deposits, there is an equa gain in deposits at the centra bank. This onefor-one gain raises the D b/d p ratio. But in a situation where reserves are in generay short suppy, bidding for deposits wi not sove the probem. What one bank gains, another bank oses. But whie attempts by individua banks to gain reserves wi be sef-defeating, they wi push up short-term rates sharpy. At the other end of the spectrum, the centra bank may respond to the increase in demand by providing additiona reserves which competey accommodate the demand. This it must do if it wishes the rate of interest, i*, to continue. Such a situation is shown in the diagram by the suppy curve S 2, drawn horizontay at the going rate of interest Chapter 2 The financia system and the rea economy Questions for discussion 1 Distinguish between saving, ending and a financia surpus. 2 A financia surpus must resut in the net acquisition of financia assets. Assume that you are in norma empoyment and that you reguary run a financia surpus. Assume further that you make no conscious decision to buy financia assets. What financia assets wi you inevitaby acquire? 3 If your income and capita account showed that you had made a negative net acquisition of financia assets, what woud this mean in practice? 4 Using the atest avaiabe figures, find the vaue of househods net acquisition of UK ordinary company shares. How does this acquisition figure compare with the stock of ordinary company shares aready hed? What were the most popuar assets acquired by househods? 5 Outine three ways in which the behaviour of the financia system coud affect the eve of aggregate demand in the economy. 6 Suppose that prices in the US stock market suffer a major coapse. What effect woud you expect this to have upon the rest of the US economy and the economies of other deveoped countries? 7 Why does a company s share price matter in a takeover batte? If you were the financia director of a predator firm, what woud you want to happen to your firm s share price? Might you be abe to infuence it in any way? 8 Why might financia systems fai to aocate resources to their most desirabe use? Further reading A D Bain, The Financia System (Oxford: Backwe, 2e, 1992) ch. 2 M Bucke and J Thompson, The UK Financia System (Manchester: Manchester UP, 4e, 2004) chs. 1 and 16 P G A Howes and K Bain, The Economics of Money, Banking and Finance (Harow: Financia Times Prentice Ha, 3e, 2005) ch. 1 P J Montie, Macroeconomics in Emerging Markets (Cambridge: CUP, 2003) ch. 12 A M Santomero and D F Babbe, Financia Markets, Instruments and Institutions (McGraw- Hi, 2e, 2001) chs. 1 and 2 Answers to exercises 2.1 (a) 83.8 miion (or 16.8%); (b) 7m; (c) 76.8 miion. 2.2 (a) Initia veocity was 0.888; (b) it was expected to fa to about (i.e. by about 2 per cent). 2.3 Initia average hodings of money are 2,000 and veocity is 1.0. After the change, money hodings are 1,100 and veocity is The oan wi finance 1,636 of spending. 48 Questions for discussion at the end of each chapter are onger questions to ponder over and discuss amongst your peers in cass. Answers for these can be found on the companion website. Further reading provides fu detais of sources to refer to for further information on the topics covered in the chapter. Answers to exercises provide answers to the boxed exercise in the chapter. xiii

