Global Financial System

Unit 1 - Environment of Global Financial System

The world is becoming increasingly integrated and interdependent, as trade and investment
flows are global in nature. With this background, therefore, it is important to understand the
core role that the financial services sector performs within the economy and some of the key
features of the global financial services sector.

The financial services sector plays a critical role in advanced and developing economies, and
the services it provides can be broken down into three core functions:
The investment chain – through the investment chain, savers and borrowers are brought
together. Savers provide financing to businesses, and businesses that wish to grow offer
opportunities for savers to take part in the growth and resulting potential returns. The
efficiency of this chain is critical to allocating what would otherwise be uninvested capital to
businesses that can use it to grow their enterprises, as well as the savings pools of the
investors. This chain therefore raises productivity and, in turn, improves the competitiveness
of those financial markets within the global economy.
• Risk – in addition to the opportunities that the investment chain provides for pooling
investment risks, the financial services sector allows other risks to be managed effectively
and efficiently through the use of insurance, and increasingly through the use of sophisticated
derivatives. These tools help businesses cope with global uncertainties as diverse as the
changing value of currencies, the incidence of major accidents or extreme weather conditions.
They also help households protect themselves against everyday contingencies.
• Payment systems – payment and banking services operated by the financial services sector
provide the practical mechanisms for money to be managed, transmitted and received quickly
and reliably. It is an essential requirement for commercial activities to take place and for
participation in international trade and investment. Access to payment systems and banking
services is a vital component of financial inclusion for individuals.

The financial services sector provides the link between organisations needing capital and
those with capital available for investment. For example, an organisation needing capital
might be a growing company, and the capital might be provided by individuals saving for
their retirement in a pension fund. It is the financial services sector that channels the money
invested to those organisations that need it, and provides execution, payment, advisory and
management services.

Financial Markets
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
institutional sector.

• Equity markets – the trading of quoted shares.

• Bond markets – the trading of government, supranational or corporate debt.
• Foreign exchange – the trading of currencies.
• Derivatives – the trading of options, swaps, futures and forwards.
• 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 investment portfolios of collective investment schemes
(CISs), pension funds and insurance funds
• investment banking – banking services tailored to organisations, such as 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.
• Financial planning and financial advice – helping individuals to understand and plan for
their financial future.

Participants
Investment Banks
Investment banks provide advice and arrange finance for companies that want to float on the
stock market, raise additional finance by issuing further shares or bonds, or carry out mergers
and acquisitions. They also provide services for institutional firms that might want to invest
in shares and bonds, in particular pension funds and asset managers.
Typically, an investment banking group provides some or all of the following services:
• Finance-raising and advisory work, both for governments and for companies. For corporate
clients, this is normally in connection with new issues of securities to raise capital, as well as
giving advice on mergers and acquisitions.
• Securities-trading in equities, bonds and derivatives and the provision of broking and
distribution facilities.
• Treasury dealing for corporate clients in currencies, including ‘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 very wealthy private clients. In the larger investment banks, the value of funds under
management runs into many billions of dollars.

Only a small number of 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.

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. Activities they undertake include the following:
Holding assets in safekeeping, such as equities and bonds.
• Arranging settlement of any purchases and sales of securities.
• Asset servicing – collecting income from assets, namely dividends in the case of equities
and interest in the case of bonds, and processing corporate actions.
• Providing information on the underlying companies and their annual general meetings
(AGMs).
• Managing cash transactions.
• Performing FX transactions when required.
• Providing regular reporting on all activities undertaken that affect the holdings in a
portfolio, including all trades, corporate actions and other transactions.

Cost pressures have driven down the charges that a custodian can make for its traditional
custody services and have resulted in consolidation within the industry. The custody business
is now dominated by a small number of global custodians who are often divisions of major
banks. Among the biggest global custodians are the Bank of New York Mellon and State
Street.
Generally, they also offer other services to their clients, such as stock lending, measuring the
performance of the portfolios of which they have custody and maximising the return on any
surplus cash.

