‘Greed, for lack of a better word, is good. This is one of the most popular quotes in the history of cinematography that has been cited by many sources over and over again. Its author Gordon Gekko, portrayed by Michael Douglas in the movie ‘Wall Street’
(1987) compared America with the malfunctioning corporation, and that greed could still save it. Between 16th to 18th centuries, in Europe, a particular economic system promoted governmental regulation of a nation’s economy to augment state power at the expense of rival national powers (Britannica, 2020). In other words, for one country to get richer, another must-have gotten poorer.
This system was called 'mercantilism' and further explained by Adam Smith in his masterpiece "The Wealth of Nations." In the same book, the father of modern economics first introduced the concept of the 'invisible hand,' which in a nutshell tells you: there is nothing wrong with pursuing your own interests. In a free market, the combined force of everyone pursuing their own interests is to benefit society as a whole, enriching everyone (Conway, 2012). Smith has only used the term 'invisible hand' three times in his book, but there is one passage that underlines its significance:
‘Every individual neither intends to promote the public interest, nor knows how much he is promoting it… by directing industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention… By pursuing his own interest he frequently promotes that of society more effectually than when he really intends to promote it…’Why are there so many people complaining that capitalism is a broken system that makes the rich richer and the poor poorer? Why do they compare Wall Street bankers and investors to some greedy monsters? As it turns out, greed can actually be beneficial to some extent. Although capitalism proved to be an imperfect system to favour those with greater capital, contributing to income distribution inequality, this is a discussion for another time. Nonetheless, this shows that our current financial system and its components have been immensely influenced by great thinkers (Adam Smith or John Maynard Keynes), technological changes, a shift in people's values and behaviour and that the current state of the financial system is not set in stones, but rather it is an evolving concept.
Howells & Bain (2014) describe a financial system as a set of markets for financial instruments and the individuals and institutions who trade in those markets, together with the system's regulators and supervisors. According to Hubbard & O'Brien (2014), the financial system is made up of three major elements:
1.Financial assets
2.Financial institutions
3.The Federal Reserve (U.S.) or the Bank of England (United Kingdom).
The Bank of England
The Bank of England's history traces back to 1964, founded as a private bank to primarily fund the war against France. King William and Queen Mary were two of the original shareholders. The institution aimed to act as a banker to Government. In 1946, the Bank of England was nationalised and fully owned by the British Government, which now had the power to appoint its governors and directors and issue directions to the bank.
‘‘ Throughout our history, we have always seen ourselves as a public institution, acting in the national interest. Although the Bank was privately owned for a long time, our activities were determined by the Government and legislation’’ (source: Bank of England). Bank of England (BoE), as the central bank in the United Kingdom, has become the "bankers' bank" and banker to the Government over the years. The principal banks in the United Kingdom, by custom, keep a substantial part of their total cash holdings in the form of balances at the BoE: these are the "clearing" banks, familiar to the public through their network of branches. Others that keep accounts with the Bank of England
include those banks whose principal business is overseas, the central banks of other countries, and the London Money Market members (source: the Bank of England: History and Functions).
The Bank of England Act 1998 delegated responsibility for formulating monetary policy
to the Bank's Monetary Policy Committee (MPC). The Act sets out that the monetary policy objective is to deliver price stability and, subject to that, support the Government's economic objectives, including those for growth and employment. MPC consists of the Governor, his two deputies, and nine non-executive directors. Main responsibilities of the BoE include (Arnold, 2012):
• stability of the monetary system. Setting interest rates and dealing with day-to-day fluctuations in liquidity;
• payment system oversights and strengthening to reduce systemic risk;
• macro-prudential regulation of the financial system as a whole;
• authorisation and micro-prudential supervision of banks and other-taking institutions;
• note issuance;
• lender of last resort in selected instances – some banks may be allowed to fail;
• managing the UK's gold and currency reserves and intervening in the foreign exchange markets.
