CISI Introduction to Securities & Investment Study Book PDF 2024

Investment Operations Certificate Introduction to Securities & Investment Edition 40, April 2024 This workbook relates to syllabus version 24.0 and will cover exams from 1 August 2024 to 31 July 2025 Welcome to the Chartered Institute for Securities & Investment’s Introduction to Securities & Investment study material. This workbook has been written to prepare you for the Chartered Institute for Securities & Investment’s Introduction to Securities & Investment examination. Published by: Chartered Institute for Securities & Investment © Chartered Institute for Securities & Investment 2024 20 Fenchurch Street, London EC3M 3BY, United Kingdom Tel: +44 20 7645 0600 Fax: +44 20 7645 0601 Email: [email protected] www.cisi.org/qualifications Author: Dianne Ramdeen, MSc, FCCA, CFA, MCSI Reviewers: JB Beckett, Chartered MCSI Kevin Rothwell, FCSI This is an educational workbook only and the Chartered Institute for Securities & Investment accepts no responsibility for persons undertaking trading or investments in whatever form. While every effort has been made to ensure its accuracy, no responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication can be accepted by the publisher or authors. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise without the prior permission of the copyright owner. Warning: any unauthorised act in relation to all or any part of the material in this publication may result in both a civil claim for damages and criminal prosecution. Candidates should be aware that the laws mentioned in this workbook may not always apply to Scotland. A learning map, which contains the full syllabus, appears at the end of this workbook. The syllabus can also be viewed on cisi.org and is also available by contacting the Customer Support Centre on +44 20 7645 0777. Please note that the examination is based upon the syllabus. Candidates are reminded to check the Candidate Update area details (cisi.org/candidateupdate) on a regular basis for updates as a result of industry change(s) that could affect their examination. The questions contained in this workbook are designed as an aid to revision of different areas of the syllabus and to help you consolidate your learning chapter by chapter. Please note that, as part of exam security, hand-held calculators are not allowed in CISI exam venues. Candidates must use the onscreen calculator for all CISI CBT exams in all languages in the UK and internationally. Workbook version: 40.1 (April 2024) ii Important – Keep Informed on Changes to this Workbook and Examination Dates Changes in industry practice, economic conditions, legislation/regulations, technology and various other factors mean that practitioners must ensure that their knowledge is up to date. At the time of publication, the content of this workbook is approved as suitable for examinations taken during the period specified. However, changes affecting the industry may either prompt or postpone the publication of an updated version. It should be noted that the current version of a workbook will always supersede the content of those issued previously. Keep informed on the publication of new workbooks and any changes to examination dates by regularly checking the CISI’s website: cisi.org/candidateupdate Learning and Professional Development with the CISI The Chartered Institute for Securities & Investment is the leading professional body for those who work in, or aspire to work in, the investment sector, and we are passionately committed to enhancing knowledge, skills and integrity – the three pillars of professionalism at the heart of our Chartered body. CISI examinations are used extensively by firms to meet the requirements of government regulators. Besides the regulators in the UK, where the CISI head office is based, CISI examinations are recognised by a wide range of governments and their regulators, from Singapore to Dubai and the US. Around 50,000 examinations are taken each year, and it is compulsory for candidates to use CISI workbooks to prepare for CISI examinations so that they have the best chance of success. Our workbooks are normally revised every year by experts who themselves work in the industry and also by our Accredited Training Partners, who offer training and elearning to help prepare candidates for the examinations. Information for candidates is also posted on a special area of our website: cisi.org/candidateupdate. This workbook not only provides a thorough preparation for the examination it refers to, it is also a valuable desktop reference for practitioners, and studying from it counts towards your Continuing Professional Development (CPD). Mock examination papers, for most of our titles, will be made available on our website, as an additional revision tool. CISI examination candidates are automatically registered, without additional charge, as student members for one year (should they not be members of the CISI already), and this enables you to use a vast range of online resources, including CISI TV, free of any additional charge. The CISI has more than 40,000 members, and nearly half of them have already completed relevant qualifications and transferred to a core membership grade. You will find more information about the next steps for this at the end of this workbook. iii iv Introduction: The Financial Services Sector................. 1 1 The workbook commences with an introduction to the financial services sector and examines the role of the sector and the main participants that are seen in financial centres around the globe. The Economic Environment........................... 19 2 An appreciation of some key aspects of macroeconomics is essential to an understanding of the environment in which investment services are delivered. This chapter looks at some key measures of economic data and the role of central banks in management of the economy. Equities....................................... 41 3 The workbook then moves on to examine some of the main asset classes in detail, starting with equities. It begins with the features, benefits and risks of owning shares or stocks, looks at corporate actions and some of the main world stock markets and indices, and outlines the methods by which shares are traded and settled. Bonds........................................ 75 4 A review of bonds follows which includes looking at the key characteristics and types of government and corporate bonds and the risks and returns associated with them. Other Markets and Investments........................ 93 5 This chapter starts the review of financial assets and markets by looking at the characteristics of cash deposits, the money markets, property and the foreign exchange markets. Derivatives..................................... 109 6 Next there is a brief review of derivatives to provide an understanding of the key features of futures, options and swaps and the terminology associated with them. Investment Funds................................. 125 7 The workbook then turns to the major area of investment funds or mutual funds/ collective investment schemes. The chapter looks at open-ended and closed-ended funds, exchange-traded funds and hedge funds, and how they are traded. v Financial Services Regulation and Professional Integrity......... 151 8 An understanding of regulation is essential in today’s investment industry. This chapter provides an overview of international regulation and looks at specific areas such as money laundering, insider trading and bribery, as well as a section on professional integrity and ethics. Taxation, Investment Wrappers and Trusts................. 173 9 Having reviewed the essential regulations covering the provision of financial services, the workbook then moves on to look at the main types of investment wrappers seen in the UK, including ISAs and pensions, and also looks at the principles of taxation and the use of trusts. Other Financial Products............................. 191 10 This chapter reviews other types of financial products which are available, including loans, mortgages and protection products, such as life assurance. Financial Advice.................................. 205 11 The workbook concludes with a look at the main areas of financial advice, the financial advice process and the legal concepts. Glossary Multiple Choice Questions Syllabus Learning Map It is estimated that this workbook will require approximately 80 hours of study time. What next? See the back of this book for details of CISI membership. Need more support to pass your exam? See our section on Accredited Training Partners. Want to leave feedback? Please email your comments to [email protected] vi Chapter One Introduction: The Financial Services Sector 1. Introduction 3 2. Professional and Retail Business 3 3. Participants 8 4. Investment Distribution Channels 14 This syllabus area will provide approximately 3 of the 50 examination questions 1 2 Introduction: The Financial Services Sector 1. Introduction 1 The financial services sector significantly contributes to the economies of developed countries, such as the UK, providing employment and overseas earnings. It serves as a crucial link between organisations seeking capital and those with available investment funds, offering execution, payment, advisory and management services. This chapter will explore the core role of the financial services sector within the economy and key features of the global financial services sector, considering its importance and evolving landscape. 2. Professional and Retail Business Learning Objective 1.1.2 Know the function of and differences between retail and professional business and who the main customers are in each case Within the financial services sector, there are two distinct areas: the wholesale and retail sectors. The wholesale sector is also sometimes referred to as the professional sector or the institutional sector. The activities that take place in wholesale financial markets are shown below and are expanded on in sections 2.1 to 2.5. The financial activities that make up the wholesale/ professional sector include: equity markets – the trading of quoted or listed shares bond markets – the trading of government, supranational or corporate debt foreign exchange – the trading of currencies 3 derivatives – the trading of options, swaps, futures and forwards, and insurance markets – major corporate insurance (including professional indemnity), reinsurance, captive insurance and risk-sharing insurance. Other activities that take place in the wholesale sector include: fund management – managing the invest ment portfolios of collective investment schemes, pension funds and insurance funds investment banking – banking services tailored to organisations, eg, undertaking mergers and acquisitions (M&A), equity trading, fixed-income trading and private equity, and custodian banking – provision of services to asset managers involving the safekeeping of assets; the administration of the underlying investments; settlement; corporate actions and other specialised activities. By contrast, the retail sector focuses on services provided to personal customers: retail banking – the traditional range of current accounts, deposit accounts, lending and credit cards insurance – the provision of a range of life assurance and protection solutions for areas such as medical insurance, critical illness cover, motor insurance, property insurance, income protection and mortgage protection pensions – the provision of investment accounts specifically designed to capture savings during a person’s working life and provide benefits on retirement investment services – a range of investment products and vehicles ranging from execution-only stockbroking to full wealth management services and private banking, and financial planning and financial advice – helping individuals to understand and plan for their financial future. 