Chapter 6

1. Sawyer: The UK Economy 16e Chapter 6 Money, Finance and Monetary Policy

2. Money and finance: The Financial System • A financial system is composed of firms and markets which fulfil a variety of economic functions. • Central to all is arranging the lending of funds from one economic agent to another. • The financial system plays a key role in allocating economic resources. • Banks and other financial institutions determine the allocation of large amounts of resources and, in particular, resources which often finance new investment.

3. Nature and Functions • Financial intermediaries are numerous and indirect finance is more common than direct finance. Advantages derive from the ability of financial intermediaries to use size and expertise to transform financial claims so that they can offer savers a wider choice of assets than ultimate borrowers are able to do. • They offer borrowers a more varied choice of credit terms than ultimate lenders are able to do.

4. Nature and Functions • Financial intermediaries also engage in ‘risk transformation’. • Retail banks provide for deposits to be transferred between accounts and thereby provide a payments mechanism. • Life assurance companies offer policies which provide for long-term saving but which also provide for a lump-sum payment in the event of the policy-holder’s early death.

5. The Bank of England • Acts as banker to the Government and keeps the main government accounts, receives tax revenues, and facilitates payments in respect of government expenditure. • Acts as banker to the clearing banks, i.e. those retail banks which operate the system whereby cheques are cleared and monies transferred from one bank to another. • In May 1997 the Chancellor of the Exchequer granted a new autonomy to the Bank of England in the conduct of monetary policy. The prime objective of policy is to maintain inflation at a low level.

6. Inflation policy • The Government specifies a target for annual inflation and the Bank seeks to keep inflation close to the target level. • The inflation target is now set in terms of the measure of inflation used in the Euro zone, the harmonised index of consumer prices (HICP), with a target rate set at 2 per cent per annum. • Main instrument of policy is the level of short-term interest rates. If the Bank thinks that inflation is likely to rise significantly above target, it will raise short-term interest rates in the expectation that this will reduce the expansion of money and credit and hence will reduce the pressure of demand in the economy.

7. Private Banks • Retail banking involves the provision of a wide range of banking services to business and personal clients. • Services provided include taking deposits at sight and short notice, making loans of various types and for various time periods, cheque clearing, foreign exchange and international remittances, safe-deposit facilities and financial advice.

8. Private Banks • Investment banking involves a mixture of banking and security trading, and most offer a range of specialised financial services to large and medium-sized companies and affluent persons. • Investment banks also manage new issues of securities by companies and also buy and sell existing securities on behalf of clients.

9. Measures of Money • Money serves first and foremost as a medium of exchange; i.e. it facilitates the exchange of goods and services. • Money also serves as a store of value. • Money may be an imperfect store of value and most monies depreciate over time due to inflation, but for many purposes it remains a convenient means of storing value. • Money also serves as a unit of account; it is the means by which we measure value.

10. Measures of Money • There can be no unambiguous statistical definition of what constitutes money. • The Bank of England has, since 1993, focused mainly on two measures: • The narrowest definition, M0, covers notes and coin in circulation plus banks’ operational balances at the Bank of England. • M4 comprises holdings by private-sector residents of notes and coin and all sterling deposits (including CDs) at banks and building societies.

11. Short-Term Money Markets • The main markets for short-term funds are the interbank market, the market in large time deposits from non-bank sources, the market in CDs, and the market in repurchase agreements or repos. • There are also markets in short-term paper, i.e. negotiable instruments maturing within a few months. These include Treasury bills (issued by the UK government), commercial bills (issued by companies to finance trade, frequently with a bank guarantee), and commercial paper (issued by companies of prime-credit standing and without bank guarantee).

12. Short-Term Money Markets • Banks regard their short-term assets a source of liquidity but they can also regard their ability to borrow new funds at short notice as an additional means of liquidity. • The repo market has become one of the most important of the short-term markets in London and is now used by the Bank of England for the conduct of open-market operations. If the Bank wishes to take money out of the banking system it undertakes a repo, i.e. sells a security for immediate payment and agrees to repurchase at a later date. If the Bank wishes to put money into the banking system it undertakes a reverse repo.

