Unit 1 Topic 1 - Introducing the financial services industry

Question 1

What is a Financial Intermediary?

Answer 1

An entity that acts as the middle man between two parties in a financial transaction. Banks and building societies are the best-known examples.

Question 2

Explain the term Disintermediation and provide an example.

Answer 2

Involves lenders and borrowers interacting directly rather than through an intermediary.

An example is ‘crowdfunding’, where a company that is looking to raise funds to invest in the business establishes a website to promote itself and find investors who are willing to led money to it.

Question 3

What are the four elements of intermediation?

Answer 3

• Geographic location
• Aggregation
• Maturity transformation
• Risk transformation

Question 4

What is the impact of Geographic location on intermediation?

Answer 4

Lenders and borrowers may have issues locating each other and would probably restricted to their own area or circle of contacts.

Question 5

What is Aggregation in relation to intermediation?

Answer 5

Without an intermediary a potential lender might not have enough money available to satisfy the borrower’s requirements.

The majority of retail deposits are relatively small, averaging under £1,000, while loans are typically larger, with most mortgages being for £50,000 and above.

Question 6

What is Maturity transformation in relation to intermediation?

Answer 6

The borrower may need the funds for a longer period of time than the lender is prepared to part with them.

Intermediaries are able to overcome this mismatch by offering a wide range of deposit accounts to a wide range of depositors, thus helping to ensure that not all of the depositors’ funds are withdrawn at the same time.

Question 7

What is Risk transformation in relation to intermediation?

Answer 7

Individual depositors are generally reluctant to lend all their savings to another individual or company, mainly because of the risk of default or fraud.

Intermediaries enable lenders to spread this risk over a wide variety of borrowers so that, if a few fail to repay, the intermediary can absorb the loss.

Question 8

What are Product sales intermediaries?

Answer 8

Brings together the product providers (such as banks and insurance companies) and the potential customers who wish to purchase the providers’ products and services.

These product sales intermediaries include financial advisers, insurance brokers and mortgage advisers.

Question 9

Define Retail banks.

Answer 9

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

Question 10

Define Wholesale banks.

Answer 10

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

Question 11

Define Life assurance.

Answer 11

Insurance that provides payment, generally as a lump sum but possibly as an income, on the death of the person covered by the policy. It is sometimes referred to as life insurance or life cover.

Question 12

Define General insurance.

Answer 12

Insurance designed to protect policyholders from the financial consequences of adverse life events. Examples include household insurance, motor insurance, travel insurance and commercial property insurance.

Question 13

What are the main functions of The Bank of England?

Answer 13

• Issuer of banknotes
• Banker to the government
• Banker to the banks
• Adviser to the government
• Foreign exchange market
• Lender of last resort
• Maintaining economic stability

Question 14

Define Liquidity.

Answer 14

Assets (eg cash) that can be quickly be made available to meet an institution’s liabilities, without affecting the market price of those assets.

Question 15

What are proprietary organisations?

Answer 15

They are owned by their shareholders, who have the right to share in the distribution of the company’s profits in the form of dividends.

They can also contribute to decisions about how the company is run by voting at shareholders’ meetings.

Question 16

What are mutual organisations?

Answer 16

Not constituted as a company and does not, therefore have shareholders. The most common types of mutual organisation are building societies, friendly societies and credit unions.

A mutual organisation is, in effect, owned by its members, who can determine how the organisation is managed through general meetings.

Question 17

What is Demutualisation?

Answer 17

A building society is able to convert to a bank (with its status changed to that of a public limited company).

Such a change requires the approval of its members, but this approval has generally been readily given, not least because of the windfall of free shares to which the members have been entitled following the conversion of the building society to a company.

Question 18

What is ‘carpetbagging’?

Answer 18

The practice of opening an account at a building society that is expected to soon convert, purely to obtain the subsequent allocation of shares.

Question 19

What is a credit union?

Answer 19

A credit union is a mutual organisation. Credit unions are run for the benefit of their members.

They provide services to different groups of people such as housing associations and employees of a national company.

In order to join a credit union, the member must meet the membership requirements, pay any required entrance fee and buy at least one £1 share in the union.

Question 20

What products and services does a credit union offer?

Answer 20

Credit unions offer simple savings and loan facilities to members. Savers invest cash in units of £1, with each unit buying a share in the credit union.

Each share pays an annual dividend, typically 2-3%.

Members’ savings create a pool of money that can be lent to other members; the loans typically have an interest rate of around 1% of the reducing balance each month (with a legal maximum of 3% of the reducing balance).

Question 21

What criteria must credit unions who choose to pay interest, satisfy?

Answer 21

Must show that they have the necessary systems and controls in place and have at least £50,000 or 5% of total assets (whichever is greater) in reserve.

Question 22

Define the Interbank market

Answer 22

A very large market which recycles surplus cash held by banks, either directly between banks or more usually through the services of specialist money brokers.

Question 23

How are credit unions members’ savings protected?

Answer 23

Members’ savings and loan balances are covered by life assurance.

This means that any loan balance will be paid off on death, and a lump sum equal to the savings held will also be paid, subject to overall limits.

Question 24

What is Libor?

Answer 24

The rate of interest charged in the interbank market is the London interbank offered rate (Libor). It acts as a reference rate for the majority of corporate lending, for which the rate is quoted as Libor plus a specified margin.