2.1 Equity Markets Equity markets, also known as stock markets, are a significant part of the global financial system. These markets serve as platforms for buying and selling ownership interests known as ‘shares’ or ‘stocks’ in publicly traded companies. Equity markets enable companies to raise capital by selling shares to investors. Investors, in turn, become partial owners of the company and may benefit from potential profits through capital appreciation and dividends. Participants in equity markets include individual investors, institutional investors (such as insurance companies, pension funds, asset managers and exchange-traded funds (ETFs)), traders, and market makers. The collective actions of these participants determine share prices of listed companies. Generally, share prices are influenced by various factors, including company performance, economic indicators, geopolitical events and investor sentiment. Supply and demand dynamics determine the value of shares in real time. Equity markets operate on organised exchanges, such as the New York Stock Exchange (NYSE) or the NASDAQ in the United States, the London Stock Exchange (LSE) in the UK, and many others worldwide. Exchanges provide a regulated environment for buying and selling securities. 4 Introduction: The Financial Services Sector Benchmark indices, like the S&P 500, Dow Jones Industrial Average (DJIA), or FTSE 100, track the 1 performance of a representative basket of shares. These indices provide insights into overall market trends and are used as performance benchmarks as well as the basis for the strategy underpinning index-tracking funds. Equity markets serve several functions, including capital allocation, price discovery and liquidity provision. They facilitate the transfer of ownership in companies, allowing investors to buy and sell shares based on market demand. Equity markets are subject to strict regulatory oversight to ensure fair and transparent trading. Regulatory bodies, such as the US Securities and Exchange Commission (SEC) or the Financial Conduct Authority (FCA) in the UK, establish rules and monitor market activities. Technological advancements have transformed equity markets, with electronic trading platforms and algorithmic trading becoming prevalent. These innovations have increased efficiency and reduced transaction costs. Equity markets are globally interconnected, allowing investors to trade stocks listed on exchanges around the world. Globalisation has increased cross-border investments and created a more interconnected financial ecosystem. Rivals to traditional stock exchanges have also arisen with the development of technology and communication networks known as multilateral trading facilities (MTFs). MTFs are systems that bring together multiple parties that are interested in buying and selling financial instruments including shares, bonds and derivatives. These systems are also known as crossing networks or matching engines that are operated by an investment firm or another market operator. We will look at equities and equity markets in more detail in chapter 3. 2.2 Bond Markets Bond markets, also known as fixed-income markets, represent that segment of the global financial system where debt instruments are bought and sold. Bond markets, therefore, provide a platform for the issuance and trading of debt securities. Governments, companies and other entities such as supranational agencies issue bonds to raise capital. Investors, seeking a combination of income and capital preservation, participate in bond markets. The dynamics of bond markets are shaped by factors such as interest rates, economic conditions and credit risk, influencing the pricing and performance of bond instruments. In this context, regulatory bodies, such as the International Capital Market Association (ICMA), play a crucial role in establishing guidelines and overseeing market activities to ensure fairness and transparency. We will look at bonds in more detail in chapter 4. 5 2.3 Foreign Exchange (FX or Forex) Markets Foreign exchange (FX or Forex) markets facilitate the exchange of one currency for another, determining exchange rates that reflect the relative value of different currencies. Participants engage in forex trading for various purposes, including international trade, investment, speculation and risk management. The diverse array of participants in forex markets includes central banks, commercial banks, institutional investors, companies and governments. Each brings unique motivations and perspectives, contributing to the liquidity and efficiency of the market. Forex markets operate in a decentralised manner, with no central exchange. Instead, trading occurs electronically over-the-counter (OTC), with a network of interconnected banks and financial institutions facilitating transactions 24 hours a day, five days a week. Currencies are traded in pairs, where one currency is exchanged for another. Major currency pairs, such as EUR/USD and USD/JPY, involve the most widely-used currencies, while minor and ‘exotic’ pairs involve currencies from smaller economies. Exchange rates, the relative values of currencies, fluctuate based on supply and demand dynamics. Factors influencing exchange rates include economic indicators, geopolitical events, interest rates and market sentiment. Forex markets are known for their high liquidity, allowing participants to buy and sell currencies with ease. Major currency pairs, characterised by significant trading volumes, offer tight bid-ask spreads, reducing transaction costs. Participants may engage in forex trading for speculative purposes, seeking to profit from currency price movements. Additionally, businesses and investors use forex markets for hedging, managing the risks associated with currency fluctuations. Central banks may intervene in forex markets to stabilise or influence their domestic currencies. Such interventions can involve buying or selling currencies to achieve specific economic objectives. Technological advancements have transformed forex trading, with electronic platforms providing real-time quotes, advanced charting tools and algorithmic trading capabilities. This has democratised access, allowing retail traders to participate alongside institutional players. We will look at FX in more detail in chapter 5. 2.4 Derivatives Markets Derivatives markets trade a range of complex products based on underlying instruments that include currencies, indices, interest rates, equities, commodities and credit risk. Futures and options are two of the most well-known derivatives. Derivatives based on these underlying elements are available on both the exchange-traded market and the OTC market (see chapter 6, section 1.1). The largest of the exchange-traded derivatives markets is the Chicago Mercantile Exchange (CME), while Europe dominates trading in the OTC derivatives markets worldwide. 6 Introduction: The Financial Services Sector Interest rate derivatives contracts account for the vast majority of outstanding derivatives contracts, 1 mostly through interest rate swaps. In terms of currencies, the interest rate derivatives market is dominated by the euro and the US dollar, which have accounted for most of the growth in this market since 2001. The growth in the market came about as a reaction to the 2000–02 stock market crash as traders sought to hedge their position against interest rate risk. We will look in more detail at derivatives in chapter 6. 2.5 Insurance Markets Insurance markets specialise in the management of risk. The market is led by a number of major players who dominate insurance activity in their sector or region; some of the largest are China Life, Allianz and AXA. Another well-known organisation is Lloyd’s (the world’s specialist insurance market and often referred to as Lloyd’s of London); with a history dating back over 300 years, it is one of the largest insurance organisations in the world. It is not an insurance company but a marketplace that brings together a range of insurers, both individuals and companies, each of whom accepts insurance risks as a member of one or more underwriting syndicates. A small number of individual members (traditionally known as ‘names’) are liable to the full extent of their private wealth to meet their insurance commitments, while the corporate entities trade with limited liability. Lloyd’s names join together in syndicates and each syndicate will ‘write insurance’, ie, take on all or part of an insurance risk. There are many syndicates, and each name will belong to one or a number of these. Each syndicate hopes that premiums received will exceed claims paid out, in which case each name will receive a share of profits (after deducting administration expenses). Lloyd’s insures specialist and complex risks in casualty, property, energy, motor, aviation, marine and reinsurance. It has a reputation for innovation (for example, developing policies for aviation, burglary and cybercrime) and is known across the world as the place to bring unusual, specialist and complicated risks. Less well known to the general public is the reinsurance industry. Just as individuals use insurance to protect against the risk of needing to make a claim, insurers protect themselves by using reinsurance companies. An insurer may seek to hedge some of the risks associated with the insurance policies it has written by laying off some of that risk with a reinsurer. The reinsurance contract can cover an entire insurance portfolio or single risks; it may involve sharing all premiums and losses or just those exceeding a threshold, and it can also cover large one-off risks, such as major construction, satellites or large sporting events. Some of the largest reinsurers in the world are Munich Re, Swiss Re, Hannover Re, Berkshire Hathaway and Lloyd’s of London. 7 3. Participants Learning Objective 1.1.1 Know the role of the following within the financial services sector: retail banks; savings institutions; investment banks; pension funds; insurance companies; fund managers; stockbrokers; custodians; platforms; third-party administrators (TPAs); industry trade and professional bodies; peer-to-peer (P2P)/crowdfunding The following sections provide descriptions of some of the main participants in the financial services sector. 