The Financial System of the United Kingdom Economy - Essay Example

Financing Options Introduction United Kingdom is a capital- enriched country. Therefore, the financial system of the economy is very strong and facilitates the institutional and retail investors of the economy with a large number of options for large purchases such as house purchase, lease, bank loan and purchase of luxuries cars etc. However, all such financing options suffer from certain underlying issues and drawbacks that affect the concerns and interests of the investors and the economy as a whole to some extent (D. Bell and C. Alex, “A New Fiscal Settlement for Scotland?”, Scottish Affairs, Vol. 41, No. 3, 2001, pp. 121-140). In this paper, various financial options available in the UK economy for large purchase will be evaluated and the issues associated with such options will also be analysed. Discussion In this segment, the various financing options for large purchase i.e. purchasing properties or luxuries cars etc will be analysed in details. Bank Loans Bank loans are considered to be the most reliable source of financing any large purchase. Bank loan is an agreement in which the borrower is provided with full or partial amount of the money required for purchasing certain assets from a large number of commercial banks such as HSBC, Barclays, Standard Chartered and Royal Bank of Scotland as well as cooperative banks such as Tesco Bank, Sainsburys Bank etc. available in the economy. Such sum of money is provided with an agreement of repaying the principle amount after completion of a stipulated period of time. Moreover, the borrower is subjected to pay the fixed or variable amount of interest rate, as applicable, on the principle amount taken as loan (M. Caglayan and A. Rashid, “The Response Of Firms Leverage To Risk: Evidence From Uk Public Versus Nonpublic Manufacturing Firms”, Economic Inquiry, Volume 5, No. 52, 2013, pp 341–363). Bank loans can be of secured and unsecured. Unsecured loans are those source of capital in which fund can be quickly availed without any obligation of collateral. Such loan is provided, depending upon the current financial position of the borrower and his reputation in the market. However, in case of large purchases, loan is always made secured by involvement of certain assets such as housing property of the borrower which is used as collateral. The lenders hold the collaterals till the tenure of the loan. If the borrower fails to repay the loan or the interest payment within the stipulated time, the banks are entitled to acquire the right of ownership of the collateral. Secured loan is considered to be the best option for accumulating large amount of money. Mortgage loans are the most prominent example of secured bank loans (I. K. Nassr and G. Wehinger, “Non-bank debt financing for SMEs”, OECD Journal: Financial Market Trends, Volume 6, No. 1, 2014, pp 139–162). Advantages of Bank Loan Flexibility: Bank loans provide wide range of flexibilities. Such loans can be obtained for multiple purchasing options such as purchase of housing cars, pursuing higher education or accomplishment of some personal requirement of large purchase. In fact, such loans are provided in a comparatively flexible terms. Lower Interest Rate: The interest rate offered by banks against the loans provided is available comparatively at a cheaper rate as the banks have to follow the guidelines imposed by the Bank of England. Other unregulated financial institution may charge higher rates but the recognised private banks are supposed to charge a uniform interest rate, as range bounded by the central bank of the economy. Acceptance: If the lender is having all the required documents readily available with him, it requires few hours to days to get the loan approved. This indicates efficiency of the commercial banks in UK that are capable of processing swiftly. Disadvantages of Bank Loan Difficult to Obtain: As availing bank loan, especially secured loan, involves a series of formalities and requires multiple legal and administrative documents to produce, it becomes difficult to get access of bank loan easily. Uncertainty: As the commercial banks are required to maintain certain credit standard, stipulated by the Bank of England, sanctioning of loans become contingent, depending upon the type and position of the large purchases such as cars or housing properties. Security: Security i.e. depositing asset of the borrower to the commercial banks as collateral is inevitable, especially in the case of large amount of loan. If the lender fails to repay the loan on time, the banks are on a position of acquiring the possession of the assets. However, in reality, if the lender holds equivalent assets, the requirement of getting bank low minimises. Rather, such loan may cause for unnecessary financial stress of losing his personal asset. Therefore, before opting for bank loans, the lenders must ensure that they hold sufficient money to pay off the loan amount, even in the time of financial difficulties (S. Cheng, “Potential Lending Discrimination? Insights from Small Business Financing and New Venture Survival”, Journal of Small Business Management, Volume 5, No. 1, 2014, pp 72-86). Mortgage and Housing Loans Considering large purchases, the most important purchase done by the individuals are housing property loans. Purchase of housing property can be financed through housing loans or mortgage loans. Such loans are available from various banks