The Financial System and Retail Banking - Case Study Example

Table of Contents Introduction 2 Financial System 3 Financial Markets and Financial Intermediaries 4 Bank of England 6 Organised market 7 Products and Services offered by the bank of England 8 References 11 Introduction Finance is often referred as the life blood of life. It is the broad term that defines the entire flow and process of the economy. In the ancient period, as there was no set standard of exchange of goods and services, so barter system was in place which emphasised on exchange of goods and services in kind. But the system had many drawbacks. The so called and so thought lower classes of the society were not allowed to exchange or even touch certain goods. Also, it was found that the influential persons tried to take advantage of the system and virtually rob the poor and the downtrodden. All these factors called for a standard means of exchange for the produced and saleable goods (and services, as the case may be). As the human civilisation advances, the society had the currency as the fixed standard. Different goods were traded on the basis of currency of the land. It ultimately led to other important factors like demand and supply to influence the trade. The goods that had higher demand and lesser supply enjoyed the premium status and were priced higher. Similarly, the goods which had abundant supply with little demand; were priced lower. The same concept was also applicable for the fund holders in the society as there are people who have abundant source of money. Again there are persons, who are in the dire needs of the same. Financial System In simple words, financial system is the system and process of channelizing funds from those who have it in excess to those who require it. So, it is under the financial system that the suppliers and the demanders of the funds come together. With the development of the banking system across the globe, the financial system has primarily governed by the central banks of the respective countries. As the international financial bodies like that of International Monetary Fund or the World Bank came into being, they also became the part and parcel of the global financial system. In the early years of the decade, Franklin Allen and Douglas Gale observed that the primary objective of a financial system is to channel funds from agents with surpluses to agents with deficits (Allen & Gale, 2001). But as the financial system has become complex day by day, it has been virtually impossible to trace out the demanders and the suppliers of the funds individually. Here comes the role of financial intermediaries. Financial intermediaries collect the money from that of the suppliers in the form of deposits and channelize the same to the demanders in lieu of certain pre-specified rate of interests in the form of loans. In the meantime, the financial intermediaries earn brokerage as they bring the demanders and the suppliers under one umbrella. The brokerage is essentially the money that they receive from the loaners less the money that they have to pay to the suppliers. In the past, the financial system was basically based upon the reputations that various financial houses possessed but as the world of finance turned more competitive and complex, there was essence of certain legal bindings that would enable the financial intermediaries to stick to the promises and obligations made to other parties. The national monetary bodies (like Federal Reserve in the United States) have been playing significant role in this respect. Financial Markets and Financial Intermediaries In the competitive world of today, the financial intermediaries that channelizes the funds from the lenders to the borrowers primarily comprises of four broad heads namely: Banks – The banks are the most traditional form of financial intermediary. The lenders deposit their abundant money for a fixed time period and receive certain rate of interest. Similarly, the borrowers take loan from the banks in lieu of differently set rate of interest. The difference of the later rate and the former rate is the incentive for the banks. Insurance companies – The primarily responsibility of the insurance companies is to assure the life of the policy holders. But in the present days of competitive finance, to attract more customers, insurance companies are also playing the role of financial intermediaries. With the advent of the capital market related product like that of ULIPS (Unit Linked Insurance Products), the companies are often providing much higher returns than that of banks. Pension Funds – It is the savings of the people to take care of them during their old age. As they people save and contribute to the pension funds all along his life, there is no point in keeping the money idle. So, these funds also act as the financial intermediary. Mutual Funds – Mutual funds are basically floated by the various asset management companies (AMCs) to tap the retail and the individual investors with relatively abundant supply of money. These funds are traded on daily basis as per the net asset value (NAV). The money invested in the mutual funds are often further channelized to the capital market where the industry leaders use it as per their needs. The aggressive finance of the present world also has contributed to the development of various forms of financial markets. The driving force behind such development has been the zeal to increase return for the original investors. The various forms of financial markets that are prevalent in the present market scenario are the inter-bank market (market exclusively for the banks to trade), the stock exchange or the capital market (where the investors purchases scrips of the listed companies with the exchange), money market (it includes the short term instruments like that of Repo, Certificate of Deposits and the Commercial Papers), bond market (comprises of government bonds, fixed income bonds and corporate bonds, etc), derivatives (it is basically related with mitigate the risk involved with various financial instruments and includes options, futures, forwards and credit derivatives) and the foreign exchange (hedging and arbitraging of currencies). Bank of England Popularly known as ‘The Old Lady of Threadneedle Street’ to the world of finance and allied services, Bank of England is the Central Bank of the United Kingdom. The bank was established way back in 1694 and was