15 Acknowedgements The pubishers are gratefu to the Financia Times Limited for permission to reprint the foowing materia: Box 4.3 Unit trust prices and yieds, Financia Times, 10/11 May 2003; Box 5.4 London money market rates, Financia Times, 7 May 2003; Box 6.8 Fed s comments resut in a tumbe, Financia Times, 10/11 May 2003; Box 6.9 Ray sends FTSE past..., Financia Times, 7 May 2003; Box 6.10 UK Gits cash market, Financia Times, 10/11 May 2003; Box 6.11 Food and drug retaiers, Financia Times, 7 May 2003; Box 7.6 UK interest rate cut surprises git traders, from FT.com, Financia Times, 6 February 2003; Box 8.2 The market interpretation of news, Financia Times, 7 February 2003; Box 9.2 Interest rate futures, Financia Times, 19 March We are gratefu to the foowing for permission to reproduce copyright materia: Tabes 2.1, 2.2 and 2.3 adapted from Annua Accounts, 2002 (Office of Nationa Statistics 2002) Crown copyright materia is reproduced with the permission of the Controer of HMSO and the Queen s Printer for Scotand; Tabes 3.2, 3.3 and 3.5 adapted from Monetary and Financia Statistics, January 2003 (Bank of Engand 2003) (a percentages are cacuated by Pearson Education and not the Bank of Engand); Tabe 3.4 adapted from Financia Statistics, December 2002 (Office of Nationa Statistics 2002) Crown copyright materia is reproduced with the permission of the Controer of HMSO and the Queen s Printer for Scotand; Figures 4.1, 4.2, 4.3 and 4.4 adapted from Financia Statistics, February 2003 (Office of Nationa Statistics 2003) Crown copyright materia is reproduced with the permission of the Controer of HMSO and the Queen s Printer for Scotand; Tabes 4.1, 6.1 and 6.2 adapted from Financia Statistics, Apri 2003 (Office of Nationa Statistics 2003) Crown copyright materia is reproduced with the permission of the Controer of HMSO and the Queen s Printer for Scotand; Tabe 11.2 adapted from UK Budget Report 2003 (HM Treasury at ) Crown copyright materia is reproduced with the permission of the Controer of HMSO and the Queen s Printer for Scotand; Tabe 11.3 adapted from Quartery Buetin (Bank of Engand Winter 2001). In some instances we have been unabe to trace the owners of copyright materia, and we woud appreciate any information that woud enabe us to do so. The authors woud ike to thank coeagues and students at the Universities of East London and the West of Engand who made numerous suggestions, spotted errors, criticised and encouraged. Our thanks go especiay to Murray Gickman, Iris Biefang- Frisancho Marisca and Derick Boyd. xiv

16 Terms used in equations B = monetary base c = coupon rate C = coupon payment d = rate of discount g = growth rate of earnings i = nomina rate of interest K = the actua return on an asset C = the expected return on an asset A = the required return on an asset K m = the rate of return on the whoe market portfoio or a whoe market index fund K rf = the risk-free rate of return, usuay equivaent to i and, in practice, normay the rate of interest on treasury bis or government bonds M = the maturity vaue (of a bond or bi) M s = money stock n = period to maturity P = the purchase or market price (the price eve, in the aggregate) G = the rate of infation G e = the expected rate of infation r = the rea rate of interest R = redemption vaue σ σ 2 y = the standard deviation (of an asset s return) = the variance (of an asset s return) = yied xv

17 Supporting resources Visit to find vauabe onine resources Companion Website for students Mutipe choice questions to test your earning Written answer questions providing the opportunity to answer onger questions Annotated inks to vauabe sites of interest on the web For instructors Instructor s Manua consisting of detaied outines of each chapter s objectives, answers to the questions for discussion at the end of each chapter, notes on how to use webinks and other resources Taking it further suppement containing notes and extra questions for each chapter, stretching the subject further and providing more advanced materia Aso: The Companion Website provides the foowing features: Search too to hep ocate specific items of content E-mai resuts and profie toos to send resuts of quizzes to instructors Onine hep and support to assist with website usage and troubeshooting For more information pease contact your oca Pearson Education saes representative or visit

18 CHAPTER 1 Introduction: the financia system Objectives What you wi earn in this chapter: What are the components of a financia system What a financia system does The key features of financia intermediaries The key features of financia markets Who the users of the system are, and the benefits they receive In this first chapter we want to find a preiminary answer to two questions. We want to know what is meant by the expression the financia system and we want to know what such a system does. For the purposes of this book, we sha define a financia system fairy narrowy, to consist of a set of markets, individuas and institutions which trade in those markets and the supervisory bodies responsibe for their reguation. The end-users of the system are peope and firms whose desire is to end and to borrow. Faced with a desire to end or borrow, the end-users of most financia systems have a choice between three broad approaches. Firsty, they may decide to dea directy with one another, though this, as we sha see, is costy, risky, inefficient and, consequenty, not very ikey. More typicay they may decide to use one or more of many organised markets. In these markets, enders buy the iabiities issued by borrowers. If the iabiity is newy issued, the issuer receives funds directy from the ender. More frequenty, however, a ender wi buy an existing iabiity from another ender. In effect, this refinances the origina oan, though the borrower is competey unaware of this secondary transaction. The best-known markets are the stock exchanges in major financia centres such as London, New York and Tokyo. These and other markets are used by individuas as we as by financia and non-financia firms. Aternativey, borrowers and enders may decide to dea via institutions or intermediaries. In this case enders have an asset a bank or buiding society deposit, or contributions to a ife assurance or pension fund which cannot be traded but can ony be returned to the intermediary. Simiary, intermediaries create iabiities, typicay in the form of oans, for borrowers. These too remain in the intermediaries 1

