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Financial Sector

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Economics

You probably don’t know it, but you have been involved in the financial sector from an early age. You have been participating in it since the first time you bought something in a shop in exchange for cash. The financial services sector or the financial sector provides financing solutions for individuals, firms, and governments, which in turn contributes to economic stability and growth. Let’s find out what the financial sector really is and what specific function it serves.

What is the financial services sector?

The financial services sector is the part of an economy that provides financial services for individuals and businesses. The financial sector is made up of firms and institutions that provide financial services to customers. These include banks, insurance companies, brokers, and real estate firms.

Most economies around the world are monetary economies in which goods and services are traded via the intermediary of money. Thus, to understand the importance of the financial services sector, we need to examine the nature of money and money supply in an economy.

Money supply in the financial sector

The money supply is the total amount of money in an economy at a point in time.

Before monetarism, money supply wasn’t given much attention because, in the Keynesian view, money has no effect on macroeconomics. This all changed at the advent of monetarism. In the 1970s, money began to gain more weight in the economy, causing economists to focus more on determining which assets to include or exclude from the money supply.

In the UK, there are two ways to measure money supply:

  • Narrow money consists of cash, liquid bank, and building society deposits, reflecting money’s function as a means of payment.
  • Broad money is made up of cash, liquid assets such as bank and building society deposits, as well as some less liquid assets.

Note here that broad money includes both liquid and illiquid assets, as opposed to narrow money which only consists of liquid assets.

Liquidity measures the ease to convert a financial asset into cash without loss of value.

The less liquid an asset is, the less likely it will be used as a medium of exchange. Cash is the most liquid asset of all as it can be immediately used as a means of payment.

Assets and liabilities in the financial sector

Assets and liabilities are two important concepts associated with services in the financial sector.

Assets are the things you own that offer a future economic benefit whereas liabilities are things you owe to others.

Banknotes and coins traded in an economy can be viewed as both an asset and a liability.

Suppose you get a loan from a commercial bank. The loan is your liability but the commercial bank’s asset. However, since the bank has to ‘deposit’ money from another account to your bank account, it creates liability for itself simultaneously.* Here, the loan is both an asset and a liability to the bank.

In the above example, the loan-creating process increases the bank’s assets and liabilities by the same amount. The creation of credit (an asset from the bank’s point of view) happens at the same time and in equal amounts as the deposit of credit (a liability from the bank’s point of view).

* The bank doesn't actually take money from another customer’s account but creates new money to lend you.

To learn more about the money creation process, check out our explanation on the Money Market.

Portfolio balance decisions in the financial sector

Portfolio balance decisions are choices people make over which assets to own. These include physical assets such as houses, land, or art and financial assets such as cash, government bonds, shares, or bank deposits. Financial assets are ranked according to the level of liquidity and profitability.

Financial sector portfolio balance decisions StudySmarterFigure 1. Portfolio balance decisions - StudySmarter.

As you can see in Figure 1, liquidity is the ease with which an asset is converted into cash. Cash is the most liquid asset and thus treated as money. Government bonds and shares (not money) are the least liquid financial assets but can earn the owner interest over time.

The impact of the financial sector on economic growth

As we said before, the financial sector is made up of firms and institutions that provide financial services to customers.

The financial sector makes money by lending savings of idle cash to those in need. Thus, it gains more profits as the interest rates drop (People are more likely to borrow money at a lower interest rate).

Businesses use these loans to purchase equipment and expand their business growth, which contributes to economic development. This is why a strong financial sector indicates a healthy economy.

The financial sector also helps to stabilize the economy by satisfying both the supply and demand sides of money. Through the financial institutions, those with idle cash can lend out their money to collect interest while companies and governments can get loans quickly to fund their financial projects.

The UK financial sector

The UK’s financial sector or financial market is a market that facilitates the trading of financial assets or securities.

Figure 2 illustrates the components of the UK financial market.

Financial sector financial market components StudySmarterFigure 2. Financial Market Components - StudySmarter.

UK financial markets are divided into capital markets that supply medium to long-term or undated financial assets and money markets which provide short-dated financial assets. There are also foreign exchange markets, consisting of spot markets and forward markets.

To learn more about the different types of financial markets, read our explanation on Financial Markets.

The impact of Brexit on the UK’s financial services sector

Brexit is the withdrawal of the UK from the European Union after 47 years of membership. The UK voted to leave the EU in 2016 but only officially left on 31 January 2020.

Brexit has brought significant changes to the relationship between the UK and the EU1:

  • Previously, goods in the UK and other European countries could be traded without taxes or restricted amounts. While this remains the same, there are new rules and standards on workers’ rights, social, and environmental regulations.
  • The UK will no longer benefit from passporting which allows it to export goods and services to EU countries without any complex procedure.
  • UK citizens are also no longer free to work in the EU and vice versa. They need to acquire a visa to stay more than 90 days in a 180-day period.
  • The UK can set its own trade policy since it is no longer a member of the EU.

