The document discusses the economic rationale for a formal financial system. It explains that a financial system encourages investment by channeling funds from ultimate lenders to ultimate borrowers through financial intermediaries like banks. This allows for a more efficient transformation of savings into investment. It also discusses the costs associated with searching, monitoring, and contracting between lenders and borrowers that financial institutions help reduce. The document provides examples of how deposit-taking institutions like banks function as intermediaries through diversification, maturity transformation, and risk transformation to overcome issues between lenders and borrowers.

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Sectiona) Question1 - Explainthe economicrationale foraformal financial system:
The fundamental role for a formal financial systemis to encourage investment, as well as
providing ultimate borrowers and lenders with low cost opportunities to make profit. This
occurs through the use of a more efficient and effective system that allows a channelling of
funds and an easy transformation of financial capital into tangible capital. It is assumed that
investment is the idea of committing a resource in the expectation of later receiving
marginal gains and benefits.
A simple model of this process would show ‘ultimate lenders’ providing financial capital in
the form of savings, this is often seen as a deposit made at a financial institution. A financial
institution then acts a broker providing a relationship with an ‘ultimate borrower’ who
invests that financial capital to create tangible capital. The borrower then pays back all
liabilities as well as the agreed upon interest rate set by either the bank or lender. This
process increases productivity overall and helps increase economic welfare through growth,
as well as encouraging trade through its ease of transactions.
All individuals have different needs and assets available to them. The ultimate lender is the
individual who’s savings are larger than their costs (surplus agent), their objective is to give
out their financial capital in return for interest on their loan. An ultimate borrower lacks the
financial capital of the lender but can provide investment opportunities which will become
tangible capital and produce a profit that will be given to all individuals involved (interest on
liabilities). It is the role of the intermediately firm to bring these two parties together as well
and settling an agreement on any compromises that either individual may have to make.
There would normally be a high cost associated with the ‘search’ of each party if no financial
intermediary was used. Firms would have to devote a large amount of time finding a
suitable borrower (financial deficit) to effectively use there surplus in financial capital. The
Bank will dramatically reduce this cost by providing suitable investors.
When an intermediately firm is not used, there are high costs associated with the
‘agreement’ in the form of a contract as both individuals will have conflicting desires but
both will try to maximise profits at the expense of the other. The bank will first try to find
solutions for each individual’s needs, if no solution is available then they will need to find a
suitable compromise in the contract that allow profit to be made on both sides. When
looking from the perspective of the ultimate lender, their ideal interaction would be to give
out a minimal amount of capital as this results in a smaller amount of risk if the other
individual is unable to pay back the invested capital or interest on the transaction. The
lender would also like to see a quick return on their investment, they would prefer a shorter
time frame on the loan which places allot of pressure on borrowers. However the borrower
would prefer the largest amount of capital to invest (at low interest) as this gives them the
ability to acquire greater returns from a larger investment, and in turn result in a greater
marginal profit. As suggested earlier the borrower would also prefer more flexibility in
repayments, this would be created through longer time frames to repay their liabilities.
However standardised contracts are often used. These are contracts that can be used for a
large number of transactions without alterations. By using a standardised contract the

