Fundamentals of Financial Services

Fundamentals of Financial Services

Banking
 Banking: Key Topic Areas
 Retail and Commercial Banking
 Retail Borrowing in Focus

 Interest Rates
 Secured and Unsecured Borrowing
 The Relative Cost of Borrowing

 Investment Banks
 Central Banks
RETAIL & COMMERCIAL BANKING
RETAIL BORROWING IN FOCUS
 Retail Bank vs. Commercial Bank
RETAIL
• Individuals are retail customers.
• Banks that provide these
customers with services are
known as retail banks.
• The purpose of the bank is to
attract deposits from savers and
A who provide such services to
lend to borrowers.
Do you remember how a bank
generates a surplus?
What other expenses may a retail
bank have to pay for before it can
determine its level of surplus?
COMMERCIAL
• This term is mainly used in the US.
• In the US it encompasses all banks
that engage in attracting deposit
and giving out loans.
• In other countries “commercial”
bank may refer solely to banks
businesses only (not individuals).
• This is also known as corporate
banking, since the bank is mainly
dealing with corporate entities.
 Retail Bank vs. Commercial Bank

Commercial Banks
The US definition – all banks that
take deposits and grant loans

Retail Banks Corporate Banks

Banks that specialise in taking
deposits and providing loans to
individuals
Banks that specialise in taking
deposits and providing loans to
businesses. In parts of the world
outside the US, these are often
referred to as commercial banks.
 • What does each method actually mean?
• What are the FEATURES of each method?
Key Features: Bank Loan • What are the advantages/disadvantages
of each method?

Bank Loan
A form of debt where a borrower receives a certain amount from a lender, in this case a
bank. The borrower agrees to pay a contracted rate of interest to the lender and also
agrees a date on which the loan will be repaid.

The loan is normally:

• For a set period that is generally less than five
years.
• At a set rate of interest.
• With a defined repayment schedule.

Unsecured Loan
A loan provided to a borrower
where the lender takes no security.

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 • What does each method actually mean?
• What are the FEATURES of each method?
Key Features: Mortgage • What are the advantages/disadvantages
of each method?

Mortgage
A mortgage loan is a long-term loan used to finance the purchase of real estate (e.g. a house). Under
the Mortgage Agreement, the borrower agrees to make a series of payments back to the lender. The
money lent by the bank (or building society) is secured against the value of the property: if the
payments are not made by the borrower, the lender can take back the property.

Mortgages are typically: Secured Loan

• For a set period (usually 25 – 35 years)
• At a variable rate of interest (it increases or decreases
to stay in line with the general interest rates)
• With a defined repayment schedule (e.g. monthly)
• Secured on the property the loan is used to buy
The situation where a lender takes
something of value as security for a loan.
If the borrower fails to repay the debt, the
lender is able to keep and sell the item.

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 • What does each method actually mean?
• What are the FEATURES of each method?
Key Features: Overdraft • What are the advantages/disadvantages
of each method?

Overdraft
A form of borrowing from a bank where the lending bank can demand repayment at any
time.

Bank overdrafts are generally:

• Flexible – able to be drawn, repaid, drawn
again up to the overdraft limit.
• At a variable rate of interest.
• An arrangement fee may also be payable.
• Unsecured and repayable on demand.

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Credit Cards Activity
Visit the American Express Website.
https://www.americanexpress.com/uk/content/all-cards/

Select one of their range of credit cards available.

Complete the following:

1. What is the name of the card?

2. What is its annual fee?
3. What are the charges for using the credit card facility?
4. What additional “rewards” are available for the user?
5. What is the eligibility criteria?
6. Which sort of borrower would go for this type of card?

Based on this research, discuss the following in your groups:

• How do you think a credit card actually works?
• What do you think the advantages/disadvantages of using a credit card are for the borrower?
• What do you think the advantages/disadvantages of issuing a credit card are for American Express?

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 Credit cards are available from banks as well as
Credit Cards specialist providers like Visa and MasterCard and even
through supermarkets, football clubs and charities.

Credit cards are typically:

• Flexible – able to be used up to the credit limit
• At a variable rate of interest, which tends to be expensive
• Repayments of at least a minimum amount are required monthly

An individual The individual

applies for a can make The borrowed
credit card, and purchases with amount that is At least part of It is best to pay
if successful, is the card and not paid off, the borrowed off the WHOLE
granted a card with each incurs a high money needs to AMOUNT
with a certain transaction the interest charge, be repaid borrowed each
borrowing limit. borrowed e.g. 20% per monthly. month.
This is known as amount annum.
the credit limit. increases.

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Look at the picture.
What do you think it is about?

