2.      FINANCIAL SYSTEM AND ECONOMY

 

 

The financial system is a collective term for all financial markets and sectors in any particular country or defined regional or international area which includes all relevant financial institutions, contracts and services. The financial system represents the total system for the creation, use, purchase and sale and extinction of financial assets within a larger economy. The real economy refers to that part of the economy involved with the manufacture and sale of goods and services. The full economy is then made up of the financial system, manufacturing and production system and total amount of net wealth, capital or assets held including land. The financial and manufacturing systems are both based on market mechanisms which allow for the sale and purchase of assets with wealth either being held in the form of real assets (such as land or property) or financial assets (including money and other financial instruments). Financial law can be considered to refer to all aspects of the law relating to the financial system, markets, institutions, rights and assets with the sale of goods and services being dealt with under commercial law.

 

(1)       Money

 

Money is a form of legal tender which means that it has inherent value and is capable of being exchanged in settlement of a debt. Legal tender refers to any form of money that must be accepted in legal discharge of debts within a particular country. This is usually the currency of the country with the central bank having been given a monopoly (exclusive) rights of issuance. Financial assets consist of money, financial instruments, financial accounts, securities and other financial contracts incorporating payment obligations, such as insurance contracts. Securities include equities, bonds or debentures, convertibles, warrants and hybrid instruments. Financial contracts may include life assurance or contingent (accidental) cover, financial derivatives, credit derivatives and other structured finance instruments (such as collateralised debt obligations (CDOs) or credit linked notes (CLNs)).

 

The key function of money is to provide a common unit of measurement, account or pricing which is essential for the valuation of any asset or claim. Money represents its own assigned value and therefore acts as a store of value or wealth and as it is tender can be exchanged in settlement of any legal debt or payment obligation. Earlier commodity money systems were backed by defined amounts of gold, silver or other specie although all modern economies now operate on a largely fiat or fiduciary basis with money no longer be convertible into specie and only being backed by the credit standing of the sovereign, central bank or other state representative used.

 

Money is most commonly used for payment purposes. Payment can either be made through barter (an exchange of goods), money, paper-based funds transfer, electronic funds transfer or electronic or digital money. Money is also considered to act as a means of deferred payment although this only constitutes a form of delayed payment or credit. As legal tender, money is the only means of securing legal discharge of a payment obligation in the absence of contrary agreement between the parties.

 

The core functions of money in a modern economy can also be considered to include acting as a means of generating additional return or wealth through lending or investment.. In carrying out all of these functions, money provides a degree of convenience and security in managing government, corporate and individual operations and needs that would not otherwise be the possible, especially in modern complex economies with all of additional conflicts of interests and information management problems that arise.

 

(2)       Central Banking

 

Central banking refers to the activities of the central bank which is the main public institution at the centre of the financial system. The central bank is principally responsible for managing the country’s money (monetary policy). Monetary policy can most simply be understood in terms of controlling the volume or amount and cost of money in circulation at any time. This central bank will also usually hold the government accounts, manage the government’s borrowing (or national debt), manage the country’s foreign reserves and oversee the payment systems.

 

The central bank is generally also responsible for maintaining financial stability which may or may not include supervising the banks or other financial institutions directly. Banking supervision was, for example, transferred from the Bank of England to the Financial Services Authority (FSA) in the UK under the Banking Act 2008 and was dealt with on an integrated basis by the FSA under the Financial Services and Markets Act (FSMA) 2000. Prudential supervision of the most important systemic institutions is now be re-transferred back by the new Coalition Government elected in the UK in May 2010 to a subsidiary of the Bank, the Prudential Regulatory Authority (PRA), with the FSA been replaced by a separate Financial Conduct Authority (FCA). A separate Financial Policy Committee (FPC) has also been set up within the Bank of England to carry out macro-prudential oversight which is concerned with monitoring the financial system and economy as a whole to identify any potential risks of exposures.

 

Central banks often emerged out of earlier large national banks. The Bank of Amsterdam Bank was originally set up in 1609 with the Swedish Stockholms Bank in 1656 which later became the Riksbanken in 1668 (Section 1(4) above). Modern central banking has nevertheless, generally been developed by the Bank of England which was set up by William Paterson in 1694. This has included acting as lender of last resort (LLR) to the banking system through the provision of emergency support credit either to the markets generally or to individual institutions in times of crisis. The LLR responsibilities of the Bank where eventually accepted with the first Barings crisis in 1890. Many aspects of bank and financial supervision and market support have had to be reconsidered following the Global Financial Crisis with the authorities having to develop a number of new mechanisms and tools on an ad hoc rather than pre-planned basis.

 

 

 

(3)       Financial Sectors and Services

 

A number of essential services are carried out within the financial system. Five key functions can be identified in terms of providing deposit (or savings) facilities, providing loan (or credit) facilities, payment facilities, securities and investment facilities and insurance or other risk cover facilities (para 4(3) below). While payment involves the transfer of money or value held, credit involves the advancement of funds in return for a service (interest) payment and promise to repay or return (the underlying principal) at an agreed future date. The credit process constitutes a key component within any modern market economy as this allows governments to spend or companies to invest and individuals to consume in advance of income or earnings on the expectation that they will receive sufficient funds to repay the debt in due course. Credit forms an essential part of most government and corporate financing and provides additional choice in consumer and household financing.