Retail/Commercial Banks
Retail/commercial banks are known by different names in different countries. They are the
financial institutions that 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, but increasingly they operate through telephone and internet-based services. As
well as providing traditional banking services, larger retail banks also offer other financial
products, such as investments, pensions and insurance. Banks that offer multiple services
such as this are known as ‘financial conglomerates’. The BIS defines a financial
conglomerate as:

‘any group of companies under common control whose exclusive or predominant activities
consist of providing significant services in at least two different financial sectors (banking,
securities, insurance)’

Savings Institutions
As well as retail banks, most countries also have savings institutions that started off by
specialising in offering savings products to retail customers, but now tend to offer a similar
range of services to those offered by banks.
They are known by different names around the world, such as cajas in Spanish-speaking
countries, credit unions in North America and building societies in Australia and the UK.
They are typically jointly owned by the individuals that have deposited or borrowed money
from them – the members. It is for this reason that such savings organisations are often
described as ‘mutual societies’ or ‘mutual savings banks’.
Over the years, many savings institutions have merged or been taken over by larger ones.
More recently, a number have transformed themselves into banks that are quoted on stock
exchanges – a process known as demutualisation.
Peer-to-Peer (P2P) and Crowdfunding
A more recent development in the banking sector has been the emergence of competitors to
the traditional role of banks in the form of crowdfunding.
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 bank or 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.
• Debt crowdfunding – investors essentially lend then receive their money back with
interest.
• Equity crowdfunding – people invest in exchange for equity or shares in the venture.
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. Peer-to-
peer (P2P) lending or debt crowdfunding cuts out the banks so that borrowers often receive
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 during 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. Most of these loans are unsecured, meaning that they are not backed
by any collateral in the event of default.
In terms of equity crowdfunding, it usually involves a start-up seeking funding from a large
number of people. Some start-ups may even seek to convert its fans and customers into
investors in order to enhance brand loyalty. To the founder, one advantage of having a large
number of funders instead of one or a few key investors is that large investors may have
different ideas and seek to influence how the business is run. Having a diverse source of
funding may help to diffuse pressure from such investors. Moreover, small investors can be
turned into brand ambassadors for the company.

Insurance Companies
As mentioned above, one of the key functions of the financial services sector is to allow risks
to be managed effectively.
The insurance industry provides solutions for much more than the standard areas, such as life
cover and general insurance cover.
Protection planning is a key area of financial advice, and the insurance industry provides a
variety 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.

Insurance companies collect premiums in exchange for the coverage provided. This premium
income is invested in equities and bonds and, as a result, the insurance industry is a major
investor in both equity and bond markets. Insurance companies will also hold a large amount
of cash to be able to satisfy any claims that may arise on the various policies and, if required,
will liquidate investment holdings.

Retirement Schemes
Retirement schemes (or pension schemes) are one of the key methods by which individuals
can make provision for their retirement needs. There are a variety of retirement schemes
available, ranging from ones provided by employers, to self-directed schemes.

Traditionally, company pension schemes provided an amount based on the employee’s final
salary and number of years of service. Nowadays, many companies find this too expensive a
commitment, given rising life-expectancy and volatile stock market returns. Most companies
offer new staff defined contribution (DC) schemes, when both the firm and the employee
contribute to an investment pot. At retirement, the accumulated fund is used to provide a
pension.

Many individuals are not members of company schemes and instead provide for their
retirement through their own personal retirement schemes (self-directed schemes).
Taken overall, retirement schemes 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.
Fund Managers
Fund managers, also known as investment managers, portfolio managers 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 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. The global asset management
industry has more than doubled in size since 2000, with the Organisation for Economic Co-
operation and Development (OECD) and the International Monetary Fund (IMF) estimating
that there are over US$90 trillion of funds under management.

Investment managers will buy and sell shares, bonds and other assets in order to increase the
value of their clients’ portfolios. They can 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 of a mutual fund. Private client managers invest the money of relatively
wealthy individuals. Obviously, institutional portfolios tend to be 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 and may also have charges
linked to the performance achieved.

Other areas of asset management include running so-called hedge funds and the provision of
investment management services to institutional entities, such as charities and local
government authorities.

