Financial system

The financial system conveys resources from lenders to borrowers, and transfers risks from those who wish to avoid them to those who are willing to take them. It is a complex interactive system, events in one component of which can have significant repercussions elsewhere. There are also complex interactions between financial transactions and other forms of economic activity, as consequence of which a malfunction of the financial system can cause a malfunction of the economy, and vice-versa. The system has evolved by adaptation and innovation, and the conduct of its participants has been modified from time to time by regulations designed to preserve its stability. Further modifications are under consideration in light of the crash of 2008.

(The termninology used in this article is largely based upon The American Banker Bankers Glossary [3]. Terms shown in italics are defined in the glossary on the related articles subpage)

Overview

The principal participants in the system are financial intermediaries whose functions are to transfer resources from those who own them but do not wish to use them to those who wish to use them but do not own them; and to transfer risk from those who wish to limit their exposure to it to those willing to accept it. It performs those functions by trading in financial instruments that represent promises to perform services in return for payment. The promises that they represent include promises to make fixed payments (represented by bonds); promises to pay dividends (represented by shares); promises to provide retirement income (represented by pension agreements); promises to bear some of the costs of accidents or financial losses (represented by insurance policies), promises to provide a cash flow, such as mortgage repayments (represented by securitised assets) - and promises, such as options, concerning transactions in other promises (represented by "derivatives"). The system includes specialised markets, regulated by custom, rules and legislation, that provide for trading in financial instruments and in the currencies in which they are denominated; and it is supported by information-providing services from analysts, advisors and rating agencies.

Components

Instruments

Bonds

In the terminology of this article, the term "bond" normally refers to an instrument, issued by a company or by local or central government, that represents a loan that is repayable after an interval of not less than a year (but in economics terminology it refers to any of the entire category of fixed-interest loan instruments). The term is also applied in some contexts to investments that do not conform to that definition - such as "investment bonds" (collections of investment funds) and "premium bonds" (a type of lottery). Unlike most other loan instruments, a bond can be bought or sold without reference to its issuer - normally on the bond market (see below). Bonds issued by the government are termed "Treasury bonds" (or "T-bonds") in the United States and "Gilt-edged securities" (or "gilts") in the United Kingdom.

The simplest form of bond is the "straight" (or "plain vanilla") bond, that makes a regular fixed interest payment and is repaid (or "redeemed") on a predetermined date. The sum of money for which the bond is to be redeemed, is called its "par value", the annual interest rate that is paid is called its "coupon", and its date of repayment is called its "maturity date". A bond's coupon divided by its market price is called its "current yield" and its internal rate of return taking account of the eventual repayment is termed its "yield to maturity".

Other forms of bond can be categorised as particular adaptations of the above payment conditions. Strictly speaking an "irredeemable bond" (or "perpetual bond" or "consol") is not a loan, but only an undertaking to make stipulated and indefinitely continuing fixed interest payments. A "zero-coupon bond", on the other hand, pays no interest, is issued at a price that is below its par value, and is held in order to obtain a capital gain. A "callable bond" has a redemption date that is at the discretion of the issuer. Convertible bonds include an option, under stated conditions, to exchange them for an equivalent amount of the issuer's equity. The interest rate paid on a “tracker bond” is related to the bank or Treasury bond rate, and the redemption payment of an “index-linked” bond is related to the current level of a consumer price index.

Bonds can also be categorised according to the degree of security provided to their purchasers. A "covered bond" is a bond that is secured by other assets so that the investor can lay claim to those assets should the issuer of the bond become insolvent. In the United Kingdom the term "debenture" refers to a company loan secured by a claim on the company's assets, but in the United States the term is applied to unsecured loans (and debentures are sometimes referred to as bonds). In the UK a "fixed-charge debenture" specifies the assets against which it is secured, whereas a "floating-charge debenture" is secured on the issuer's assets as a whole. Repayment of a "guaranteed bond" is guaranteed by a body other than the issuer - such as its parent company or its government. The term "default risk means the risk that the issuer will be unable to repay the loan and the "risk premium" (or "spread") is the difference between the yield on a bond and the yield on a government bond – except that “sovereign spread” is the difference between the yield on a government bond and the yield on the least risky government bond that is available. Default risk premia are linked to risk ratings issued by credit risk agencies (see below). Bonds that are rated below a minimum credit risk level (Baa for Moody’s or BBB for Standard and Poor) are termed "junk bonds" (or "high-yielding bonds") and bonds rated above that level are termed "investment-grade bonds".

