CHAPTER OBJECTIVES

What you will learn in this chapter:

o What services are provided by each of the main

categories of non-deposit-taking intermediary

o What assets are held by each

o The comparative size of each as measured by total assets

and inflows of funds

o Where they directed their funds in 2004/5

o How some NDTIs have become involved recently in a

number of controversial issues
 INTRODUCTION

o In this chapter, we will examine of each of the major types

of non-deposit-taking institution.
o We shall describe the services offered by each NDTI, look
at its balance sheet, and explain the regulatory framework
to which it is subject
o ‘financial institution’ does not correspond to ‘financial firm’;
o ‘financial firm’; a particular type of financial institution is
better understood as a particular type of financial
activity undertaken by a specialist subsidiary of a large
financial corporation which may be engaged in a wide
variety of activities.
 INTRODUCTION

o There is a distinction between stock and flow data.

o Balance sheets show us the (asset) stock position for
each type of NDTI and this gives us an indication of
what each type of institution has done with the funds it
has received in the past.
o We are also interested in the magnitude of new funds
which NDTIs receive each year and in the destination of
these funds. These funds are used to buy additional
assets, or to make what is called in the official statistics
‘net acquisitions’ of assets.
 INTRODUCTION

Box 4.1 Measuring financial activity

o UK official statistics on financial activity use the following
terms, which must be carefully distinguished:
Holdings at year end:
o refers to the stock of assets (or liabilities) at a particular
moment.
o It is the data that is used to compile a balance sheet of
assets and liabilities.
 INTRODUCTION
Box 4.1 Measuring financial activity
Net acquisitions:
o refers to the quantity of assets (or liabilities) acquired during
a period.
o This is flow data and for financial institutions it must match
the inflow of funds from savers during the period in
question.
Turnover:
o The total value of transactions (the sum of purchases and
sales) during a period of time.
o This is also flow data, but the figures will normally be much
larger than those showing net acquisitions.
 INTRODUCTION

o NDTIs all engage in the principal features of financial

intermediaries:
 They create assets for lenders and liabilities for
borrowers which are more attractive than would be the
case if the parties had to deal directly.
 They do this in part by ‘maturity transformation’.
 This in turn depends upon large size which enables
them to pool and diversify risk.
 INSURANCE COMPANIES

o Primary activity is to provide insurance against financial loss.

o They do this by collecting premiums or contributions
from large numbers of people in return for an
agreement to compensate the policyholder in the
event of a specified event occurring within a specified
time.
o Examples
o Life Insurance
o Motor Insurance
o Health Insurance
 INSURANCE COMPANIES

o The level of premium paid to insure against an event

depends obviously upon
o The likelihood or risk of the event occurring and
o The level of compensation or benefit to be paid when it
does.
o Alternatively, we may say that for a given level of benefit,
the premium will be determined by the risk.
o The premium : Benefit ratio is a function of risk.
 INSURANCE COMPANIES

o The payment of premiums creates a pool of funds at the

companies’ disposal, awaiting claims to be made against it.

o Provided sufficient funds are available or can be easily

recovered in order to meet unexpected claims,

o This pool of funds can be invested in earning assets by the

companies to provide a further source of income.

o Thus their investment success is a second factor which

influences the ratio of premium : benefit levels.
 INSURANCE COMPANIES

o Since the premium : benefit ratio is one of the main criteria

on which clients are likely to choose an insurance company,
the management of risk is clearly very important for
insurance companies.

o It is also quite difficult for reasons arising out of asymmetric

information.

o There is often an inequality in the information available

to the two parties in any financial transaction.
 INSURANCE COMPANIES

Asymmetric information:

o A situation where one party to a financial transaction

has better information than the other about factors
relevant to the transaction.
o In this case, asymmetry arises between the insurance
company itself and the insured.

o Typically, and especially in general insurance, it is the

insured who has the better information since he knows
his activities and the risks involved in much greater
detail than the insurance company does.
 INSURANCE COMPANIES

o This particular asymmetry gives rise to two specific

problems.
Moral Hazard

o This arises when an insured person becomes less careful

about her actions precisely because she is insured.

o Since safety measures typically have a cost, it might be

tempting to some people to cut down on these measures,
knowing that the insurance company will have to pay in the
event of an accident.
 INSURANCE COMPANIES
Adverse Selection
o This arises when the riskiest clients express the strongest
demand for insurance products.
o The insurance company does not normally have the
information to distinguish very accurately between
customers of different degrees of risk.
o It has thus to set a price for its contracts (the premiums)
which it hopes will provide a positive return for the average
level of risk to which it is exposed.
o Both problems can be tackled to some degree by risk
screening.
o Typically, this involves the study of past statistics on
client characteristics and outcomes.
 PENSION FUNDS

o After their retirement from employment, most people in the

can expect to receive some form of pension.
o This comes in one of three forms:
o A flat-rate pension paid by the state to everyone above
a certain age;
o An occupational pension provided from a fund to
which the employer and employee have contributed;
o A personal pension paid from a fund to which the
individual has made contributions.
o Only the second and third forms strictly involve financial
intermediation.
 PENSION FUNDS
Funded pension schemes:

o Schemes where payments to pensioners are made out

of the income earned by a fund of savings which has
been built up in earlier years by (usually regular)
savings contributions.
Unfunded pension schemes:

o Schemes where payments to pensioners are financed

by simultaneous contributions from those in work. Such
schemes are often called ‘pay as you go’ or PAYG
schemes.
 PENSION FUNDS

