CeMAP 1 UKFR 20/21 - Unit 1 - Topic 1 Introduction to the Financial Service Industry

Question 1

For money to be acceptable as a medium of exchange, what must it be?

Answer 1

• Divisible into small quantities
• Generally acceptable to all parties in all transactions
• A store of value
• Portable
• Sufficient in quantity

Question 2

What is Intermediation?

Answer 2

An entity acting as a middleman between two parties.

For example, Banks/Building Societies use saving deposits to lend to borrowers.

Question 3

What is Disintermediation?

Answer 3

Where borrowers interact directly with the lender.

For example, Crowdfunding.

Question 4

What are the four elements of Intermediation?

Answer 4

• Geographical Location: Access to lenders from various locations, so borrowers are not limited to their own contacts.
• Aggregation: Intermediaries are able to combine lots of small deposits, enabling them to loan larger amounts to borrowers.
• Maturity Transformation: A single lender may not be prepared to offer the loan period required by the borrower, but intermediaries will have deposits of varying length making cash available to loan over a longer period of time.
• Risk Transformation: Individuals may not be comfortable with the risk of lending, instead intermediaries accept this risk and loan their deposit to a borrower, paying a lower interest on the deposit, and charging a higher interest rate on the loan.

Question 5

Product Sales Intermediaries

Answer 5

Slightly different in nature, product sales intermediaries bring together product providers (such as banks and insurance companies) and potential customers.

Examples of these are Financial Advisers, Insurance Brokers and Mortgage Advisors.

Question 6

Retail Banks

Answer 6

Banks that provide payment services, savings and loans to personal customers or smaller businesses.

Question 7

Wholesale Banks

Answer 7

Banks that provide funding for wholesale institutions or very large corporate clients.

Question 8

Life Assurance

Answer 8

Insurance that provides payment, generally a lump sum but possibly as an income, on the death of the person covered by the policy.

It is also sometimes referred to as Life Insurance or Life Cover.

Question 9

General Insurance

Answer 9

Insurance designed to protect policyholders from the financial consequences of adverse life events.

Examples are household insurance, motor insurance, travel insurance or commercial property insurance.

Question 10

Potential range of services offered by Financial Services Group

Answer 10

Insurance Services
Retail Banking
Mortgage Services
Credit Card Services
Wealth Management Services
Financial Asset Management
Investment Banking

Question 11

What is the Role of the Bank of England?

Answer 11

• Issuer of Bank Notes: Ensure adequate supply of notes in circulation
• Banker to the Government: Provides finance to cover any deficit by making automatic loans to the government. If there is a surplus, the bank may lend it out.
• Banker to the Banks: All major banks have accounts for depositing, obtaining cash and other transactions. Due to this, the Bank of England has considerable influence over the rates of interest in various money markets, through the interest it charges banks to borrow or pays on deposits.
• Adviser to the Government: It has specialised knowledge of the UK economy and therefore advises the government to help it formulate monetary policy. Its role was significantly enhanced when responsibility was given to the MPC (Monetary Policy Committee) in 1997.
• Foreign Exchange Market: Manages the UK’s official reserves of gold and foreign currencies on behalf of the treasury.
  Lender of Last Resort: Traditionally makes funds available when the banking system is short of liquidity, in order to maintain confidence in the system.
  Maintaining Economic Stability: The Financial Policy Committee sits within the Bank of England. It looks at the economy in broad terms to identify and address risks that affect economic stability.

Note: The Bank of England was previously responsible for issuing new gilt-edged securities, however this was transferred to the Treasury’s Debt Management Office (DMO) to avoid conflict of interest with setting of interest rates.

Question 12

What is the role of the Monetary Policy Committee (MPC)?

Answer 12

In 1997 the responsibility for setting UK interest rates was given to the MPC. The committee meet 8 times per year, and its mandate is to set the base rate to ensure the governments inflation target is met.

The MPC falls under the Bank of England.

Question 13

What is the Debt Management Office (DMO) responsible for?

Answer 13

Responsible for debt and cash management for the UK Government, they issue gilt-edged securities (government loans).

Question 14

What is liquidity?

Answer 14

Assets (e.g. cash) that can quickly be made available to meet liabilities.

Question 15

What are gilt-edged securities?

Answer 15

Loans to the government. There are a variety of gilts in issue, for varying periods at different rates of interest.

