Finance & Financial Intermediaries

Functions & Qualities of Money• 4 Main functions:

– Medium of exchange– Act as a store of value (impaired by inflation)– Unit of account– Standard of deferred payment

Qualities of money:– Durability– Acceptability of both buyers and sellers in a transaction– Transportability – Maintains a stable value and purchasing power (reduced by inflation)– Not easily counterfeited

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The flow of fundsHouseholds

FirmsGovernment

• Funds flow between the three main parts of the economy• Households, firms and governments borrow in order to

obtain funds in addition to income• Funds may be used for capital investments or to cover a

gap in the flow of income• Households and firms may have a surplus of income that

they are prepared to lend in order to earn interest

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• Governments also lend, but mostly in order to finance activity they wish to promote, rather than to earn interest

Solvency requires a balance between income and expenditure but payments and receipts cannot always by synchronised since there may be irregularity of income and expenditure will cover both small and large items (see table 1 below)

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Table 1

Reason for Irregularity of income Reasons for peaks of expenditure

Households Variations in fees & overtime: causal labour; periodic receipt of investment income

Household purchase; holidays; property maintenance; major purchases

Firms Seasonal and cyclical variations in trade receipts; periodic receipt of investment income

Capital expenditure; tax payments; finance of working capital

Governments Seasonal and cyclical variation in tax receipts

Seasonal & cyclical variation in welfare & other payments; natural disasters and other contigencies

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Financial Intermediation• Financial intermediaries provide the facilities and financial

instruments to transfer funds from surplus units, or lenders, to deficit units or borrowers in the business, personal, overseas & government sectors

• Clearing or retail banks provide banking services to the public• Investment banks or “merchant banks” provide advice and

major finance to corporate clients• Insurance companies, pension funds, unit trusts & investment

trusts make longer term investments for clients

Functions of Financial Intermediaries• Aggregation: relatively small deposits can be combined into

major loans for borrowers• Maturity transformation: by receiving a constant flow of savers

and lending to a large number of borrowers, intermediaries can spread risk of any non-payment of debt, whereas that risk may have been too high for an individual lender to lend to a single borrower

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• Source of funds: borrowers are assisted to obtain the funds they need

Financial Instruments

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Borrowing Lending

Short Term Short Term

Overdraft Deposit a/c

Bills of exchange payable Money market

Bills of exchange receivable

Medium Term Medium Term

Bank loans Term deposits

Hire purchase Certificates of deposit

Finance leases Bank loans

Long Term Long Term

Debentures Bank loans

Mortgages Mortgages

Equity (way of raising capital) Equity

Bank loans Debentures

Institutions & MarketsCapital Markets:• London stock exchange

– 1) Main market; with firm regulation, for raising funds through new issues of shares and trading existing shared

– Alternative Investment Market: for newer companies, less firmly regulated

• Gilt edged market for UK government stock• International capital markets are operated between

banks in larger countries to provide major finance for very large companies and institutions. Confusingly, their securities are known as Eurobonds

• Certain stocks not traded on recognised stock exchanges are traded in over the counter markets

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Money Markets:• Short term investment and borrowing of funds is handled

on the money markets. These are operated by the banks and other financial institutions and include markets for:

– Certificates of deposit– Bills of exchange and commercial paper– Treasury bills– Building society bulk borrowing– Local authority bills and other short term borrowing

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Insurance• Insurance transfers risk from one party to another, in return

for a payment, called a premium. Insurance companies are intermediaries in the risk market

• An underwriter is a person who estimates and accepts risk, normally on behalf of an insurance company or other risk bearer

• Assurance deals with risk of something definitely happening

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Credit & Banking

Banks & CreditFunctions of Commercial Banks:• Payments mechanism: payments made by cheque cleared

and net balances transferred via banks’ deposits at the central bank

• Storage & safeguarding of wealth: most accounts attract interest

• Lending money: earn income by charging interest• Financial Intermediation• Business Services: foreign exchange dealing; bill

discounting; business advice; insurance broking...etc

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Banks & Assets & Liabilities:• Banks aim to use money in their possession to make

profits. At the same time they have to ensure the security of their assets and maintain sufficient liquidity to meet their customers’ requirements for cash. They therefore maintain an asset structure of graduated liquidity & profitability