3.1 Retail Banks Retail banks (or high street banks) provide services such as taking deposits from and lending funds to retail customers, as well as providing payment and money transmission services. They may also provide similar services to business customers. Historically, these banks have tended to operate through a network of branches located on the high street, although we have seen a rising number of branch closures in recent years as an increasing number of customers move to online banking. As well as providing traditional banking services, larger retail banks also offer other financial products such as investments, pensions and insurance. 3.2 Savings Institutions As well as retail banks, most countries also have savings institutions. Savings institutions originally specialised in offering savings products to retail customers but now tend to offer a similar range of services to those offered by banks. In the UK, they are usually known as building societies. They were established in the 19th century when small numbers of people would group together and pool their savings, allowing some members to build or buy houses. Building societies are jointly owned by the individuals who have deposited money with or borrowed money from them – the ‘members’. It is for this reason that such savings organisations are often described as ‘mutual societies’. Over the years, many smaller building societies have merged or been taken over by larger ones or banks. In the late 1980s, legislation was introduced allowing building societies to become companies – a process known as ‘demutualisation’. Some large building societies remain as mutuals, such as the Nationwide Building Society. They continue to specialise in services for retail customers, especially the provision of deposit accounts and mortgages. 8 Introduction: The Financial Services Sector Another UK example is National Savings & Investment (NS&I) which is the largest single savings organisation in the UK and can trace its origins back over 150 years. It offers a range of savings products, 1 including premium savings bonds and national savings certificates, as well as traditional savings products. It is operated by the government and so, when customers invest in NS&I products, they are lending to the government. In return, the government pays interest or prizes for premium bonds and offers 100% security on all deposits. More recently, competition to traditional banks has emerged from ‘challenger banks’. These are smaller banks, specialising in areas underserved by large, traditional banks, and which distinguish themselves from historic banking by deploying modern financial technology with no community branches. 3.3 Peer-to-Peer (P2P) and Crowdfunding A more recent development in the banking industry has been the emergence of competitors to the traditional role of banks in the form of peer-to-peer (P2P) lending or crowdfunding. In the traditional banking model, banks take in deposits on which they pay interest and then lend out at a higher rate. The spread between the two is where they earn their profit. P2P lending cuts out the banks, so borrowers often get slightly lower rates, while savers get far improved headline rates, with the P2P firms themselves profiting via a fee. In exchange for accepting greater risk, savers can earn higher returns which can be very useful in periods of low interest rates. Available rates vary depending on the type of borrower that the P2P site lends to and the risk the lender is prepared to accept. The deposit is lent out to individuals and businesses, but it may take time before all of a large deposit is lent and interest is earned. No interest is paid while it is waiting to be lent out. Immediate withdrawals are not always possible and, where they are, may take time and incur a charge or a reduced interest rate. Since April 2016, an Innovative Finance Individual Savings Account (ISA) has been available as an investment option so that the P2P deposit can be sheltered in a tax-free wrapper. Crowdfunding is the practice of funding a project or venture by raising small amounts of money from a large number of people. Traditionally, financing a business, project or venture involved asking a few people for large sums of money. Crowdfunding switches this idea around, using the internet to access many potential funders. Crowdfunding can take the following forms: A donation – people simply believe in the cause or innovation. Debt crowdfunding – investors receive their money back with interest. Equity crowdfunding – people invest in exchange for equity or shares in the venture. 3.4 Investment Banks Investment banks provide advice and arrange finance for companies that want to float on a stock market, raise additional finance by issuing further shares or bonds, and carry out mergers and acquisitions. They also provide services for those who might want to invest in shares and bonds, for example, pension funds and asset managers. 9 Typically, an investment banking group provides some or all of the following services, either in divisions of the bank or in associated companies within the group: Corporate finance and advisory work, normally in connection with new issues of securities for raising finance, takeovers, mergers and acquisitions. Banking for governments, institutions and companies. Treasury dealing for corporate clients in foreign currencies, with financial engineering services to protect them from interest rate and exchange rate fluctuations. Investment management for sizeable investors, such as corporate pension funds, charities and high net worth private clients. This may be either via direct investment for the wealthier, or by way of collective investment schemes (CISs) (see chapter 7). In larger firms, the value of funds under management runs into many billions of pounds. Securities trading in equities, bonds and derivatives, and the provision of broking and distribution facilities. Only a few investment banks provide services in all these areas. Most others tend to specialise to some degree and concentrate on only a few product lines. A number of banks have diversified their range of activities by developing businesses such as proprietary trading, servicing hedge funds, or making private equity investments. 3.5 Pension Funds Pension funds are one of the key ways by which individuals can make provision for retirement. There is a variety of pension schemes available, ranging from those provided by employers to self-directed schemes. Pension funds are large, long-term investors in shares, bonds and cash. Some also invest in physical assets, like property. To meet their aim of providing a pension on retirement, the sums of money invested in pensions are substantial. 3.6 Insurance Companies One of the key functions of the financial services sector is to ensure risks are managed effectively. The insurance industry provides solutions for much more than the standard areas of life and general insurance cover. Protection planning is a key area of financial advice, and the insurance industry offers a wide range of products to meet many potential scenarios. These products range from payment protection policies designed to pay out in the event that an individual is unable to meet repayments on loans and mortgages, to fleet insurance against the risk of an airline’s planes crashing (see chapter 10 for examples of further types of products offered). Insurance companies collect premiums in exchange for the cover provided. This premium income is used to buy investments such as shares and bonds and as a result, the insurance industry is a major player in the stock market. Insurance companies will subsequently realise these investments to pay any claims that may arise on the various policies. The UK insurance industry is the largest in Europe and the fourth largest in the world after the US, China and Japan. 10 Introduction: The Financial Services Sector 3.7 Fund Managers 1 Fund management is the professional management of investment portfolios for a variety of institutions and private investors. The UK is the largest centre for fund management in Europe, second in size globally only to the US. The fund management industry in the UK serves a large number of domestic and overseas clients and attracts significant overseas funds. London is the leading international centre for fund management. Fund managers, also known as investment or asset managers, run portfolios of investments for others. They invest money held by institutions, such as pension funds and insurance companies, as well as for collective investment schemes (CISs), such as unit trusts and open-ended investment companies (OEICs) for wealthier individuals. Some are organisations that focus solely on this activity; others are divisions of larger entities, such as insurance companies or banks. Fund management is also known as asset management or investment management. Investment managers who buy and sell shares, bonds and other assets in order to increase the value of their clients’ portfolios can conveniently be subdivided into institutional and private client fund managers. Institutional fund managers work on behalf of institutions, for example, investing money for a company’s pension fund or an insurance company’s fund, or managing the investments in a unit trust. Private client fund managers invest the money of relatively wealthy individuals. Institutional portfolios are, unsurprisingly, usually larger than those of regular private clients. Fund managers charge their clients for managing their money; their charges are often based on a small percentage of the value of the fund being managed. Other areas of fund management include the provision of investment management services to institutional entities, such as companies, charities and local government authorities. 3.8 Stockbrokers and Wealth Managers Traditionally, stockbrokers arranged trades in financial instruments on behalf of their clients, which include investment institutions, fund managers and private clients. Today, most of these are institutional brokers who make their money by using their discretion and skill to execute large trades in the market. Others are execution-only brokers (see section 4.3) that offer trading services to retail clients. These firms earn their profits by charging commissions on transactions. Stockbrokers also advised investors about which shares, bonds or funds they should buy and the services offered expanded to include investment management services and wealth management. As a result, many stockbrokers now offer a range of wealth management services to their clients and so are referred to as wealth managers. These wealth management firms can be independent companies, but some are divisions of larger entities, such as investment or commercial banks. They earn their profits by charging fees for their advice and commissions on transactions. Also, like fund managers, they may look after client assets and charge custody and portfolio management fees. 11 3.9 Custodian Banks Custodians are banks that specialise in safe custody services, looking after portfolios of shares and bonds on behalf of others, such as fund managers, pension funds and insurance companies. The core activities they undertake include: holding assets in safekeeping, such as equities and bonds arranging settlement of any purchases and sales of securities processing corporate actions, including collecting income from assets, namely dividends in the case of equities and interest in the case of bonds providing information on the underlying companies and their annual general meetings (AGMs) managing cash transactions performing foreign exchange transactions when required, and providing regular reporting on all their activities to their clients. Competition has driven down the charges that a custodian can make for its traditional custody services and has resulted in consolidation within the industry. The custody business is now dominated by a small number of global custodians, which are often divisions of investment banks. 