A flat-rate pension
o This is paid for out of general taxation.
o The state scheme in fact operates on a ‘pay as you go’
(PAYG) basis.
o Crucially, no pool of investible funds is created.
o Include most public sector occupational schemes like
those for teachers, the Civil Service, etc.
o However, the PAYG principle is not thought to be suitable
for private sector occupational schemes.
o The practice with the private sector is for employers
and employees to make contributions to a fund.
 PENSION FUNDS

Funded Schemes
o The practice with the private sector is for employers and
employees to make contributions to a fund.
o The fund is kept strictly separate from the firm’s own
assets, employees’ pensions should remain secure even if
the firm ceases trading.
o Crucially for our purposes they involve the accumulation
of a fund of assets.
o These assets are someone else’s liabilities.
o Hence funded pension schemes are involved in
channeling funds from savers to borrowers.
 PENSION FUNDS

Funded Schemes
o The practice with the private sector is for employers and
employees to make contributions to a fund.
o The fund is kept strictly separate from the firm’s own
assets, employees’ pensions should remain secure even if
the firm ceases trading.
o Crucially for our purposes they involve the accumulation
of a fund of assets.
o These assets are someone else’s liabilities.
o Hence funded pension schemes are involved in
channeling funds from savers to borrowers.
 PENSION FUNDS

Funded Schemes
‘Defined Benefit’ (DB) Scheme
o The rules of the scheme specify at the outset what a
pensioner can expect to receive, provided he or she
maintains the required level of contribution.
o For example, most DB schemes award a pension equal to
some proportion of ‘final salary’.
o Final salary’ might be defined as the average salary of an
employee’s last three years of employment.
o The contract might then specify that each year of service
entitles the employee to, say, one-eightieth of that figure.
 PENSION FUNDS

Funded Schemes
‘Defined Contribution’ (DC) Scheme
o DC arrangement, places the risk largely upon the
employee.
o This is because the scheme lays down the contribution
rates for employer and employees but makes no
stipulation about the level of benefit which will be
forthcoming at the point of retirement.
o When the employee retires, however, he receives a lump
sum which is his share in the value of the fund, whatever it
may be at that particular time.
 UNIT TRUSTS

o The purpose of a unit trust is to accept funds from

individuals or companies and to invest those funds in a
wide variety of assets.
o Contributors to the trust then have a share in the income
and capital appreciation of the underlying assets.
o A unit trust offers you exposure to a range of assets, which
are selected and managed by investment professionals.
 UNIT TRUSTS

o The purpose of a unit trust is to accept funds from

individuals or companies and to invest those funds in a
wide variety of assets.
o Contributors to the trust then have a share in the income
and capital appreciation of the underlying assets.
o A unit trust offers you exposure to a range of assets, which
are selected and managed by investment professionals.
Open-ended fund:
o A fund which will expand in response to new
contributions and contract in response to withdrawals.
The value of shares in the fund corresponds to the
value of the underlying assets.
 UNIT TRUSTS

Closed-ended fund:
o A fund with a fixed number of shares. The value (not
the number) of the shares responds to inflows and
withdrawals and thus may differ from the value ofthe
underlying assets
o Each individual trust is always the responsibility of two
companies:
o Firstly, there is the company responsible for the day-to-
day management of the trust.
o The management company will make the detailed
investment decisions, accept funds from investors, issue
certificates of unit ownership and pay income to
investors as appropriate.
 UNIT TRUSTS

o Each individual trust is always the responsibility of two

companies:
o In addition to its managing company, each trust has a
trustee.
o These are mainly specialist subsidiaries of major banks.
o The job of the trustee is to see that the fund is
managed within the terms of its ‘trustee deed’.
o This deed specifies the objectives of the trust and lays
down broad conditions governing the management of
the funds.
o There is an obvious sense, therefore, in which the
trustee company is acting as guardian of the unit
holders’ interests.
 INVESTMENT TRUSTS
o Investment trusts differ from all the other institutions we
have discussed in this chapter in a number of significant
ways.
o The difference lies:
o The chief of these is that while all previous
intermediaries are ‘open ended’, investment trusts are
‘closed’.
o Their legal status and their regulatory framework are
others.
o They are not trusts at all in the sense that unit trusts
are. There is no trust deed, no trustee and the saver’s
claim upon the assets of the trust is only the very
general claim that any shareholder has upon a
company.
 INVESTMENT TRUSTS

o The difference lies:

o Indeed, being a limited company makes an investment
trust subject to the relevant Companies Acts and it is
these which principally constrain the trusts’ conduct of
business.
o Investment trusts, therefore, are not regulated by the
Financial Services Authority as are unit trusts.
o The fact that investment trusts do not continually take in
new funds and channel them to ultimate borrowers
obviously raises the question of whether they should be
considered as financial intermediaries at all.