Topic 1: Introducing the financial services industry

Question 1

What are the two important functions of money?

Answer 1

1. it is a medium of exchange, meaning that people will accept it in exchange
   for goods and services; and
2. it is a unit of account, a common denominator against which the value of
   all products can be measured.

Question 2

To be acceptable as a medium of exchange, money must have certain properties. What are these?

Answer 2

1. sufficient in quantity;
2. generally acceptable to all parties in all transactions;
3. divisible into small units, so that transactions of all sizes can be precisely carried out;
4. portable.

Question 3

What is inflation?

Answer 3

A sustained increase in
the general level of prices
of goods and services.

Question 4

Whats the difference between commercial financial institutions and mutual organisations?

Answer 4

Commercial financial institutions seek to make a profit from providing
services, including to provide a return on capital to shareholders. Certain
financial services providers, such as mutual organisations (ie organisations
‘owned’ by their members or customers) or not-for-profit organisations (ie
charities), may prioritise other objectives, such as social value, over profit
when providing products or services.

Question 5

Financial institutions offer products and services that provide benefits including:

Answer 5

• convenience (eg current accounts enable holders to make and receive
  payments rather than having to do so using physical cash);
• a means of achieving otherwise difficult objectives (eg mortgages enable
  people to fund the purchase of a home, and investment products enable
  savers to achieve long-term savings goals); and
• protection from risk (eg insurance protects policyholders or beneficiaries
  from the financial consequences of adverse life events).

Question 6

What is intermediation?

Answer 6

A financial intermediary borrows money from a surplus party
and lends it to a deficit party. The intermediary charges interest to the party
with the deficit and pays some of this interest to the party with the surplus. An
intermediary’s profit margin is the difference between the two interest rates.

Question 7

What is a financial intermediary?

Answer 7

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

Question 8

What is disintermediation

Answer 8

It involves lenders and borrowers
interacting directly rather than through an intermediary. For example crowd funding.

Question 9

What are the four elements of (reasons) for intermediation?

Answer 9

1. Geographic location - People from different locations can lend and borrow money through an intermediary.
2. Aggregation - Lenders might not have enough money for the borrower. Intermediaries can overcome this size difference by aggregating small deposits.
3. Maturity Transformation -even supposing that a borrower could find a
   lender who had the amount they wanted, there is a further problem. The
   borrower may need the funds for a longer period of time than the lender is
   prepared to part with them. The majority of deposits are very short term
   (eg instant access accounts), whereas most loans are required for longer
   periods (personal loans are often for two or three years, while companies
   often borrow for five or more years and typical mortgages are for 25 or more
   years). 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.
4. Risk Transformation - Intermediaries enable lenders to spread risk over a wide variety of borrowers so that, if a few fail to repay (i.e default) the intermediary can absorb the loss.

Question 10

What is insurance and how does it work?

Answer 10

“a means of shifting the burden
of risk by pooling to minimise financial loss”. Insurance involves individuals
contributing – via their insurance premiums – to a fund from which the losses
of the few who experience certain adverse circumstances are covered. Without
the services of a central organisation – the insurance company – individuals
would struggle to find a convenient way of sharing their risks. Insurance
companies therefore provide another form of intermediation.

Question 11

What are ‘product sales’ intermediaries?

Answer 11

This is the intermediation that 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 12

What are retail banks?

Answer 12

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

Question 13

What are wholesale banks?

Answer 13

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

Question 14

What is life insurance?

Answer 14

Insurance that provides payment, generally as a lump sum but sometimes
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 15

What is general insurance?

Answer 15

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

Question 16

What is the Bank of England?

Answer 16

A central bank acts as a banker to the government, supervises the economy
and regulates the supply of money.The Bank of England has a mission “to promote the good of the people in the United Kingdom by maintaining monetary and financial stability”; in pursuing this mission, it performs a number of important roles within the UK economy.

Question 17

What are the 7 main functions of the bank of England?

Answer 17

1. Issuer of banknotes
2. Banker to the government
3. Banker to the banks
4. Advisor the the government
5. Foreign exchange market
6. Lender of last resort
7. Maintaining economic stability

Question 18

Who issues gilt-edged securities (gilts)?

Answer 18

HM Treasury’s Debt Management Office.

Question 19

What are Gilt-Edged Securities?

Answer 19

Gilt-edged securities, commonly known as gilts, are loans to the government. There is a wide variety of gilts in issue
offering loans at different rates of interest and for varying periods.

Question 20

The Financial Services Act 2012, effective from 1 April
2013, divided responsibility for financial stability between
the Treasury, the Bank of England and two new regulators?

Answer 20

The Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA).

The Bank of England and Financial Services Act 2016 modified the Financial Services Act 2012 to give more powers to the Bank
by bringing the PRA within it, ending its status as a subsidiary, and establishing a new Prudential Regulation Committee (PRC).

Question 21

What is liquidity?

Answer 21

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

Question 22

What is a Proprietary Organisation?

Answer 22

The great majority of the large financial institutions are proprietary organisations, which means that they are limited companies. 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 23

What is a Mutual Organisation?