3.10 Platforms Platforms are online services used by intermediaries, such as independent financial advisers (IFAs), to view and administer their clients’ investment portfolios. They offer a range of tools which allow advisers to see and analyse a client’s overall portfolio and to choose products for them. As well as providing facilities for investments to be bought and sold, platforms generally arrange custody for clients’ assets. Examples of platforms include those offered by Cofunds and Hargreaves Lansdown. The term ‘platform’ refers to both wraps and fund supermarkets. These are similar, but while fund supermarkets tend to offer wide ranges of unit trusts and OEICs, wraps often offer greater access to other products too, such as ISAs, pension plans and insurance bonds. Wrap accounts enable advisers to take a holistic view of the various assets that a client has in a variety of accounts. Advisers also benefit from using wrap accounts to simplify and bring some level of automation to their back office using internet technology. Platform providers also make their services available direct to investors, and platforms earn their income by charging for their services. The advantage of platforms for fund management groups is the ability of the platform to distribute their products to financial advisers. 12 Introduction: The Financial Services Sector 3.11 Third-Party Administrators (TPAs) 1 Third-party administrators (TPAs) undertake investment administration on behalf of other firms and specialise in this area of the investment industry. The number of TPA firms and the scale of their operations has grown with the increasing use of outsourcing. The rationale behind outsourcing is that it enables a firm to focus on the core areas of its business (for example, investment management and stock selection, or the provision of appropriate financial planning) and fix its costs, and leaves a specialist firm to carry out the administrative functions, which it can process more efficiently and cost effectively. 3.12 Trade and Professional Bodies The investment industry is a dynamic, rapidly-changing business, and one that requires cooperation between firms; this ensures that the views of various industry sections are represented, especially to government and regulators. The industry also facilitates and enables cross-firm developments to take place to create an efficient market in which the firms can operate. This is essentially the role of the numerous professional and trade bodies that exist across the world’s financial markets. Some examples of such bodies include the following: Bonds – International Capital Market Association (ICMA). Derivatives – FIA Europe; International Swaps and Derivatives Association (ISDA). Fund managers – Investment Association (IA). Insurance companies – Association of British Insurers (ABI). Wealth management – Personal Investment Management and Financial Advice Association (PIMFA, formerly the Wealth Management Association (WMA)). Banks – UK Finance represents nearly 300 of the leading firms providing finance, banking, markets and payments-related services in, or from, the UK. UK Finance has been created by combining most of the activities of the Asset Based Finance Association, the British Bankers’ Association, the Council of Mortgage Lenders, Financial Fraud Action UK, Payments UK and the UK Cards Association. Investment funds – the Tax Incentivised Savings Association (TISA) is an industry-funded body working to improve savings and investment schemes available to UK citizens; the Depositary and Trustee Association (DATA) represents the industry views of depositaries of open-ended investment companies (OEICs) and trustees of unit trusts within the UK. 13 4. Investment Distribution Channels Learning Objective 1.1.3 Know the role of the following investment distribution channels: independent financial adviser; restricted advice; execution-only; robo-advice 1.1.4 Know about the following themes: Fintech; environmental, social, and governance (ESG) 4.1 Financial Planning Financial planning is a professional service available to individuals, their families, and businesses who need objective assistance in organising their financial affairs to achieve their financial and life style objectives more easily. Financial planning is clearly about financial matters, so it deals with money and assets that have monetary value. Invariably this will involve looking at the current value of clients’ bank balances, any loans, investments and other assets. It is also about planning, ie, defining, quantifying and qualifying goals and objectives and then working out how those goals and objectives can be achieved. In order to do this, it is vital that a client’s current financial status is known in detail. Financial planning is ultimately about meeting a client’s financial and life style objectives, not the adviser’s objectives. Any advice should be relevant to the goals and objectives agreed. Financial planning plays a significant role in helping individuals get the most out of their money. Careful planning can help individuals define their goals and objectives, and work out how these may be achieved in the future using available resources. Financial planning can look at all aspects of an individual’s financial situation and may include tax planning, both during lifetime and on death, asset management, debt management, retirement planning and personal risk management – protecting income and capital in the event of illness and providing for dependants on death. The Chartered Institute for Securities & Investment (CISI) offers qualifications and related products at all levels for those working in, or looking for a career in, financial planning. Further details can be found on the CISI’s website (www.cisi.org). 4.2 Financial Advisers Financial advisers are professionals who offer advice on financial matters to their clients. Some recommend suitable financial products from the whole of the market and others from a narrower range of products. Typically, a financial adviser will conduct a detailed survey of a client’s financial position, preferences and objectives; this is sometimes known as a fact-find. The adviser will then suggest appropriate action to meet the client’s objectives and, if necessary, recommend a suitable financial product to match the client’s needs. 14 Introduction: The Financial Services Sector Investment firms must now clearly describe their services as either independent advice or restricted 1 advice. Firms that describe their advice as independent will have to ensure that they genuinely do make their recommendations based on comprehensive and fair analysis of all products available in the market, and provide unbiased, unrestricted advice. If a firm chooses to only give advice on its own range of products – restricted advice – this will have to be made clear. Their activities are supervised by the FCA. 4.3 Execution-Only In the UK, the practice of execution-only services within the financial sector operates under the regulatory framework set by the FCA. This approach places a significant responsibility on both financial firms and customers, emphasising transparency and accountability in investment decisions. Execution-only services occur when a customer instructs a financial firm to buy or sell a specific investment product without seeking prior advice from the firm. In essence, the customer independently decides on the investment without the firm’s advisory input. Crucially, in execution-only transactions, the client bears the responsibility for assessing the suitability of the chosen investment product. Unlike advised services where the firm provides guidance, an execution-only transaction puts the onus on the client to make an informed decision regarding the product’s suitability based on their own understanding and risk tolerance. To operate within regulatory guidelines, financial firms providing execution-only services must adhere to specific rules set by the FCA. The firm is obligated to do the following: Give no advice – Clearly communicate that no advice is being provided during the transaction. This ensures that customers are aware that the firm’s role is limited to executing the trade and does not involve offering guidance or recommendations. Make suitability clear – Explicitly state that the firm is not responsible for assessing the suitability of the chosen investment product. This disclosure is essential for managing customer expectations and safeguarding against misunderstandings regarding the nature of the service. In line with regulatory requirements, financial firms engaging in execution-only services must maintain thorough documentation. This includes written evidence that the firm provided no advice and made it explicitly clear that it was not responsible for assessing the product’s suitability. This record-keeping is a vital aspect of compliance, ensuring transparency and accountability in the event of regulatory scrutiny. 4.4 Robo-Advice Robo-advice is the application of technology to the process of providing financial advice, but without the involvement of a financial adviser. A prospective investor enters data and financial information about themselves, and the system then uses an algorithm to score the information and decide what investments should be chosen. The system then presents the investment strategy, which is usually passively focused around index funds or ETFs, and allows easy implementation. 15 Robo-advice can be fully automated or provide guidance and tools to enable investors to choose their own solutions. The approach uses an asset and risk model, as well as the construction of risk-targeted portfolios or funds to achieve a client’s objectives, and then the ongoing monitoring and rebalancing against those objectives. Robo-advice is already established in the US, with some of the industry’s largest players involved. More providers are coming online in the UK to fill the gaps in the advice market and, particularly, for pensions planning as a result of major changes to how pension benefits can be taken (see chapter 9, section 4.2). 