and non-banking financial institutions of United Kingdom. Home loan, in general, provides finances to individuals for purchasing housing properties. However, through home loan, finances can be raised for some other purposes such as purchase of car or consolidation of debts. In fact, such loans can be used for raising cash in exchange for a percentage of the equity in your home. In such cases, though the individuals reside in the home, however, the ownership of the house is partly or wholly owned by the financing company till lifetime. Under mortgage loan, the existing properties are used as collateral and depending upon the value of the property, the amount of loan is granted to the borrower so that big purchases can be made. In other words, Mortgage is a legal document that secures the concern of the lenders behind providing the loan amount. Such debt instrument also provides conditional ownership of the property until the entire amount has not been paid. However, the main difference between mortgage loan and home loan can be presented as, in mortgage, the property is obligated to the financial institution as collateral whereas in case of home loan, the collateral used by the borrower, may or may not be secured. Moreover, in home loan, the borrower is facilitated with actually money using which he purchases the house. In contrast, as mortgage is an agreement in which a legal document is presented that the borrower must present at the time of claiming his property, after completion of the tenure of loan payment. In fact, in case home loan, the property is assigned to the borrower for a certain period of time i.e. till the tenure of the loan. If the borrower fails to repay the loan amount within the specified time period, the property is captured by the lending party. On the contrary, mortgage loan is made available against the lien of the property. The lien is used only when the debt is totally paid off. Therefore, while considering purchase of the property, most of the inhabitants of United Kingdom prefers mortgage loan over normal housing loans (M. Goergen and L. Renneboog, “Investment policy, internal financing and ownership concentration in the UK”, Journal of Corporate Finance, Vol. 7, no. 3, 2001, pp. 257–284). Advantages of Mortgage Loan Leverage: The biggest advantage of mortgage loan is the leverage that the borrowers obtain from mortgage loan. For example, it is assumed that an individual purchases the property with $100,000 down payment and takes up mortgage loan up to $400,000. Now, if the price of the property appreciates by 10% in the next year, the individual will gain a profit of 50% in the next year on his investment. Had the individual kept the money idle, it would have grown only by the prevailing rate of saving bank account in the financial system. Security: Mortgage loan provides the similar sense of security to the individual as keeping the cash in bank. For instance, any case of natural catastrophe such as earthquake or tsunami, as the mortgage provider financial institution holds a large chunk of ownership of the property; it becomes the responsibility of that particular financial institution to keep the mortgaged property insured. Interest Deduction: As per the tax law of United Kingdom, the interest pain on the mortgage loan is liable to receive deduction up to a certain limit on the tax return of individuals. However, the extent of deduction depends upon the tax bracket in which the tax payer falls under. Investment Opportunities: As the economy of United Kingdom is proceeding towards further maturity, the per capita income and purchasing power of the individuals are also better off, reducing the level of unemployment. This has increased the need for housing property to a great extends and accordingly, the economy is experiencing appreciation of the price of housing property at a rapid speed. Therefore, many UK investors has taken this opportunity as an investment instrument and started purchasing properties, taking mortgage loan. As the rate of appreciation is much higher than the rate of interest in mortgage loan, the net gain is huge for the individuals from such investments (E. R. Yescombe, Principles of Project Finance, Waltham, Academic Press, 2013). Disadvantages of Mortgage Loan Involvement of Additional Fees: Though it appears that while opting for mortgage loan, the borrower is bound to pay only the cost of interest, in reality, there involves hefty amount of additional fees along with the mortgage loans. Conveyance cost i.e. the cost required to precede the legal work associated with the mortgage and penalties in case the individual wishes to repay the loan early, also constitutes for huge amount of costs for the investor in mortgage loan. Long Term Debt Obligation: As the tenure of the mortgage loan may prolonged to the lifetime of an individual, such loan results in long term debt obligation for most of the borrowers. Moreover, as the own property of the individual borrowers are taken into account, the investors are subject to continue payment of the mortgage loan in order to safeguard the property from the financial institutions. During the period of global financial crisis that had originated mainly from the housing bubble in United States spillover effect of such turmoil had caused many people in UK as well to loss their property and capital (W. Spiess-Knafl and S. A. Jansen, “Social Enterprises and the Financing of Different Scaling Strategies”, Advances in