Stockbrokers and Wealth Managers

Stockbrokers arrange stock market trades on behalf of their clients, who are investment
institutions, fund managers or private investors. They may advise investors about which
shares, funds or bonds they should buy or, alternatively, they may offer execution-only
services, when the broker executes a trade on a client’s instruction without providing advice.
Many stockbrokers now offer wealth management services to their clients and so are also
referred to as wealth managers.
The services offered by stockbrokers and wealth managers can be divided into four main
categories:
Execution-only stockbrokers – these offer telephone or internet-based trade execution and
settlement for retail clients. No advice is offered and commission is charged per trade. They
are aimed at day traders and investors who are confident in making their own investment
decisions and, typically, investors with small portfolios.
• Robo-advisers – a recent innovation, a robo-adviser is an online wealth management
service that provides automated, algorithm-based portfolio management advice without the
use of human financial planners. The robo-adviser typically charges a monthly or annual fee
based on the size of the portfolio (amount of assets under management).
• Advisory and discretionary wealth managers – these offer a wealth management service
to private investors – either advice only or a fully managed (discretionary) service. Their
target market ranges from mass affluent to high net worth clients with large portfolios and
they charge fees for management of the portfolio based on the value of the portfolio.
• Institutional brokers – these are stockbrokers who arrange trades on behalf of large
institutions. Their skill lies in their ability to execute what are typically large trades in the
market, without having a significant adverse effect on the share price. This may involve
breaking up a large order into smaller trades and executing them through a variety of
different trading venues so as to minimise their impact on the market. Institutional brokers
usually charge basis point fees per trade.

Like fund managers, stockbrokers and wealth managers look after client assets and charge
custody and portfolio management fees.

Stockbrokers also advise investors about which shares, bonds or funds they should buy. As a
result, the traditional distinction between the two has blurred and is rapidly disappearing.
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, as with fund managers, they may
look after client assets and charge custody and portfolio management fees.

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 mutual funds, wraps often offer greater access
to other products too, such as 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 directly 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.

Private Banks

Private banks provide a wide range of services for their clients, including wealth
management, estate planning, tax planning, insurance, lending and lines of credit. Their
services are normally targeted at clients with a certain minimum sum of investable cash, or
minimum net worth. These clients are generally referred to as high net worth individuals
(HNWIs).
Private banking is offered both by domestic banks and by those operating ‘offshore’. In this
context, offshore banking means banking in a jurisdiction different from the client’s home
country – usually one with a favourable tax regime.

Competition in private banking has expanded in recent years as the number of banks
providing private banking services has increased dramatically. The private banking market is
relatively fragmented, with many medium-sized and small players.
The distinction between private and retail banks is gradually diminishing as private banks
reduce their investment thresholds in order to compete for this market. Meanwhile, many
high street banks are also expanding their services to attract the ‘mass affluent’ and HNWIs.

Sovereign Wealth Funds (SWFs)

A sovereign wealth fund (SWF) is a state-owned investment fund that holds financial assets
such as equities, bonds, real estate, or other financial instruments. Examples of SWFs include
the Norway Government Pension Fund, Abu Dhabi Investment Authority, SAMA Foreign
Holdings of Saudi Arabia and China Investment Corporation.

SWFs are defined as special purpose investment funds or arrangements owned by a

government. Their key characteristics are as follows:

SWFs hold, manage, or administer assets to achieve financial objectives.

• They employ a set of investment strategies which include investing in foreign financial
assets.
• The assets of an SWF are commonly established out of balance of payments surpluses,
official foreign currency operations, the proceeds of privatisations, fiscal surpluses, and
receipts resulting from commodity exports.

SWFs have emerged as major investors in the global markets over the last ten years, but they
date back at least five decades to the surpluses built up by oil-producing countries and, more
recently, to the trade surpluses that countries such as China have enjoyed.
SWFs have colossal funds under management and are predicted to grow beyond the US$10
trillion mark within a few years.
They are private investment vehicles that have varied and undisclosed investment objectives.

Typically, their primary focus is on well-above-average returns from investments made

abroad. Their size and global diversification allows them to participate in the best
opportunities, spread their risks and, by diverting their funds overseas, prevent the
overheating of their local economies. They may also use part of their wealth as reserve capital
for when their countries’ natural resources are depleted. For some of the wealthiest SWFs, it
should be noted that the term ‘sovereign’ is not synonymous with public ownership.
SWFs are becoming increasingly important in the international monetary and financial
system, attracting growing attention. This growth has also raised several issues:

Official and private commentators have expressed concerns about the transparency of SWFs,
including their size and their investment strategies, and that SWF investments may be
affected by political objectives.
• There are also concerns about how their investments might affect recipient countries,
leading to talk about protectionist restrictions on their investments, which could hamper the
international flow of capital.