4.5 Financial Technology – Fintech Financial technology, or Fintech, refers to the use of technology to enhance and deliver superior financial service product offerings. The term describes a variety of financial activities; at its most basic, we see and use Fintech in our daily lives in the form of internet banking or more recently mobile pay. It is worth noting the importance that this development played during the coronavirus (COVID-19) pandemic, when many retail outlets were only accepting contactless payment. The emergence of Fintech has seen global financial firms rebrand their offering from that of a purely financial firm to one that offers a product via the most technologically advanced methods. This is important not only in terms of keeping pace with an ever-changing market but also in terms of winning new business and being the first to market with new product offerings. Fintech can be utilised by organisations in many ways including data collection, faster client onboarding, data aggregation in portfolio construction and real-time pricing updates to name a few. In 2015–16, the Financial Planning Standards Board (FPSB) examined how the advent of Fintech platforms and tools and automated advice could shape the future of financial planning. Initially there was trepidation among those financial professionals surveyed, however, a year later the response was more favourable and Fintech was emerging as a trend which complimented existing service and product offerings. 16 Introduction: The Financial Services Sector In 2019, the Department for International Trade and the HM Treasury published the ‘UK FinTech: State 1 of the Nation’, a comprehensive summary of the UK’s Fintech industry. The document highlights the UK Market as a forerunner in the Fintech sector. Contributing factors include the thriving ecosystem (an area we will discuss in more detail under Environmental, Social and Governance (ESG) (section 4.6)) and the quality of the workforce. The UK government says it is setting the global standard on innovation in financial services. It is also important to note the FCA’s proactive approach to the Fintech industry, an action that no doubt has contributed to the UK’s global standing. In its infancy, the FCA identified the need to have a dedicated team to allow innovators in the Fintech navigate the area of regulation. This was initially done through the use of robo-advice and later evolved in the guise of the sandbox. The sandbox gives firms the opportunity to test Fintech-related ideas with real customers in a controlled environment. Demand for the sandbox initiative is high and it continues to evolve with the recent launch of the Green Fintech Challenge. 4.6 Environmental, Social and Governance (ESG) The emergence of a more conscious investor has contributed to the development of the latest theme within the financial sector. ESG factors are used by these investors to determine if an investment suits their objectives. Environmental factors include sustainability and climate change. Social factors and concerns include consumer protection and diversity. Governance factors and concerns include employee relations and management structures. It is not only important for firms to ensure their product offering to their investors/consumers covers ESG factors but it is also extremely important that firms looking to deal with other firms adopt this and demonstrate this culture. For example, an investment firm which demonstrates a commitment to ESG will not want to associate with an administration firm whose social environment could be called into question. Investors can utilise the services of an ESG rating agency in deciding which investments suit their objectives. The rating agency will assign weightings to investments based on ESG factors, these weightings will be used to determine a rating. MSCI is one such organisation that determines the ESG rating. A rules- based methodology is used to identify industry leaders and those on the opposite end of the spectrum. Companies are rated on a scale according to their ESG risk exposure and how it is perceived that those risks are managed relative to industry peers. Such ratings allow ESG-conscious investors access to expert industry insights similar to that of debt ratings when making investment decisions. 17 End of Chapter Questions Think of an answer for each question and refer to the appropriate section for confirmation. 1. Name four main activities undertaken by the professional financial services sector and five by the retail sector. Answer Reference: Section 2 2. How does a mutual savings institution differ from a retail bank? Answer Reference: Sections 3.1 and 3.2 3. How does peer-to-peer (P2P) lending differ from traditional banking? Answer Reference: Section 3.3 4. What are the main types of services provided by investment banks? Answer Reference: Section 3.4 5. What is protection planning, and what scenarios might necessitate the use of protection policies? Answer Reference: Section 3.6 6. What services does a custodian offer? Answer Reference: Section 3.9 7. What is a platform and why might they be considered a useful distribution channel? Answer Reference: Section 3.10 8. What is the role of a third-party administrator? Answer Reference: Section 3.11 9. What are the two types of financial adviser, and how does the range of products they advise on differ? Answer Reference: Section 4.2 10. What records should be kept when a transaction is undertaken on an execution-only basis? Answer Reference: Section 4.3 18 Chapter Two The Economic Environment 1. Introduction 21 2. Factors Determining Economic Activity 21 3. The Economic Cycle and Economic Policy 24 4. Central Banks 28 5. Key Economic Indicators 32 This syllabus area will provide approximately 4 of the 50 examination questions 19 20 The Economic Environment 1. Introduction In this chapter, we turn to the broader economic environment in which the financial services sector 2 operates. First, we will look at how economic activity is determined in various economic and political systems, and the stages of the economic cycle. Then, we will look at the role of the government in determining economic policy as well as the role of central banks in the economy. The chapter concludes with an explanation of some of the key economic measures that provide an indication of the state of an economy. 2. Factors Determining Economic Activity Learning Objective 2.1.1 Know the factors which determine the level of economic activity: state-controlled economies; market economies; mixed economies; open economies Every country has a set of characteristics, such as natural resources and a skilled workforce, which can influence their ability to grow their economy. While it is not just economic factors that influence economic development, they are important for understanding the capacity or the ability of an economy to develop on its own. There are several factors affecting economic growth, and it is helpful to split them into demand-side factors (eg, consumer spending) and supply-side factors (eg, productive capacity). Each factor influences the available economic resources and growth opportunities within a country. 21 Economic systems are the means by which countries determine how they will use these resources to resolve the basic problem of what, how much, how, and for whom to produce. The main types of economic systems are a state-controlled economy, a market economy and a mixed economy, while an open economy refers to a country’s economic relationship with the rest of the world. Each of these are considered below. 2.1 State-Controlled Economies A state-controlled economy is one in which the state (in the form of the government) decides what is produced and how it is distributed. It is also known as a planned economy or a command economy. The best-known example of a state-controlled economy was the Soviet Union throughout most of the 20th century. Sometimes, these economies are referred to as ‘planned economies’, because the production and allocation of resources is planned in advance rather than being allowed to respond to market forces. The perceived advantage of a planned economy is suggested to be low levels of inequality and unemployment, with the common good replacing profit as the primary incentive of production. However, this may not be the case and large inequalities can arise, as seen in countries such as Russia and Venezuela. The need for careful planning and control can bring about excessive layers of bureaucracy and state control inevitably removes a great deal of individual choice. These latter factors have contributed to the reform of many planned economies and the introduction of more mixed economies (covered in more detail in section 2.3). 2.2 Market Economies In a market economy, the forces of supply and demand determine how resources are allocated. Businesses produce goods and services to meet the demand from consumers. The interaction of demand from consumers and supply from businesses in the market will determine the market-clearing price. This is the price that reflects the balance between what consumers will willingly pay for goods and services and what suppliers will willingly accept for them. If there is oversupply, the price will be low and some producers will leave the market. If there is undersupply, the price will be high, which will attract new producers into the market. There is a market not only for goods and services, but also for productive assets, such as capital goods (eg, machinery), labour and money. For the labour market, it is the wage level that is effectively the ‘price’, and for the money market it is the interest rate. People compete for jobs and companies compete for customers in a market economy. Scarce resources, including skilled labour, such as a football player, or a financial asset, such as a share in a successful company, will have a high value. In a market economy, competition means that inferior football players and shares in unsuccessful companies will be much cheaper and ultimately competition could bring about the collapse of the unsuccessful company, and result in the inferior football player searching for an alternative career. 22 The Economic Environment 2.3 Mixed Economies A mixed economy combines a market economy with some element of state control. The vast majority of economies are mixed to a greater or lesser extent. 2 While most of us would agree that unsuccessful companies should be allowed to fail, we generally feel that the less able in society should be cushioned against the full force of the market economy. In a mixed economy, the government will provide a welfare system to support the unemployed, the infirm and the elderly, in tandem with the market-driven aspects of the economy. Governments will also spend money running key areas such as defence, education, public transport, health and police services. Governments raise finance for their public expenditure by: collecting taxes directly from wage-earners and companies collecting indirect taxes (eg, VAT and taxes on petrol, cigarettes and alcohol), and raising money through borrowing in the capital markets. Civil servants, primarily working for the government to raise money and spend it, tend to be one of the largest groups in the labour market. In the UK, it is the civil servants working for the Treasury who raise money and allocate it to the ‘spending departments’, such as the National Health Service (NHS). 