According to the New Financial², so far Brexit has impacted the UK’s financial services sector in three main ways:

  • More than 440 banking and financing institutions have relocated from the UK to the EU.
  • 10% of UK bank assets (the equivalent of £ 900 billion) have been or will be moved to the EU.
  • 7400 financial services jobs have also been moved to the EU.

There will be disruptions to trade, investment, immigration, and jobs in the UK, but there are also major benefits as the country is no longer held under EU regulations and rules. It can choose its own path and increase its competitiveness in the global market.3

Financial Markets - Key takeaways

  • Financial markets support the trading of financial instruments in an economy.
  • Money is a major component of the financial market.
  • Trading in the financial market is associated with assets and liabilities. Assets are the things you own that contribute to future income whereas liabilities are what you owe to others.
  • The financial sector can drive economic growth and is important for balancing the supply and demand of money in the market.
  • The financial market is divided into the capital market, money market, and foreign exchange market

References

1. BBC News, Brexit: What you need to know about the UK leaving the EU, 2020.

2. Eivind Friis Hamre and William Wright, Brexit & The City: The Impact So Far, New Financial, 2021.

3. The Week, The pros and cons of leaving the EU customs union, 2019.

Financial Sector

The financial services sector is the part of an economy that supports the trading of financial instruments such as stocks, bonds, foreign currency, insurance and commodities. It also regulates the balance of supply and demand of money by lending money from private savings to those in need.

A company that struggles financially can default on its debt and this results in a loss for the investors. Credit risk management helps executive managers to identify accounts with a higher risk of defaults and avoid losses.

Brexit has brought significant changes to the relationship between the UK and EU:  


  • Previously, goods in the UK and other European countries can be traded without taxes or restricted amounts. While this remains the same, there are new rules and standards on workers' rights, social and environmental regulations. 
  • The UK will no longer benefit from passporting which allows it to export goods and services to EU countries without any complex procedure. 
  • UK citizens are also no longer free to work in the EU and vice versa. They need to acquire a visa to stay more than 90 days in a 180-day period. 
  • The UK can set its own trade policy since it is no longer a member of the EU.  

  • Banking
  • Insurance
  • Accounting
  • Financial planning
  • Investmenets and pensions
  • Taxes

Final Financial Sector Quiz

Question

Define what a bank is.

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Answer

A business that makes its profit by paying interest to people who keep money there and charging a higher rate of interest to borrowers who borrow money from the bank.

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What are the two types of banks?

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Commercial and investment banks.

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What are bank reserves?

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Money and liquid assets (such as securities that can be sold quickly) held by banks in order to meet withdrawals by customers

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What do you understand by private equity?

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Investments in private companies, buyouts of private shares for the purpose of funding new technology, make acquisitions, expand working capital, adn to bolster and solidify a balance sheet.

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What are commercial banks?

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Commercial banks are one of the most important types of financial institutions in an economy. They work by accepting deposits from customers and using those deposits to make loans.

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How do commercial banks get their money?

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Commercial banks get their money from customer deposits.

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How do commercial banks make profit?

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Banks make profits buy providing lower interest rates on deposits and charging higher interest rate on loans.

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What are the main functions of commercial banks?

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  • Guaranteeing safe deposits.
  • Providing interest on deposits.
  • Offering loans.
  • Other financial services.

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Why deposits on commercial banks are considered to be safe?

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The central bank of a country serves as a lender of last resort for commercial banks. In case, anything would happen the Bank of England would step in and guarantee you get your money back.

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Why is interest earned on deposits important during times of inflation?

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To keep the actual worth of your money intact.

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When does commercial banking become more profitable?

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Commercial banking becomes more profitable when banks lend money to businesses and individuals and there’s a wide difference between the interest charges on loans and deposits.

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Question

Mention some of the other financial services a commercial bank offers.

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-Enabling clients to access cash in a matter of seconds, by just going to an ATM. 

-Allowing and facilitating international payments to pay for goods and services you might want to receive from other countries. 

-Offer financial advice for your retirement fund or any other financial matter you might need advice on.

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Question

What is a balance sheet of a commercial bank?

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Answer

The balance sheet of a commercial bank provides an overall overview of how well the bank is operating.

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What does a balance sheet of a commercial bank contain?

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Assets and liabilities.

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How are assets and liabilities displayed on a commercial bank's balance sheet?

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In a balance sheet, assets and liabilities are displayed on the right-hand side and left-hand side, respectively.

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What are the assets of a commercial bank?

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A commercial bank generates revenue and profit through its assets.

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What are liabilities for a commercial bank?

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Liabilities are those items that the bank owes to other parties.

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Why are commercial banks required to keep a portion of their customer deposits?

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To ensure that the bank has enough money in case a client wants to withdraw their funds.

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What's one of the most important liabilities on a bank's balance sheet?

