British Non-Bank Financial Intermediaries

David Goacher, Peter Curwen, R. Apps, Grahame Boocock, Leigh Drake

• Publisher: Taylor & Francis
• Year: 2017
• Print ISBN: 9781138569126
• eBook ISBN: 9781351337830
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Originally published in 1987, British Non-Bank Financial Intermediaries the book is the diversification of and overlaps in the operations of UK financial intermediaries forms. The book provides a coherent analysis of the broader implications of ongoing developments in the financial services sector and an insight into the 'back-room activities of the non-bank institutions. The book also focuses on institutions offering some form of financial markets, within which many of the financial intermediaries operate. In doing this, the book outlines a theoretical framework of financial intermediation and provides an overview of the broader evolution of the UK financial system. This volume will be of use to students and practitioners studying in the financial services sector.

CHAPTER ONE

The Theoretical Basis of Financial Intermediation

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The Nature of Financial Intermediation

The process of financial intermediation involves the channelling of funds between those who wish to lend and those who wish to borrow; that is, between people and institutions with budget surpluses and people and institutions with budget deficits. Financial intermediaries are normally thought of as comprising banks, building societies and the like, but it is important to appreciate that the intermediation activity stretches well beyond these widely known components of the financial system. In fact, whenever an individual or institution (irrespective of its size) channels funds between lenders and borrowers by way of a business venture, then the process of financial intermediation occurs. In the UK, in addition to the banks and building societies, the major financial intermediaries include the National Savings Bank, finance houses, unit trusts, investment trust companies, pension funds and insurance companies.¹ There is also a host of less widely recognized institutions involved in somewhat more specialist forms of intermediation, often relating to the particular financial needs of the business community, and including, for example, the venture capital companies such as 3i, which space does not permit us to discuss in this text.

The structure of the modern financial system is extremely complex, and hence, as might be expected, there are many variations on the basic financial intermediation activity. For example, some intermediaries, mainly within the banking sector, channel funds almost exclusively between other financial intermediaries and thus facilitate the working of the financial system as a whole, rather than interacting directly with ultimate lenders and ultimate borrowers. Discount houses, for example, operate in this way, channelling wholesale (large-volume) short-term funds between commercial banks, and between the latter and the Bank of England's Banking Department. There are also institutions which obtain all, or nearly all, of their funds from other financial intermediaries for the purpose of on-lending outside the financial sector. Some UK finance houses operate in this way. However, the majority of financial intermediaries, at some stage of their operations, raise funds from and/or lend funds to the domestic non-bank private sector, although even in this respect there may be differing balances between personal and corporate sector activity, and between domestic and overseas activity.²

Irrespective of the precise form of financial intermediary, the intermediation activity will always lead to the creation of new financial assets and liabilities. The funds originally held by the ultimate lender will be transformed into a financial asset which is the liability of the financial intermediary. This type of asset, which is usually interest-bearing, is often referred to as a secondary (or indirect) security, as it constitutes a claim on the financial intermediary rather than on an ultimate borrower. The financial intermediary will normally utilize a large proportion of the funds deposited with it to purchase interest-bearing (or at least income-earning) financial assets, which are the liabilities of ultimate borrowers, and which are often referred to as primary securities. Thus, for example, an individual may deposit cash into a share account at a building society. This act leads to the creation of interest-bearing building society shares, which are an asset of the shareholder and a liability of the building society. Some or all of the money (depending upon the building society's reserve position)³ may be on-lent to an individual wishing to borrow funds in order to purchase a dwelling. Thus, an interest-bearing mortgage loan is created which is an asset of the building society and a liability of the borrower. Clearly, the process of financial intermediation has led to the creation of additional amounts of two financial assets matched by equal amounts of financial liabilities. Where ultimate lenders provide funds directly to ultimate borrowers, additional pairs of assets and liabilities will always be created, but these are purely in the form of primary securities; there are no indirect securities created. The existence of financial intermediaries leads to a multiplication of the financial claims generated. There is always at least one additional pair of assets and liabilities (indirect securities) flowing from a transaction where financial intermediation is involved, relative to the situation where the ultimate lender provides funds directly to the ultimate borrower.