2.4 Open Economies The term ‘open economy’ relates to a country’s economic relationship with outside countries. In an open economy, there are few barriers to trade or controls over foreign exchange. Although most western governments create barriers to protect their citizens against illegal drugs and other dangers, they generally have policies to allow or encourage free trade. From time to time, issues will arise when one country believes another is taking unfair advantage of trade policies and employs some form of retaliatory action, possibly including the imposition of sanctions as has been seen in the most recent trade wars between the US and China. When a country prevents other countries from trading freely with it in order to preserve its domestic market, the practice is usually referred to as protectionism. The World Trade Organization (WTO) exists to promote the growth of free trade between economies. It is, therefore, sometimes called upon to arbitrate when disputes arise. In addition to global agreements on trade under WTO rules, there are many regional and bilateral trade agreements that go beyond commitments made in the WTO that aim to increase trade and boost economic growth. 23 3. The Economic Cycle and Economic Policy Learning Objective 2.1.2 Know the stages of the economic cycle and the role of government in determining: economic policy; fiscal policy; monetary policy Traditionally, the role of government has been to manage the economy through taxation and through economic and monetary policy, and to ensure a fair society by the state provision of welfare and benefits to those who meet certain criteria, while leaving business relatively free to address the challenges and opportunities that arise. Governments can use a variety of policies when attempting to reduce the impact of fluctuations in economic activity. Collectively, these measures are known as stabilisation policies and are categorised under the broad headings of fiscal policy and monetary policy. Fiscal policy involves making adjustments using government spending and taxation, while monetary policy involves making adjustments to interest rates and the money supply. 3.1 Macroeconomic Objectives Macroeconomic policy is the management of the economy by government in such a way as to influence the performance and behaviour of the economy as a whole. The main objectives are as follows: As far as possible, all factors of production, ie, land, labour capital Full employment and enterprise should be fully utilised. Economic growth Measured by increases in gross domestic product (GDP). Achieving price stability – typically, a rate of inflation of 2% is set Low inflation as a target. Balance of payments Deficits in external trade, with imports exceeding exports, might equilibrium be damaging for the prospect of economic growth. Simultaneous achievement of all four objectives is extremely difficult. For example, the balance of payments tends to deteriorate as economic growth improves. This is because when growth is triggered by an increase in aggregate demand, it often leads to an increase in imports as foreign goods are bought by UK manufacturers and consumers. 24 The Economic Environment 3.2 Stages of the Economic Cycle Over time, the level of economic activity within an economy tends to fluctuate as GDP increases and decreases. The following diagram illustrates the four typical stages of the economic cycle, ie, peak, 2 contraction, trough and expansion: Level of National Economic Activity Peak – GDP is at its highest point. Any growth in output stops. This is the point at which GDP is expected to decline, ie, contraction of the economy is expected. Contraction – this is the period over which GDP declines as economic activity slows. When there are two consecutive quarters of declining GDP or ‘negative growth’, economists refer to this as a recession. Trough – GDP is now at its lowest point. The contraction phase is over. Expansion – economic activity picks up and GDP begins growing once again. Early expansion is usually characterised by a moderate increase in GDP whereas with late expansion, the rate of increase is higher. Section 5.2.1 will expand on this cycle. 25 3.3 Fiscal Policy Fiscal policy is any action by the government to spend money, or to collect money in taxes, with the purpose of influencing the condition of the economy. The government will use the following tools to influence the level of spending in the economy: The budget – the government budget is a statement of public income and expenditure over a period of one year. There will be a balanced budget where income equals expenditure, a deficit budget where expenditure exceeds income, or a surplus budget where income exceeds expenditure. With a budget deficit, ie, where public expenditure is more than public income, the government must borrow to make up the difference. This is known as the public sector borrowing requirement (PSBR). Taxation – taxation can be direct, for example, PAYE tax levied on income, or indirect, eg, VAT charged on goods and services. Through the taxation system, the government can influence the level of spending in the economy. If the government were to reduce taxation and keep its own spending constant, it would mean that firms and households would have more disposable income. This is one method of stimulating demand. On the other hand, a government could reduce demand by raising taxes or reducing its expenditure. 3.3.1 Implications of Fiscal Policy for Business Planning Since fiscal policy influences the level of aggregate demand in the economy, businesses need to take this into account when planning output levels, future employment levels and also deciding on investments. Planning will be much easier if government policy is stable. 26 The Economic Environment Costs Taxation, especially employers’ national insurance contributions, will affect total labour costs, hence the ultimate cost for products and services. In addition, if indirect taxes such as VAT rise, the cost would either have to be absorbed by the firm or passed on to the customer. 2 3.4 Monetary Policy Monetary policy is the regulation of the economy through control of the monetary system by operating on such variables as the money supply, the level of interest rates and the conditions for the availability of credit. Monetary policy is generally concerned with the volume of money in circulation and the price of money or the interest rate. The Money Supply The stock of money in the economy is believed to influence the volume of expenditure in the economy. This, in turn, influences the level of output and prices. Under monetary policy, the government can target the stock of money as an economic tool. Governments may decide to impose a ‘credit squeeze’ and restrict credit lending to control the level of spending and reduce inflation. Alternatively, governments may impose reserve requirements on banks, eg, a minimum cash reserve ratio. Interest Rates Interest represents the price of money or the cost of borrowing. It is, therefore, assumed that there is a direct relationship between the interest rate and the level of spending in the economy. An increase in interest rates is thought to discourage spending in the economy and thereby reduce the level of aggregate spending. Consumers would be encouraged to save with higher interest rates. Mortgage payments would rise, leaving less disposable income for homeowners. The higher cost of credit would deter borrowing and hence spending. The level of corporate investments would decline due to higher borrowing costs. The corporate sector may lose confidence in the economy and become pessimistic about future prospects. It has been argued, however, that a higher level of interest rates will not necessarily achieve the above. Other effects of a high rate of interest need to be considered. Higher interest means greater interest income for savers. They may increase their spending. Demands for higher wages could arise out of the need to make higher mortgage payments. Higher interest rates attract capital inflows. This would lead to an appreciation in the exchange rate, making imports cheaper and, thus, more attractive. This will contribute to the balance of payments deficit. Lower demand could result in higher unemployment and lower tax income for the government. Unemployment benefits may, therefore, increase. Low investment now would mean poor prospects for future economic growth. 27 4. Central Banks Learning Objective 2.1.3 Know the function of central banks: the Bank of England including the Monetary Policy Committee; the Federal Reserve; the European Central Bank Rather than following one or another type of policy, most governments now adopt a pragmatic approach to controlling the level of economic activity through a combination of fiscal and monetary policy. In an increasingly integrated world, however, controlling the level of activity in an open economy in isolation is difficult, as financial markets, rather than individual governments and central banks, tend to dictate economic policy. Governments typically implement their monetary policies using their central bank, and a consideration of their role in this implementation is explained below. 4.1 The Role of Central Banks Central banks operate at the very centre of a nation’s financial system. They are usually public bodies but, increasingly they operate independently of government control or political interference. They usually have some or all of the following responsibilities: Acting as banker to the banking system by accepting deposits from, and lending to, commercial banks. Acting as banker to the government. Managing the national debt. Regulating the domestic banking system. Acting as lender of last resort in financial crises to prevent the systemic collapse of the banking system. Setting the official short-term rate of interest. Controlling the money supply. Issuing notes and coins. Holding the nation’s gold and foreign currency reserves. Influencing the value of a nation’s currency through activities such as intervention in the currency markets. Providing a depositors’ protection scheme for bank deposits. 4.2 Bank of England (BoE) The Bank of England (BoE) is the central bank of the UK. It was founded in 1694 and its roles and functions have evolved and changed over its 300-year-plus history. Since its foundation it has been the government’s banker and, since the late 18th century, it has been banker to the banking system or, more generally, the bankers’ bank. As well as providing banking services to its customers, the BoE manages the UK’s foreign exchange and gold reserves. 28 The Economic Environment The Bank has two core purposes – monetary stability and financial stability. Monetary stability means stable prices and confidence in the currency. Stable prices involve meeting the government’s inflation target which, since November 2003 has been a rolling two- 2 year target of 2% for the consumer prices index (CPI). This it does by setting the base rate, the UK’s administratively set short-term interest rate. Financial stability refers to detecting and reducing threats to the financial system as a whole. A sound and stable financial system is important in its own right, and vital to the efficient conduct of monetary policy. It also undertakes the other typical responsibilities of a central bank with the exceptions of managing the national debt and providing a depositors’ protection scheme. As we will see in section 4.2.3, these are undertaken by separate agencies. 