Finally, bonds can be categorised according to their currency of denomination. The term "eurobond" (or "global bond") refers to a bond that is traded outside the country in whose currency it is denominated - so called because it is often applied to a bond issued by a non-European company for sale in Europe.

Money market securities

Money market securities are short term loan instruments issued by governments banks and businesses. Those that can be bought and sold during the period between issue and repayment are termed “negotiable”. Those that a marketed on a “yield basis” are repaid on the due date by the amount invested, together with a stipulated interest payment. The category of money market security that are marketed on a yield basis includes "money market deposits" which are repayable after intervals ranging from one day to one year and are not negotiable, and “certificates of deposit” which are receipts from banks for deposits made with them, and are negotiable. Money market securities that are marketed on a “discount basis” are sold at a price "below par" (– ie below the amount to be repaid), but without any additional interest payment. That category includes Treasury bills, which are promises to repay loans to the government – usually after 90 days; "bills of exchange" (or "trade bills", or "commercial bills") which are similar to Treasury bills but are issued by companies; and "bankers acceptances" which are negotiable, and "commercial paper" which consists of unsecured promissory notes issued by companies.

Shares

A share in a corporation is evidence of a share in the ownership (or "equity") of that corporation, and represents a claim on its assets and its profits. The shares in a company are referred to collectively as its "stock" or its "equity". The term "equity" is also used to mean the value of the firm after all its debts and other obligations have been paid. Except for "non-voting shares" the possession of a share carries the right to vote on matters raised at its general meetings. Holders of "preference shares" are entitled to a specified form of preferential treatment compared with holders of "ordinary shares" - sometimes a guaranteed dividend, sometimes a guaranteed repayment if the company were liquidated. The "par value" of a share sometimes denotes the amount due on liquidation to the holder of a preference share, and it is unrelated to the share's market value.

Derivatives

A derivative is financial instrument whose value depends upon the value of another instrument. The principal categories of derivative are "forward contracts", "futures", "options", and "swaps". A forward contract is an agreement to buy or sell a specified quantity of an asset on a specified date, at a specified price. An option is an agreement that gives the holder the right, but not the obligation, to buy ("call option") or sell ("put option") an asset, on or before a specified date . A swap is an agreement to exchange a series of cashflows from one asset with a series of cashflows from another asset. Swaps are widely used as credit risk transfers (see below). Some derivatives are used to create leverage, as a means of speculation, or for hedging against risk.

Mortgages

A mortgage is a loan secured on property - usually real estate, although ships and aircraft are commonly mortgaged. A mortgage may be used to help finance the purchase of the property or to obtain money for other purposes.
Mortgage interest payments may be fixed or may be varied by the provider of the loan - usually in response to changes in the general level of interest rates. The term "adjustable rate mortgage" (ARM) is used in the United States to denote a mortgage for which the interest rate payable is related to a published index, and a "hybrid mortgage" is one in which the interest rate is fixed for a period, and then varied. "Subprime mortgages" are designed for the use of borrowers with low credit ratings (typically below a FICO rating of 620 in the United States). They are offered at higher interest rates than for other mortgages, but may provide for reduced payments in their early years.
If the market value of the property that is mortgaged falls below the amount of the loan, the borrower is said to have "negative equity" in the property and thus to cease benefiting from the mortgage agreement.
Failure to make the agreed payments is termed "default" and usually entitles the provider of the loan to "repossess" the property.
A mortgage loan may be financed by its provider by selling claims to its repayments - a procedure known as "securitisation".

Structured finance

The term "structured finance" refers to assets created by "securitising" cash flows such as debt repayments by converting them into marketable securities that are structured according to their maturity and risk rating, and among which priorities concerning payments and liabilities for losses are stipulated in "waterfall clauses" . The cash flows that are securitised may be income from corporate bonds, in which case the assets that are created are termed "collateralised debt obligations (CDOs)" or "asset-backed securities (ABSs)", or they may be mortgage repayments, in which case the assets are termed "collateralised mortgage obligations (CMOs)". CMOs are normally segregated into "tranches", each with its own maturity date and risk rating.

