The UK Financial Services Industry: Functions, Structure, and Regulation
Functions of Financial Services in the Wider Economy
Financial services perform four essential functions within a global economy, acting as the mechanism that connects savers, borrowers, and risk-takers:
Capital Movement: Providing a vehicle through which savings are protected and channelled into capital management.
Maturity Transformation: Providing a means by which savers’ desire for ready access to their capital can match borrowers’ requirements for long-term funds. This allows financial institutions to take positions with longer terms and potentially greater returns.
Risk Assumption: Allowing individuals and companies to insure against risks they do not wish to take, but which others are prepared to assume in return for payment.
Risk Dispersal: Allowing investors to disperse risk across a number of different investment products.
Short-Term Savings and Banking Mechanisms
Banks and building societies facilitate the safety and accessibility of money. While a bank protects customer money, it benefits by using those deposits to generate a return through lending.
Fractional-Reserve Banking: Banks may lend out a higher amount than they receive in deposits. Repayment liquidity often comes from the inter-bank lending market, the failure of which was a primary contributor to the $2008/09$ financial crisis.
Capital Requirements: Banks must maintain substantial capital, often held in Government bonds. Fluctuations in bond values affect the bank's available liquid capital to repay depositors.
Assets vs. Liabilities:
Asset: A bank's loan book is an income-producing asset because loans generate interest and are eventually repaid.
Liability: Deposits are considered liabilities because the bank must pay them back to the customer.
Building Societies: Historically established as ‘mutually owned’ organisations to lend money to members for house purchases. Because there are no shareholders to pay dividends to, they often provide more interest to account holders or charge less to borrowers.
Case Study: Silicon Valley Bank (SVB) Collapse ($2023$): SVB collapsed due to poor liquidity controls. It held capital in long-term Government bonds subject to high-interest-rate risk. As rates rose in $2022$, bond values fell, squeezing liquidity. A subsequent bank run by depositors led to its failure, requiring intervention by the US Federal Reserve Bank.
Government Savings and Debt Instruments
The UK Government funds its borrowing by issuing fixed-interest investments through the UK Debt Management Office (DMO) and National Savings and Investments (NS&I).
Gilts (Government Securities):
Conventional Gilts: These represent the majority of UK debt. They promise a fixed coupon (interest) rate every six months and return the nominal (face value) investment at maturity.
Index-linked Gilts: Both the nominal value and interest rate are linked to the Retail Prices Index (RPI) to protect against inflation. The Government plans to transition to the Consumer Prices Index including Housing (CPIH) for index-linking by $2030$.
Green Gilts: First issued in $2021$, these fund green projects to meet UK net-zero goals, often featuring different interest rates than conventional counterparts.
National Savings and Investments (NS&I): An institution best known for issuing Premium Bonds, used to fund Government borrowing.
Insurance and Risk Management Principles
Insurance is a means of risk transfer where the policyholder pays a premium and the insurer assumes the financial risk of loss.
Protection Needs: Individuals and companies seek protection for physical assets, earnings, profit potential, and financial transactions.
Pooling of Risk: Insurers pool relatively small premiums to create reserves. These reserves are invested to grow the value against inflation and pay out claims.
Reinsurance: When a risk is too large for a single company, it is passed to a reinsurance company for a portion of the premium. Lloyd’s of London is a preeminent specialist insurance and reinsurance market operated through underwriting syndicates.
Financial Transactions: Instead of traditional insurance policies, financial instruments called derivatives are used to offset potential losses in transactions.
Capital Markets and Long-Term Investment
Capital markets provide real growth potential and allow companies to raise funds without bank loans.
Shares (Equities): Represent a percentage ownership of a company. Investors benefit from dividends (distributed profits) and capital growth, and typically receive voting rights on key decisions.
Fixed-Interest Stocks (Bonds): Investors lend money to a company for a predefined interest payment. Interest rates are higher than bank rates to compensate for the higher risk of default.
Access: While some individuals invest directly, most access capital markets through collective schemes for savings, investments, and pensions.
UK Financial Services Structure and Infrastructure
The financial sector is composed of infrastructure, markets, firms, and authorities.
Financial Infrastructure:
Payment Systems: Include high-value wholesale systems and widely used retail systems like CHAPS, Cheque and Credit Clearing Company, Faster Payments Scheme, and BACS.
Regulators: The Bank of England oversees payment systems and clearing houses. The Payments Systems Regulator (PSR) governs the $\pounds 102$ trillion industry, though its responsibilities will be taken over by the FCA and Bank of England in March $2025$.
Financial Markets:
On-exchange: Trading of equities and derivatives via electronic or physical floors, regulated by the FCA.