Answer 23

A mutual organisation is one that is 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; some
life assurance companies are mutual, too.

A mutual organisation is, in effect, owned by its members, who can determine how the organisation is managed through general meetings similar to those attended by shareholders of a company. In the case of a building society, the members comprise its depositors and borrowers; for a life assurance company, they are the policyholders.

Question 24

What is Demutualisation?

Answer 24

Since the Building Societies Act 1986, a building society has been able to demutualise – in other words, 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 25

What is a Credit Union?

Answer 25

A credit union is a mutual organisation run for the benefit of its members. In the past, the members had to be linked in a particular way – in other words, they had to share a ‘common bond’, for example, by working for the same organisation, living in a particular area or belonging to a particular club or other association. Changes to the Credit Unions Act 1979 that came into force on 8 January 2012 mean that credit unions no longer have to prove that all members have something in common with each other. As a result, they can now provide services to different groups of people, such as housing associations and employees of a national company, even if some of the tenants/employees live outside the geographical area that the credit union serves.

Question 26

How to join a Credit Union?

Answer 26

- A member must meet the membership requirements - Pay any required entrance fee and buy at least £1 share in the union. Credit unions can choose whether to offer ordinary shares (which are paid up and bring all the benefits of credit union membership), or deferred shares, which are only payable in special circumstances. All members of the credit union are equal, regardless of the size of their shareholding.

Question 27

What are Credit Unions good for?

Answer 27

It has been recognised that credit unions have a strong role to play in combating financial exclusion and delivering a range of financial services and financial education to those outside the mainstream. The government has therefore supported a number of initiatives and enacted legislation to widen the scope of the movement.

Question 28

Who own Credit Unions?

Answer 28

Credit unions are owned by the members and controlled through a voluntary board of directors, all of whom are members of the union. Board members are elected by members at the annual general meeting (AGM). Although the directors control the organisation, the day-to-day management is usually carried out by employed staff. Credit unions are authorised and regulated by the Financial Conduct Authority (FCA), and savers are protected through the Financial Services Compensation Scheme (FSCS).

Question 29

What products and services does a Credit Union offer?

Answer 29

Credit unions offer simple savings and loan facilities to members. While some credit unions offer a fixed rate of interest on savings, most offer a yearly dividend pay-out. The amount varies depending on how much profit the credit union has made in the year. Credit unions that choose to pay interest must show that they have the necessary systems and controls in place and have at least £50,000 or 5 per cent of total assets (whichever is greater) in reserve.

Question 30

What interest rates does a Credit Union offer?

Answer 30

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

Question 31

Explain Credit Union Life Assurance?

Answer 31

A unique feature of credit unions is that 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 32

What is the difference between Retail and Wholesale Banking?

Answer 32

The main distinction between retail and wholesale transactions is one of size – wholesale transactions being generally much larger than retail ones. Because of this, the end-users of retail services are normally individuals and small businesses, whereas wholesale services are provided to large companies, the government and other financial institutions.

Question 33

What is a Retail Bank?

Answer 33

Retail banking is primarily concerned with the more common services provided to personal and corporate customers, such as deposits, loans and payment systems. It is largely carried out by high-street banks and building societies, which deliver their products through traditional branch networks, call centres and the internet.

Question 34

What is Wholesale banking?

Answer 34

Wholesale banking refers to the process of raising money through the wholesale money markets in which financial institutions and other large companies buy and sell financial assets. This is the method normally used by finance houses, but the main retail banks are also heavily involved in wholesale banking in order to top up deposits from their branch networks as necessary. For example, if a bank has the opportunity to make a substantial profitable loan but does not have adequate deposits, it can raise the money very quickly on the interbank market.

Question 35

What is ring fencing?

Answer 35

Due to the 2007-09 financial crash regulators sought to ensure that banks involved in both retail and wholesale banking did not expose their retail customers’ deposits to risk as a result of their wholesale operations.

Question 36

Can building societies raise funds on the wholesale market and what is the restriction?

Answer 36

Building societies are also permitted to raise funds on the wholesale markets, but are restricted to 50 per cent of their liabilities; the remainder must come from deposits. For banks, there is no restriction.

Question 37

What is the Interbank Market?

Answer 37

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 38

What is Libor?

Answer 38

The rate of interest charged in the interbank market used to primarily be the London interbank offered rate (Libor). Libor used to act as a reference rate for the majority of corporate lending, for which the rate is quoted as Libor plus a specified margin. Libor rates were fixed daily and varied in maturity from overnight through to one year.

Question 39

What is Sonia?

Answer 39

Sonia (sterling overnight index average). Sonia was introduced in 1997 and has been administered by the Bank of England since 2016, with calculation and publication responsibilities also passing to the Bank following a reform of Sonia in 2018 (Bank of England, 2021). It is based on actual transactions and reflects the average of the interest rates that banks pay to borrow sterling overnight from other financial institutions and other institutional investors. Sonia is an important benchmark used by financial businesses and institutions to calculate the interest paid on swap transactions and sterling floating rate notes.