Credit risk transfer

A "credit default swap" (CDS), enables a "protection buyer" to transfer the credit risk from holding a security to a "protection seller" in return for an annual percentage charge, known as the "CDS spread", that is determined by the credit rating of the protected security. Credit default swaps can be combined to create a "synthetic CDO," in which credit losses are allocated to tranches according to stated priority rules. A "total return swap" transfers market risk as well as credit risk. Another form of risk transfer is a bank guarantee which is an undertaking to pay compensation if there is a specified form of default by a third party.

Participants

(for links and notes on selected financial institutions go to the addendum subpage)

Categorisation

Some participants in the financial system specialise in trading in a single category of financial instrument while some find it necessary or advantageous to combine different trading or advisory activities; and interaction between different activities can occur even when they are performed by different participants. The attribution in the following paragraphs of a single activity to each participant is a simplification adopted for the sake of clarity.

There is no functional difference between investment banks and other finance providers: both use short-term borrowing to pay for long-term loans and the use of leverage by banks is often emulated by other providers of finance. But the deposit facility provided by commercial banks places them in a different functional category. In some contexts it is obvious that the term "bank" is used to denote a commercial bank, but it is normally used to denote either type or a combination of both.

Financial intermediaries

Banks

"Commercial banks" accept payments from depositors and lend money to personal and commercial borrowers. In addition to the money they get from depositors, they can get short-term loans from their central bank's "discount window", or from the money market or from other banks via the "interbank market". They make profits by charging higher interest rates to their borrowers than they pay to their lenders - a difference that is known as their "spread".

The banks that lend money to borrowers but do not accept deposits from the public, include "wholesale banks" that deal with other banks or financial companies; "investment banks", that raise money for companies by finding buyers for their equity and bonds; and "universal banks" that combine all of those activities. Other institutions that lend money to personal or commercial borrowers are referred to collectively as the "shadow banking system".

The practice of retaining only a fraction of the money deposited with it as a "reserve" and lending out the rest is known as "fractional reserve banking". That practice, together with the fact that borrowed money can be deposited in commercial banks and repeatedly used for the provision of further loans, gives commercial banks an unique role in the expansion and contraction of the supply of credit.

Other finance providers

Loans to consumers are on offer from a number of cooperative (or “mutual”) providers, including savings and loans associations ("building societies" in the UK), credit unions, and friendly societies; and from several types of commercial organisation including pawnbrokers , and providers of hire purchase (instalment plans in the United States).

Equity capital is raised by the larger firms through the services of investment banks, "securities brokers" and "flotation companies" and, through other intermediaries, by "initial public offerings" (IPOs) of shares to the public, and it is made available to firms that are too small to qualify for stock exchange listing by "venture capital companies" (termed "private equity companies" in the UK). Long-term loan finance is obtained by the issue of corporate bonds, and short-term borrowing by the sale of commercial paper on the money market. Companies also raise capital by selling the rights to their receipts from invoices and "accounts receivable" to "factoring companies" (or "invoice finance brokers"). They often finance capital equipment purchases by hire purchase, or leasing, and otherwise raise capital by the sale and leaseback of equipment that they own.

Financial services

Analysts and investment managers

The function of transferring resources and risks, attributed above to financial intermediaries, is augmented by the activities of analysts and financial advisors, operating within and outwith the financial intermediary organisations. They collect and analyse financial information and use their findings, either to inform and advise their clients, or to manage a package of financial assets known as a "fund", or to manage their clients' investment portfolios. Financial advisors may be independent of the organisations on whose products they advise, or may be related to them directly or by commission payments , and are sometimes provided by companies with information not available to the general public. Among the funds that are so managed are "mutual funds" (called "unit trusts" in the UK), which are collectively owned by their investors, including "hedge funds". Company-owned trusts include "unit trusts" (in the USA) and "investment trusts". Investment trusts and unit trusts invest in bonds, shares and money market assets, are widely marketed, and are closely controlled by regulatory authorities, hedge funds are offered only to small groups of wealthy investors, adopt unorthodox investment strategies, often employ very high levels of leverage, and often escape regulation.