• Cash:– Market loans More Liquid– Bills (usually repayable in 90 days)– Advances (term loans)– Investments Less Liquid

• Central banks use the Basle Agreement rules on capital adequacy to supervise their banks and ensure they have sufficient provision for bad debts

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The Credit Multiplier• The bank or credit multiplier is the name given to banks’

ability to create credit and hence money, by maintaining their cash reserves at less than 100% of the value of the deposits they hold

The basics of credit creation:– The total amount of money in a modern economy is many times the

amount of cash in circulation– A bank receiving a deposit is able to lend most of it out, retaining only

a small proportion to meet the depositor’s needs– The money lent is in turn deposited and supports a further loan

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Calculating the credit multiplier• The relationship between the amount of a deposit and the

credit that can be based on it is called the credit multiplier and takes the form:

Deposits= Cash/Cash Ratio or D=C/R

• Where the cash ratio is the % of the cash deposited the bank feels is prudent not to lend.

• Thus with a cash ratio of 20%, a cash receipt of 1,000euro can support total deposits of 5,000euro

• The 1,000euro originally paid in and 4,000euro credited to borrowers’ accounts.

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Yield• There are two aspects of yield on an investment:

– Interest (on dividends)– Capital Growth

• Interest is paid separately from repayment of the principal. Capital growth can only be realised when the investment is repaid or sold

• Bonds normally pay a fixed rate of interest: this is the nominal or coupon rate. Running or current yield on a bond is found by dividing its market price into its nominal rate

• Net dividend yield on equities is similar: current share price is divided into the annual net dividend income

• Bills of exchange and other bills such as treasury bills provide yield by being offered at a price lower than their maturity or face value: the bill rate is thus a measure of capital growth

• Yield Maturity includes both interest and capital appreciation

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The Term Structure of Interest Rates

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Term

R%This normal yield curve illustrates the way interest rates vary with the term of the loan.There is greater risk of losses from default and inflation the longer theterm of the loan .Longer term loans therefore attracthigher interest rates

• The normal yield curve rises in the longer term– Increased uncertainty about the more distant future increases the risk premium– Investors wish to avoid being locked into low yields in case interest rates generally rise

• Reverse yield curves indicate market expectation of future interest rate reductions

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The Central Bank• A country’s central bank plays a vital role in the management

of the monetary system.• The functions of any given central bank may vary from those

of another, especially in the areas of monetary policy and financial supervision.

Functions of The Central Bank:• Provides a banking service to the government• Central note issuing authority• Manages the National Debt• Lender of last resort• Banker to the commercial banks, holding operational deposits

to permit interbank transfers: can require special deposits to control money supply

• Manages national foreign currency reserves• Monetary Policy Committee sets the UK benchmark interest

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Setting the Interest Rates• The bank’s interest rate policy must also take account of

the need to expand the money supply to support economic growth

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Key points from Section B to know for the assessment

(i) identify the equilibrium price in a product or factor markets likely to result from specified changes in conditions of demand or supply;

(ii) calculate the price elasticity of demand and the price elasticity of supply;

(iii) identify the effects of price elasticity of demand on a firm’s revenues following a change in prices;

(iv) explain market concentration and the factors giving rise to differing levels of concentration between markets;

(v) explain market failures, their effects on prices, efficiency of market operation and economic welfare, and the likely responses of government to these;

(vi) distinguish the nature of competition in different market structures;

(vii) identify the impacts of the different forms of competition on prices and profitability. 20

Key points from Section C to know for the assessment(i) identify the factors leading to liquidity surpluses and deficits

in the short, medium and long run in households, firms and governments;

(ii) explain the role of various financial assets, markets and institutions in assisting organisations to manage their liquidity position and to provide an economic return to holders of liquidity;

(iii) explain the role of insurance markets in the facilitation of the economic transfer and bearing of risk for households, firms and governments;

(iv) explain the role of the foreign exchange market and the factors influencing it, in setting exchange rates and in helping organisations finance international trade and investment;

(v) explain the role of national and international governmental organisations in regulating and influencing the financial system, and the likely impact of their policy instruments on businesses.

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