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Interested owed to customer deposits.

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Mention some examples of the largest commercial banks in the UK.

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HSBC, Barclays, Lloyds Banking group, and NatWest groups.

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What role do commercial banks play in the economy?

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Providing financing to businesses and individuals which enables them to perform activities such as opening up a startup or buying a house.

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What are other financial institutions?

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While commercial banks concentrate on providing services to the broad public, other financial institutions are more likely to serve only a certain group of customers with more specialised products and services.

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How is financing of other financial institutions done?

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There are various ways how other financial institutions receive financing. Main ones include gathering funds and investing those funds on different securities.

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How are commercial banks different from other financial institutions?


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The main difference between a commercial bank and other financial institutions is that commercial banks can take deposits from their customers.

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What are the aims and objectives of other financial institutions?


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Providing: 

  • Services in the banking industry
  • Insurance services
  • Capital formation
  • Investing tips and advice
  • Brokerage services
  • Pension fund administration
  • Trust fund services

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Why are financial institutions important for economies all over the world?

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Answer

Financial institutions are crucial to all economies all over the world as individuals and businesses depend on these institutions for transactions and funding. 

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How do financial institutions such as the Central Bank keep the money supply under control?

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To control liquidity in the economy, the central bank employs a variety of tools known as monetary policies.

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Explain insurance services provided by other financial institutions.

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Financial institutions, such as insurance firms, provide individuals protection against the loss of their lives or the loss of a specific asset in the event of a catastrophe.

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Explain capital formation provided by other financial institutions.

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This includes helping companies grow their capital stock like plant, machinery, tools, and equipment, structures, modes of transportation, and communication, among other things. 

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Explain the brokerage services offered by other financial institutions.

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Brokerage services help investors buy stocks, invest in private equity, and facilitate other types of investment transactions.

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Explain how credit unions work.

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Credit unions serve specific groups of people such as teachers. They have a similar function to the traditional banking system. However, these types of financial institutions are created and owned by individuals participating in them. They create a pool where funds are poured into and then use this pool to generate loans to each other at low-interest rates.

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Explain the difference between investment banks and commercial banks.

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Investment banking organisations operate differently from banks because they do not take deposits or lend money. In exchange for providing services, investment banking corporations charge substantial fees on behalf of their clients for executing trades on behalf of those clients.

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Explain how other financial institutions administrate pension funds.

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Answer

Individuals usually prepare for their retirement with the assistance of financial institutions, which provide a variety of different types of investment programs.

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What are trust fund services?

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Other financial institutions manage the assets of their clients, invest them in the most advantageous options accessible in the market, and ensure that the funds are kept secure.

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What are the most common types of financial institutions?

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One of the most common types of financial institutions that everyone knows about are commercial banks and central banks. 

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What is credit creation?

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Credit creation is a process where a bank uses a part of deposits made from their customer, to offer loans to individuals and businesses; resulting in more money created in an economy.

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What is the process of credit creation?

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By expanding their deposits, banks create credit in an economy. They do this by loaning a part of the deposits they have, therefore, generating money and funds for other people. 

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What is the credit creation multiplier formula?

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Total credit creation = original deposit x money multiplier

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What does credit creation theory states?

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Credit creation theory states that as a result of bank lending activities, the bank produces deposits which then creates new purchasing power.

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Where do banks get the capacity to issue credit?

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The capacity of banks to issue credit is a result of their exemption from the ‘client money rules’ which prohibits other non-banking organisations to use their client's money for lending purposes

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What's a monopoly banking system?

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A hypothetical situation where there's one bank in an economy and it's able to create money in the economy by making use of initial deposits.

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Why are banks required to keep a portion of their deposits in reserves?

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 All banks are required to keep a portion of these deposits in their reserves. The reason for that is to meet the cash demand from its depositors as they know that depositors will not demand or withdraw their funds at once.

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What does it mean if the money multiplier is 5?

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The money multiplier is 5, which means that £1 can theoretically generate £5. 

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What are the limitations of credit creation?

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Limitations of credit creation include the amount of cash in the deposits, the reserved required ratio, and default risk. 

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Who sets the reserved required ratio for banks?

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The central bank.

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What happens in case there is an increase in bank deposits?

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The money supply would increase in an economy.

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Why do default risk limits credit creation?

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Because banks don't want to offer credit to those individuals that have a high default risk as they could end up not paying back their loan.

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Question

Name some of the functions of banks.

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Answer

Safety deposits

Interest on deposits

Loans

Credit creation

Other services such as financial advice or enabling monetary transactions

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Why are banking regulations important for an economy?

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Because if banks get involved into too much risk it might trigger economic crisis.

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Name the most important financial regulator in the UK.

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One of the main regulatory body in the UK is the Financial Conduct Authority (FCA). It ensures that financial institutions in the UK comply with rules and regulations that create an efficient financial ecosystem.

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