Abstract
A financial system is made up of institutions and markets interacting in a complex manner to mobilize investment funds and provide facilities that including payment systems to finance commercial activity. Financial institutions in the system act as intermediaries between funds providers and funds seekers and where risk is transformed and managed (OECD website). The financial system of the UK is of interest to analysts globally because it underwent fundamental changes to its regulatory structure during the 1980s and is the basis on which the development of financial markets in the EU is based. Consequently, this paper will focus on the structure of the UK financial system starting off with a brief history followed by the participants of the UK financial system. Then the financial markets will be analysed next followed by the securities traded in these financial markets. The regulation of the system will then be looked at followed by the main challenges facing the UK financial system. Finally, there will be a conclusion.
1. Introduction
1.1. History
The Bank of England was founded in 1694 as a privately-owned bank taking deposits and giving loans to the private sector. Its assets, mainly government securities and notes became a widely accepted payment method from London to the British empire. It monopolized currency supply in 1833, but by 1844 the Bank Act had separated banking operations from note issuance to control the bank’s discretionary monetary policy. Other private banks opened in London in the eighteenth and early nineteenth century in response to growing commerce and industry. Country banks (outside London), building societies (savings banks) for lower income savers to allow pooling of financial resources, and clearing houses (for settling interbank claims) developed in this period.
Britain attained faster maturity financially with London as the centre of the finance industry and eventually the top international centre for financial services due to its role in the gold market and in the development of the Eurodollar market. A criterion was devised in 1979 and revised in 1987 distinguished deposit-taking institutions hence affecting measurement of aggregates like money supply. The big reform (Big Bang) of 1986 was the amendment of rules to blur the distinction between banks and near-banks, and changing the UK’s banking industry competitive structure. The Securities and Investment Board supervisory role was usurped by the Bank of England (BoE) until 1 June 1998 when the Financial Services and Markets Act of 2000 gave supervisory duties to the Financial Services Authority (FSA). The FSA was then replaced through the Financial Services Act 2012 after the 2007-2009 financial, where the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA) of the Bank of England were formed.
1.2 Size of the UK Financial System
The UK financial system has had obdurate rapid growth in recent decades and is one of the biggest with annual payments processing estimated at more than £70 trillion, which is more than 40 times the UK GDP. Bank balances of UK banks are the biggest globally approximated at 4 times the UK national income. UK GDP in 2016 was £2.6 trillion. The financial system, summing all UK financial assets (owned by banks and non-bank financial companies), stood at £20 trillion which is about twelve times the size of UK annual GDP as measured in the National Accounts. The UK financial system is bigger than the United States, France and Japan, but comparable to other countries with a historic specialisation in financial services, such as Switzerland. The largest part of the UK financial system is the banking system.
Table 1.1 below shows financial system size comparison using Broad Money as a percentage of GDP between four countries of UK, USA, Switzerland, and Japan.
Table 1.1
Source: Worldbank, Financial Indicators
2. Financial System Participants
2.1 Banks:
There are more 300 banks and more than 45 building societies in UK accepting deposits, raising capital from lenders and investors and giving loans and buying securities. UK bank sector leads in Europe and is fourth globally in size. Many foreign banks are active with UK banks performing high levels of international operations. Studies conducted before the financial crisis of 2008 by Beck & Levine (2004) find a positive correlation between size and financial stability while Arcand et al (2012) and Cecchetti et al (2011) find in their studies after the financial crisis, that there is a ceiling beyond which more financial development negatively affects economic development. Investment banks are private companies providing financial services like raising financial capital, issuing securities on clients’ behalf, in mergers and acquisitions, trade derivatives and securities. They are regulated by the PRA.
2.2 Non-bank financial intermediaries
a. Building societies
Building societies are financial institutions entirely owned by the members as mutual organisations providing banking and various financial services to the members. They specialize in savings and mortgages e.g. Nationwide Building Society.
b. Finance houses
Finance houses are financial institutions which specialize in giving instalment credit (hire purchase) to individuals or businesses, or leasing machinery etc. They operate independently but are often owned by banks. In 2017, £96 billion was in consumer credit while £32 billion went to businesses and public sector (Finance and Leasing Association website).
c. Insurance and Pension companies
The UK boasts the biggest insurance industry in Europe while coming third globally, generating a quarter of the total EU premium income, and is divided into life and non-life products. Pensions are taken up by more than 40 percent of the working population. It plays an important role in the UK economy overseeing investments in excess of £1.8 trillion while paying taxes of more than £12 billion.
d. Investment and unit trusts
Unit trusts and Open-Ended Investment Companies (OEICs) are collective investment funds where money is pooled from different investors to buy different investments including property, bonds, shares etc. Each fund contains different kinds of investments and investors own a share of the overall OEIC or unit trust. The size of the trust rises and falls depending on investors actions to buy or sell. Unit trusts are open-ended funds while investment trusts are close-ended (fixed number of units). Exchange-traded funds have features of both unit and investment trusts but only big institutional investors participate. Hedge funds are open-ended, managed in the UK but the funds are overseas. Private Equity funds are used to buy a controlling stake in firms with a view to manage them.