A less obvious example of financial intermediation is where an individual contributes (often through his employer) to a pension fund, in order to ‘purchase’ a claim to a stream of income after retirement. With the contributions received the pension fund is likely to purchase fixed interest securities and equity shares, and thereby hold claims against the government and company sectors with the view to earning sufficient income and realizable capital gains in future periods to be able to meet its financial liabilities (to pay pensions) as they fall due. Therefore, the pension fund acts as an intermediary between ultimate lenders (those saving for retirement) and ultimate borrowers. It makes little difference to the parties concerned whether the funds are on-lent to the government or company sector directly via the purchase of newly issued securities, or indirectly via the purchase of pre-existing securities. In the latter case the pension fund merely takes over a claim on the ultimate borrower from some other institution or individual wishing to make a portfolio reallocation.⁴

The Assets Created by the Financial Intermediation Process

The form of assets (and hence liabilities) created by the financial intermediation process will depend largely upon the type of financial transaction undertaken. For many individuals, perhaps the most familiar financial asset, after cash itself, is the bank deposit or building society deposit (or share).⁵ Quite simply, funds are deposited with an intermediary on the understanding that they may be withdrawn either on demand or after some minimum period of notice of withdrawal, and that the financial intermediary will either pay interest periodically on the funds or will provide some service to the depositor in return for the use of the funds. Where the financial intermediary does not pay interest on deposits, it is almost invariably the case that money transmission services will be offered to the depositor, involving the provision of cheque book, standing order and direct debit facilities and so on. These services will either be free of charge, or offered at a price below cost. However, a large proportion of deposits with banks, and all deposits with other financial intermediaries, do attract interest payments which tend to be related to the nominal period of notice required for withdrawal. In general, within any particular institution, the rate of interest paid on deposits will be higher the longer is the period of withdrawal notice required, although it is common for financial intermediaries to waive the formal period of notice and merely to deduct an appropriate amount of accrued interest in lieu.

A second important form of financial asset which may be created by the financial intermediation process is the marketable security. In this instance, the lender of the funds effectively purchases a document which constitutes a legal claim upon the financial intermediary and which is negotiable (tradable in a secondary market). This type of financial instrument may be issued and redeemed at par (face) value, and will attract interest, either to be paid periodically or at the time of maturity. Alternatively, the instrument may be issued at a discount on its par value but redeemed at par value, and thus technically provides the holder with a yield on his asset rather than an interest payment in the strict sense. Examples of the former type of assets are government gilt-edged securities and bank certificates of deposit. Instruments issued at a discount include Treasury bills and commercial bills. An important advantage of marketable securities to the lender is that, irrespective of their original or residual maturity, they may be sold prior to maturity to some other individual or institution, and thus the lender may attempt to realize his investment at a time of his own choosing. However, although financial claims in the form of marketable securities are transferable, there is no guarantee that a buyer will be found for the securities in the secondary market at any particular time.

In practice, the marketability of any instrument will depend upon its nature in terms of the associated interest payments and its residual maturity, as well as the creditworthiness of the issuer of the instrument. The less creditworthy is the issuer, the riskier is the asset, and hence the lower is the price that it is likely to realize for any given interest payment. Similarly, an instrument paying an interest rate on par value which is low relative to the ruling market rate of interest is also likely to trade below its par value. Therefore, whilst the holding of marketable securities may enhance the overall liquidity of an assets portfolio, there is also the risk that a capital loss may accrue if realization of the securities is desired prior to their maturity.

The nature of the return on marketable assets will have an important influence on the associated risk. For example, a commitment to fixed nominal interest payments means that the lender may find that he holds an asset offering a relatively poor yield should market rates of interest subsequently rise; conversely, a reduction in market rates of interest will enhance the attractiveness of the asset. If inflation rates should exceed those which were expected when the asset was initially purchased then the real return on the asset may prove to be disappointingly poor. An index-linking agreement may overcome this particular uncertainty for the lender, but will mean that the borrower has to make an open-ended commitment to nominal interest payments. To neutralize the effect on the capital value of the asset flowing from changes in the market rate of interest, the asset may offer a floating rate of interest, itself linked to market rates. Once again, the nature of the risks to be accepted by both the borrower and the lender are altered. Furthermore, a large body of marketable securities, referred to as equities, involve no specific commitment to pay interest (fixed or otherwise). Instead the issuing company allots some portion of its profits to be distributed amongst its equity shareholders. Here, the return received by the shareholders (and ultimately the capital value of the shares) will depend crucially upon the success of the operations of the company. In addition, in normal circumstances, equities are not redeemable, and hence the existence of a ready market in these instruments is extremely important to the potential investor.

Finally, it should be noted that some securities, issued as the counterpart to the borrowing of funds, are non-marketable. National Savings certificates and bonds, and certificates of tax deposit fall into this category. To a large extent these instruments are very little different from ordinary term deposits. Technically the lender is obliged to hold the debt until it matures, whereupon the funds will be repaid. However, facilities are sometimes offered for the early redemption of such securities, although this may involve some form of interest penalty. Where this does not occur, and to the extent that there is a significant period of time until maturity, the lender holds an illiquid asset. Therefore, if funds are required urgently the holder of the non-marketable security may himself be forced to borrow funds, perhaps using the security as a form of collateral. Clearly, once again the lender must be willing to accept a degree of risk in addition to that normally associated with default.