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agreement costs are reduced as a new legally binding contract does not need to be devised
e.g. current account, loan, etc.
A 3rd area of cost is through the ‘monitoring’ of funds and the assurance of repayments. By
delegating this role to a bank, a lender does not need to spend resources financing
employees to monitor the financial welfare of the borrower (ability to repay liabilities) and
the confidence that their financial capital is being used for appropriate and profitable
investment. The bank should monitor all transactions taking place between all parties, as
well as making sure that the borrower has the ability to repay the loan on the agreed upon
date.
Financial institutions have multiple ways to overcome these problems. Deposit-taking
institutions (DTI’s) such as banks or building societies whose liabilities are primarily deposits,
are an example of an efficient intermediator firm that can increase investment. A DTI will
act as both a borrower and lender and create a primary and secondary transaction in the
channelling of funds. To overcome the lenders conflicting desire to produce a minimal
amount of financial capital (smaller than the borrower’s needs), a building society will take
small deposits made by a large number of account holders and create a pool of capital, this
is called diversification as the bank holds a large number of assets rather than few. They can
then create larger pools of funds that meet the requirements of the borrower. This also
overcomes the conflict in time restrictions on liabilities as larger institutions don’t have the
need of fast returns or immediate payment in interest, this is called maturity transformation
as it’s the act of converting funds lent for a short period of time into loans of longer
duration. By paying the bank the interest it will cover the banks liability to the saver
(lenders) that they have used to create the financial capital. They have this ability as large
institutions have a constant flow of deposits and withdrawal of funds which cancel each
other out, portfolio equilibrium is the optimum mixture between liquidity in funds and yield
from deposits which is balanced for risk and return.
Intermediators also create a liquidity in funds. This has three defining aspects, the speed at
which assets can be exchanged for funds, the possibility that the asset may have
depreciated in value, cost and sacrifices that have to be made in carrying out the exchange.
This is useful for investment as it speeds up transactions and the overall process as well as
reducing the risk of the investment; a reduction in risk is called risk transformation, this is
the reduction of risk that can be reduced through diversification of lending and the
screening of borrowers. This is beneficial to economic growth by increasing the rate of
investment and reducing any negative impacts that may occur in the economy.
This shows that there is clear rational for the use of a financial systemin the current
economy. There are clear benefits of cost reduction between borrowers and lenders, this
increases the amount of investment and increases the rate of investment, and in turn this
helps the overall economic welfare and the country’s GDP. It also provides solutions for
problems that occur between parties during the transactions, this improves the quality of
investment and will again encourage more investments.

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Section B) Question 2 - choose a UK clearing bank
After the financial crisis of 2009, Deposit taking institutions have come under scrutiny after
many customers were unable to withdraw money that they had deposited into banks. This
has led to many new preventative measures being put into place in order to protect both
the banks and their customers. One new implementation is the increase in the cash reserve
ratio each bank has. HSBC will be the example bank used to demonstrate how this works
and why it is needed.
The cash reserve ratio is the ratio between funds deposited into HSBC and the total cash
that the bank holds. A typical balance sheet for a deposit taking institution will show various
liabilities, the largest being retail and wholesale deposits, as well as the bank’s assets which
will vary in liquidity. As banks are profit maximising institutions they use a fractional reserve
banking approach. This allows them to use customer’s deposits for a pool of funds which
can then be used to provide loans for other customers. This then has the credit creation
multiplier effect. The bank has a required reserve held from each deposit made at the bank,
the excess reserve is then used as a loan. This loan is then deposited back into the bank, and
the excess reserve is loaned out again. This results in increases to the balance sheet (figure
1) and multiplies both there total assets and liabilities despite no new cash entering the
system.
Figure 1)
Based on data from Bloomberg (2015)
This effect has the ability to transform an initial deposit of £100 into a final deposit of £900
when the reserve ratio is 10%. This then means that the lower the reserve ratio the greater
the profit the bank can make. However with high probability banks will suffer liquidity
issues. This is because the required reserves must accommodate the financial needs of
customers needing to withdraw money from their accounts. If there is a lack of liquidity of
HSBC balancesheet (inmillionsof
GBP)
Year 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Cash + Cash
equivalent
14552.9 13880.1 15908.6 40067.9 41522.2 40699.8 89051.5 91635.9 10420
1.4
86569.
5
Total
deposits
430219.9 463168.9 552852.2 765232.
9
717757 787457.
5
808514.
4
825030.
2
89509
3.6
86685
1.9
Cash reserve
ratio (%)
3.383 2.997 2.878 5.236 5.785 5.169 11.014 11.107 11.641 9.987

