Lecture notes- Financial Environments

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