Chapter 1 - UK Financial Services Overview

Question 1

Four essentials functions of financial services.

Answer 1

1. Providing a vehicle through which savings are protected and channelled into capital management.
2. Providing a means by which savers desire for accessible capital matches borrowers needs for long-term funds. This allows financial institutions to take positions with longer terms and potentially greater return.
3. Allowing all to insure against risks they do not wish to take but others are willing to take for payment.
4. Allow investors to disperse risk across a number of investment products.

Question 2

Banks & Building societies functions

Answer 2

Banks or building societies offer protection of money while using that money to make a return for itself.
E.g. bank lends out money to borrowers and as long as there is enough cash reserves - system works. Bank makes return by charging interest.
Building societies owned by share accounts not shareholders therefore can provide lower interest rates due to not having to pay dividends and paying share accounts interest.
Perform important function of turning short-term savings into long-term lending. Diversified product range.

Question 3

What do banks do with the money they receive?

Answer 3

They place it into other long-term investments and some is lent back to the customers in the form of loans.

Question 4

Government Savings & NS& I

Answer 4

Used savings of private individuals to fund borrowing.
Acts as its own financial institution and offers fixed interest investments (UK Debt Management Office).
Investments act as a loan to the government whilst offering interest rates and original capital at the end of the term. Gilts are best known example.
NS&I - Government institution that issues premium bonds - savings and deposits also used to fund Government.

Question 5

Conventional Gilts

Answer 5

majority of UK debt, pay a fixed coupon rate six monthly, face value at end of term which may differ to initial investment amount, differing terms and some are protected against inflation.

Question 6

What is the main purpose of Gilts?

Answer 6

The issue of gilts allows the Government to borrow money from investors in return for a fixed level of interest. There is some variability in the interest of index-linked gilts due to their link twin the movement of Retail Price Index (RPI).

Question 7

Insurance and Risk Management

Answer 7

To protect and safeguard assets from financial effects of damage or loss.
Protection needs on physical assets, earnings, potential profits and financial transactions.
Small premiums pooled by insurer who then invest money on a short or long term basis - returns serve to maintain or grow their reserves against inflation.
If too risky, insurance company then pass onto reinsurance company for a portion of the premium.
Derivatives are used for protection of financial transactions.

Question 8

Apart from physical assets, what else can be insured?

Answer 8

Potential profits, financial transaction and earnings.

Question 9

Capital Markets Objective & Instruments

Answer 9

Capital markets developed to meet to objectives:
1. Enable investors to invest in assets that provide growth over and above general increases in prices.
2. Help companies raise money without borrowing from banks.
This gave rise to two financial instruments:
1. Shares - can buy ownership percentage in the company. Benefit from an increase in value of the company and get a share of the profits (dividends). Can vote in shareholder meetings.
2. Fixed-interest stock (Bonds) - allow lending of money subject to predetermined terms in exchange for interest payment. Generally higher interest rate than banks due to increased risk.

Question 10

4 Components of UK Financial Services Structure

Answer 10

1. Financial Infrastructure - payment, settlement, clearing and trading systems.
2. Financial Markets - on-exchange & OTC
3. Financial Firms - Banks, pension & insurance firms.
4. Authorities - BoE, FCA, PRA & HM Treasury.

Question 11

Financial Infrastructure

Answer 11

Payment systems - deal with very high values and are used by customers. High value systems failure could result in rapid transmission of shocks from firm to firm and across markets.
BoE oversees payments systems in UK - monitors and facilitates the functioning of Sterling money markets and payment systems. Close links with with companies responsible for maintenance of efficiency and integrity of systems (CHAPS, BACS etc.).
UKPA - main service company for providers of payment systems.
Clearing houses and settlement systems - provide infrastructure for clearing and settlement of securities and derivatives markets.
FCA is regulator of recognised investment exchanges.
BoE supervises recognised clearing houses under European Market Infrastructure Regulation (EMIR).

Question 12

Payments Systems Regulator (PSR) - Obj & Main Purpose

Answer 12

Related to financial infrastructure. Economic regulator for £81 trillion payment systems in the UK.
Their objectives are;
- Ensure payment systems are operated and developed in consideration of all users.
- Promote effective competition for providers & operators.
- Promote development and innovation in payments systems. Emphasis on infrastructure used to operate systems.

Overall purpose is to make payment systems work well for those that use them.

Question 13

Financial Markets

Answer 13

On exchange markets are used to trade investments such as equities and derivatives. FCA regulated.

No physical exchanges for OTC markets. Committees formed to examine how their markets function.