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funds the bank will not hold enough cash to give the fluctuating number of customers
withdrawing money.
Figure 2)
Based on data from Bloomberg (2015)
Figure 1 shows a simplified version of HSBC’s balance sheet between 2005 and 2014. It
shows total cash, total deposits and the cash reserve ratio for each year. HSBC shows very
low cash reserves (around 3%) between 2005 and 2007, this would show that the institution
was making high profits during this period, reaching around $22bn pre-tax (data reported
from the guardian). This ratio then rises to 5% in 2008. This increase in reserves is likely due
to HSBC’s liquidity needs as effects of the mortgage lending crisis in the US start to become
a global financial crisis. This again then increases to a much higher 11% in 2011.
The initial increase in cash reserve ratio in 2008 is most likely a preventative measure in a
response of the financial crisis. In 2008 HSBC made a $17.2bn loss in the US housing market.
This would have highlighted the banks financial uncertainty and its need for more liquid
finance in the following few years as credit became limited and economies entered
recession. This increase in reserve ratio also resulted in lower profit growth as HSBC’s profit
only rose 10% pre-tax, whilst the inflation rate rose to 5%. During this period financial
institution’s solvency and liquidity issues were uncertain, this lead to large numbers of
consumers withdrawing money from deposit taking institutions simultaneously. When a
bank run occurs it is vital that banks have a high required reserve and that they can provide
their customers with cash they have deposited, therefore increasing the reserve ratio was a
necessary measure for HSBC.
During 2011 the reserve ratio more than doubled to 11%. In 2011 HSBC experienced various
changing of hands and new strategies focusing less on commercial banking and more on
investment. This increase in reserves again is likely to be a preventative measure. During
this period global economic growth had slowed again with natural disasters in japan and
trouble in the Eurozone with Greece. High required reserves would result in more liquidity
0
2
4
6
8
10
12
14
2 0 0 5 2 0 0 6 2 0 0 7 2 0 0 8 2 0 0 9 2 0 1 0 2 0 1 1 2 0 1 2 2 0 1 3 2 0 1 4
CASHRESERVERATIO(%)
CASH RESERVE RATIO (%)

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in funds that could be used if global financial markets detreated again, repeating the effect
of 2008.
Section C) Question 4 - choose a week in December 2015, identify the change in the discount
rate, and hence price of the UK government’s 3 month Treasury bill across the week.
UK treasury bills are issued by the government and traded on traditional money markets.
They are issued with their rate of return being expressed as the discount rate of their
redemption value. Their length of maturity ranges between 3, 6 and 12 moth periods.
Changes in yield (discount rate) have been taken from a 3 month UK treasury bill over a
week in December, starting on the 14/12/2015 (figure 3).
Figure 3)
Source: Bloomberg (2016)
Equation for pricing UK Treasury bill:
P = R – d*(R*n)
P = Price, R = redemption value, d = discount rate, n = number of years until maturity
0.496
0.496
0.502
0.497
0.495
1 2 / 1 8/20151 2 / 1 7/20151 2 / 1 6/20151 2 / 1 5/20151 2 / 1 4/2015
YIELD(%)
UK TREASURY BOND (3 MONTHS)

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To analyse the effects of yield on UK treasury bills, the pricing equation must be used. This
equation demonstrates how changes to the discount rate (yield) can increase or decrease
the price. The redemption value is the set sum that the owner will receive at the date of
maturity. The discount rate or yield is the percentage amount discounted at the time of
purchase. As the maturity length is 3 months n will remain constant at 0.25. The redemption
value is also kept constant as it has been agreed upon at the time of purchase. Therefore
changes in discount rate will be inversely proportional to that of price, as discount rate is
negative and all other variables are constant. As the discount rate rises the price of UK
treasury bills will fall, as the discount rate decreases price will increase. Therefore change to
the UK’s interest rates will cause inverse fluctuations to the UK Treasury bill’s price across all
maturity lengths.
However supply and demand can cause many of the fluctuations in price and yield. Treasury
bills are traded on both a primary and secondary market, in a primary market the supply is
price inelastic. The quantity of bills in the market can expand or contract depending on
economic growth, the governments need for funding or the costs of other alternative
sources. Demand is effected by income, inflation and liquidity needs.
The changes in UK Treasury bill yield can be explained using the pricing equation as well as
demand and supply (figure 4). An article by BBC news describes how the US federal funds
rate increased by 0.25% overnight on 15/12/2015. By increasing interest rates (discount
rate) on US treasury bills their price decreased, as the equation shows that price and yield
are inversely proportional. This caused demand of US treasury bills to increase and UK
treasury bills to decrease as the US now provided a cheaper alternative source, by lowering
the opportunity cost of US bills. This drop in demand caused a decrease in price of UK
treasury bills and an increase in yield, therefore resulting in the high 0.502% yield seen on
16/12/2015. However price changes in markets often tend to overshoot when the initial
change occurs, allowing the price to return somewhere near the initial price. This occurs as
the UK bills now have a high discount rate at 0.502% which causes demand to rise until the
return on UK bills is equal to US bills. When the price and return are equal there is no
opportunity cost and alternative cheaper source.
Figure 4)