4.2.1 Monetary Stability The BoE is perhaps most visible to the general public through its banknotes and, since the late 1990s, its interest rate decisions. The BoE has had a monopoly on the issue of banknotes in England and Wales since the early 20th century, but it is only since 1997 that the BoE has had statutory responsibility for setting the UK’s official interest rate. Interest rate decisions are taken by the BoE’s Monetary Policy Committee (MPC). The MPC is made up of nine members – the Governor of the BoE, the three Deputy Governors for Monetary Policy, Financial Stability and Markets and Banking, the Chief Economist and four external members appointed directly by the Chancellor. External members are appointed to make sure that the MPC benefits from the thinking and expertise that exists outside of the BoE. A representative from HM Treasury also sits with the MPC at its meetings. The Treasury representative can discuss policy issues but is not allowed to vote. They are there to make sure that the MPC is fully briefed on fiscal policy developments and other aspects of the government’s economic policy, and that the Chancellor is kept fully informed about monetary policy. Each member of the MPC has expertise in the field of economics and monetary policy. Members do not represent individual groups or areas – they are independent – and they serve fixed terms, after which they will either be replaced or reappointed. The MPC’s primary focus is to ensure that inflation is kept within a government-set range, set each year by the Chancellor of the Exchequer, to support the government’s economic objectives, including those for growth and employment. The MPC does this by setting the base rate which is otherwise known as the ‘official bank rate’. This is the MPC’s main policy instrument. At its monthly meetings, the MPC must gauge all of those factors that can influence inflation over both the short and medium term. These include the level of the exchange rate, the rate at which the economy is growing, how much consumers are borrowing and spending, wage inflation, and any changes to government spending and taxation plans. The MPC also has responsibility for formulating monetary policy within the Bank. 29 When setting the base rate, the MPC must also be mindful of the impact any changes will have on the sustainability of economic growth and employment in the UK and the time lag between a change in rate and the effects it will have on the economy. Depending on the sector of the economy we are looking at, this can be anything from a very short period of time (eg, credit card spending when consumers are already stretched), to a year or more (businesses altering their investment and expansion plans).1 4.2.2 Financial Stability Since the financial crisis of 2007–08, the Bank’s role of protecting and enhancing the stability of the financial system has gained greater emphasis and importance. The purpose of preserving financial stability is to maintain the three vital functions which the financial system performs in the economy: providing the main mechanism for paying for goods, services and financial assets intermediating between savers and borrowers, and channelling savings into investment via debt and equity instruments, and insuring against and dispersing risk. In April 2013, the UK government brought in a major reform of the regulatory regime which significantly increased and broadened the Bank’s role and responsibilities for financial stability. These changes are a response to the weaknesses identified as a result of the financial crisis, of which perhaps the most significant failing was that no single institution had the responsibility, authority or powers to oversee the financial system as a whole. In June 2011, the government announced details of its plans to establish a new committee at the BoE – the Financial Policy Committee (FPC). The FPC is tasked with monitoring the stability and resilience of the UK financial system and using its powers to tackle those risks. It also gives direction and recommendations to the Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA). The PRA is part of the BoE and has assumed responsibility for the supervision of banks and key market infrastructure firms (such as the London Clearing House and Euroclear UK & Ireland). The FPC has two key policy levers – its powers of direction and of recommendation. FPC directions are binding instructions on the PRA and FCA who will then make banks, building societies and other investment firms carry out the resulting actions. FPC recommendations can be on a comply-or-explain basis to the regulators. This means that, if the regulators decide not to implement a comply-or-explain recommendation, they are required to explain publicly their reasons for not doing so. The FPC can also make general recommendations to other bodies. 1 Review the latest minutes from the MPC and identify their key decisions and observations at https://www.bankofengland. co.uk/monetary-policy-report/2024/february-2024 and select Monetary Policy Committee Minutes or the Monetary Policy Summary and minutes of the Monetary Policy Committee. 30 The Economic Environment 4.2.3 Other Bank of England Responsibilities In addition to these responsibilities, the Bank also assumes responsibility for all other traditional central bank activities (listed in section 4.1), with the exception of managing the national debt and providing 2 a depositors’ protection scheme for bank deposits. Managing the national debt is undertaken by the Debt Management Office (DMO), and operating the depositors’ protection scheme by the Financial Services Compensation Scheme (FSCS). 4.3 Federal Reserve (Fed) The Federal Reserve System in the US dates back to 1913. The Fed, as it is known, comprises 12 regional Federal Reserve Banks, each of which monitors the activities of, and provides liquidity to, the banks in its region. Although free from political interference, the Fed is governed by a seven-strong board appointed by the President of the US. This governing board, together with the presidents of five of the 12 Federal Reserve Banks, makes up the Federal Open Market Committee (FOMC). The chairman of the FOMC, also appointed by the US President, takes responsibility for the committee’s decisions, which are directed towards its statutory duty of promoting price stability and sustainable economic growth. The FOMC meets every six weeks or so to examine the latest economic data in order to gauge the health of the economy and determine whether the economically sensitive Fed funds rate should be altered. In late 2015, it made the decision to raise interest rates for the first time since the 2008 financial crisis. As lender of last resort to the US banking system, the Fed has rescued a number of US financial institutions and markets from collapse during the financial crisis. In doing so, it has prevented widespread panic and prevented systemic risk from spreading throughout the financial system (known as ‘contagion’). 4.4 European Central Bank (ECB) Based in Frankfurt, the ECB assumed its central banking responsibilities upon the creation of the euro, on 1 January 1999. The ECB is principally responsible for setting monetary policy for the entire Eurozone, with the objective of maintaining internal price stability. Its objective of keeping inflation, as defined by the Consumer Price Index (CPI), ‘close to but below 2% in the medium term’ is achieved by influencing those factors that may affect inflation, such as the external value of the euro and growth in the money supply. The ECB sets its monetary policy through its president and council; the latter comprises the governors of each of the Eurozone’s national central banks. Although the ECB acts independently of EU member governments when implementing monetary policy, it has on occasion succumbed to political persuasion. It used to be one of the few central banks that did not act as a lender of last resort to the banking system, but that changed when the Eurozone crisis forced it to support banks and economies in struggling European countries. 31 In 2014, the ECB was given a supervisory role to monitor the financial stability of banks in Eurozone states. The Single Supervisory Mechanism (SSM) is a new framework for banking supervision in Europe and comprises the ECB and national supervisory authorities of participating EU countries. Its main aims are to: ensure the safety and soundness of the European banking system, and increase financial integration and stability in Europe. The SSM is an important milestone towards a banking union within the EU. 5. Key Economic Indicators Learning Objective 2.1.4 Understand the impact of the following economic data: gross domestic product (GDP); balance of payments; budget deficit/surplus; level of unemployment; exchange rates; inflation/ deflation As well as being essential to the management of the economy, indicators can provide investors with a guide to the health of the economy and aid long-term investment decisions. This section takes a closer look at several economic indicators, including: inflation as an indicator of how the overall process of goods and services in the economy are changing gross domestic product (GDP) as a measure of economic activity economic growth and economic cycles the balance of payments as a summary of all the country’s transactions with the rest of the world the budget deficit and national debt, and unemployment and exchange rates. 5.1 Inflation Inflation is a persistent increase in the general level of prices. There are a number of reasons for prices to increase, such as excess demand in the economy, scarcity of resources and key workers, or rapidly increasing government spending. Most Western governments seek to control inflation at a level of about 2–3% pa without letting it get too high (or too low). High levels of inflation can cause problems: Businesses have to continually update prices to keep pace with inflation. Employees find the real value of their salaries eroded. Those on fixed levels of income, such as pensioners, will suffer as the price increases are not matched by increases in income. Exports may become less competitive. The real value of future pensions and investment income becomes difficult to assess, which might act as a disincentive to save. 32 The Economic Environment There are, however, some positive aspects to high levels of inflation: Rising house prices can contribute to a ‘feel-good’ factor (although this might contribute to further inflation as house-owners become more eager to borrow and spend). 