THE
FINANCIAL ENVIRONMENT
THE
BANKING SYSTEM
The clearing banks
The clearing banks participate in systems which simplify
daily payments so that all the thousands of individual customer payments are
reduced to a few transfers of credit between the banks. The work of these
institutions can best be understood through a consideration of the main items
in their balance sheets.
Clearing bank liabilities
The
money for which the banks are responsible comes chiefly from their customers' sight
and time deposits - mostly current and deposit accounts with which most people are
familiar. An important additional item relates to Certificates of Deposit.
These are issued generally for a minimum amount of £50,000 and a maximum of
£500,000 with an initial term to maturity of from three months to five years.
Inter-bank lending
Short-term
lending’s between banks are referred to as 'inter-bank' loans. The inter-bank markets
in sterling and euro currencies are the largest of the short-term lending
markets (money markets).
Buying
Treasury bills
The
clearing banks and discount houses also hold the government's own short-term securities
(Treasury bills), which operate in much the same way as commercial bills.
Buying
commercial or trade bills
These constitute a definite agreement to pay a certain sum
of money at an agreed place and time. A bill is really a sophisticated IOU
which is of very great value in foreign trade because it allows exporters to
give credit to foreign buyers and yet obtain payments from banks as soon as goods
are shipped. The necessary arrangements are nearly always handled by merchant
banks. A commercial bill can be held until payment is due (unusual), or
discounted with a bank or discount house (normal), or used to pay
another
debt (not common in modern practice).
Trade
investments
There are many specialist financial and lending activities
that the banks are reluctant to handle through their general branches. They
prefer to finance these indirectly through the ownership and overall control of
specialist subsidiaries. Such activities include the following:
• Hire-purchase,
much of it for the purchase of motor vehicles.
• Leasing, i.e.
hiring vehicles or equipment as opposed to purchase or hire-purchase, a practice
encouraged by the peculiarities of the British taxation system.
• Factoring and
invoice discounting, i.e. lending to business firms on the security of approved
trade debts or taking over responsibility for the collection of trade debts. This
is a method that allows a firm to give credit in competitive markets and still
be paid for goods in order to keep necessary cash flowing through the firm.
Credit creation
This section considers the process for creating credit (in
effect, creating money) under a modem banking system where banks keep only part
of their assets in the form of cash to repay investors. The rest of the assets
are in the form of investments which cannot easily be converted into cash.
Intermediation refers to the process whereby
potential borrowers are brought together with potential lenders by a third
party, the intermediary.
There are many types of institutions and other organization
that act as intermediaries in matching firms and individuals who need finance
with those who wish to invest.
Money and capital markets
Financial markets
The financial markets, both capital and money markets, are
places where those
Requiring finance (deficit units) can meet with those able
to supply it (surplus units). They offer both primary and secondary markets.
Primary markets
Primary
markets provide a focal point for borrowers and lenders to meet. The forces of supply
and demand should ensure that funds find their way to their most productive usage.
Primary
markets deal in new issues of loanable funds. They raise new finance
for
the deficit units.
Secondary
markets
Secondary markets allow holders of financial claims (surplus
units) to realize their investments before the maturity date by selling them to
other investors. They therefore increase the willingness of surplus units to
invest their funds. A well-developed secondary market should also reduce the
price volatility of securities, as regular trading in 'secondhand' securities
should ensure smoother price changes. This should further
encourage
investors to supply funds.
Secondary
markets help investors achieve the following ends.
Diversification
By
giving investors the opportunity to invest in a wide range of enterprises it
allows them to spread their risk. Investors 'Don't put all their eggs in one
basket'
Risk shifting
Deficit units, particularly companies, issue various types
of security on the financial markets to give investors a choice of the degree
of risk they take. For example company loan stocks secured on the assets of the
business offer low risk with relatively low returns, whereas equities carry
much higher risk with correspondingly higher returns.