Financial assets
An asset is anything of value that the firm or an individual owns. It could be an inventory, a building, a photograph, or car…literally anything that can potentially represent a value. In turn, a financial asset, often called a financial instrument, represents a claim on someone else for a payment (Hubbard, 2012). For instance, if you own a share in a company listed on a stock exchange, you are, in fact, in possession of a financial asset.
Financial assets are often categorised as those that are tradable and non-tradable. A
security is a tradable financial asset that can be sold or purchased in a financial market.
For example, if you own a national government bond, it means you own security because you can sell it. On the other hand, a classic bank account would be an asset but not security as it is not tradable on the market (it is possible to close a bank account, but it cannot be sold).
Figure 1. Different types of financial assets (Howells & Bain, 2014). Retrieved from https://ereader.perlego.com/1/book/810794/42
Ordinary shares
Ordinary shares represent the firm's equity capital and are a means of raising long-term finance to run a business (Arnold, 2012). Ordinary shares are sometimes known as 'common stock.' For public companies whose shares are traded on the Stock Exchange, share capital is usually of great financial significance. An initial public offering (IPO) is the first sale of stock issued by a company. In other words, it is when a business decides to start selling its shares to the public. The company will decide how many shares it wants to offer, and an investment bank will suggest an initial price for the stocks based on the predicted demand for them. Such shares are then sold in primary markets before being traded on the secondary markets. In other words, primary markets are where these shares are first issued and sold, while secondary markets allow trading those shares that have already been in circulation.
The typical benefits of holding ordinary shares include voting rights, the return of capital on winding up, a share of annual profits (dividends), the ability to transfer shares (Mayson, French & Ryan, 2018). A company's Article of Association may allow for creating different types of ordinary shares, which each class (e.g., class A shares or class B shares) enjoying different rights. If there is only one class of share, then each share will carry the same right to vote. However, different classes of share may carry different voting rights (McIntyre, 2018).
Preference shares
A preference share is a share that entitles the holder to an annual dividend of a fixed amount per share (usually expressed as a percentage of the nominal value of the share), paid in priority to any dividend payments to other members (Mayson, French & Ryan, 2018). On the other hand, preference shareholders usually have limited voting rights. Other less common shares include deferred shares, non-voting ordinary shares, redeemable shares, no par value shares.
Government bonds
These are a type of financial instruments (assets) that are commonly traded. Investors who buy government bonds are, in fact, lending money to governments. They must pay a principle which is the face value of the bond; in return, a government will make payments (interests) at regular intervals, and once the bond matures (expires), the principal is returned to an investor. Issued bonds can be traded on the market, and their prices will fluctuate. However, when a bond matures, the holder will only receive the face value- the initial cost of the bond called the principal. The main reason for a government to issue bonds is to increase spending or cover budget deficits. In the UK, bonds are often called gilts, and in the United States – treasuries.
Corporate bonds
Companies also issue bonds called corporate bonds to raise capital and fund their business activities. Reputable and financially strong companies tend to pay lower interest rates on issued bonds as the investment risk level is typically lower. On the other hand, buying bonds from weaker organisations increase the risks, and, in some cases, you face losing the principal. However, such investments often called 'high yield bonds,' pay higher interest rates that could generate a better investment value.
Treasury bills
Treasury bills are debt securities issued by a central bank to finance the national debt. UK Treasury bills first appeared in the early 1700s (issued by the Bank of England) and are now issued by the Debt Management Office (DMO) by allotment to the highest bidder at a
weekly (Friday) tender to a range of counterparties (source: the Bank of England).
With the face value or par value of £100, Treasury bills can be issued with a minimum maturity of 1 day and a maximum maturity of 364 days. However, weekly tenders are typically for maturities of 1 month (approximately 28 days), 3 months (approximately 91 days), and 6 months (approximately 182 days). UK Treasury bills are sold at a discount to par value with the minimum purchase amount of £500,000. Most holders of Treasury Bills are financial institutions, e.g., banks.