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Section C) Question 6 - choose a FTSE100 company. Choose a market trading day in
February 2016.
Figure 5 shows the change in share price of sports direct on the 26th of February 2016.
Relevant news and economic theory will be used to explain why the share price initially falls
and gradually increases throughout the rest of the day.
Figure 5)

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Source: Bloomberg (2016)
On the 26th of February 2016 sports direct declared that loans exceeding £250million would
no longer be taken from Mike Ashley’s loan facility, who is the current largest shareholder
of sports direct at 55%. Previously acquired funds were borrowed with approximately 50%
lower interest than alternative source. This overtime had saved sports direct over £1million
in repayable fees, whilst increasing the company’s dependence on Mike Ashley’s role within
the firm. However current governance issues and scrutiny from the media have forced
sport’s direct to follow more conventional means of finance as well as prompt a ‘long
overdue governance overhaul’.
P = E1/(r-g)
P = fairprice of share,E1 = expectedearningsof followingyear,r= requiredrate of return(assumed
constant),g = expectedgrowthrate of earnings
The earnings valuation equation demonstrates why sports directs decision to seek other
means of finance resulted in the initial drop in share price from £399.4 (closing price
25/02/2016) to £386.6. If required rate of return is assumed constant, then negative
changes to expected earnings or growth will result in a drop in price. As sports direct will
now incur higher borrowing costs expected earnings will decrease resulting in a drop in
price. Sports direct has also shown a 42% fall in share prices over the course of the year
showing expected growth rate to also be low. This is the cause of the initial 3.2% drop seen
at the start of the day. However this decision may also prompt a governance overhaul by
reducing sports directs reliance on Mike Ashley. This in turn could cause the gradual
increase in share price, as investors see this structural change as the beginning of possible
growth for the company, increasing g in the equation.
Supply and Demand can also demonstrate the changes in share price (figure 6). As investor
confidence decreases in the expected earnings demand for sports direct share drops. This
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PRICE(£)
SPORTS DIRECT PRICE [26/2/2016]

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sets a new lower market price. However investors who believe the share is worth more than
the new asking price (lower required rate of return) or believe that the market has overshot
with the new information, prompt a new increase in demand. This causes the price to
gradually rise to the new fair value price which closed at 397.4.
Figure 6)
References:
ACDCLeadership (2014) how banks create money and the money multiplier – macro 4.8
[online video] available: https://www.youtube.com/watch?v=JG5c8nhR3LE [accessed:
15/04/2016]
BBC news (March 2008) HSBC in $17bn credit crisis loss [online article] available:
http://news.bbc.co.uk/1/hi/business/7274385.stm [accessed: 15/04/2016]
Howells, P. and Bain, K. (2007). Financial markets and institutions. Harlow, England: Prentice
Hall/Financial Times. Pages (1 – 28)
IMF (September 2011) world economic outlook (WEO) [web page] available:
http://www.imf.org/external/pubs/ft/weo/2011/02/ [accessed: 15/04/2016]
James Davey, edited by Greg Mahlich (February 2016) sports direct to stop borrowing from
founder [online article] available from: http://www.reuters.com/article/sports-direct-loan-
facility-idUSL8N1651OB?type=companyNews [accessed: 18/04/2016]
Jill Treanor, the guardian (may 2011) HSBC cuts threaten thousands of jobs [online article]
available: http://www.theguardian.com/business/2011/may/11/hsbc-strategic-review-fast-
growing-markets [accessed 15/04/2016]

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Julia Kollewe, the guardian (march 2007) record profits at HSBC [online article] available:
http://www.theguardian.com/money/2007/mar/05/accounts.business [accessed:
15/04/2016]
Nils Pratley the guardian (may 2011) HSBC’s new strategy sounds familiar [online article]
available: http://www.theguardian.com/business/2011/may/11/viewpoint-hsbc [accessed:
15/04/2016]
Unknown author (December 2015) sports direct’s corporate governance needs a radical
overhaul [online article] available:
http://www.theguardian.com/business/2015/dec/16/sports-direct-corporate-governance-
needs-a-radical-overhaul [accessed: 18/04/2016]
Unknown author (december 2015) US Fed raises interest rates by 0.25% [online article]
available: http://www.bbc.co.uk/news/business-35117405 [accessed: 17/04/2016]