The Interest Rate Paid on a Financial Asset

Implicit in the above discussion are the three related reasons as to why nominal interest rates are positive. First, the lender requires compensation for giving up current consumption possibilities, since basic human nature prefers consumption in the current period thereby generating a positive time preference in most individuals. Secondly, the lender requires compensation for giving up liquidity as a result of exchanging funds (immediately available spending power) for some other form of financial asset. Thirdly, the lender requires a positive return for accepting the risk attached to lending. However, the actual rate of interest established on a borrowing/lending transaction will be determined by the combined characteristics of the transaction, as these characteristics will affect the supply of, and the demand for, the type of funds implicit in the transaction, and hence will affect the price of the asset created. Moreover, the pattern of interest rates established in the economy will be determined by the relative supplies of, and demands for, the various types of financial assets available.

The major characteristics of a financial transaction which will ultimately determine the rate of interest established may be summarized as follows:

(1)Risk In addition to the possible losses which may accrue on marketable securities, there is the more extreme risk that the borrower may either default on the interest payments on a loan or on the repayment of the principal. Indeed, if the risk is thought to be unacceptably high there will be no rate of interest which will offer sufficient compensation to the lender, and hence the loan will not be made. Similarly, there is the risk that a company in which equity shares have been purchased will prove to be unprofitable, or perhaps even go bankrupt with insufficient residual assets to cover even the normal creditors of the business.

(2)Time to maturity In general, other things being equal, the longer is the term to maturity of a loan, the higher will be the interest rate desired by the lender. This reflects the underlying liquidity preference of the lender and the increasing uncertainty surrounding transactions as time passes. It is only where there are sufficiently strong expectations of interest rate reductions that rates on longer-term debt may fall below those on shorter-term instruments.⁶

(3)Marketability of the asset The easier is access to an active market in securities, the lower will tend to be the rate of interest which the securities will attract, other things being equal. This characteristic relates to the liquidity of the asset in the broadest sense.

(4)Type of loan In relation to banks, funds may be lent through normal term loans (on which interest must be paid irrespective of whether or not the funds are actually used by the borrower) or through overdraft facilities (where only the portion of the funds actually used by the borrower attracts interest). With fixed-maturity debt there may also be some form of agreement on rolling-over facilities.

(5)Absolute size of the transaction Unit administration costs will tend to be lower the larger is the amount of funds borrowed/lent, and thus a financial intermediary will often be willing to pay a higher rate of interest for large (wholesale) deposits than smaller (retail) deposits. In addition, the added risk for the lender of reduced portfolio diversification, arising from the making of a relatively small number of large loans (as opposed to a large number of small loans) may tend to promote higher rates of interest on wholesale loans. However, in respect of on-lending activities of financial intermediaries, the reduced unit administration costs arising from economies of scale in operations will tend to counteract the pressure for higher rates of interest as a result of the limited portfolio diversification implied by wholesale activities.

(6)Expectations of inflation These are likely to differ between individuals, and certainly they will vary over time within society as a whole. Thus, the nominal rates of interest acceptable to lenders for any given underlying desired real rate of interest will tend to vary both at a point in time within society, and over time.

(7)Market imperfections Concentration of financial power with individual participants in particular sectors of financial markets, or the existence of legal constraints on financial activities, may cause segmentation of markets, leading to interest rates being established which may appear to be inconsistent with the general pattern of interest rates according to normal market criteria. In addition, the lack of reliable financial information may allow interest rate structures to become distorted.

(8)Tax-treatment The tax positions of the borrower and lender, as well as tax concessions available in respect of specific forms of debt instruments, are likely to affect the structure of interest rates established.

(9)Management policy of the financial intermediary It may be the case that specific intermediaries are willing to set interest rates with the view to maintaining customer loyalty, and hence longer-term profitability or organizational stability, rather than with the aim of maximizing short-term profitability. However, the extent to which individual institutions are able to allow their interest rates to deviate from the general market levels is probably quite limited, unless, of course, the institution is willing to risk seve...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Table of Contents
• List of Tables
• List of Figures
• Preface
• Chapter One The Theoretical Basis of Financial Intermediation
• Chapter Two The Classification of Financial Intermediaries
• Chapter Three Recent Developments in the British Financial System
• Chapter Four Building Societies
• Chapter Five Finance Houses
• Chapter Six The National Savings Movement
• Chapter Seven Insurance Companies
• Chapter Eight Pension Funds
• Chapter Nine Unit Trusts
• Chapter Ten Investment Trust Companies
• Chapter Eleven The Evolution of British Financial Intermediaries Since 1970
• Chapter Twelve The Regulatory Framework
• Bibliography
• Index