There are a range of financial institutions operating in the UK financial market.
The different institutions offer different combinations of services to their customers.
1. The Bank of England.
The Bank of England is the central bank of the UK. Owned by the Government, it is
responsible for carrying Government monetary policy.
It has a number of major functions:
a) Responsible for the issue of notes and coin.
b) Manages the country’s foreign exchange reserve
c) Acts as the banker to banks:
All banks in the UK keep 0.5% of their liabilities with the B of E and these
balances are used to settle accounts between banks after cheques have been
The B of E lends money to the commercial banks if they need it and is therefore
known as “the lender of last resort”
d) Since 1997 it has been responsible for setting the level of short-term interest rates
to meet the Governments inflation target.
Traditionally the Bank of England acted as the banker to the government and
managed the national debt. However since 1998, this function has been carried out by
the Debt Management Office (DMO).
The creation of the DMO reduced the responsibilities of the Bank of England in order
to balance the extra work involved in the operational control of monetary policy.
2. The retail banks.
Also known as high street or clearing banks. These banks are the main link between
individuals and the financial system. e.g. Natwest, HSBC, Ulster Bank.
The main role of the retail banks is to:
a) Accept deposits from customers, (saving accounts)
b) Lend funds. Short term and long term loans to individuals companies and
c) Money transmission services. Banks provide a range of methods for payment and
receiving funds, ( BACS, cheques, debit cards.)
d) Other financial services. Foreign currency, investment advice, fund management)
3. Merchant banks.
Merchant or investment banks such as Morgan Grenfield, and, Rothschilds deal
mainly with commerce and industry.
The main role of the merchant bank is to:
a) Accept promises to pay. Merchant banks act as a guarantee to IOU’s issued by
firms. They charge a commission for this.
b) Give financial advice to companies. On topics like how to handle a merger or
c) Issue shares. Carry out the work involved in floating a company on the stock
d) Investment management. Will manage investment or unit trusts on behalf of other
e) Wholesale banking. Lending to other banks and financial institutions or providing
finance for firms.
4. Building societies.
Originally building societies did not compete with retail banks.
Until the mid 1980’s they were mutual societies (owned by borrowers and lenders)
who accepted deposits from individuals and lent this money out as mortgages. Since
the introduction of the Building societies act in 1986, building societies have
expanded their services to include most of the services offered by retail banks.
Some have converted to PLC’s (abbey national) and are now very similar to banks in
that they aim to make a profit.
5. The London stock exchange.
The LSE deals with the trading of shares and securities. Shares and securities are a
form of long term borrowing by firms. With out a stock exchange these assets would
be very illiquid and thus very few people would buy them.
The LSE provides a market where holders can sell these assets and therefor it makes
these assets more liquid.
(more on the LSE later)
6. Insurance companies.
Collect monthly/annual premiums from individuals and undertake to pay a lump sum
either at a set date or in the event of death or injury.
The company then invests this money in securities to make a profit.
7. Unit trusts.
Savers buy a share (unit) of a fund. This money is then invested, by the fund manager,
in the shares of certain companies. All profits are shared between the owners of the
8. Investment trusts.
These are similar to unit trusts, however, it is limited companies who use their capital
to buy shares in other companies in order to make a profit.
The Financial Services Authority (FSA)
There are a large number of financial institutions in the UK, all offering a range of
financial services to customers. (e.g. banks, building societies, mortgage companies,
credit card providers, financial advisors etc).
Financial services are a very complex business. The details of how financial markets
work are beyond that of the average customer.
This situation of “asymmetric information”1, means that there is potential for the
seller of financial products, to take advantage of the lack of knowledge of the
customer, and therefore sell the customer a product which does not fully satisfy his
To ensure that financial service providers do not abuse this situation the government
set up the FSA in 1997.
The FSA is an independent (non-governmental) organization, which regulates the
financial services industry in the UK.
The FSA has four main goals:
1) Maintaining confidence in the UK financial system
2) Promoting public understanding of the financial system
3) Securing the right degree of protection for consumers
4) Contributing to a reduction in financial crime.
The FSA requires that firms in the financial services industry adhere to a number of
The FSA requires that firms should:
Observe high standards of integrity and fair dealing.
Act with due care, skill and diligence.
Seek from its customers any information that will help it fulfil its responsibilities
Give customers all information needed to allow them to make balanced and
Avoid any conflicts of interest.
Safeguard its customer’s assets.
The Bank of England traditionally carried out the role of the FSA. This transfer of
responsibility from the Bank of England to the FSA is another example of the
government balancing the central bank’s increased control over monetary policy with
a reduction of its other functions.
The FSA and the DMO represent a significant change in the organisation of UK
financial markets and in the functions of the Bank of England.
Changes to the structure of the financial sector.
Asymmetric information occurs when one party in a deal, has greater information than the other
Traditionally the UK financial market was very structured. The different types of
financial institutions dealt in different markets and therefore did not compete directly
with each other.
e.g. traditionally building societies dealt in the mortgage and savings market, and the
retail banks operated in the market for current accounts, cheque accounts etc.
Today building societies offer a wide range of banking services and retail banks offer
In addition many of the retail banks have their own, in-house, discount departments
which compete with the 8 main discount houses.
The main reason for these changes was the deregulation of the financial markets in the
The conservative Govt felt that the regulations and rigid structure of the financial
markets acted as a bar to competition and efficiency. For this reason they set about
deregulating the industry.
Results of deregulation.
1. Increased competition.
Building societies have taken a greater share of the retail banking market and
reduced the power of the big 4. In addition retail banks have taken a share of the
2. Better deals for customers.
The increase in competition means that firms offer better deals to customers.
Cheaper mortgages, loans etc.
However there have also been negative effects
Deregulation lead to an increase borrowing which increased the money supply
(M4) and lead to a consumer spending boom and inflation.
The increase in competition forced banks to become more efficient and lead to
the closure of branches especially in rural areas.
1. What is meant by the term “lender of last resort”.
2. Explain the difference between retail and merchant banks.
3. What is meant by the term “discounting”?
4. Using a numerical example explain how discount houses make money through
5. What is the difference between a unit trust and an investment trust?
6. How do insurance companies make money?
7. What are the main functions of the Bank of England?
8. Explain the role of the Financial Services Authority.
9. Why did the government take away some of the responsibilities of the Bank of
England by creating the DMO and the FSA?