Commercial paper (UK)
To finance accounts receivables (debtors) and inventories or meet short-term cash needs. Corporations issue commercial papers- an unsecured short-term instrument of debt (Arnold, 2012). In some cases, commercial papers are also issued by banks and municipalities. This debt instrument promises the holder a sum of money to be paid in a set number of days – it is a promissory note. The buyer, usually other firms, insurance companies, or pension funds, are effectively lenders to a firm issuing commercial paper, which has an average maturity of about 40 days, but it can be as long as 270 days.
Certificates of deposit (CDs)
Banks issue term securities called certificates of deposit (CDs) when funds are deposited with them by other banks, corporations, individuals, or investment companies (Arnold, 2012). A sterling certificate of deposit is a document produced by the U.K. office of a British or foreign bank, stating that a sterling deposit has been made with a bank which is repayable to the bearer (lender) upon the surrender of the certificate at maturity (source: Bank of England). CDs have an average maturity of 1-4 months but can be any length of time between a week and a year. The document also states the rate of interest and date of repayment. Sterling CDs may be issued in multiples of £10,000 with a minimum of £50,000 and a maximum of £500,000 of investment.
Repos
Repos are a common method for banks to lend and borrow money from each other.
Repo can be defined as an agreement in which one party sells securities or other
assets to a counterparty, and simultaneously commit to repurchase the same or
similar assets from the counterparty, at an agreed future date or on-demand, at a
repurchase price equal to the original sale price plus a return on the use of the sale
proceeds during the term of the repo (source: Euroclear bank)
Arnold (2012) provides a similar definition:
A repo is a way of borrowing for a few days using a sale and repurchase agreement in which securities are sold for cash at an agreed price with a promise to buy back the securities at a specified (higher) price at a future date. The interest on the agreement is the difference between the initial sale price and the agreed buy-back, and because the agreements are usually collateralised (secured) by government-backed securities (e.g. Treasury bills), the interest rate is lower than a typical unsecured loan from a bank.Derivatives
A derivative instrument is an asset whose performance is based on (derived from) the behaviour of the value of an underlying asset, which may include commodities (e.g., coffee beans, soy, etc.), shares, bonds, share indices (for instance, FTSE 100 or S&P 500), currencies and interest rates. Derivatives are the contract that gives the right, and sometimes the obligation, to buy or sell the quantity of the underlying or benefit in another way from a rise or fall in the value of the underlying asset. It is the legal right that becomes an asset, with its own value, and it is the right that is bought and sold (Arnold, 2012). Some key building blocks of derivative instruments include:
• forward contracts;
• future contracts;
• swap contracts; or
• option contracts.
Financial Institutions
At the beginning of the article, the Bank of England's role was explained within the financial system context. BoE is the central bank in the United Kingdom and is responsible for printing money or setting the UK's monetary policy, amongst many other tasks it has. A developed financial system would not exist without its institutions.
Although money lending and money-changing activities date back to Babylonian times, the first banking institutions were established in the 12th century, Italy. Until the 1990s, banks' activities were hugely regulated, and competition was restricted, e.g. UK banks were restricted from carrying out certain securities and investment banking business until 1986 when various reforms allowed commercial banks to acquire stockbroking firms (Casu, Girardone, & Molyneux, 2015). Banks started to increase their product offering and services by moving from traditional banking to modern. According to Casu et al. (2015), the implementation of the EU's Second Banking Directive in 1992 established a formal definition of what constituted banking business throughout the Europe, which introduced the so-called universal banking model. Traditionally, banks' business model consisted of taking deposits and making loans. The main income source was the difference between interest revenues from lending minus the interest costs on deposit (net margin interests).
Today, banks engage in all aspects of financial services, with many institutions deciding to specialize (investment banking, commercial banking) and/or diversifying their products offer.