19 Chapter 1 Introduction: the financia system Figure 1.1 baance sheets unti they are repaid. Intermediaries themseves wi aso make use of markets, issuing securities to finance some of their activities and buying shares and bonds as part of their asset portfoio. The choice between deaing directy, deaing through intermediaries and deaing through markets is summarised in Figure 1.1. Heping funds to fow from enders to borrowers is a characteristic of most components of the financia system. However, there are a number of other functions, each of which tends to be associated with a particuar part of the system. For exampe, the financia system usuay provides a means of making payments. In most cases this is the responsibiity of deposit-taking institutions (or a subset of them). Such institutions are usuay members of a network (a cearing system ) and accept instructions from their cients to make transfers of deposits to the accounts of other cients. Traditionay this was done by issuing a paper instruction (a cheque ) but today it is done increasingy by eectronic means. We assume that most peope are risk-averse. That is, they are prepared to make a payment (or sacrifice some income) in order to avoid uncertainty, especiay if the uncertainty may mean the possibiity of a serious oss. Among the non-deposittaking institutions, this service is carried out by insurance companies. They aow peope to choose the certainty of a sighty reduced current income (reduced by the premiums they pay) in exchange for avoiding a catastrophic oss of income (or weath) if some accident shoud occur. Pension funds, unit trusts and investment trusts a offer savers the opportunity to accumuate a diversified portfoio of financia assets, though each does it in a sighty different way. Pension funds, in particuar, hep peope to accumuate weath over a ong period and then to exchange this for income to cover the (uncertain) period between retirement and death. Lasty, it shoud aways be remembered that whie savers may be buiding up a portfoio of weath by acquiring financia assets, they want to be abe to rearrange that portfoio from time to time as they observe changes in the risk/return characteristics of the assets which they hod. If we use the phrase net acquisition to describe the additiona assets that a househod is abe to add to its portfoio each year, we must 2

20 Introduction: the financia system remember that tota purchases of assets may be much arger because some assets aready in the portfoio may have been sod as part of the portfoio adjustment process. A financia system must provide peope with the means to make cheap and frequent adjustments to their portfoio of assets (and iabiities). Box 1.1 A financia system channes funds from enders to borrowers creates iquidity and money provides a payments mechanism provides financia services such as insurance and pensions offers portfoio adjustment faciities Notice that this description of what a financia system does (which we have summarised in Box 1.1) is ony one way of answering our second question. It is the answer that most economists woud give because the activities on which it focuses are important to the functioning of the economy as a whoe. Making borrowing and ending cheap and easy makes it easier for firms to invest and shoud, therefore, increase the rate of economic growth. An efficient payments system makes it easier to carry out transactions and encourages trade and exchange. The quantity of money in circuation, how weathy peope fee and the iquidity of their weath are a potentia infuences upon the eve of aggregate demand. We ook at the connections between financia and rea economic activity in more detai in Chapter 2. But this is ony one way of ooking at what a financia system does. In the past thirty years, the UK has seen a dramatic increase in the size and compexity of its financia system. Within the categories that we ist in Box 1.1 there is a much wider range of products and services than there was a generation ago. Consider the exampe of a mortgage oan taken out to buy the famiy home. Thirty years ago, such a oan woud amost certainy have come from a buiding society. The borrower woud probaby have had to wait in a queue which he or she coud join ony after having saved for some period with the society. The oan woud have been in stering and the borrower woud have paid a rate of interest which varied at short notice (broady) with changes in the eve of officia interest rates imposed by the monetary authorities. The interest woud have been paid monthy together with a sma additiona sum cacuated to repay the oan over a schedued period. In 2003, by contrast, such oans were instanty avaiabe from a range of institutions. They coud be repaid by the method described above or they coud be interest-ony mortgages in which the borrower pays ony the interest but makes simutaneous payments into a ong-term savings scheme (typicay an endowment insurance poicy) which is designed to repay the mortgage when the poicy matures. The mortgage may have a rate of interest which can be fixed for ong periods. The mortgage can even be arranged in a foreign currency if the borrower is convinced that a foreign interest rate wi remain ower than the UK rate in future and that the pound is not going to fa in vaue against the foreign currency. 3