Hedging
Financial markets offer participants the opportunity to
reduce risk through hedging which involves taking out counterbalancing
contracts to offset existing risks. For example, if a UK exporter is awaiting
payment in francs from a French customer he is subject to the risk that the
French franc may decline in value over the credit period. To hedge this risk he
could enter a counterbalancing contract and arrange to sell the French francs
forward (agree to exchange them for pounds at a fixed future date at a fixed
exchange rate). In this way he has used the foreign exchange market to insure
his
future sterling receipt. Similar hedging possibilities are
available on interest rates and on equity prices.
Arbitrage
Arbitrage
is the process of buying a security at a low price in one market and
simultaneously
selling in another market at a higher price to make a profit.
Although
it is only the primary markets that raise new funds for deficit units, well developed
secondary markets are required to fulfill the above roles for lenders and borrowers.
Without these opportunities more surplus units would be tempted to keep their
funds 'under the bed' rather than putting them at the disposal of deficit
units.
The
capital markets
Capital markets deal in longer-term finance, mainly via a
stock exchange. The major types of securities dealt on capital markets are as
follows:
•
Public sector and foreign stocks
•
Company securities
•
Eurobonds.
Eurobonds
Eurobonds are bonds denominated in a currency other than
that of the national currency of the issuing company (nothing to do with
Europe!). They are also called international bonds.
As stock markets are of crucial importance in meeting the
financial needs of business and government, their operation is dealt with in
more detail later.
The money markets
Money markets deal in short-term funds, usually in the form
of bank bills, trade bills, certificates of deposit, unsecured loans and other
types of credit. No physical location exists, transactions being conducted by
telephone or telex.
The money market is a market mainly for short-term and very
short-term loans, in both sterling and foreign currencies, though some longer-term
transactions are also undertaken. In fact, it is not one single market but a
number of different markets which closely inter-connect with each other. The
main participants in these markets are the central banks (e.g. Bank of England)
and the commercial banks. Other participants include the finance houses,
building societies, investment trusts and unit trusts, local authorities, large
companies, and some private individuals.
International capital
markets
An
international financial market exists where domestic funds are supplied to a
foreign user or foreign funds are supplied to a domestic user. The currencies
used need not be those of either the lender or the borrower.
The
most important international markets are:
•
The Euromarkets
•
The foreign bond markets.
The Euromarkets
The term 'Euromarkets' is somewhat misleading, but the name
has stuck. The markets originated in the 1950s, dealing in Eurodollars, but
they have now grown to encompass other currencies including Euro-yen, Euro-sterling,
Euro-Swiss and so on. Eurocurrency is money deposited with a bank outside its
country of origin. For example, money in a US dollar account with a bank in
London is Eurodollars. Note that these deposits need not be with European
banks, although originally most of them were.
Nowadays in fact active Euromarkets centres are in London,
New York,
Tokyo, Singapore and Bahrain. Once in receipt of these
Eurodeposits, banks then lend them to other customers and a Euromarkets in the
currency is created.
Types of Euromarkets
The
Eurocurrency market
This incorporates the short- to medium-term end of the Euromarkets.
It is a market for borrowing and lending Eurocurrencies. Various types of
deposits and loans are available.
Deposits vary from overnight to five years. Deposits can be in the
form of straight term deposits, with funds placed in a bank for a fixed
maturity at a fixed interest rate. However, these carry the problem of interest
rate penalties if early repayment is required.
Alternatively, deposits can be made in the form of
negotiable Certificates of Deposit (CDs). There is an active secondary market
in CDs and investors are therefore able to have access to their funds when
required. Deposits can be made in individual currencies or in the form of
'currency cocktails' to allow depositors to take a diversified currency
position. One common cocktail is the Special Drawing Right, consisting of US
dollars, Deutschmarks, yen, French francs and sterling.
Euromarkets loans
may be in the form of straight bank loans, lines of credit (similar to overdraft
facilities) and revolving commitments (a series of short-term loans over a given
period with regular interest rate reviews). Small loans may be arranged with individual
banks, but larger ones are usually arranged through syndicates of banks. Much
of the business on the Eurocurrency market is interbank, but there are also a large
number of governments, local authorities and multinational companies involved. Firms
wishing to use the market must have excellent credit standing and wish to borrow
(or deposit) large sums of money.