Question 14

Financial Firms (linked to)

Answer 14

Financial firm which holds account connected to the following:
Money market - wholesale market for commercial borrowers and lenders.
Capital market - trading stocks and shares, fixed interest investments & derivatives.
Commodity market - Trading physical goods
Foreign Exchange - currencies
Insurance companies - insure physical assets and provide banking and investment management.
Investment companies - invest surplus funds for longer term gain.
Life assurance & Pension companies - invest assets to meet long term obligations for policy holders.
Reinsurance companies - provide security to diversify risk.
Investment Houses - issue pooled investments like unit-trusts and OEICs.

Question 15

Banks & Building Societies - Core Services & Demutualisation

Answer 15

Current Accounts - most flexible, offer security, easy access, direct debits, standings orders etc. Little to no interest.
Deposit Accounts - less accessible but still accessible. Rates of interest can vary due to a number of factors such as amount deposited, fixed term, notice periods or withdrawals.
Mortgages & Loans - provided to finance purchase of assets.

Demutualisation - building societies abandoned mutual status in favour of becoming banks. Usual for members to get windfall or shares when this happened.

Question 16

Banks & Building Societies - Indirect Services

Answer 16

Portfolio Management (stocks) - investment managers establish and manage suitable portfolio and make all decisions (discretionary service). Alternatively, bank will administer clients own portfolio and make suggestions on what to buy/sell. Client can choose level of involvement (advisory service).
Stockbroking - enable customers to buy & sell securities, gilts and/or bonds (execution-only service).
Wills & Executorship service offered.
Collective Investments - Offer access to Unit-trusts and OEICs. Widespread of investments, low level of involvement, good for lower capital levels. Firms with own UTs or OEICs funds will usually fall under tied or multi-tied advisory arm.
Insurance & Pensions - Most offer insurance products and pensions.

Question 17

Types of advisory firm & Banks model

Answer 17

Independent - All retail investments considered - no restrictions.
Whole of market - can give advice from any provider in the market but any one restriction in products or providers makes it lose independent name.
Multi-tied - Limited range of providers.
Tied - Single provider.

1. Arm or subsidiary offering range of products from a limited number of providers, one of which could be the banks bancassurer. (Multi-tied)
2. Arm offering fully independent financial advice.

Question 18

Bancassurers

Answer 18

Banks & BS’s have set up their own life insurance company which forms basis of tied and multi-tied offering.

Question 19

Life Assurance Companies (Financial Firms) & RDR

Answer 19

Can distribute products via intermediaries (advisers) or their own sales team.

Retail Distribution Review (RDR) - large impact on distribution of financial products and brought about considerable change.

Question 20

Friendly Societies

Answer 20

Mutual self- help groups with no shareholders taking profits, all profits repayable to societies members, tax exempt which lead to offering tax efficient plans but limit on nature and size of contracts offered, small industrial life policies.

Since Friendly Societies Act (1992) they can apply for corp status and offer more services such as ISA’s & UTs & OEICs.

Question 21

Multi-Distribution Organisations

Answer 21

Companies such as M&S and Virgin start to offer financial products. Product range typically includes life assurance, ISA’s, UT’s/OEICs and some cases pensions.

Catalyst for expansion was requirement for government approval of products that fall within defined rules relating to Charges, Access & Terms (CAT) - ISA’s 1999 & Pensions 2001. Restricted requirement for fact find and advice allowed companies to sell products without using a qualified sales team.

Question 22

The role & structure of international markets - EU

Answer 22

Three European Supervisory Authorities (ESAs):

• European Banking Authority (EBA)
• European Securities & Markets Authority (ESMA)
• European Insurance & Occupational Pensions Authority (EIOPA)

Additionally, there is the European Central Bank (ECB), it coordinates and controls monetary policy and interest rated in the EU states using the Euro.

European Systematic Risk Board (ESRB) - monitor and asses risk to financial system as a whole.
European System of Financial Supervision (ESFS) - supervises individual financial institutions which consists of a network of financial supervisors e.g. FCA.

Question 23

Global - FSF, FATP, FAIS, IOSCO, BCBS, ISDA, TBMA & ISMA

Answer 23

Financial Stability Forum (FSF) - coordinates national financial authorities and makes recommendations about global financial system.
Financial Action Task Force (FATF) - sets international standards on anti-money laundering.
International Organisation of Securities Commissioners (IOSCO) - brings together worlds securities regulators to set common standards.
International Association of Insurance Supervisors (IAIS) - set common standards for international insurance sector.
Basel Committee on Banking Supervision (BCBS) - primary standard setter for prudential regulation of banks and provides a forum for banking supervisory matters.
International Swaps & Derivatives Association (ISDA) - represents those in privately negotiated derivatives industry. Includes interest rate, currency, commodity, credit and equity swaps.
The Bond Market Association (TBMA) - represents firms trading fixed-income securities.
The International Securities Market Association (ISMA) - trade association and self regulating organisation, supervising markets in international debt.

