Introduction: the nancial system

remember that total purchases of assets may be much larger because some assets already

in the portfolio may have been sold as part of the portfolio adjustment process. A

nancial system must provide people with the means to make cheap and frequent

adjustments to their portfolio of assets (and liabilities).

Box 1.1

A nancial system

l	channels funds from lenders to borrowers
l	creates liquidity and money
l	provides a payments mechanism
l	provides nancial services such as insurance and pensions
l	offers portfolio adjustment facilities

Notice that this description of what a nancial system does(which we have

summarised in Box 1.1) is only one way of answering our second question. It is the

answer that most economists would give because the activities on which it focuses

are important to the functioning of the economy as a whole. Making borrowing

and lending cheap and easy makes it easier for rms to invest and should, therefore,

increase the rate of economic growth. An efcient payments system makes it easier to

carry out transactions and encourages trade and exchange. The quantity of money in

circulation, how wealthy people feel and the liquidity of their wealth are all potential

inuences upon the level of aggregate demand. We look at the connections between

nancial and real economic activity in more detail in Chapter 2.

But this is only one way of looking at what a nancial system does. In the past thirty

years, the UK has seen a dramatic increase in the size and complexity of its nancial

system. Within the categories that we list in Box 1.1 there is a much wider range of

products and services than there was a generation ago. Consider the example of a

mortgage loan taken out to buy the family home. Thirty years ago, such a loan would

almost certainly have come from a building society. The borrower would probably have

had to wait in a queue which he or she could join only after having saved for some

period with the society. The loan would have been in sterling and the borrower would

have paid a rate of interest which varied at short notice (broadly) with changes in

the level of ofcial interest rates imposed by the monetary authorities. The interest

would have been paid monthly together with a small additional sum calculated to repay

the loan over a scheduled period. In 2003, by contrast, such loans were instantly

available from a range of institutions. They could be repaid by the method described

above or they could be ‘interest-only’ mortgages in which the borrower pays only the

interest but makes simultaneous payments into a long-term savings scheme (typically

an endowment insurance policy) which is designed to repay the mortgage when the

policy matures. The mortgage may have a rate of interest which can be xed for long

periods. The mortgage can even be arranged in a foreign currency if the borrower is

convinced that a foreign interest rate will remain lower than the UK rate in future and

that the pound is not going to fall in value against the foreign currency.

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Chapter 1 • Introduction: the nancial system

The point about all of this is the substantial increase in complexity that now attends

the major nancial decisions that most households have to make. If we assume

that the relationship between nancial ‘consumers’ and ‘suppliers’ is characterised

by ‘asymmetric information’, then the increase in complexity puts consumers at an

even bigger disadvantage when compared with suppliers. One consequence of this

asymmetry has been a number of notable scandals where people have been sold

products which were not suitable for their needs (for example, pension and endow-

ment products). Another consequence has been the increase in the scope of nancial

regulation designed at least to limit the exploitation of this information advantage. A

third has been the growth of a nancial advice industry which one can see as allowing

consumers to ‘buy’ additional protection for themselves by paying for information.

Seen from this consumerist perspective, Box 1.1 would look rather different. We

would stress the categories of ‘product’ which the nancial system provides. So we

would focus upon ‘protection products’ (insurance), ‘mortgage products’, ‘long-term

savings products’ (managed funds) and ‘deposit products’. These, together with

‘regulation’ and ‘advice’, would be the chapter headings of this book. But, as we said

above, our main interest lies with how the nancial system grows out of and in

return satises (to some degree at least) the needs of the real economy.

Thus, in this introductory chapter we shall look rstly at the institutions or inter-

mediaries which make up part of the nancial system. Then, in section 1.2, we turn

our attention to nancial markets (which make up another part). In section 1.3

we look at the end-users of the system and at some of the motives and principles

underlying their behaviour. We can then appreciate some of the advantages that the

end-users obtain from the nancial system.

1.1	Financial institutions

1.1.1

Financial institutions as rms

Financial institutions are rms and their behaviour can be analysed in much the same

way that economists analyse any other type of rm. Thus we can think of them as

producing various forms of loans out of money which people are willing to lend.

Furthermore, we can assume that they are prot maximisers and that the prot

arises from charging interest to borrowers at a rate which exceeds that paid to lenders.

One characteristic of most nancial rms (though this still does not make them any-

thing special) is that they are large and therefore the prots are being maximised for

shareholders rather than for ‘entrepreneurs’ who themselves own and manage the

rms. Like any other rm, prots will be maximised at the point where total revenue

minus total costs is at its greatest, that is where the marginal revenue accruing from an

extra unit of output is just matched by the marginal cost of producing it. Also, quite

conventionally, we can assume that the marginal cost of production is rising in the

short term. Imagine, for simplicity, that a rm’s output consists of loans and that the

major variable input is the deposits which it can attract from members of the public

who are able to save. Other things being equal, it will attract more deposits (than at

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