Business Ethics Research, Volume 5, No. 4, 2014, pp 67-83). Lease Purchase and Finance Lease Lease purchase and lease financing is another method for financing the requirement of large purchase of the individuals. Such arrangement is mainly prominent at the time of purchasing vehicles such as personal car or cars for rent business, software and other business equipments. In this financing system, the lessor or the financing company purchases the equipment on behalf of the borrower or the lessee, depending upon the down payment done by the lessee. Such purchase is done on the agreement between the two parties that the lessee will repay the whole amount within an agreed period of time. After the completion of the contract, the lessee is facilitated with the full ownership of the vehicle or equipment (O. Kume and A. Iqbal, “Impact of Financial Crisis on Firms’ Capital Structure in UK, France, and Germany”, Multinational Finance Journal, Vol. 11, No. 3, 2001, pp. 121-140) The main characteristics of lease purchase or financing through leasing can be attributed as once entered into the agreement, the system of financing cannot be cancelled as the large proportion of the investment has been done by the financing company. However, the lessor i.e. the financing company does not to bear the cost of insurance or any liability related to maintenance or repairing; such costs is borne by the lessee in spite of not having the full ownership of the equipment (J. Hussain and H. Matlay, "Financing preferences of ethnic minority owner/managers in the UK", Journal of Small Business and Enterprise Development, Vol. 14, no. 3, 2007, pp. 487 – 500). The main advantages and disadvantages of the mode of financing are as follows. Advantages of Lease Financing No Requirement of Infusing Large Outlay: The main advantage of the lease financing is that there is no requirement for the lessee to pay the whole amount of large purchase upfront. Therefore, it becomes easier for the individuals to maintain hold strong financial position or sound level of cash flow in business. No Long Term Commitment: Lease financing generally comes with shorter investment tenure because of the lesser value for the equipments or vehicles as compared to mortgage. In fact, the requirement of monthly interest payment is also very low. Moreover, the lease agreement is transferrable as well which means if the lessee fails to pay the interest due to certain financial crunch and he can find out some other investor interested in the equipment, the can shift the liability of the interest payment to that particular investor. Of course, at the end of the tenure of the lease, the ownership of the equipment or vehicle will shift to that particular investor. Tax Advantages: As the lease interest is considered as operating cost, the interest payment is deducted from the taxable profit. Therefore, it will reduce the aggregate tax liability of the individual. Budgeting: As the interest payment of the lease agreement is a fixed contract, it becomes easier to prepare budget and forecast the expenses of the individuals. Disadvantages of Lease Financing No Ownership: In case of lease financing, though the insurance, maintenance and repairing cost is borne by the lessee only, still the lessee does not enjoy the right of ownership right. Ownership is only provided to the lessee at the end of the payment of the interest within the stipulated time period. Huge Maintenance Cost: Though the equipment or vehicle or software is owned by the lessor, the maintenance cost is imposed on the lessee. This appears to be an additional burden to the lessee, apart from the cost of interest payment (G. N. Milstein and V. Spokoiny, “Construction of Mean-Self-Financing Strategies for European Options under Regime-Switching”, SIAM Journal on Financial Mathematics, Vol. 5, No. 1, pp. 532–556). Reference List Bell, D. and Alex, C., “A New Fiscal Settlement for Scotland?”, Scottish Affairs, Vol. 41, No. 3, 2001, pp. 121-140. Caglayan, M. and Rashid, A., “The Response Of Firms Leverage To Risk: Evidence From Uk Public Versus Nonpublic Manufacturing Firms”, Economic Inquiry, Volume 5, No. 52, 2013, pp 341–363. Cheng, S., “Potential Lending Discrimination? Insights from Small Business Financing and New Venture Survival”, Journal of Small Business Management, Volume 5, No. 1, 2014, pp 72-86. Goergen, M. and Renneboog, L., “Investment policy, internal financing and ownership concentration in the UK”, Journal of Corporate Finance, Vol. 7, no. 3, 2001, pp. 257–284. Hussain, J. and Matlay, H. "Financing preferences of ethnic minority owner/managers in the UK", Journal of Small Business and Enterprise Development, Vol. 14, no. 3, 2007, pp.487 – 500. Kume, O. and Iqbal, A., “Impact of Financial Crisis on Firms’ Capital Structure in UK, France, and Germany”, Multinational Finance Journal, Vol. 11, No. 3, 2001, pp. 121-140. Milstein, G. N. and Spokoiny, V., “Construction of Mean-Self-Financing Strategies for European Options under Regime-Switching”, SIAM Journal on Financial Mathematics, Vol. 5, No. 1, pp. 532–556. Nassr, I. K. and Wehinger, G., “Non-bank debt financing for SMEs”, OECD Journal: Financial Market Trends, Volume 6, No. 1, 2014, pp 139–162. Spiess-Knafl, W. and Jansen, S. A., “Social Enterprises and the Financing of Different Scaling Strategies”, Advances in Business Ethics Research, Volume 5, No. 4, 2014, pp 67-83. Yescombe, E. R., Principles of Project Finance, Waltham, Academic Press, 2013. Read More