Question 24

How the EU impacts UK regulation

Answer 24

Subject to regs imposed by both EU and UK Government.

70% of FCA’s policy making is driven by EU initiatives including Financial Services Action Plan (FSAP). Many of these rules have been written into UK law and therefore will stand after Brexit.

Three European Supervisory Associations (ESA) created in response to 07/08 financial crisis.

• European Banking Authority (EBA)
• European Insurance & Occupational Pensions Authority (EIOPA)
• European Securities & Markets Authority (ESMA)

These three bodies have a significant effect on financial services regulation and supervision within the EU.

Question 25

Brexit

Answer 25

EU Referendum - UK invoked article 50 of the Lisbon Treaty on 29th March 2017. Whilst negotiating leave terms, the UK is still subject to rules and regulations of the EU and firms must abide by their obligations under UK law. Overall impact will depend upon UK Governments relationship with EU.

FCA issued the following advice;

Close contact with Treasury, BoE & other authorities and continue to monitor development of financial markets. EU legislation will remain in place until changed.

Consumers rights and protections are unaffected by the referendum result and remain unchanged until Government changes legislation.

Question 26

FSAP Objectives & What They led To + Euro Comission updates and changes

Answer 26

FCA plays a key role in international regulation and views better reg in the EU as a strategic priority.

FSAP has had a role in improving European single market for financial services and prompted a comprehensive legislation plan which has been implemented in the UK.

Three original FSAP objectives:

• Create a single EU wholesale market.
• Achieve open and secure retail markets
• Create start-of-the -art prudential rules & structure of supervision

These three objectives improve Europe’s wider economy through removing barriers and increasing competition among FS firms. This makes markets more efficient and reduces the cost to the wider economy.

Since 1999, European Commission has updated or adopted the following;

• Amount of capital firms should hold
• The rules they must comply with when carrying business with their customers.
• Controls that are applied to counter money laundering and terrorist financing
• Tests to apply when assessing suitability of new controllers or large shareholders.
• Requirements they impose to counter the risk of market abuse
• Disclosures that companies must make when seeking new capital.

Question 27

UK regulation of financial services

Answer 27

UK Government department responsible for this is the Treasury under the Chancellor of the Exchequer. CotE responsible for regulation and conduct of business both directly and via legal instruments that they introduce. Subject to change depending on party.

Key legal instruments governing reg and conduct of business are;

• Financial Services & Markets Act 200 (FSMA)
• Financial Services Act 2012
• BoE & Financial Services Act 2016

Question 28

Current UK regulatory framework - bodies

Answer 28

Prudential Regulation Authority (PRA) - Part of BoE that looks after authorisation and prudential regulation of certain larger firms such as banks and insurers.
Prudential Regulation Committee (PRC) - committee of the BoE which operates alongside Financial Policy Committee & Monetary Policy Committee.
Financial Policy Committee (FPC) - within BoE & monitors the economy.
FCA - conduct & market responsibilities. Authorises financial intermediaries and mortgage brokers.

The current model means that banks, insurers and investment firms have two groups of supervisors - PRA & FCA. All other firms are solely supervised by FCA.

Question 29

What does prudential mean?

Answer 29

Issues such as level of capital, solvency and risk management.

Question 30

Key Characteristics of the model - PRA & FCA

Answer 30

• There are two independent supervisors for banks, insurers and investment firms, PRA & FCA (prudential & conduct)
• Supervisors make their own set of regulatory judgements against different objectives.
• Designed to allow internal coordination between both supervisors to maximise exchange of relevant information but still acting separately when engaging with firms.
• Principle of seeking to ensure that regulatory data is only collected once.

Question 31

Taxation within the UK

Answer 31

High taxation reduces ability of consumers to spend and businesses to invest which slows down economic growth for the financial sector.

Low taxation leaves more money for private expenditure and commercial investment which stimulates economic activity.

Primary aim is to raise revenue for the Government but can also be used to re-distribute wealth among society (subject to what party is in power)

Government can also encourage savings and investment through tax concessions with the following products: Pension schemes, ISA’s, life assurance policies, friendly society savings plans, capital gains on gilts & corporate bonds & certain NSI products. Removal of tax concessions can cause a change in investment strategy.

