topic 1 - intro to financial service industry

Question 1

Inflation

Answer 1

a sustained increase in the general level of prices of goods and services

Question 2

Financial intermediary

Answer 2

(eg a bank/building society)

borrows money from surplus party and lends to a deficit party

Charging interest to the party with a deficit and pays some of this interest to the party with the surplus

Their profit is the difference between the two interest rates

Question 3

Disintermediation

Answer 3

involves lenders and borrowers interacting directly. An example is ‘crowdfunding’

Question 4

Four elements of intermediation

Answer 4

Geographic location – helps lenders and borrowers locate each other

Aggregation – an individual lender might not have enough funds to fulfil a borrower’s requirements

Maturity transformation – the borrower might need funds for longer than the lender is prepared to lend

Risk transformation – spread risk over a variety of borrowers

Question 5

Risk transfer

Answer 5

insurance involves individuals contributing via their insurance premiums to a fund for which the loses of the few who do experience certain adverse circumstances are covered

Question 6

Main functions of The Bank of England

Answer 6

• issuing bank notes
• banker to the government
• banker to the banks
• advisor to the government
• foreign exchange market
• lender of last resort
• maintaining economic stability

Question 7

Monetary Policy Committee (MPC)

Answer 7

• responsibility for setting interest rates in the UK
• meet 8 times a year, setting the base rate to ensure the government’s inflation target is met

Question 8

Financial Policy Committee (FPC)

Answer 8

• sits within the Bank of England.
• looking at the economy in broad terms to identify and address risks that affect economic stability.

Question 9

Gilts

Answer 9

• are issued by HM Treasury’s Debt Management Office
• are loans to the government

Question 10

The Financial Services Act 2012

Answer 10

• divided responsibility for financial stability between the Treasury, the Bank of England and two new regulators - FCA & PRA
• Modified by the Bank of England and Financial Services Act 2016

Question 11

Prudential Regulation Committee (PRC)

Answer 11

• The Bank of England and Financial Services Act 2016, gave more powers to the Bank by bringing the PRA within it
• established the PRC

Question 12

Proprietary organisations

Answer 12

• owned by shareholders and is a limited company
• these are the majority of large financial institutions

Question 13

Mutual organisation

Answer 13

• owned by its members
• not constituted as a company so does not have shareholders
• commonly are building societies, friendly societies and credit unions

Question 14

Demutualisation

Answer 14

• since the Building Societies Act 1986
• a building society has been able to demutualise, to convert to a bank
• requires approval of its members which then receive shares

Question 15

Credit union

Answer 15

• A mutual organisation, run for the benefit of its members
• Members must pay a share, but all members are equal, regardless of the size of their shareholding
• Offer simple savings and loan facilities to members. Some offering a fixed rate of interest on savings, most offer a yearly dividend pay-out
• A unique feature is that members savings/loans are covered by life assurance

Question 16

Wholesale banking

Answer 16

• financial institutions and other large companies buy and sell financial assets
• if the branch has the opportunity to make a substantial profitable loan but doesn’t have adequate deposits, it can raise the money very quickly on the interbank market
• Riskier than retail banking
• Building societies are permitted to raise funds on the wholesale markets but are restricted to 50% of their liabilities

Question 17

Interbank market

Answer 17

a very large market which recycles surplus cash held by banks, either directly between banks or more usually through specialist money brokers

Question 18

Libor

Answer 18

• The rate of interest charged in the interbank market used to primarily be the London interbank offered rate
• acted as a reference rate for the majority of corporate lending
• Rates were fixed daily and varied in maturity from overnight to one year

Question 19

The Libor scandal

Answer 19

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

Question 20

Sonia

Answer 20

• An index of very short-term unsecured loans among and between UK financial institutions
• As a result of the Libor scandal, a shift has been made to Sonia (sterling overnight index average)
• It is based on actual transactions and reflects the average of interest rates that banks pay to borrow sterling overnight from other financial
  institutions
• An important benchmark used by financial businesses and institutions to calculate the interest paid on swap transactions and sterling floating rate notes.

Question 21

Swap transactions

Answer 21

a contract between 2 firms that each exchange one type of cash flow for another. Typically, a variable interest rate eg Sonia), is swapped for a fixed interest rate

Question 22

Floating rate notes

Answer 22

a fixed interest security (bond) where the interest rate (the coupon) varies in line with the benchmark (eg Sonia) used