Trade and Professional Bodies

The investment industry is a dynamic, rapidly changing business, and one that requires
cooperation between firms to ensure that the views of various industry sections are
represented, especially to governments and regulators, and that cross-firm developments can
take place to create an efficient market in which those firms can operate.

This is the role of the numerous trade bodies that exist across the world’s financial markets.
Examples of these that operate globally are the International Capital Market Association
(ICMA), which concentrates on international bond dealing, and the International Swaps and
Derivatives Association (ISDA), which produces standards that firms that operate in OTC
derivatives follow when dealing with each other.

Third-Party Administrators (TPAs)

Third-party administrators (TPAs) undertake investment administration on behalf of other
firms, and specialise in this area of the investment industry.

The number of firms, and the scale of their operations, has grown with the increasing use of
outsourcing by firms. The rationale behind outsourcing has been 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 leave another firm to carry
on the administrative functions which it can process more efficiently.

Technological Advances

Technology and the demand for greener solutions are changing the way that the financial
services sector operates.
Technology is embedded in everything we do, changing the way we live, work, and
experience the world. Advances in technology have radically altered how we use the internet
and communicate which, in turn, are disrupting traditional industries.

Financial technology, known as FinTech, is impacting on the traditional banking and wealth
management industry and therefore requires the development of new digital services and
platforms. People across all generations are now digitally proficient and they desire constant
access to sophisticated tools and services, with clients of financial services firms being no
different.

We have looked already at how challenger banks, peer–to–peer (P2P) lending and robo-
advice is challenging the long-established provision of banking and investment services.
Technological developments in communications are also changing the face of the industry.
Today, we communicate using the latest apps or buy products online based on the artificial
intelligence (AI) recommendations of digital providers. Customers are demanding the same
range of digital capabilities that they have become used to for other products and services. As
an example, China’s fund management industry has gone from fledgling asset management to
global pioneer in a short number of years in terms of how fund purchases take place. In 2012,
only a handful of investors made fund purchases online but, according to a survey by the
Asset Management Association of China, more than two-thirds of investors now subscribe to
funds via mobile phone apps.

Environmental, Social and Governance (ESG) Investment

In today’s world, many individuals are concerned about the environment, business practices
and ethical issues. As a result, many want to reflect their personal values in the investments
they make whether that is avoiding the likes of tobacco and oil shares, supporting
environmentally conscious companies or using their funds for impact investing that generates
a social and environmental impact alongside a financial return.

In the investment industry, the expressions ‘ethical investment’, ‘environmental investment’,

‘green investment’, ‘responsible investment’ and ‘socially responsible investment’ are often
used
interchangeably and so can be quite confusing. Together, these strands are often brought
together under the label of environmental, social and governance (ESG) which includes a
range of approaches that includes various issues; it may also be referred to as ‘responsible
investing’.

Broadly speaking, ‘responsible investing’ reflects the ethical, moral, religious or socially
responsible beliefs of the client, and can heavily influence their choice of investments. Also
included in this group is the growing number of Shariah investments, which meet the rules of
Islamic finance. A key trend in recent years has been the increasing debate on environmental
and social issues and the scale of concern about environmental change is being reflected in
the asset management industry.

Green finance and sustainable finance are becoming increasingly important topics in the
financial
services sector. Sustainable finance refers to the process of taking due account of
environmental and social considerations in investment decision-making, leading to increased
investments in longer term and sustainable activities. Climate finance is an emerging form of
green finance available for projects in developing countries which helps reduce emissions or
adapt to climate change. This is achieved either via increasing the revenues available to
public and private development projects, such as tariff support or carbon finance, or by
improving project capital structure, for example by reducing the costs of debt and equity.

Research suggests that, by 2025, 50% of investment funds will have an investment mandate
requiring them to invest in accordance with ESG principles.