Money, Finance and Monetary Policy

1
Chapter 6
Sawyer The UK Economy 16e

• Money, Finance and Monetary Policy

2
Money and finance The Financial System

• A financial system is composed of firms and
  markets which fulfil a variety of economic
  functions.
• Central to all is arranging the lending of funds
  from one economic agent to another.
• The financial system plays a key role in
  allocating economic resources.
• Banks and other financial institutions determine
  the allocation of large amounts of resources and,
  in particular, resources which often finance new
  investment.

3
Nature and Functions

• Financial intermediaries are numerous and
  indirect finance is more common than direct
  finance. Advantages derive from the ability of
  financial intermediaries to use size and
  expertise to transform financial claims so that
  they can offer savers a wider choice of assets
  than ultimate borrowers are able to do.
• They offer borrowers a more varied choice of
  credit terms than ultimate lenders are able to do.

4
Nature and Functions

• Financial intermediaries also engage in risk
  transformation.
• Retail banks provide for deposits to be
  transferred between accounts and thereby provide
  a payments mechanism.
• Life assurance companies offer policies which
  provide for long-term saving but which also
  provide for a lump-sum payment in the event of
  the policy-holders early death.

5
The Bank of England

• Acts as banker to the Government and keeps the
  main government accounts, receives tax revenues,
  and facilitates payments in respect of government
  expenditure.
• Acts as banker to the clearing banks, i.e. those
  retail banks which operate the system whereby
  cheques are cleared and monies transferred from
  one bank to another.
• In May 1997 the Chancellor of the Exchequer
  granted a new autonomy to the Bank of England in
  the conduct of monetary policy. The prime
  objective of policy is to maintain inflation at a
  low level.

6
Inflation policy

• The Government specifies a target for annual
  inflation and the Bank seeks to keep inflation
  close to the target level.
• The inflation target is now set in terms of the
  measure of inflation used in the Euro zone, the
  harmonised index of consumer prices (HICP), with
  a target rate set at 2 per cent per annum.
• Main instrument of policy is the level of
  short-term interest rates. If the Bank thinks
  that inflation is likely to rise significantly
  above target, it will raise short-term interest
  rates in the expectation that this will reduce
  the expansion of money and credit and hence will
  reduce the pressure of demand in the economy.

7
Private Banks

• Retail banking involves the provision of a wide
  range of banking services to business and
  personal clients.
• Services provided include taking deposits at
  sight and short notice, making loans of various
  types and for various time periods, cheque
  clearing, foreign exchange and international
  remittances, safe-deposit facilities and
  financial advice.

8
Private Banks

• Investment banking involves a mixture of banking
  and security trading, and most offer a range of
  specialised financial services to large and
  medium-sized companies and affluent persons.
• Investment banks also manage new issues of
  securities by companies and also buy and sell
  existing securities on behalf of clients.

9
Measures of Money

• Money serves first and foremost as a medium of
  exchange i.e. it facilitates the exchange of
  goods and services.
• Money also serves as a store of value.
• Money may be an imperfect store of value and most
  monies depreciate over time due to inflation, but
  for many purposes it remains a convenient means
  of storing value.
• Money also serves as a unit of account it is the
  means by which we measure value.

10
Measures of Money

• There can be no unambiguous statistical
  definition of what constitutes money.
• The Bank of England has, since 1993, focused
  mainly on two measures
• The narrowest definition, M0, covers notes and
  coin in circulation plus banks operational
  balances at the Bank of England.
• M4 comprises holdings by private-sector residents
  of notes and coin and all sterling deposits
  (including CDs) at banks and building societies.

11
Short-Term Money Markets

• The main markets for short-term funds are the
  interbank market, the market in large time
  deposits from non-bank sources, the market in
  CDs, and the market in repurchase agreements or
  repos.
• There are also markets in short-term paper, i.e.
  negotiable instruments maturing within a few
  months. These include Treasury bills (issued by
  the UK government), commercial bills (issued by
  companies to finance trade, frequently with a
  bank guarantee), and commercial paper (issued by
  companies of prime-credit standing and without
  bank guarantee).

12
Short-Term Money Markets

• Banks regard their short-term assets a source of
  liquidity but they can also regard their ability
  to borrow new funds at short notice as an
  additional means of liquidity.
• The repo market has become one of the most
  important of the short-term markets in London and
  is now used by the Bank of England for the
  conduct of open-market operations. If the Bank
  wishes to take money out of the banking system it
  undertakes a repo, i.e. sells a security for
  immediate payment and agrees to repurchase at a
  later date. If the Bank wishes to put money into
  the banking system it undertakes a reverse repo.

