Interactions in the macro economy between governments, businesses and consumers take place within an institutional environment that includes a large number of financial intermediaries. These range from banks and building societies to pension funds, insurance companies, investment trusts and issuing houses, all of which provide a number of services of both direct and indirect benefit to businesses. As part of the financial system within a market-based economy, these institutions full fill a vital role in channelling funds from those able and willing to lend, to those individuals and organisations wishing to borrow in order to consume or invest. It is appropriate to consider briefly this role of financial intermediation and the supervision exercised over the financial system by the central bank, before concluding the section with a review of important international economic institutions.
Elements of the financial system
A financial system tends to have three main elements:
1 Lenders and borrowers these may be individuals, organisations or governments.
2 Financial institutions, of various kinds, which act as intermediaries between lenders and borrowers and which manage their own asset portfolios in the interest of their shareholders and/or depositors.
3 Financial markets, in which lending and borrowing takes place through the transfer of money and/or other types of asset, including paper assets such as shares and stock.
Financial institutions, as indicated above, comprise a wide variety of organisations, many of which are public companies with shareholders. Markets include the markets for short-term funds of various types (usually termed ‘money markets’) and those for long-term finance for both the private and public sectors (usually called the ‘capital market’). Stock exchanges normally lie at the center of the latter, and constitute an important market for existing securities issued by both companies and government.
The vital role played by financial intermediaries in the operation of the financial system is illustrated in Figure and reflects the various benefits which derive from using an intermediary rather than lending direct to a borrower (e.g. creating a large pool of savings; spreading risk; transferring short-term lending into longer term borrowing; providing various types of funds transfer services). Lenders on the whole prefer low risk, high returns, flexibility and liquidity; while borrowers prefer to minimize the cost of borrowing and to use the funds in a way that is best suited to their needs. Companies, for example, may borrow to finance stock or work-in progress or to meet short-term debts and such borrowing may need to be as flexible as possible. Alternatively, they may wish to borrow in order to replace plant and equipment or to buy new premises borrowing which needs to be over a much longer term and which hopefully will yield a rate of return which makes the use of the funds and the cost of borrowing worth while.
The process of channelling funds from lenders to borrowers often gives rise to paper claims, which are generated either by the financial intermediary issuing a claim to the lender (e.g. when a bank borrows by issuing a certificate of deposit) or by the borrower issuing a claim to the financial intermediary (e.g. when government sells stock to a financial institution). These paper claims represent a liability to the issuer and an asset to the holder and can be traded on a secondary market (i.e. a market for existing securities), according to the needs of the individual or organisation holding the paper claim. At any point, financial intermediaries tend to hold a wide range of such assets (claims on borrowers), which they buy or sell (‘manage’) in order to yield a profit and/or improve their liquidity position. Decisions of this kind, taken on a daily basis, invariably affect the position of investors (e.g. shareholders) and customers (e.g. depositors) and can, under certain circumstances, have serious consequences for the financial intermediary and its stakeholders (e.g. the bad debts faced by western banks in the late 1980s and early 1990s).
Given the element of risk, it is perhaps not surprising that some financial institutions tend to be conservative in their attitude towards lending on funds deposited with them, especially in view of their responsibilities to their various stakeholders. UK retail banks, for instance, have a long-standing preference for financing industry’s working capital rather than investment spending, and hence the latter has tended to be financed largely by internally generated funds (e.g. retained profits) or by share issues. In comparison, banks in Germany, France, the United States and Japan tend to be more ready to meet industry’s medium and longer-term needs and are often directly involved in regular discussions with their clients concerning corporate strategy, in contrast to the arm’s length approach favoured by many of their UK counterparts.8
The role of the central bank
A critical element in a country’s financial system is its central or state bank; in the United Kingdom this is the Bank of England. Like most of its overseas counterparts, the Bank of England exercises overall supervision over the banking sector with the aim of maintaining a stable and efficient financial framework as part of its contribution to a healthy economy. Its activities have a significant influence in the financial markets (especially the foreign exchange market, the gilts market and the sterling money market). These activities include the following roles:
_ banker to the government;
_ banker to the clearing banks;
_ manager of the country’s foreign reserves;
_ manager of the national debt;
_ manager of the issue of notes and coins;
_ supervisor of the monetary sector; and
_ implementer of the government’s monetary policy.
In the last case, the Bank’s powers were significantly enhanced following the decision by the incoming Labour government (1997) to grant it ‘operational independence’ to set interest rates and to conduct other aspects of monetary policy free from Treasury interference. This historic decision has given the Bank the kind of independence experienced by the US Federal Reserve and the Deutsche Bundes bank and has been designed to ensure that monetary policy is conducted according to the needs of the economy overall, particularly the need to control inflation.
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