3. Financial Markets
Financial markets enable movement of funds between those with surplus and those with a deficit, allowing traders to buy and sell assets and trade in securities. They are as follows:
3.1 Money Market
The money market is a part of the financial market where the trading of financial instruments that are very liquid with short maturities (under a year) takes place. Only wholesale (large amounts) transactions by institutions and companies take place, but individuals can participate through the money market fund. Instruments include treasury bills which are bearer government securities representing a charge on the Consolidated Fund of the UK issued in minimum denominations of £5,000 at a discount to their face value for any period not exceeding one year (Bank of England). Other securities are the commercial paper (a short term unsecured debt instrument issued by a company to meet short term obligations) and certificates of deposit (issued to depositor by bank and paying higher interest than a savings account, promising to pay holder a given amount). Money market instruments must have: 1. A value that can be determined at any point time; and 2. A maturity at issuance of 397 days or less. They also do not include an instrument of payment.
3.2 Capital Market
A capital market means a financial market where long-term debt (longer than 365 days) or equity-backed securities are traded between those saving and companies or governments looking to make long-term investments. Governments and banks issue bonds while companies issue shares or corporate bonds while also borrowing from banks. Further sub-divisions of the capital market yield the primary market (issuance and direct sell of new securities to investors by issuer e.g. initial public offering by a company) and the secondary market (investors trade in securities that they own already increasing liquidity of the securities in the process).
The London Stock Exchange in London is the third largest in the world with a market capitalization of over £4.7 trillion. It is also one of the oldest stock exchanges tracing its roots to more than three hundred years back. It is organized into three markets as follows;
a. Main market
The Main Market is the principal market for the bigger and establishes companies. The listing and trading environment for equities and debt is world-class with access to the deep depth of European liquidity, profile and capital. The Main Market has more than 2,600 companies representing 60 countries and 40 sectors. Securities traded include ordinary shares, depositary receipts, debt and investment entities e.g. investment trusts (London stock exchange website)
b. AIM
Formerly known as the Alternative Investment Market, AIM targets small and medium-sized companies that are still growing. It has been in existence since 1995 with more than 3,600 companies operating in over 100 countries and 40 different sectors. It has over £70 billion in market capitalisation.
c. PSM
The Professional Securities Market (PSM) is a listed market in the London Stock Exchange enabling capital raising through specialist securities like depositary receipts and debt. Issuers benefit from regulatory flexibility while investors are assured by the listed securities. It is best suited to and targets non-EU companies.
3.3 Foreign Exchange Market
The foreign exchange market is a sub-market of the London Stock Exchange where buyers and sellers of different currencies trade. Exchange rates are prices at which bank deposits in one currency are exchanged for bank deposits in another currency. Banks and brokers are the two main participants in this market. Brokers provide an information system that is relied on by banks to provide rates. Foreign exchange can be traded in the spot market (orders settled instantly or within a short time) or forward market (order settled at a future date).
4. Financial Securities
A security is a financial instrument representing ownership in a publicly-traded company through stock, bond (creditor to a government organization or company), or ownership rights (option). Securities can be divided into three groups including equity securities, debt securities, and derivative securities.
4.1 Equity Security
Equity securities (shares) enable shareholders of an entity to have ownership interest through capital stock share. The holders benefit through dividends and selling the security at a profit (capital gains) assuming the share value appreciates. The holders have voting rights but in case of a bankruptcy, they only share residual interest because creditors come first.
4.1.1 Types of shares
These include: 1) Ordinary shares having no restrictions or special rights but have voting rights and are preceded by preference shareholders in dividends and capital return. Ordinary shares can be further sub-divided into classes of different nominal values etc. 2) Deferred ordinary shares enable shareholders to only get a dividend after other groups have received a minimum dividend, and they will come last in share interest in the event of a wind up. 3) Non-voting ordinary shares holders have no voting rights but are the same as ordinary shareholders in all other aspects. 4) Redeemable shares allow the entity to buy back the shares in future with the redemption price same as issue price. The company is required to also have in issue non-redeemable shares. 5) Preference shares enable holders to receive a fixed dividend amount (usually a percentage of nominal value) ahead of ordinary shareholders. They have non-voting rights but come before ordinary shareholders in case of a wind up. 6) Cumulative preference shares allow shareholders to receive missed dividends first before ordinary shareholders get residuals if any. 7) Redeemable preference shares have features of both the redeemable and preference shares.
Table 1.2 below shows S&P percentage annual change in global equity indices for selected countries:
Figure 1.2
Source: World Bank, World Development Indicators
4.2 Debt security
A debt security is a financial instrument issued by a publicly traded corporation and sold to investors representing the promise to pay until maturity or renewal date, the face value (nominal amount) and interest (coupon rate) regardless of the issuer’s financial performance. The term is fixed with no voting rights. Debt securities are lower risk and safer returns compared to other equities hence the lower interest rate. Secured debt securities are backed by collateral to reduce lending risk. Unsecured debt securities are riskier with higher interest.