Income tax on different forms of investment can vary the attractiveness to investors. Examples:

• availability of gross interest on bank, gilts & National savings products along with personal savings allowance can make them more attractive.
• tax-free interest on National Savings products appeals to higher rate tax payer.
• Inability of non-tax payers to recover tax paid on life assurance funds discourages their investment.

Tax rates determine level of revenue received by the Treasury, affect economic activity, the ability of people to invest and influences best investment choice for an individual.

Question 32

How can changes in tax rates be used to manipulate the economy?

Answer 32

Higher taxation reduces the ability of consumers to spend and businesses to invest therefore slowing down the private sector whilst lower taxation means more capital available to invest and private expenditure resulting in stimulating economic activity.

Additionally, changes in tax rates will affect the way businesses and people choose to invest their money.

Question 33

Economic policy

Answer 33

The set of actions a a government proposes to take on expenditure, borrowing & setting interest rates to help control the country’s economy.

Fiscal Policy - Control of taxation, borrowing and government spending methods.
Monetary Policy - Actions that involve interest rates and money supply.

CotE responsibility to define level of Government expenditure and borrowing but it is the Monetary Policy Committee’s (MPC)responsibility to the control interest rates. MPC is a branch of BoE.

Question 34

Government Spending

Answer 34

Government tend to spend money on UK companies within UK which stimulates the companies concerned and feeds through to the economy.

Government spending can exert a more significant effect on the economy that tax cuts.

Question 35

Government Borrowing

Answer 35

Government can borrow at low rates by offering financial instruments such as gilts. Gilts are issued by Debt Management Office then subsequently traded on the stock exchange.

Government borrowings effects the economy as borrowing takes money out of circulation which could dampen the economy whilst when repaying loans or gilts mature, money is injected back into the economy which can stimulate economic activity.

Quantative Easing - Involves BoE buying back gilts and corporate bonds from t he financial sector thereby injecting more liquidity to stabilise the banking and financial sector.

Question 36

Interest Rates - Repo Market

Answer 36

BoE has primarily used the Gilt Repo Market to influence short term interest rates. Repo is short for sale and repurchase agreement, this is where one party sells gilts to another with a legally binding agreement to purchase gilts in the future at an agreed price.

Repo rate - interest rate implied by the difference between the sale and the repurchase price.

MPC is responsible for setting interest rate - announces bank lending rate which all bank interest rates derive from. Made up on 9 members with four external members to gain extra expertise and ensure balance of opinion.

Final decision on interest rates given to independent committee to ensure that it is used to influence current rate of inflation rather than political gain.

Question 37

Controlling the economy without using interest rates

Answer 37

Taxation, spending and borrowing all have a significant effect on the overall economy.

Increased money supply stimulates the economy and reduced money supply reins it in.

Question 38

Welfare & benefits - what does it cover?

Answer 38

• NHS
• Sickness & Disability benefits
• Unemployed benefit
• Tax credits
• State Pension
• Pension Credits
• NHS funded nursing care

Question 39

Welfare & Benefits provision

Answer 39

State’s level of provision has decreased over the years e.g. reduction of mortgage support for unemployed.

Continual mounting evidence to suggest that there will be a future pensions crisis meaning people will have to work for longer. NHS underfunded and overburdened meaning people cannot rely upon the welfare state for a comfortable life.

Amount of State Pension payable is now calculated by how many years of NI contributions - min 10, max 35 (up from 30). State pension age is also being increased to reflect that people live longer and also as a tool for managing the Government’s pension liability.

Government is trying to stimulate private pension uptake with intro of auto-enrolment and NEST. Other government actions such as removal of dividend credits and changes to accounting regulations have contributed to final salary pensions to be closed or benefits reduced.

Long term care seen as money not well spent and lack of tax relief adds to this.

UK has an ageing population which with declining birth rate will lead to fewer taxpayers in the future to support increasing numbers of individuals who are retired or on benefits.

Question 40

Steps Government could take to reduce burden on welfare & benefit system

Answer 40

• Extensions of laws requiring compulsory pension contributions by employees and employers.
• Introduction of compulsory medical insurance.
• Intro of tax breaks for health insurance, medical ins & long-term care.
• Further increases in the State pension age.

Against the above - Cost of introduction
For - overall savings will cover costs of intro in the long term.

Question 41

Does the UK welfare system offer sufficient benefits to avoid the need to make private provision?

Answer 41

No. UK welfare system is generally overestimated - people should look to save into private pensions and get the necessary insurance to cover themselves for the future.