Financial markets and institutions

1 Introduction

Everything a business does eventually turns into a payment. Wages leave the bank, customers pay in, a supplier is settled in a foreign currency, a new machine has to be financed and a surplus has to be parked somewhere safe until it is needed. The financial system is what makes all of that possible, and this chapter is about the three parts of it the syllabus names: the institutions that stand between savers and borrowers, the instruments they trade, and the central bank that sits above them.

Nothing here is difficult, but a lot of it is vocabulary, and objective test questions in this area are usually won or lost on whether you know exactly what a word means — the difference between a gilt and a Treasury bill, between maturity transformation and credit creation, and between total deposits and credit created.

2 Money and financial intermediaries

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2.1 The functions of money

Money is not one thing but four jobs, and an economy needs all four of them.

2.2 Flows of money and credit

Four sectors trade with each other — individuals, businesses, government and the rest of the world — and every one of them deals with every other. Individuals buy from businesses and businesses pay them wages; businesses pay tax to government and government sometimes pays grants back; businesses import and export.

What the diagram adds is that almost none of those flows is settled directly. They pass through a financial intermediary.

The point is a practical one. A business could pay its staff in cash, and once did; it is safer and cheaper to pay into their bank accounts. It could pay its tax by delivering banknotes to the Treasury; a bank transfer makes more sense. You could buy your holiday currency from somebody on a street corner; changing it at a bank or withdrawing it from an ATM abroad reduces the chance of being robbed.

2.3 Banks as financial intermediaries

Banks are the most important intermediaries. They perform seven functions, and you should be able to name and explain all of them.

2.4 Other financial intermediaries

2.5 How the system solves an organisation’s liquidity problem

The syllabus outcome is not really about lists of institutions. It asks how financial assets, markets and institutions help an organisation manage its liquidity position — and how the people who supply that liquidity are paid for it. Liquidity means being able to meet a payment when it falls due, which is a different question from being profitable.

An organisation has two liquidity problems, and the financial system answers both.

Two things follow, and both are examinable. The first is that liquidity is itself priced: an investor who gives up access to their money for a long time expects to be paid more for it, which is exactly what the yield curve in §5 describes. The second is that a market matters as much as an instrument. A share in a private company and a share in a listed company can be identical in every legal respect, but the listed one can be sold on a stock exchange this afternoon and the private one may take months to sell at all. It is the market that makes an asset liquid.

3 Financial markets and financial instruments

3.1 What is a financial instrument?

The instruments below differ in three ways: the rights they give the holder, the obligations they place on the issuer, and their term — how long they last.

• Equity shares

• Preference shares

• Debentures and bonds

• Convertibles

• Loans and overdrafts

• Lease contracts

• Certificates of deposit

• Government borrowing: gilts and Treasury bills

• Bills of exchange

3.2 Equity shares

An investor can subscribe for new equity shares or buy shares that have already been issued. Shareholders vote at company meetings and receive dividends if the directors declare them.

Shareholders in a private company often find it hard to sell, because there is no market to set a price or to find a buyer. Once a company is listed on a stock exchange its shares have a market price and buyers and sellers are matched for them, so listed shares are far more liquid than private ones.

Equity is a long-term and usually permanent source of finance. The market value of shares in a successful company can rise steeply and make large gains for investors; if the company does badly the shareholders lose value, and if it fails they are last in the queue and normally lose everything. Equity is the highest-risk instrument in this list, which is why investors require the highest return from it.

3.3 Preference shares

Relatively uncommon. They promise a fixed dividend each year, so their value does not grow with the company, and preference shareholders usually have no vote.

They are a long-term source of finance, but may be redeemable — repayable — at a stated future date. Because the dividend is fixed and ranks ahead of the ordinary dividend, they are less risky than equity and carry a lower expected return.

3.4 Debentures and bonds

A debenture, loan certificate or bond is a written acknowledgement of a debt. They are issued by companies to investors, state the fixed rate of interest that will be paid, and are often secured on the company’s assets. They may be irredeemable or redeemable; if redeemable they state the date the debt will be repaid. Many are quoted on the bond market, which gives investors liquidity.

Debentures are a relatively safe investment because:

• they are usually secured on the company’s assets;

• the interest is fixed and must be paid before any dividend;

• if the company is wound up, debenture holders are repaid before shareholders.