13
Short-Term Interest Rates

• The Bank of England has the ability to influence
  the level of short-term interest rates, and while
  that influence is felt first in the repo market,
  arbitrage will ensure it is immediately
  generalized across all short-term sterling
  markets.
• The Bank of England operates at the very short
  end of the lending spectrum - providing funds
  mostly for periods of about 14 days.
• Longer term rates of interest are usually above
  short-term rates but by how much they are above
  depends on supply and demands for funds in the
  different markets.

14
The Capital Market

• The capital market covers the markets in which
  securities - chiefly equity shares and bonds -
  are traded.
• Equity shares represent a share in the ownership
  of a company and entitle shareholders to
  participate in company profits their value rises
  when profits rise and falls when profits fall.
  They are risky assets.
• Bonds are generally fixed-interest, term
  securities and pay a fixed return each year until
  maturity.

15
The Capital Market

• Equity shares can be issued in three main ways
• A public offer involves a hitherto privately
  owned company deciding to go public, to raise
  money (for the company or for the existing
  owners) by selling shares to the public at large.
  
• A private placement involves selling shares to a
  relatively small number of large investors and is
  cheaper than a public offer.
• A rights issue is an issue by a public company of
  additional shares offered, in the first instance,
  to existing shareholders.
• There are frequently periods of years when the
  level of share prices is rising (a bull market)
  or falling (a bear market). Chart shows the
  movements in recent years in the FTSE index of
  100 leading UK shares.

16
Markets in Financial Futures and Traded Options

• Markets in financial futures and traded options
  have grown in number and in trading volumes in
  recent years.
• Financial futures are financial assets such as a
  three-month bank deposit or a government bond
  which are traded today for delivery in the
  future.
• They are one method of managing risk.
• An alternative strategy is to sell bond futures.

17
Other Financial IntermediariesLife Assurance
Companies and Pension Funds

• The essence of life assurance contracts is that
  the assured pays either a single premium or
  series of premiums over a number of years and at
  an agreed future date the insurance company
  guarantees to pay a lump sum.
• Life assurance companies comprise a number of
  specialist companies as well as large general
  insurance companies that also offer marine, fire
  and accident insurance.
• Pension funds provide pensions for members of a
  particular occupational group, or for employees
  of a particular company. Those covered by the
  fund make regular contributions over a number of
  years and, upon retirement, are entitled to a
  pension until death.

18
Other Financial IntermediariesUnit Trusts and
Investment Trusts

• Unit trusts and investment trusts are the main
  forms of mutual investment in the United Kingdom.
  The purpose of mutual investment is to enable
  small investors to pool resources in order to
  gain the benefits of diversification.

19
Regulating the Financial System

• During the last 25 years, there has been a series
  of Acts of Parliament to develop formal financial
  oversight and to create supervisory agencies.
• The latest, the Financial Services and Markets
  Act of June 2000 provides statutory backing for a
  powerful new regulatory body, the Financial
  Services Authority (FSA).
• The changes in British regulations have been
  influenced by negotiations in various
  international committees.
• In the field of banking a key role has been
  played by the Basel committee, a committee of
  banking supervisors meeting regularly in Basel,
  Switzerland which has developed standards for
  minimum capital resources for banks.

20
Regulating the Financial System

• It is an objective of the European Commission to
  achieve a single European financial market with
  financial institutions able to do business
  anywhere in the Community unhindered by
  artificial obstacles and constraints.

21
Regulating the Financial System

• The Commission has pursued this aim with a
  three-pronged approach.
• First, there should be that minimum harmonisation
  of regulations necessary to ensure fair
  competition and adequate consumer protection.
• Second, institutions should not need
  authorisation to do business in each country
  once duly authorised by the competent authorities
  in one member country, they should be free to
  operate throughout the Community (the principle
  of the single passport).
• Third, all activities of each institution should
  be supervised by the authorities of the country
  in which its chief office is situated (the
  principle of home country control).

22
Basel Committee and Capital Adequacy

• The Basel committee seeks to devise rules which
  make banking safer and which are applicable in
  many countries. Initially the goal was to create
  standards which could be applied within the 12
  countries represented on the committee but
  nowadays there is extensive consultation and
  dialogue across the globe and the objective is to
  create standards that will be acceptable
  worldwide.

23
Basel Committee and Capital Adequacy

• The main effort in recent years has been has been
  to ensure that banks have adequate capital
  resources.
• The Basel committee has adopted the principle of
  risk-weighted capital requirements.
• The minimum required capital (which once agreed
  upon is imposed on UK banks by the FSA) varies
  according to type of bank assets.
• The risk weightings applied have been attacked as
  too crude a loan to a large well-known public
  company is assessed as being as risky as a loan
  to a back-street garage.