The Eurobond market
A Eurobond is a bond issued in more than one country
simultaneously, usually through a syndicate of international banks, denominated
in a currency other than the national currency of the issuer. This represents
the long-term end of the Euromarkets.
The bonds can be privately placed through the banks or
quoted on stock exchanges. They may run for periods of between three and twenty
years, and can be fixed or floating rate. Convertible Eurobonds (similar to
domestic convertible loan stocks) and Option Eurobonds (giving the holder the
option to switch currencies for repayment and
interest)
are also used.
The major borrowers are large companies, international
institutions like the World Bank, and the EC. The most common currencies are
the US dollar, the euro, the Swiss franc, and to a smaller extent sterling.
Stock markets
A country's stock market is the institution that embodies
many of the processes of the capital market. Essentially it is the market for
the issued securities of public companies, government bonds, loans issued by
local authority and other publicly owned institutions, and some overseas
stocks. Without the ability to sell long-term securities easily few people
would be prepared to risk making their money available to business
or public authorities. A stock market assists the allocation
of capital to industry; if the market thinks highly of a company, that
company's shares will rise in value and it will be able to raise fresh capital
through the new issue market at relatively low cost. On the other hand, less popular
companies will have difficulty in raising new capital. Thus, successful firms are
helped to grow and the unsuccessful will contract.
The role of speculation
Any consideration of a stock market has to face up to the
problem of speculation, i.e. gambling. It is suggested that speculation can
perform the following functions.
It smoothes price fluctuations. Speculators, to be
successful, have to be a little ahead of the rest of the market. The skilled
speculator will be buying when others are still selling and selling when others
are still buying. The speculator, therefore, removes the peaks and troughs of
inevitable price fluctuations and so makes price changes less violent.
Speculation ensures that shares are readily marketable. Almost
all stock can be quickly bought and sold, at a price. Without the chance of
profit there would be no professional operator willing to hold stock or agree
to sell stock that is not immediately available. The fact that there are always
buyers and sellers is of considerable importance to the ordinary individual
investor who may have to sell unexpectedly at any time with little warning.
Stock
markets help in the determination of a fair price for assets, and ensure that assets
are readily marketable.
Buying and selling shares
An investor will contact a broker in order to buy and sell
shares. The broker may act as agent for the investor by contacting a
market-maker (see below) or he may act as principal if he makes a market in
those shares (i.e. buys and sells on his own behalf). In the latter case he is
a broker-dealer.
Market-makers
maintain stocks of securities in a number of quoted companies,
appropriate to the level of trading in that security, and
their income is generated by the profits they make by dealing in securities. A
market-maker undertakes to maintain an active market in shares that it trades,
by continually quoting prices for buying and prices' for selling the shares
(bid and offer prices). If share prices didn't move, their profits would come
from the difference (or 'spread') between the bid and offer prices. This profit
is approximately represented by the difference between the 'bid' and 'offered'
price for a given security - the price at which a
market-maker is prepared to buy the stock and the price at which he would be
prepared to sell it.
Share
prices are dictated by the laws of supply and demand. If the future return/risk
profile of the share is anticipated to improve, the demand for that share will
be greater and the price higher.
Types of stock market
A
country may have more than one securities market in operation. For
illustration, the UK has the following:
(a) The London Stock
Exchange - The main UK market for shares, on which the shares of large public
companies are quoted and dealt. Costs of meeting entry requirements and
reporting regulations are high.
(b)
The Alternative Investment Market (AIM)
- This is a separate market for the
Shares of smaller companies. Entry and reporting
requirements are significantly less than those for the main market of the
London Stock Exchange.
(c) An
'Ofex ' (off exchange) market in which shares in some public companies are traded,
but through a specialist firm of brokers and not through a stock exchange.
Sample Questions.
1.
Distinguish between money and capital
markets.
2.
What is a Eurodollar?
3.
Explain briefly how stocks markets work
and assess their usefulness to businesses as a source of long term finance