Investment banking
Investment banks have become very powerful (Arnold, 2012). They are complex organizations selling a wide range of services and trading securities for their own profit. Unlike retail or commercial banks, investment banks do not take deposits from individuals and provide them with checking accounts. Investment banks engage in financial market activities such as raising capital for companies, assisting in acquisition and merger, and providing services as market-making and the trading of derivatives, foreign exchange, commodities, and stocks. Private companies willing to become public and be listed on the Stock Exchange will involve an investment bank to help with the initial public offering process. Some notable investment banks are Goldman Sachs, JP Morgan, Morgan Stanley, or Deutsche Banks.
Commercial banking
Commercial banks are the major financial intermediary in any economy (Casu, 2015) and are the main credit providers to households (retail banking) and corporations. Commercial banks have well-diversified deposit and lending books and usually offer a full range of financial services, e.g., checking and saving accounts, mortgage and loans providers, stockbroking services or credit card issuer, wealth management, etc.
While commercial banking refers to institutions whose main business is deposit-taking and lending, it is important to note that the largest commercial banks also engage in investment banking, e.g., Barclays, Deutsche Banks, HSBC, Citigroup, and many more.
Cooperative banks
Cooperative banks are similar in nature to commercial banks; however, cooperatives are owned by members (usually their customers) rather than shareholders and typically offer retail and small business banking services. This ownership model appears to have profound effects on the priorities and performance of the institutions. It places an incentive on managers to maximise long-term customer value and ensures that profit is treated as a means to an end rather than an end in itself. They have a less aggressive revenue generation model by targeting lower returns and generating more stable profits. Cooperative banks focus directly on services that are relevant to their customers. They are an important part of the financial system in Germany, Italy, France, or the Netherlands (Casu, 2015).
Building societies
A building society is a mutual organisation. This means that eligible customers, both savings and mortgage customers, are known as members. Members all have certain rights to vote and receive set information and attend and speak at meetings. Each member has one vote, regardless of how much money they have invested or borrowed or how many accounts they have. Each building society has a board of directors who run the society and are responsible for setting its strategy. Building societies are different from banks, which are companies (normally listed on the stock market) and are therefore owned by, and run for, their shareholders. Societies have no external shareholders requiring dividends and are not companies. This normally enables them to run on lower costs and offer cheaper mortgages, better rates of interest on savings, and better service levels than their
competitors. The major difference between building societies and banks is that there is a limit on the proportion of their funds that building societies can raise from the wholesale money markets. A building society may not raise more than 50% of its funds from the wholesale markets. The average proportion of funds raised by building societies from the wholesale markets is 30% (Darlington Building Society).
Finance houses
A finance house is an institution that advances credit, usually through factoring, a hire purchase agreement, or a lease. Strictly, these organisations, as 'non-bank institutions,' but provide debt finance and are often owned by major banks. They do not typically take deposits but obtain their funds from money and bond markets (Arnold, 2012).
Bibliography:
The Bank of England (n.d.) Wholesale Treasury Bills ( online) Available at https://www.bankofengland.co.uk/statistics/details/further-details-about-wholesale-treasury-billsdata#:~:text=Treasury%20Bills%20are%20bearer%20Government,period%20not%20exceeding%20one%20year.
Britannica (n.d.) Mercantilism (online) Available at https://www.britannica.com/topic/mercantilism
Casu, B., Girardone, C. and Molyneux, P. (2015). <i>Introduction to Banking 2nd edn</i>. 2nd ed. [ebook] Pearson. Available at: https://www.perlego.com/book/811299/introduction-to-banking-2nd-edn-pdf
Hubbard, R.G. and O'Brien, A.P. (2014). Money, Banking and the Financial System, International Edition. 2nd ed. [ebook] Pearson. Available at: https://www.perlego.com/book/811901/money-banking-and-the-financial-system-international-edition-pdf
Mishkin, F.S. and Eakins, S. (2018). Financial Markets and Institutions, Global Edition. 9th ed. [ebook] Pearson. Available at: https://www.perlego.com/book/810715/financial-markets-and-institutions-global-edition-pdf