4.2.1 Types of debt securities
These include: 1) Bonds, notes and medium-term notes which include government bonds (also known as gilt-edged securities or gilts), corporate bonds, retail bonds (Orb, lower minimum investment), covered bonds (backed by mortgages or public-sector loans), and zero-coupon bonds (no interest paid but traded at a discount). Bonds and notes are issued either as stand-alone, one off basis or medium-term notes (MTN) on a programme that can be repeated, 2) Commercial paper (CP) which are short-term unsecured debt securities with maturities of less than a year from the issue date, 3) Zero coupon securities which are non-interest bearing and discounted debt securities, 4) High yield securities (high yield bonds) that pay higher rates of interest due to their high-risk characteristic, 5) Asset-backed securities (ABSs) which are limited recourse debt securities backed by income generating financial assets and issued by special purpose vehicle or SPV, 6) Depositary receipts which are transferable and issued by a bank to represent publicly traded securities of a foreign corporation, 7) Sovereign bonds are government issued debt securities in domestic or foreign/international securities markets, 8) Sukuk is a debt instrument that does not bear interest as it is structured to conform to Shariah law, 9) Project bonds used to fund projects, 10) Retail bonds which target retail investors and are in small denominations, 11) Green bonds target funding environmentally sustainable projects, 11) Private placements securities are direct to pre-selected institutions, and 12) Mini-bonds issued by small and medium-sized companies that do not meet the amount threshold required by law.
5. Regulation of UK financial system
The government of Margaret Thatcher is credited with commencing the financial markets deregulation process in 1986 where he introduced the Big Bang policy. The Big Bang policy was successfully introduced to stop the decline of London as a global financial powerhouse with the 1997 Labour government expanding the policy. However, the financial crisis of 2008-2009 exposed the weaknesses of existing policies leading to the adoption of the Financial Services Act (2012) in the UK, which empowered the Bank of England (BoE)to regulate the financial system. It formed the Prudential Regulation Authority (PRA) which is a subsidiary of the BoE, and the Financial Conduct Authority (FCA). The FPC or Financial Prudence Committee focuses on macroprudential regulation while the PRA and FCA focus on micro-prudential regulation. Macroprudential regulation regulates financial system stability by the identity, monitoring and action taking to minimize/eliminate risk. Micro prudential regulation on the other hand identifies, monitors and manages risks relating to individual firms.
5.1 The Financial Policy Committee (FPC)
The interim FPC started in 2011 but the establishment wasn’t until 1st April 2013 where it was primarily tasked with identifying, monitoring and taking necessary action to eliminate or minimize UK financial system risks, and increase system resilience to shocks like the one experienced in the global financial crisis 0f 2008-2009. The FPC secondary task was supporting government economic policy. Its powers include directing the PRA and FCA and making compliance or explanation recommendations to the two authorities including government.
5.2 The Prudential Regulation Authority (PRA)
The PRA sets the standards for and supervises banks, credit unions, building societies, investment firms and insurance companies at the firm level. It may set capital and liquidity ratios to be maintained to ensure soundness of individual financial firms to enhance stability levels of the UK financial system.
5.3 The Financial Conduct Authority (FCA)
The FCA sets rules, investigates and enforces regulation in the financial services industry through promoting competition among the players and consumer protection. This leads to a financial system that is resilient and stable.
6. Challenges
6.1 Cybercrime
Cybercrime poses a risk to the UK financial system where highly sensitive commercial data is stored. The 2012 and 2015 Royal Bank of Scotland IT failures attributed to software error, and the 2017 ransomware that paralysed the NHS operations through blocking staff access to patient information on computers, are UK examples. Financial institutions heavy reliance on technology widely used is a weakness for potential cyber criminals who have become sophisticated by the day. The FCA is confronting this challenge through establishing Cyber Coordination Groups and partnering with other countries in information sharing regarding the issue of cybercrime.
6.2 Financial Technology (FinTech)
The intersection between finance and technology refers to innovative technology that improves, or disrupts the current, customer experience in financial services. Given the enormous growth in its popularity, the UK government has adopted its policy to attract and market the developers of such financial technologies to protect global position. Since FinTech is still in its formative stages globally, there is a challenge in the regulation of its products and services, which puts the UK financial system at risk. This exposes the dilemma between compliance and innovation.
The FCA’s ‘Project Innovate’, supports innovative firms success through authorisation processing and informing on regulatory requirements. The ‘Regulatory Sandbox’, under Project Innovate, allows approved firms to test the operation and regulatory compliance of their innovations in real life before they can be released to the consumer, safeguarding safety of the UK financial system. The BoE operates the ‘Fintech Accelerator’ but it operates at a lower level to FinTech. Regulation Technology (RegTech) reduces the cost of compliance by providing technology that makes the process faster under close supervision by FCA.
Conclusion
A survey by the Bank of England into the biggest risk to the UK financial system showed 91 percent of respondents ranking the current political climate in the country (Brexit) top. The threat of cybercrime and regulation of technological innovations cannot be ignored either. Furthermore, previous research shows that the size of the system makes it more vulnerable to collapse in the event of another financial crisis due to the complex level of interconnectivity among banks. There is need for further study on existing policies by looking at the evolution of the financial system long term through simulation and modelling.
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2.04.2018