2 Borrowers benefit, because the value of borrowers’ debt falls in real terms – ie, after adjusting for the effect of inflation. Inflation also erodes the real value of a country’s national debt and can benefit an economy in difficult times. Deflation, by contrast, is defined as a general fall in price levels. Although not experienced as a worldwide phenomenon since the 1930s, it has been seen more recently in many economies, including Japan, and in Eurozone countries, such as Greece and, to a lesser extent, Spain. While it may seem that lower prices would be a good thing, deflation can ripple through the economy, such as when it causes high unemployment, and can turn a bad situation, such as a recession, into a worse situation, such as a depression. Deflation can spiral where it creates a vicious circle of reduced spending and a reluctance to borrow as the real burden of debt in an environment of falling prices increases. Deflation can, then, become a self-reinforcing loop – falling prices create the circumstances for prices to continue falling, leading to a depression. It should be noted that falling prices are not necessarily a destructive force per se and, indeed, they can be beneficial if they are as a result of positive supply shocks, such as rising productivity growth and greater price competition caused by the globalisation of the world economy and increased price transparency. 5.1.1 Measuring Inflation Consumer price indices measure changes in prices to estimate how the prices of goods and services are changing over time. Over any given period, the price of some goods will rise and some will fall, so inflation measures present a picture of what is happening with the average level of prices in the economy. If inflation is rising, then this implies that, overall, the cost of goods and services is rising; this equates to a fall in the purchasing power of money, ie, £1 now buys less than it did before. People buy different things and use a variety of services, so estimates of inflation are based on typical goods and services that a household consumes. In the UK, inflation measures are calculated by the Office for National Statistics (ONS). The ONS publishes three main measures of inflation – the consumer price index (CPI), the CPI including occupier’s housing costs (CPIH) and the retail price index (RPI) – which is due to be phased out by 2030 due to shortcomings in the way it is calculated. The CPI and CPIH use essentially the same data except for the inclusion of housing costs in the latter. The way that the ONS calculates inflation is to collect price data on a typical ‘shopping basket’ of some 700 items from month to month. The content of the basket is fixed for a period of 12 months and different weights are attached to various items in the basket reflecting their importance in a typical household budget. The content and the weightings attached are reviewed regularly to ensure they remain up to date. 33 5.2 Measures of Economic Data In addition to inflation measures, there are a number of other economic statistics carefully watched by the government and by other market participants as potentially significant indicators of how the economy is performing. 5.2.1 Gross Domestic Product (GDP) At the very simplest level, an economy comprises two distinct groups: individuals and firms. Individuals supply firms with the productive resources of the economy in exchange for an income. In turn, these individuals use this income to buy the entire output produced by firms employing these resources. This gives rise to what is known as the circular flow of income. 34 The Economic Environment This economic activity can be measured in one of three ways: by the total income paid by firms to individuals by individuals’ total expenditure on firms’ output, and by the value of total output generated by firms. 2 Gross domestic product (GDP) is the most commonly used measure of a country’s output. It measures economic activity on an expenditure basis and is typically calculated quarterly as below: Gross Domestic Product consumer spending plus government spending plus investment plus exports less imports equals GDP 5.2.2 Balance of Payments The balance of payments is a summary of all the transactions between the UK and the rest of the world. If the UK imports more than it exports, there is a balance of payments deficit. If the UK exports more than it imports, there is a balance of payments surplus. The main components of the balance of payments are the trade balance, the current account and the capital account. The trade balance comprises a visible trade balance – the difference between the value of imported and exported goods, such as those arising from the trade of raw materials and manufactured goods; and an invisible trade balance – the difference between the value of imported and exported services, arising from services such as banking, financial services and tourism. If a country has a trade deficit in one of these areas or overall, this means that it imports more than it exports, and, if it has a trade surplus, it exports more than it imports. The current account is used to calculate the total value of goods and services that flow into and out of a country. The current account comprises the trade balance figures for the visibles and invisibles. To these figures are added other receipts such as dividends from overseas assets and remittances from nationals working abroad. The results of the current account calculations provide details of the balance of trade a country has with the rest of the world. Being a post-industrial economy, the UK typically runs a deficit on visible trade but an invisible trade surplus. Also, because it is an open economy, imports and exports combined total over 50% of UK GDP. The capital account records international capital transactions related to investment in business, real estate, bonds and stocks. This includes transactions relating to the ownership of fixed assets and the purchase and sale of domestic and foreign investment assets. These are usually divided into categories 35 such as foreign direct investment, when an overseas firm acquires a new plant or an existing business; portfolio investment, which includes trading in stocks and bonds; and other investments, which include transactions in currency and bank deposits. For the balance of payments to balance, the current account must equal the capital account plus or minus a balancing item – used to rectify the many errors in compiling the balance of payments – plus or minus any change in central bank foreign currency reserves. A current account deficit resulting from a country being a net importer of overseas goods and services must be met by a net inflow of capital from overseas, taking account of any measurement errors and any central bank intervention in the foreign currency market. Having the right exchange rate is critical to the level of international trade undertaken, to a country’s international competitiveness and, therefore, to its economic position. This can be understood by looking at what happens if a country’s exchange rate alters. If the value of its currency rises, then exports will be less competitive unless producers reduce their prices, and imports will be cheaper and, therefore, more competitive. The result will be either to reduce a trade surplus or worsen a trade deficit. If its value falls against other currencies, then the reverse happens: exports will be cheaper in foreign markets and, therefore, more competitive, and imports will be more expensive and less competitive. A trade surplus or deficit will, therefore, see an improving position. 5.2.3 Budget Deficit and National Debt A key function of government is to manage the public finances, and so a key economic indicator is the level of public sector debt, or the national debt as it is more frequently referred to. In the past, a state would incur budget deficits, usually as a result of military conflicts, and finance these through taxation. In the UK, this changed in the late 1600s when the government’s need to finance another war with France led to the creation of the BoE in 1694 and the first ever issue of state public debt. Following on from this, the early 1700s saw the emergence of banking and financial markets and the ability to raise money by creating debt through the issue of bills and bonds and the beginning of the national debt. Some key statistics from the ONS show how the national debt has grown since then: The national debt rose from £12 million in 1700 to £850 million by the end of the Napoleonic Wars in 1815. The two world wars of the 20th century caused debt levels to rise, from £650 million in 1914 to £7.4 billion by 1919, and from £7.1 billion in 1939 to £24.7 billion in 1946. The period of relatively high inflation in the 1970s and 1980s saw debt rise from £33.1 billion in 1970 to £197.4 billion in 1988. The national debt has since continued to grow rapidly and exceeds £2 trillion following heavy government spending to support the economy during the COVID-19 pandemic. 36 The Economic Environment There are a wide number of measures used as key economic indicators, which can be quite confusing. Each measures different sets of data, but essentially they fall into two main types: Government debt – essentially this is what the government owes. The most widely quoted is public 2 sector net debt. Budget deficit – essentially the shortfall between what the government receives in tax receipts and what it spends. The most widely quoted is the Public Sector Net Cash Requirement (PSNCR). Debt measures are also usually presented as a percentage of GDP, since comparisons over time need to allow for effects such as inflation. Dividing by GDP is the conventional way of doing this. The PSNCR is the difference each year between government expenditure and government income; the latter mainly from taxes. In a buoyant economy, government spending tends to be less than income, with substantial tax revenues generated from corporate profits and high levels of employment. This enables the government to reduce public sector (ie, government) borrowing. The reaction to the economic impact of the COVID-19 pandemic saw the government use fiscal policy measures to mitigate some of the immediate economic disruption. This saw additional government spending at a time when tax receipts were slowing due to lower economic activity linked to imposed national lockdowns, leading to a growing budget deficit. This has pushed government borrowing to a level not seen other than during the first and second world wars. If left unaddressed, high levels of public borrowing and debt risk undermining growth and economic stability. As mentioned earlier, excessive government spending, causing a growing PSNCR, has the potential to bring about an increase in the rate of inflation. 5.2.4 Level of Unemployment The extent to which those seeking employment cannot find work is an important indicator of the health of the economy. There is always likely to be some unemployment in an economy – some people might lack the right skills and/or live in employment black spots. Higher levels of unemployment indicate low demand in the economy for goods and services produced and sold to consumers and therefore low demand for people in the UK to provide them. High unemployment levels will have a negative impact on the government’s finances. The government will need to increase social security payments, and its income will decrease because of the lack of tax revenues from the unemployed.

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