nationalised in 1946. The bank is assigned with the responsibility of maintaining the financial health and stability of the United Kingdom through proper monetary measures and policies (Bank of England, n.d.). Organised market Benefits The first and foremost benefit that an organized sector offers is that it allows transactions between complete strangers, so that the circle of traders gets broader. In case of unorganized sector, the operations are mainly within a known circle that makes the level operation very low. Secondly, operating in the organised sector makes it possible to keep a track of the supply and demand conditions of money in the economy, so that the adverse implications of a higher money supply and hence of a greater liquidity in the economy can be avoided. Thirdly, operating in the organized financial market firms and their intermediaries is also beneficial in avoiding risks in the sense that they help in acting as hedging instruments. The various contracts entered into in an organized financial market like the futures market, act like an asset and help in portfolio diversification. This helps in hedging against risks in the financial market arising due to any liquidity crunch or excess liquidity problem. Costs The most important cost of operating in an organized financial sector is that the lenders and borrowers have to deal with a standardized contract and thus the exchange of contracts become more like a barter trade. This feature makes it difficult for the people to find an ideal counterpart whose needs would complement their own needs (Telser Lester G. & Higinbotham Harlow N., 1977, pp 1 & 2). Products and Services offered by the bank of England Besides setting the monetary policy for the nation in any given financial year, the Bank of England being the central bank of England also provides a varied range of services to its customers like various financial firms and intermediaries as well as the government of England. The Customer Banking Division is the department of the bank that provides these services. Moreover, the Market Services Division is another department of the Bank of England that operates in the back office and has been attributed the power of making safe and efficient payments for the Bank of England. Another important division of the Bank of England banking services is the Notes Division. This section is responsible for the manufacture, issuing, circulation and eventual destruction of notes within the country. Hence, this is a very responsible task indeed since it needs the assessment of the liquidity position or rather the monetary stability condition within the England market. The Customer Banking Services provide a number of lucrative services to its key customers, i.e., the government of England and the various financial intermediaries. The Bank of England maintains as a safety measure high level bank accounts for the central government of the economy that the government could access at times of liquidity crunch. The bank also offers gold custody services to the London Bullion Market and offer liquid money in exchange. The Market Services Division on the other hand helps in making payments for the various financial institutions of the nation to both indigenous and foreign institutes, with the daily payments amounting to higher than five hundred billion pounds. The services of the bank are focussed towards a wide range of the English population. It seems that the Bank of England has something to offer to everyone in the country and this large set of services makes it very lucrative for the entire population turn towards the Bank of England when the need arises (Bank of England, n.d., Banking Services). The Bank of England’s chosen rate of interest on loans stood at 4.25% in September, 2008, i.e., one year from today. A year before that in October, 2007, the rate of interest offered by the Bank of England was 5.75%. It was In October, 2006, it was 5% per annum. Hence an investor investing 5000 pounds three years, two years and one year ago respectively would yield at a compound rate of interest, the following amounts in 2009. Years of investing the 5000 pounds Rate of Interest Amount yielded 1 (2008-2009) 5.75% 5287.5 2 (2007-2009) 5% 5512.5 3 (2006-2009) 4.25% 5664.978 The main users of the lending sector are the investors and the borrowers in the financial market. The investors are actually the lenders in the market. By and large there are three types of investors in an economy. Firstly, the starters who prefer to get along with the crowd and do not involve themselves much in the speculation business. Secondly there are the “dice rollers” who just keep on trying their luck in business, irrespective of the risk element prevailing in the society. Thirdly, there is a group of rational speculators who invest only after judging the market conditions prevailing. These people are the ultimate lenders in the financial market (Galland David, February, 2007, para 1-3). On the other hand, there are three types of borrowers – the prime borrowers, who are very vulnerable to risks and the banks and various investors offer loans to them at a very high rate of interest which is the only incentive operating behind advancing them loans. The second category of borrowers is the Alt-A type who is just in a position to pay their loans and the third category is the Prime borrowers who have a higher capacity of paying back than the amount they are taking as loans. References Allen, G. & Gale, D., 2001. What is a Financial System? New York University. [Pdf] Available at: http://www.nyu.edu/econ/user/galed/papers/paper01-04-01.pdf [Accessed 17 August 2009]. Bank of England, No Date. About the Bank. Bank of England. [Online] Available at: http://www.bankofengland.co.uk/about/index.htm [Accessed 17 August 2009]. Bank of England, n.d., Banking Services. The Bank of England. [Online]. Available at http://www.bankofenglandjobs.co.uk/the-work-of-the-bank/banking-services/ [Accessed 17 August 2009] Galland David, February, 2007. Three Types of Investors, The Daily Reckoning [Online]. Available at http://www.dailyreckoning.com.au/investors/2007/02/07/. [Accessed on 17 August 2009] Telser Lester G. & Higinbotham Harlow N., 1977. Organized Futures Market. Journal of Political Economy, vol. 85, no. 5 [pdf]. Available at http://people.hofstra.edu/Ahmet_K_Karagozoglu/organized_futures_markets_costs_and_benefits_jpe77.pdf. [Accessed on August 17, 2009] Read More