13. Short-Term Interest Rates • The Bank of England has the ability to influence the level of short-term interest rates, and while that influence is felt first in the repo market, arbitrage will ensure it is immediately generalized across all short-term sterling markets. • The Bank of England operates at the very short end of the lending spectrum - providing funds mostly for periods of about 14 days. • Longer term rates of interest are usually above short-term rates but by how much they are above depends on supply and demands for funds in the different markets.

14. The Capital Market • The capital market covers the markets in which securities - chiefly equity shares and bonds - are traded. • Equity shares represent a share in the ownership of a company and entitle shareholders to participate in company profits: their value rises when profits rise and falls when profits fall. They are risky assets. • Bonds are generally fixed-interest, term securities and pay a fixed return each year until maturity.

15. The Capital Market Equity shares can be issued in three main ways: • A public offer involves a hitherto privately owned company deciding to ‘go public’, to raise money (for the company or for the existing owners) by selling shares to the public at large. • A private placement involves selling shares to a relatively small number of large investors and is cheaper than a public offer. • A rights issue is an issue by a public company of additional shares offered, in the first instance, to existing shareholders. There are frequently periods of years when the level of share prices is rising (a bull market) or falling (a bear market). Chart shows the movements in recent years in the FTSE index of 100 leading UK shares.

16. Markets in Financial Futures and Traded Options • Markets in financial futures and traded options have grown in number and in trading volumes in recent years. • Financial futures are financial assets such as a three-month bank deposit or a government bond which are traded today for delivery in the future. • They are one method of managing risk. • An alternative strategy is to sell bond futures.

17. Other Financial Intermediaries:Life Assurance Companies and Pension Funds • The essence of life assurance contracts is that the assured pays either a single premium or series of premiums over a number of years and at an agreed future date the insurance company guarantees to pay a lump sum. • Life assurance companies comprise a number of specialist companies as well as large general insurance companies that also offer marine, fire and accident insurance. • Pension funds provide pensions for members of a particular occupational group, or for employees of a particular company. Those covered by the fund make regular contributions over a number of years and, upon retirement, are entitled to a pension until death.

18. Other Financial Intermediaries:Unit Trusts and Investment Trusts Unit trusts and investment trusts are the main forms of mutual investment in the United Kingdom. The purpose of mutual investment is to enable small investors to pool resources in order to gain the benefits of diversification.

19. Regulating the Financial System • During the last 25 years, there has been a series of Acts of Parliament to develop formal financial oversight and to create supervisory agencies. • The latest, the Financial Services and Markets Act of June 2000 provides statutory backing for a powerful new regulatory body, the Financial Services Authority (FSA). • The changes in British regulations have been influenced by negotiations in various international committees. • In the field of banking a key role has been played by the Basel committee, a committee of banking supervisors meeting regularly in Basel, Switzerland which has developed standards for minimum capital resources for banks.

20. Regulating the Financial System • It is an objective of the European Commission to achieve a single European financial market with financial institutions able to do business anywhere in the Community unhindered by artificial obstacles and constraints.

21. Regulating the Financial System The Commission has pursued this aim with a three-pronged approach. • First, there should be that minimum harmonisation of regulations necessary to ensure fair competition and adequate consumer protection. • Second, institutions should not need authorisation to do business in each country; once duly authorised by the competent authorities in one member country, they should be free to operate throughout the Community (the principle of the single passport). • Third, all activities of each institution should be supervised by the authorities of the country in which its chief office is situated (the principle of home country control).

22. Basel Committee and Capital Adequacy • The Basel committee seeks to devise rules which make banking safer and which are applicable in many countries. Initially the goal was to create standards which could be applied within the 12 countries represented on the committee but nowadays there is extensive consultation and dialogue across the globe and the objective is to create standards that will be acceptable worldwide.

23. Basel Committee and Capital Adequacy • The main effort in recent years has been has been to ensure that banks have adequate capital resources. • The Basel committee has adopted the principle of risk-weighted capital requirements. • The minimum required capital (which once agreed upon is imposed on UK banks by the FSA) varies according to type of bank assets. • The risk weightings applied have been attacked as too crude: a loan to a large well-known public company is assessed as being as risky as a loan to a back-street garage.