Topic 1 Flashcards
Introducing the financial services industry
What are the three main functions of money?
Medium of exchange – Money is accepted in exchange for goods and services.
Unit of account – Money provides a common measure to compare the value of products.
Store of value – Money can be saved and used for future transactions.
What properties must money have to be an acceptable medium of exchange?
Sufficient in quantity.
Generally acceptable.
Divisible into smaller units.
Portable.
What does ‘store of value’ mean in relation to money?
Money can be saved and used for transactions in the future. For this to work, money must retain its purchasing power. However, inflation has a negative impact on the exchange value of money.
Besides cash, what else is considered ‘money’?
Money includes:
Current account balances
Deposit account balances
Other forms of investments
What is the main purpose of the financial services industry?
It facilitates the use of money by channeling funds from those with a surplus (lenders/investors) to those who need to borrow.
How do commercial financial institutions generate profit?
They provide financial services and seek to earn a return on capital for their shareholders.
What are three key benefits of financial services products?
Convenience – e.g., current accounts enable electronic payments instead of cash.
Achieving goals – e.g., mortgages help people buy homes, investment products help with long-term savings.
Protection from risk – e.g., insurance safeguards policyholders from financial losses.
What is inflation
A sustained increase in the general price level of goods and services, reducing the purchasing power of money.
Which function of money helps someone compare the cost of renting four films on a streaming service versus buying one DVD?
Unit of account, because it allows for the comparison of different prices using money as a common denominator.
What is a surplus party in an economy?
A surplus party (e.g., an individual or firm) is cash-rich, meaning they have more liquid funds than they currently wish to spend. They lend money to increase its future value.
What is a deficit party in an economy?
A deficit party is cash-poor, meaning they do not have enough liquid funds to meet their spending needs. They borrow money and agree to pay interest in the future.
What is the role of a financial intermediary?
To borrow money from a surplus party and lend it to a deficit party. It charges interest to the borrower and pays a portion of that interest to the lender, keeping the difference as profit.
How does a financial intermediary make a profit?
By charging a higher interest rate to borrowers than the rate it pays to lenders. The difference between these rates is the intermediary’s profit margin.
What is disintermediation?
When lenders and borrowers interact directly, bypassing financial intermediaries.
Give an example of disintermediation.
Crowdfunding – where businesses raise money directly from investors via online platforms instead of using banks or financial institutions.
Why do surplus and deficit parties usually rely on financial intermediaries instead of transacting directly?
Because financial intermediaries provide security, convenience, and risk management, which individual lenders and borrowers may struggle to handle on their own.
What are the four main reasons why individuals and companies need financial intermediaries?
Geographic location – Helps connect lenders and borrowers who may not otherwise find each other.
Aggregation – Combines small deposits to fund larger loans.
Maturity transformation – Matches short-term deposits with long-term loans.
Risk transformation – Spreads risk across multiple borrowers to reduce default impact.
How do financial intermediaries solve the problem of geographic location?
They provide a central place (e.g., banks) where borrowers and lenders can connect, overcoming physical distance limitations.
What is aggregation in financial intermediation?
The process of pooling multiple small deposits to fund larger loans.
Why is aggregation important for lending?
Because most individuals have small savings, while borrowers (e.g., mortgage applicants) typically require large sums. Intermediaries combine these small deposits to provide sufficient loan funds.
What is maturity transformation?
The process where intermediaries match short-term deposits with long-term borrowing needs, ensuring continuous funding for loans.
Why is maturity transformation necessary?
Most depositors prefer short-term access to their funds, while most borrowers need long-term loans (e.g., 25-year mortgages). Intermediaries manage this difference.
What is risk transformation in financial intermediation?
It is the spreading of lending risk across multiple borrowers so that if some default, the overall impact is minimised.
Why do depositors benefit from risk transformation?
It reduces the risk of losing all their money if an individual borrower defaults, as the intermediary absorbs losses across a diverse loan portfolio.