Over-the-counter (OTC): No physical exchange; markets are managed by committees.
Financial Firms: Interconnected entities including the Money Market (wholesale), Capital Markets, Commodity Markets, Foreign Exchange (FX), and various insurance and investment houses.
Banking Services and Distribution of Advice
Banks and building societies offer both core and indirect services to capitalise on brand awareness.
Core Services: Current accounts (flexible but low interest), deposit accounts (less accessible, higher interest), and mortgages/loans.
Indirect Services: Portfolio management (discretionary or advisory), stockbroking (execution-only), wills and executorship, collective investments (unit trusts/OEICs), and insurance/pensions.
Advice Categories:
Independent: Considers a sufficient range of diverse retail investment products from the whole market to meet client objectives.
Restricted: Can only recommend specific products, providers, or a limited range. They cannot use the term ‘independent’.
Bancassurers: Banks that have established their own life insurance companies to provide tied or multi-tied offerings.
Global Regulation and Post-Brexit Divergence
UK regulation is influenced by international bodies and its historical relationship with the EU.
International Bodies:
Financial Stability Board (FSB): Coordinates national authorities on global financial stability.
Financial Action Task Force (FATF): Sets standards for anti-money laundering and countering terrorist financing.
Basel Committee on Banking Supervision (BCBS): Standard setter for the prudential regulation of banks.
EU Authorities: EBA (Banking), ESMA (Securities), and EIOPA (Pensions). The European Central Bank (ECB) coordinates euro-based monetary policy.
Divergence: After Brexit, the UK lost ‘passporting’ rights. While many EU rules were ‘onshored’ via the European Union (Withdrawal) Act $2018$, the UK is increasingly developing its own regimes, such as the Consumer Composite Investment (CCI) regime ($2025$).
Temporary Transitional Power (TTP): Allowed UK regulators to make transitional provisions to legislation for a temporary period following onshoring.
UK Regulatory Framework
The Treasury, under the Chancellor of the Exchequer, is the primary government department for financial regulation.
Prudential Regulation Authority (PRA): Part of the Bank of England; responsible for the authorisation and prudential supervision (solvency, capital, risk) of large firms like banks and insurers.
Financial Conduct Authority (FCA): Responsible for conduct of business and market integrity; regulates smaller firms and intermediaries.
Dual Regulation: Large firms (banks, insurers) are supervised by both the PRA (prudential) and FCA (conduct).
Solo Regulation: Smaller firms are supervised exclusively by the FCA.
Economic Policy and the Role of Government
Fiscal Policy: Concerns Government spending, borrowing, and taxation (e.g., Income Tax, VAT).
Monetary Policy: Concerns interest rates and the money supply, managed by the Bank of England’s Monetary Policy Committee (MPC).
The Monetary Policy Committee (MPC): Consists of nine members (Governor, 3 Deputy Governors, Chief Economist, and 4 external members). It meets eight times a year to set interest rates to meet the Chancellor's inflation target of $2\%$ CPI.
Quantitative Easing (QE): The Bank of England injects liquidity by buying gilts and bonds. QE reached $\pounds 895\text{bn}$ by October $2021$.
Gilt Repo Market: The primary tool for influencing short-term interest rates. The ‘repo rate’ is the interest implied by the difference between a sale and repurchase price of gilts.
Taxation and Benefit Provision
Tax Concessions: The Government encourages savings through tax breaks on ISAs, Pensions, Junior ISAs (JISAs), and specific National Savings products.
Benefits System: Provides a safety net for sickness, disability, unemployment, and retirement.
Pensions Crisis: An ageing population and declining birth rate put pressure on the State Pension. The current regime requires between $10$ and $35$ years of National Insurance contributions. State pension age is gradually increasing to manage liabilities.
Health and Social Care: The NHS is funded by general taxation. Increasing costs are leading individuals to seek private medical insurance or savings plans for long-term care.
Questions & Discussion
Q: What do banks do with the money they receive in current accounts?
A: They may place some into long-term investments and use some to provide loans to customers.
Q: What is the main purpose of a gilt?
A: To allow the Government to borrow money from investors in exchange for a fixed level of interest.
Q: Apart from physical assets, what else can be insured?
A: Earnings, profit potential, and financial transactions.
Q: How can changes in tax rates be used to manipulate the economy?
A: By changing tax benefits, the Government can encourage saving (restricting growth) or unlock capital to spend on goods (stimulating growth).
Q: Does the UK benefit system offer a sufficient safety net to avoid needing private provision?
A: Most individuals would find State benefits are at a subsistence level, significantly lower than the standards they expect.