Question 16

The Bank of England’s Role as Regulator

Answer 16

The Bank of England was previously responsible for the supervision and regulation of the UK banking sector. This was transferred to the Financial Services Authority in 1998. The 2007-2008 financial crisis almost brought the banking system to collapse, so the government took steps to strengthen regulatory structures. The Financial Services Act 2012, effective April 2013, divided responsibility for financial stability between the Treasury and Bank of England and two new regulators - the FCA (Financial Conduct Authority) and PRA (Prudential Regulation Authority). The Bank of England and Financial Services Act 2016 modified the Financial Services Act 2012 to give more powers to the Bank by bringing the PRA within it. The PRC (Prudential Regulation Committee) was also then established.

Question 17

Proprietary and Mutual Organisations

Answer 17

Proprietary organisations are limited companies, they have shareholders who receive a share of the profits in the form of dividends. They can contribute to decisions about how the company is run at shareholders’ meetings.

Mutual organisations are owned by their members, who decide how company is run at general meetings. Members comprise of depositors and borrowers. For a life assurance company, they are the policyholders.

Question 18

What is Demutualisation?

Answer 18

When a building society converts to a bank, it demutualises. It’s status will change to a public limited company. This change requires approval from the members, but is usually already given, especially given the windfall of free shares which members are entitled to.

Question 19

What is carpetbagging?

Answer 19

Historically when a building society was expected to demutualise (converts to a bank), people would open accounts to receive a share allocation. To protect the interests of its members, building societies often place restrictions on new accounts ahead of demutualisation.

Question 20

What is a credit union?

Answer 20

A mutual organisation, run for the benefit of its members. Previously members had to be linked by a “common bond”, but changes to the Credit Unions Act 1979 which came into force in 2012 mean this was longer the case.

Run by a voluntary board of directors, all members. Board members are elected at the annual general meeting (AGM).

To join, members must meet entry requirements, pay any required entrance fee and buy at least £1 share in the union.

All members are equal regardless of the size of their shareholding.

Authorised and regulated by the FCA, with savers protected by the FSCS.

Credit unions can choose to offer ordinary shares, or differed shares which are only paid in special circumstances.

Historically an alternative to loan sharks, in more recent years Credit Unions have been recognised for their role in combating financial exclusion.

Savers invest in units of £1, each unit buying a share in the credit union, and each share paying dividends around 2-3% with no maximum (that was removed in 2012 with changes to the Credit Union Act). The changes also allowed interest to be paid instead of just dividends, but companies that wish to do this must have £50,000 or 5% of total assets in reserve whichever is greater.

Pooled savings are then lent to borrowers with an interest rate between 1-3% (max) of the reducing balance each month.

Savings and loan balances are covered by life assurance, subject to overall limits.

Question 21

What products and services do credit unions offer?

Answer 21

L - Loans
I - Insurance services
M - Mortgages
B - Basic bank accounts
S - Savings

Question 22

What is LIBOR?

Answer 22

Londer Interbank Offer Rate.

The rate of interest charged in the interbank market is LIBOR. It acts as a reference rate for the majority of corporate lenders, the rate is quoted as LIBOR plus a specified margin. LIBOR is fixed daily and loans vary in maturity from overnight to one year.

Question 23

How is LIBOR calculated?

Answer 23

LIBOR is an average calculation of the information submitted by major banks in London regarding the interest rates they are paying to borrow from other banks. It’s supposed to indicate the health of the financial system, and the confidence felt by the banks as to the health of the system, reflected in the interest rates they submit.

Question 24

What is the LIBOR scandal?

Answer 24

In the summer of 2012, it was discovered that banks were falsely inflating the rates they claimed to be paying so as to profit from the trades, or to give the impression they were more credit worthy than they were.

A review by Martin Wheatley, the MD of then regulator FSA recommended the rates be submitted on actual interbank deposit transactions and not what the rates should be or are expected to be. It’s also recommended that the banks keep records of the transactions to which the rates relate and that their submissions be published.

Question 25

Changes to LIBOR regulation and move to SONIA

Answer 25

Administering and providing information to specified benchmarks was brought in under the Financial Services Act 2012. Knowingly making false or misleading statements in relation to libor-setting became a criminal offence. Responsibility for administering LIBOR passed from the British Bankers Asssociation to the Intercontinental Exchange Benchmark Administration in 2014.

UK authorities have planned for shift to SONIA (sterling overnight index average) as the primary interest rate benchmark in sterling markets to replace LIBOR in 2021. BoE, FCA and RFRWG (Working Group on Sterling Risk Free Reference Rates) have issued various documents setting this out.