The other side of that safety is that a debenture holder gains very little from the growth of the company. Whatever the company earns, the coupon stays the same.

3.5 Convertibles

Convertibles begin life as debentures but give the investor the option to convert them into shares. That lets the investor take a wait-and-see position: lend safely while the company is unproven, watch how it performs, and convert into equity if it starts to do well.

Because that option is worth something, a convertible carries a lower rate of interest than a straight debenture of the same company. The investor accepts less interest in exchange for the chance of a capital gain.

3.6 Loans and overdrafts

Usually provided by banks. Loans may be short term (roughly under a year), medium term (one to five years) or long term (usually over five years).

An overdraft is strictly repayable on demand, so it is not suitable for a long-term capital requirement. It is for short-term liquidity: a shop that has to buy inventory in October for a December selling season can fund the gap on overdraft and repay it out of the sales.

3.7 Lease contracts

Leasing is provided by banks and specialist finance companies. A lease lets an asset be rented rather than bought outright, so the cash cost is spread over the period of use rather than falling all at once. It is a very important source of liquidity, particularly for machinery, vehicles and IT equipment.

3.8 Certificates of deposit

A certificate of deposit is evidence that a sum has been deposited with a bank at a fixed rate of interest, repayable on a set date. The depositor does not have to wait for that date to get their money back, because the certificate itself can be traded on the money market. That is what makes it useful to a treasurer: a better rate than an instant-access account, without giving up access to the cash.

3.9 Government borrowing: gilts and Treasury bills

Governments borrow by issuing securities, and there are two distinct kinds. They are often spoken of loosely as though they were the same thing. They are not, and the difference matters as soon as you look at a yield curve.

Both are regarded as effectively risk free, because a government that borrows in its own currency can always repay. That does not make them safe in every sense: as §3.11 shows, the market value of a long-dated bond moves a great deal when interest rates move, so an investor who has to sell before redemption can still lose money.

3.10 Bills of exchange

A bill of exchange is a non-interest-bearing instrument, used mainly in international trade, that binds one party to pay a fixed sum to another at a predetermined future date. It works much like a cheque and is used to transfer funds. Bills can also be sold to a bank at a discount before they mature, which turns a receivable into cash — another route to liquidity. They are much less common now that electronic payment is available.

3.11 Why a bond’s market value moves with interest rates

Consider a 5% Treasury bond redeemable in 2050 with a nominal (par) value of $100. Two of those numbers never change, and one of them changes every day.

If the interest rate available elsewhere in the economy is 5%, the bond is worth its nominal value of $100: paying $100 to receive $5 a year is exactly the going rate.

Now suppose interest rates rise to 7%. Nobody will pay $100 for a bond paying $5 when a bank deposit pays $7 on the same money, so the market value falls. How far it falls depends on how long is left until redemption, because the holder of a redeemable bond also gets the $100 back at the end.

The simplest case — and the one exam questions at this level use — is an IRREDEEMABLE bond: one that pays its $5 a year for ever and is never repaid (chapter 1 §9.4 mentions them). The $5 is then the only cash flow, so the market value falls until the $5 represents a 7% return:

Check it: buying the bond for $71.43 and receiving $5 a year is a return of 5 ÷ 71.43 = 7%.

If instead interest rates fell below 5%, the market value would rise, again until the fixed $5 gave a buyer the going rate. At 2.5%, for example, an irredeemable bond would be worth 5 × 100 ÷ 2.5 = $200.

A REDEEMABLE bond moves in the same direction but by less, because the $100 repaid at redemption is fixed and has to be valued too. Our 2050 bond, with one year left and rates at 7%, would be worth (5 + 100) ÷ 1.07 = $98.13, not $71.43. So interest ÷ rate gives the market value only of an irredeemable bond; the inverse relationship below holds for both.

4 Central banks

A central bank is the bank that acts for the government. In the UK it is the Bank of England; in the USA it is the Federal Reserve; in the euro area it is the European Central Bank.

4.1 The functions of a central bank

• It is the government’s banker — it receives tax and the proceeds of bond issues and makes government payments.

• It manages the national debt, making sure repayments are made when due and finding buyers for new issues of government bonds.

• It is the central note-issuing authority and looks after the money supply.

• It manages foreign exchange movements and holds the country’s reserves.

• It sets interest rates. In the UK the Bank of England’s Monetary Policy Committee meets regularly to decide the rate.