 

Government or corporate borrowers can also use the capital markets in more complex economies for borrowing and investment purposes.  This can principally be achieved through the issuance of bonds by governments and shares and debentures by companies. Financial intermediaries also provide a range of risk cover or protection services, principally through insurance or the purchase of other financial instruments including financial derivatives. In acting as financial intermediaries, banks and other financial institutions collect and redistribute surplus funds from public entities, companies or individuals across the economy which allows for their most efficient and productive use.

 

(4)       Financial System and Financial Policies

 

The financial system consists of the total or aggregate set of markets and institutions within an economy and the inter-connections between them. This will include all of the separate markets referred to above as well as the relationships between all of the financial intermediaries either within markets or between markets and the use, transfer and extinction of all of the financial assets involved.

 

The economy refers to the larger structured system for the organisation of the production and sale of goods and services. Production is based on labour, capital and enterprise with goods and services being exchanged for money through payment. Adam Smith summarised the system in 1776 in An Inquiry into the Nature and Causes of the Wealth of Nations in terms of the division of labour, natural prices, private exchange, free trade and larger self interest which resulted in the most effective means of economic management through the ‘invisible hand’ of the markets. Smith specifically understood the economy in terms of household and government, income, expenditure and wealth. Wealth or capital can still be understood in terms of total net worth with assets less liabilities.

 

Policies involved in managing the financial system include Monetary policy as well as Regulatory policy, Fiscal policy, Economic policy and Macro-prudential policy most recently. Monetary policy, as has already been noted, refers to management of the volume and cost of money in circulation. The amount of money or credit in circulation is measured in terms of the money supply with different monetary aggregates being used (such as MO (notes and coins), M1 (bank reserves not in MO), M2 (money equivalents), M3 (M2 with large monetary deposits) and MB (total currency)). This is principally dealt with through open market operations by the Bank of England setting a base rate (referred to as the ‘bank rate’ in the UK) in its dealings with the major financial institutions in the primary money or Discount Market. Funds are then distributed or recycled through the rest of the economy at a margin above bank rate. Different objectives can be set for monetary policy (such as promoting price stability (inflation), growth and low unemployment) with different target regimes being available (including money supply growth over inflation or price level targeting).

 

Regulatory policy is concerned with the regulation and supervision of individual financial institutions with this to be re-transferred from the FSA to the PRA under the Coalition Government’s reform proposals. (Regulatory design is discussed further in Section 7 available.) Fiscal policy refers to government expenditure, taxation and budget management including debt and deficit management. The government or national debt is the total amount of money owed by the government. The public sector deficit refers to the amount by which government spending exceeds income on an annual basis. Fiscal policies can either be neutral, expansionary of contractionary depending on whether total government expenditure is covered by total government receipts.  Economic policy refers to the promotion of growth and employment through the larger management of the economy including labour markets, growth and development and innovation as well as related international trade policies.

 

Macro-prudential policy refers to the new initiatives being undertaken following the global financial crisis to ensure that authorities are able to manage all risks and exposures across the financial system and economy (Section 7(2)(e)). Other more specific policies may also have to be considered from time to time. Interest rate policy is concerned with the management of interest rates which forms part of larger monetary policy. Foreign exchange rate policy involves the management of the currency’s exchange rate value as against other currencies. This may either be managed on a fixed, partially fixed or floating basis. Competition policy is concerned with the promotion of market competition through the removal of distorted practices or abusive dominant positions.

 

All of these policies have to be managed appropriately if the financial system and larger economy are to work effectively and produce the maximum benefits for governments, companies and households.

 

(5)       Financial Stability

 

A stable financial system depends upon a number of factors being managed properly and effectively. These include maintaining:

 

(a)         Price and asset price stability, specifically including low inflation and the avoidance of asset price bubbles such as in the areas of commercial real estate or residential property as a current before the recent crises;

(b)        Continuing provision of core financial and payment services which carry out critical functions including safe savings, credit, payment, investment and insurance or risk cover;

(d)        An effective system of supervision and regulation of financial institutions to ensure that they maintain necessary risk management systems and controls, adequate capital and  liquidity, appropriate suitability and governance arrangements, effective accounts and regulatory reporting systems and reconstruction and resolution procedures (living wills) in the event of financial difficulties arising;

(c)         Effective loss allocation through the purchase of insurance or other financial assets for investment or hedging purposes of private losses been borne by the private sector; and

(e)         An effective system of macro-prudential oversight and effective crisis management and support in the event of major crisis arising to contain any potentially disruptive systemic threats materialising.

 

A number of benefits arise where the financial system and economy are managed effectively. These are considered further in section 5(4) below.