21 Chapter 1 Introduction: the financia system The point about a of this is the substantia increase in compexity that now attends the major financia decisions that most househods have to make. If we assume that the reationship between financia consumers and suppiers is characterised by asymmetric information, then the increase in compexity puts consumers at an even bigger disadvantage when compared with suppiers. One consequence of this asymmetry has been a number of notabe scandas where peope have been sod products which were not suitabe for their needs (for exampe, pension and endowment products). Another consequence has been the increase in the scope of financia reguation designed at east to imit the expoitation of this information advantage. A third has been the growth of a financia advice industry which one can see as aowing consumers to buy additiona protection for themseves by paying for information. Seen from this consumerist perspective, Box 1.1 woud ook rather different. We woud stress the categories of product which the financia system provides. So we woud focus upon protection products (insurance), mortgage products, ong-term savings products (managed funds) and deposit products. These, together with reguation and advice, woud be the chapter headings of this book. But, as we said above, our main interest ies with how the financia system grows out of and in return satisfies (to some degree at east) the needs of the rea economy. Thus, in this introductory chapter we sha ook firsty at the institutions or intermediaries which make up part of the financia system. Then, in section 1.2, we turn our attention to financia markets (which make up another part). In section 1.3 we ook at the end-users of the system and at some of the motives and principes underying their behaviour. We can then appreciate some of the advantages that the end-users obtain from the financia system Financia institutions Financia institutions as firms Financia institutions are firms and their behaviour can be anaysed in much the same way that economists anayse any other type of firm. Thus we can think of them as producing various forms of oans out of money which peope are wiing to end. Furthermore, we can assume that they are profit maximisers and that the profit arises from charging interest to borrowers at a rate which exceeds that paid to enders. One characteristic of most financia firms (though this sti does not make them anything specia) is that they are arge and therefore the profits are being maximised for sharehoders rather than for entrepreneurs who themseves own and manage the firms. Like any other firm, profits wi be maximised at the point where tota revenue minus tota costs is at its greatest, that is where the margina revenue accruing from an extra unit of output is just matched by the margina cost of producing it. Aso, quite conventionay, we can assume that the margina cost of production is rising in the short term. Imagine, for simpicity, that a firm s output consists of oans and that the major variabe input is the deposits which it can attract from members of the pubic who are abe to save. Other things being equa, it wi attract more deposits (than at 4