• It controls credit, including by setting the reserve ratio banks must keep (§6).

• It has a role in overseeing the financial system. In the UK, prudential supervision of banks and insurers sits with the Prudential Regulation Authority, part of the Bank of England, while conduct is regulated by the independent Financial Conduct Authority, which was created on 1 April 2013.

• It is the lender of last resort to the banking system (§4.2).

• It is responsible for controlling inflation. In the UK the Bank of England is set a numerical inflation target by the government and is expected to hit it.

4.2 Lender of last resort

If a bank suffers a run — many depositors demanding their money at the same time — it will need cash quickly, because most of what was deposited has been lent on and is not sitting in the vault. The central bank will nearly always lend it, which is why it is called the lender of last resort.

The rate the central bank charges for that lending feeds through to every other rate in the economy, so this function is also the mechanism by which interest rates are actually controlled.

4.3 Monetary policy and quantitative easing

Setting the short-term interest rate is a central bank’s ordinary tool. Raise it, and borrowing costs more and saving pays more, so spending and inflation are damped; cut it, and the opposite happens. The effects of that on an individual business are the subject of chapter 11 §2.

The tool runs out when the rate is already close to zero, which is what happened after the financial crisis of 2008 and again in 2020. A central bank cannot cut much below zero, so it needs a way of loosening policy that does not work through the rate. That is quantitative easing.

It is intended to work through three channels:

• Buying bonds pushes their price up, and §3.11 shows that a higher bond price means a lower yield. Long-term interest rates therefore fall even though the central bank’s own short-term rate has not moved.

• The sellers now hold cash instead of bonds. Some of them buy other assets — shares, corporate bonds — which pushes those prices up too and makes it cheaper for companies to raise finance.

• Banks end up with larger reserves, which supports lending and so, through §6, the wider money supply.

The risks are the mirror image. Too much of it, for too long, inflates asset prices, rewards those who already own assets and can eventually feed into general inflation. Reversing it — selling the bonds back, sometimes called quantitative tightening — pushes long-term rates back up.

5 The structure of interest rates: the yield curve

There is no such thing as the interest rate. There is a different rate for every length of borrowing, and a yield curve plots them: the expected yield on bonds of similar risk against the time remaining to their maturity. Reading one tells you what the market expects interest rates to do.

Suppose four bonds of similar risk mature in three months, one year, five years and twenty years. You would normally expect the yield to rise as you go along that list. There are two reasons, and both are examinable.

• Liquidity preference. Locking your money away for twenty years is riskier than locking it away for three months — you cannot get at it, and more can go wrong — so you require more for doing it. This is the same idea as §2.5: liquidity is priced.

• Expectations. If you expect interest rates to rise over the next twenty years, you will not accept today’s short rate for twenty years; you demand a yield that anticipates the rises.

So the normal yield curve slopes upwards:

Sometimes the curve inverts:

An inverted curve says the market expects interest rates to fall. Nobody wants to be locked into paying a high rate for twenty years when they think rates are about to come down, so long-dated yields drop below short-dated ones. For an investor the implication is the reverse: it may be worth locking into a long-term bond now, even at a lower rate, because the rate available later may be lower still.

6 Credit creation by banks

When you deposit money in a bank, the bank lends most of it on. The borrower spends it, and whoever receives it deposits it in their own bank, which lends most of that on in turn. The reserve ratio is the proportion of every deposit a bank must keep as cash rather than lend.

With an original deposit of $1,000 and a reserve ratio of 25%, the cycle looks like this:

Two different totals come out of that table, and objective test questions turn on telling them apart.

By altering the reserve ratio the central bank can make credit and the money supply expand or contract, and this is an important instrument of monetary control. A ratio of 10% would support $10,000 of deposits and $9,000 of credit on the same original $1,000; a ratio of 50% would support only $2,000 of deposits and $1,000 of credit. Higher reserve ratios also make banks more stable, because they keep a larger proportion of each deposit in cash.

7 Foreign exchange markets

7.1 What the foreign exchange market does

A UK exporter selling to the United States is paid in dollars but pays its staff and its suppliers in pounds. A UK importer is invoiced in dollars but holds pounds. Somebody has to turn one into the other, and that is what the foreign exchange market is for: it is the market in which currencies are bought and sold, and without it international trade could not be settled.