Credit rating agencies

Credit ratings reflect their authors' estimates of borrowers' ability to repay what they have borrowed and if accepted, relieve their creditors of the problem of judging the risk of default. Some agencies provide such ratings for individuals, others for the issuers of debt instruments and their derivatives. For bonds, the highest ratings are assigned to issuers who are expected never to default - such as the United States Treasury - and prospective buyers of other issuers' bonds respond to the assignment of a lower rating by demanding a higher yield than that obtainable on Treasury bonds in order to compensate for the greater risk of default. The yield to be expected of a structured finance instrument such as a "collateralised mortgage obligation" (see above) depends entirely upon the credit rating of its tranche. Following the crash of 2008 the methods used by the major credit rating agencies are under review .

Markets

Stock exchanges

Trading in the different categories of instrument takes place in different types of market. "Primary markets" for pensions and insurance policies take the form of one-to-one "over-the-counter" (OTC) transactions with their suppliers, and there is seldom any further trading because those instruments are considered to be "non-negotiable". The primary markets in stocks and shares and bonds usually start with an "initial public offering" (IPO) in which the issuers deal directly with professional traders, and through them with the public. Subsequent trading in those instruments can take place, either as over-the-counter deals between dealers and individual customers, or in "auction markets" in which numbers of holders trade with each other, or in "dealers markets" in which numbers of holders trade with dealers. The traditional way of making deals on an exchange is by "open outcry" in which sellers/buyers shout an offer and buyers/sellers shout an acceptance. Few financial exchanges now use that method and those that do plan to change to an electronic trading system such as London's "Stock Exchange Electronic Transfer System" (SETS), (augmented by clearing and settlement systems that provide the buyer with his stock and the seller with his payment). A company's shares may be traded on a stock exchange only if it is granted a "listing", the granting of which is typically subject to rules concerning the meeting of a minimum capital value requirement, and concerning the qualifications and conduct of its directors. Most stock exchanges also provide for trading in other financial instruments including structured products, and some provide a second-level market for the shares of smaller firms (such as London's "Alternative Investment Market).

The foreign exchange market

National currencies are traded against each other in countries all over the world and the transactions are facilitated by multiple clearance systems. The activities of the traders in the different countries interact so strongly that the system behaves as though all trading were done in one centrally-administered exchange. The system is referred to as the foreign exchange (or "Forex") market although there is no central market to coordinate its transactions. The central banks of countries with "fixed exchange rates" buy and sell their countries' currencies in order to keep its exchange rate with the dollar (or other reference currency) within an intended range. Otherwise, most trading is done by banks, on there own account or on behalf of private-sector clients. Other central banks do not normally intervene in the forex market (although they sometimes act to sterilise the domestic effects of foreign exchange movements).

Exchange rate movements influence other international financial transactions and - because of the interactive character of the global financial system - they influence, and are influenced by, financial activities within trading countries.

Regulators

Governments have sought to regulate the conduct of participants in their financial systems in view of the influence of that conduct upon other sectors. The main purpose of financial regulation has typically been to preserve the financial system from the danger of systemic failure, and it has sometimes been used to further its efficient operation, for example by requiring open access to financial information, but an important secondary purpose has been to protect investors against fraud and the misuse of inside information.

Regulation has usually developed piecemeal in response to a sequence of problems - starting with the banks, and getting applied elsewhere as the need seemed to arise. In the United States, for example, federal governments have, over time, appointed six regulatory bodies, together covering all of the participants in its financial system except the non-bank lenders, the hedge funds and the traders in OTC derivatives. , and, until 2000, Britain's financial industry was regulated by nine different bodies. In the 1990s, however, unified systems of financial regulation were adopted by Norway, Denmark and Sweden, followed in 2000 after intensive all-party investigation, by Britain, and subsequently by Australia (except for separate prudential supervision of the banks), and in March 2009 the US Treasury announced plans to create "a single independent regulator with responsibility over systemically important firms and critical payment and settlement systems" .

The crash of 2008 has led to generally agreement that current regulatory systems are inadequate for the purposes that they are intended to serve.

The central banks

A central bank normally implements its country’s monetary policy and acts as the government’s banker and as lender-of-last-resort to its country’s banks. In some countries the central bank also regulates the banking system

Reform

In preparation for a meeting of the world leaders in November 2008, an ebook was published by an international group of twenty leading financial economists. They agreed on the need to augment IMF resources and to strengthen existing arrangements for global governance. Several of them also argued for new approaches to the regulation of large cross-border financial institutions.

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