22 1.1 Financia institutions present) with which to increase its production of oans ony if it offers a higher rate of interest or better service (than at present). Whatever it does to get the extra deposit is ikey to cost more than was invoved in getting the previous margina business. Making the assumption that financia firms are profit maximisers, however, does not mean that we have to think of financia firms operating according to the mode of perfect competition. Financia firms tend to be arge and we sha see in section that this is because economies of scae are very common in the production of financia products. This has inevitaby ed, and continues to ead, to situations where some financia business is dominated by a few, arge organisations. In such cases we can observe many of the characteristics which oigopoistic theories of the firm woud ead us to expect, for exampe, itte apparent competition over prices but a great dea of effort going into marketing and product differentiation. We can move even further away from the mode of perfect competition and sti stay on fairy famiiar ground. We can drop the assumption of profit maximisation. There have been occasions in the recent past, particuary invoving the major retai banks, when it has ooked to outsiders as if decisions have been made to pursue other objectives, at east in the short run. These other objectives might have been to increase market share at the expense of competitors, or to achieve a rate of growth (measured by the number of account hoders) greater than that of their rivas. Obviousy, this sort of behaviour is possibe ony if a certain eve of profit has aready been achieved and is reasonaby secure, but it is quite different from rigorous profit maximisation. Even so, this sti eaves the behaviour of financia firms ooking very much ike that of many other types of firm. Whie it is important to bear in mind these simiarities between financia and other types of firm, there is of course much that is distinctive about the business of financia firms: their products, and peope s reasons for buying the products, are different from those of manufacturing and retai firms. For exampe, the decision to buy a financia product often invoves making a judgement about events which might deveop quite a ong way into the future. This is not necessary when buying goods for everyday consumption. Furthermore, there are aso significant differences between the products offered by financia firms. One distinction which is very commony made, for exampe, ies between deposit-taking institutions (DTIs) and non-deposit-taking institutions (NDTIs). Deposit-taking institutions are organisations such as banks and buiding societies, whose iabiities (assets to enders) are primariy deposits. These can be withdrawn at short (sometimes zero) notice and usuay form part of the nationa money suppy. Non-deposit-taking institutions are organisations such as ife assurance companies whose iabiities are promises to pay funds to savers ony in response to a specified event. Uness the specified event occurs, it is very difficut to withdraw these funds and there is usuay a considerabe financia penaty for savers who do so. Simiary, contributions to a pension fund cannot be easiy withdrawn unti the pension fas due for payment. We sha see in Chapters 3 and 4 that these differences in the ease with which savers can demand repayment have a major effect on what DTIs and NDTIs can do with the funds at their disposa. The two types of intermediaries are shown in Box

23 Chapter 1 Introduction: the financia system Box 1.2 Some deposit and non-deposit-taking intermediaries Deposit takers Non-deposit takers Banks Retai banks Insurance companies Investment banks Pension funds Overseas banks Unit trusts Buiding societies Investment trusts Financia institutions as intermediaries We now know that financia institutions take different forms and offer a wide range of products and services. Is there anything that they have in common? As a genera rue, financia institutions are a engaged to some degree in what is caed intermediation. Rather obviousy intermediation means acting as a go-between for two parties. The parties here are usuay caed enders and borrowers or sometimes surpus sectors or units, and deficit sectors or units. What genera principes are invoved in this going-between? The first thing to say is that it invoves more than just bringing the two parties together. One coud imagine a firm which did ony this. It woud keep a register of peope with money to end and a register of peope who wished to borrow. Every day, peope woud join and eave each register and the job of the firm woud be to scan the ists continuousy in order to match potentia enders whose desires matched those of potentia borrowers. It woud then charge a commission for introducing them to each other. With today s technoogy this woud be quite easy and profitabe, as many dating agencies and insurance brokers have discovered. This process, however, is not intermediation. If anything, it is best described as broking. When we use the term intermediation, the going-between invoves more than just introducing the parties to each other. Something ese has to be provided. As a genera rue, what financia intermediaries do is: to create assets for savers and iabiities for borrowers which are more attractive to each than woud be the case if the parties had to dea with each other directy. What this means is best understood if we consider an exampe. Take the case of a person wishing to borrow 140,000 to buy a house, intending to repay the oan over twenty years. Without the hep of an intermediary, this person has to find someone with 140,000 to end for this period and at a rate of interest which is mutuay agreeabe. The borrower might be successfu. In that case, the ender has an asset (an interest-bearing oan) and the borrower has a iabiity (the obigation to pay interest and repay the oan). In practice, however, even if the woud-be borrower empoyed a broker, it seems unikey that the search woud be successfu. There are probaby not many peope wiing to end 140,000 to a comparative stranger, knowing that 6