Introduction to the Financial Sector
What is the purpose of banks?
What is the basic purpose of banks and other financial institutions?
Their purpose is to make money available to those who want to spend more than their income. This could be individuals looking to borrow money or a business also looking to borrow money.
Where does this money come from?
It comes from places where people spend less than their income e.g. savers.
To achieve this, financial institutions create products for:
Savers (bank accounts, pension funds)
Borrowers (loans, mortgages)
Financial institutions can also trade and issue assets in the capital markets e.g. equities and bonds
Forms of borrowing for individuals (mainly)
Personal loans – loans to individuals over a small number of years. Loans can be secured or unsecured
Secured loans are loans that are backed up by an asset e.g. a house. In the event a borrower doesn’t pay their monthly payments, the bank will use these assets to pay the debt.
Example of secured loan
If you own a house, and your house is worth £300,000, that means your wealth is tied up in an illiquid form. So, a secured loan is a way of getting money that you might need, and saying to the bank that you have a house that is worth a lot of money and if I don’t pay you back then you can sell my house and get the money I owe you.
Unsecured loans have no asset to back them, therefore they are riskier for banks.
Mortgages – loans that are used to buy property e.g. a house. Longer term than a personal loan, maybe 25-35 years.
Credit cards – allows borrowers to spend on goods and services using a card with a predefined borrowing limit. A borrower must make a monthly minimum payment on a credit card to pay some of the debt off that they owe.
Pay-day loans – small, short-term and unsecured loans that are needed in emergency. Often used by people with bad credit histories (or a lack of) who can’t get credit cards. Interest rates can easily exceed 1000% per year!
Overdrafts – a pre-agreed loan from the bank which is built into your bank account. If you overspend, then your bank balance can essentially fall into a negative balance. If this happens, you will be in your overdraft.
Overdrafts can be planned or unplanned. Unplanned overdrafts attract higher fees than planned overdrafts. Planned overdraft involves an agreement with the bank to have a certain amount.
Unplanned overdraft is when your bank balance falls below 0 and the bank let’s you go into your overdraft without a defined overdraft limit being agreed.
Forms of borrowing for firms
Firms have two main forms of finance:
Debt finance: when the firm borrows money from the bank that has to be paid back with interest e.g. 7% interest per year.
Equity finance: when the firm issues share in their company in return for a share in the profits e.g. 25% share in the company.
Why do we need financial institutions?
Financial institutions are the middle-men between borrowers and lenders. They are needed because they help speed up borrowing and lending activity, in a safe and reliable way.
Banks gather information from borrowers about their incomes and credit histories before matching them with loans. Therefore, banks help reduce information failure in these markets.
Banks can also speed up trade within the economy. Therefore, they aid economic growth because people have an easy way to pay for things they want to buy e.g. online bank transfer, debit/credit card.
Banks provide firms with credit. Firms are unlikely to grow without a source of finance which they need to invest. This is a big problem for countries with poor financial sectors (developing countries in particular) Because there is a lack of available money to lend, firms in developing countries are unable to borrow what they need at sensible interest rates. This restricts growth.
Banks provide a variety of products including pensions, insurance products – just go to a bank’s website and you’ll see that it’s not just a bank account that’s on offer!
Financial Markets
You need to know about 3 types of financial market:
Money markets – these markets provide short-term finance to banks, companies, governments and individuals. Repayment period can be 24 hours up to a year.
Capital markets – medium to long term finance. Governments and firms can issue bonds. Firms can raise finance and issue shares or borrow from banks.
Primary capital markets – for new shares and bonds
Secondary capital markets – 2nd hand assets such as shares are traded e.g. the stock market. When you buy a share, you’re buying 2nd hand. Somebody before you owned that share. Quite likely, it was first issued years ago.
Foreign Exchange Market – these are the markets that trade currency. This allows international trade and investment to take place.
Spot market – these markets are for transactions that are happening right now.
Forward market – these markets are for transaction that’s are taking place in the future, at an agreed time. Forward markets are useful for firms who import and export. It gives them more certainty about what the exchange rate will be. The exchange rate is agreed today but delivery is in the future. It helps reduce exchange rate risk.
More about Bonds
They are a form of borrowing. If you want to borrow some cash, you can issue a bond. A bond is just a promise that the lender will receive their money back in the future with more money on top as a reward.
When you buy a bond, you are buying it at its “face value” – also called the nominal value.
If you buy a bond, you are a bondholder.
You do not have to hold onto this bond forever. You can sell them if you want to get your money back. So, you can sell them in the secondary capital markets.
You can actually make money from selling your bonds – the market price may have increased. You can make extra money when the value of this asset rises.
Bonds also generate yields. A yield is basically a return on investment (like an interest rate at a bank).
Bond payments are called coupons. To calculate the yield use the following formula:
Yield % = [Coupon / Market Price] x100
e.g. If the coupon payment was £7, and the current market price is £80 then the yield percentage is going to be 8.75%.
Calculation is as follows:
[7/80) x 100 = 8.75
When the bond matures, the current bondholder is paid back the nominal value of the bond by the issuer. So, the original debt has been repaid.
In summary, we have learned:
The purpose of banks
Financial products
Financial markets
Bonds
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