It is not a place. It is a network of banks dealing with each other and with their customers, around the clock, and it is by far the largest financial market in the world by turnover.

The market does two jobs for the syllabus.

• It facilitates trade. An exporter can convert its foreign receipts, an importer can buy the currency it owes, and — as chapter 11 explains — both can fix the rate in advance through a forward contract, so that a price agreed today is not undone by a movement before payment.

• It determines the exchange rate. Where a currency floats, its rate is simply the price at which supply and demand for it balance. Demand for pounds comes from foreigners buying British exports, investing in Britain or wanting to hold sterling; supply of pounds comes from Britons buying imports or investing abroad. Anything that changes either side — a trade surplus, an interest rate rise that attracts deposits, a change of political mood — moves the rate.

7.2 Fixed and floating exchange rates

A government can try to fix — peg — its currency against another currency or a group of them. That gives importers and exporters certainty: they know exactly what a foreign price is worth at home.

Maintaining the peg is the hard part. Because the rate is not allowed to move, the government must buy or sell its own currency to keep supply and demand in balance at the fixed rate. If the market believes the currency is overvalued, holders will sell before it falls, and the government must buy it up using its reserves — gold, or another currency — to pay for the purchases. If investors panic there is a run on the currency, and preventing a devaluation becomes very expensive and eventually impossible.

A fixed rate also cannot respond to the health of the economy. If a country is not producing goods the world wants, its exchange rate stays where it was and its exports stay expensive. Letting the currency devalue would make those exports cheaper abroad, stimulate output and in time raise tax receipts.

With floating exchange rates the rate changes continuously in response to market forces. That introduces uncertainty for importers and exporters — the subject of chapter 11 — but the government never has to spend reserves defending it, and the rate moves with the economy’s health, which is a self-correcting mechanism.

In practice no currency is purely fixed or purely floating. Under a fixed regime, market pressure still shows itself, often through a black market rate that reflects genuine supply and demand, and the central bank may then have to revalue or devalue the official rate to bring it into line. Under a floating regime, central banks still intervene to damp down volatility. There are intermediate systems too, such as an adjustable peg with margins: the rate floats freely within a band, and the band itself is moved if there is a fundamental imbalance.

7.3 Single currency zones

On 1 January 2002 a group of European Union member states replaced their national currencies with euro notes and coins. The euro area has taken in further members in most years since and it is still growing, so the number of countries in it is not worth learning — what is examinable is what a single currency zone does, which is the rest of this section.

Claimed advantages of a single currency zone:

• The single currency covers a large economic area, which gives it credibility and makes it more stable against speculation than the small national currencies it replaced. Greater stability lowers risk and should lower interest rates.

• Convenience for individuals travelling within the zone: money does not have to be changed.

• Convenience and certainty for importers and exporters within the zone, which removes both transaction costs and exchange risk on intra-zone trade and should stimulate trade and jobs.

Claimed disadvantages:

• One monetary policy cannot suit every member. All members have the same interest rate, but one may need a lower rate to escape a recession while another needs a higher one to control inflation.

• Members are at different stages of their economic cycles, which makes the problem above a permanent one rather than an occasional one.

• Loss of national sovereignty over monetary policy, and pressure towards common positions on tax, spending and inflation. Much of the euro’s difficulty has come from having one currency and very diverse national economic policies.

• A member country can no longer devalue to restore its competitiveness, so adjustment has to come through wages and prices instead, which is slower and more painful.

7.4 Reserves and exchange controls

Foreign currency reserves are the foreign currency and gold held by a central bank. They are used to buy and sell the country’s own currency in order to influence or maintain its exchange rate, and they stand behind the country’s external debt — the equivalent of telling a creditor that you hold assets you could sell to pay them.

The most important reserve currency is the US dollar.

The amounts are very large. At the end of 2016, for example, reserves measured in US dollars were roughly:

Governments and central banks also impose exchange controls from time to time. These intervene not only to hold a rate different from the one the market would set, but also to require buyers and sellers of foreign currency to deal in particular ways.

If savers thought their currency was about to be devalued, for example, they could all move into US dollars — which would itself weaken the currency further — so the government might simply ban exchanges above a stated amount. In the UK in the 1960s, when the economy was very weak, citizens travelling abroad were limited to changing £50.

8 Tests

Work each one before reading the answer.

9 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s key terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.