Pawnbrokers
needs to be repaid for the borrower to reclaim the item.
The decision is usually made
immediately by the
pawnbroker on whether the
loan will be issued or not.
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A pawnbroker is a business that provides loans to
individuals. The pawnbroker takes an item of security
(such as jewellery) in exchange for the loan. The loan
The item pawned
The item pawned
might hold
must hold monetary
sentimental value
value.
e.g. a wedding ring
It is a secured loan,
as the pawnbroker
can keep the item if
the loan is not
returned on time or
in full.
Borrowers can avoid a lengthy
approval process compared to
other methods such as
overdraft or credit card.
Pawnbrokers

Why do you think that a loan from a pawnbroker

is more expensive than a loan or overdraft from
the bank, or borrowing on a credit card?

The pawnbroker knows little about the

borrower. They may never return the money.
This is a BIG risk for the pawnbroker.

This is due to the RISK taken on by

the pawnbroker, combined with the The borrower is obviously very desperate.
DESPERATION of the borrower. Needs the money immediately, and cannot
find it easily elsewhere., and therefore forced
to pay a higher rate of interest

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 H&T Pawnbrokers
The process:
• Fair & accurate offer based on
estimating the asset the borrower
wishes to pawn.
• No income checks performed –
loan is issued purely on the value of
the item
• All items are secured and insured Click on image to access the website

during the period of the loan

The offer:
• Loans by H&T can be offered from
£250-£50,000 over a period of 6
months.
• Interest will be charged dependent on
amount borrowed.
• No penalties for early repayment

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INTEREST RATES
What are interest rates?

The COST of borrowing.

The REWARD for saving.

The price paid for borrowing money. Generally,

interest is expressed as a percentage rate over a
period, such as 5% per annum.
 Interest Rates
APR
Annual Percentage Rate
• This is normally the advertised or quoted
rate.
• By law lenders have to show this rate to
customers.
• It is used so that customers can easily
compare financial products.
• APR shows the cost of borrowing if
interest is charged on an annual basis.
EAR
Eff e c ti v e A n n u a l R a t e
• Takes the APR (or quoted rate) and
adjusts it to take into account the
frequency of interest charges.
• Often, interest is not charged once a year
but on a quarterly or monthly basis
• The EAR is higher than the quoted rate
(APR)
 Calculating the EAR from the Quoted Rate

What is the effective annual rate if the quoted rate is 6% and interest is
charged quarterly?
1. Take the quoted rate and divide it by the frequency
Opening Interest Closing with which interest is charged:
Month Balance Rate Interest Balance 6% / 4 = 1.5%
January 1,000.00 1,000.00 2. Turn the interest rate into a decimal:
February 1,000.00 1,000.00
1.5% / 100 = 0.015
March 1,000.00 1.50% 15.00 1,015.00
April 1,015.00 1,015.00 3. Add one to the decimal:
May 1,015.00 1,015.00 0.015 + 1 = 1.015
June 1,015.00 1.50% 15.23 1,030.23
July 1,030.23 1,030.23 4. Multiply this number to the power of the number
of times interest is charged:
August 1,030.23 1,030.23
September 1,030.23 1.50% 15.45 1,045.68 1.015 to the power of 4
October 1,045.68 1,045.68 (1.015 x 1.015 x 1.015 x 1.015)
November 1,045.68 1,045.68 = 1.0613634
December 1,045.68 1.50% 15.69 1,061.36 5. Minus the one and turn the number back into a
percentage:
1.0613634 – 1 = 0.0613634
0.0613634 x 100 = 6.14% EAR
 Class Question
United Bank is offering a loan at a quoted rate of 2% per month (that’s 24%
per annum). What is the effective annual rate?

• Take the quoted rate and divide it by the frequency with which
interest is charged.
• Turn the interest rate into a decimal
• Add 1 to the decimal
• Multiply this number to the power of the number of times
interest is charged
• Minus the one and turn the number back into a percentage
INVESTMENT BANKS & CENTRAL
BANKS
The Role of an Investment Bank

Watch the video clip.

This is a career video giving a basic

overview of investment banking.

Answer the following questions:

1. Who are their clients? (3)
2. What areas can an investment
bank provide advice on? (3) http://www.goldmansachs.com/careers/why-goldman-sachs/our-
divisions/investment-banking/
The Role of an Investment Bank

Capital Raising Strategy support

• They support with large scale capital raising • Investment banks may provide strategic
for corporates starting from around $5 advice to businesses who are seeking
million and upwards to around £100 billion. growth.

• The investment bank will provide advice to a

business looking to raise long-term finance.
• Growth can take place in two forms
including mergers with other
businesses, or acquisitions of other
• Capital could be raised in the form of DEBT
or EQUITY. business. This is known as M&A
(Mergers & Acquisitions).
• The investment bank will EXECUTE THE
DEAL, if the business decides to act upon the
advice given. They will organise all the paper
work and market the deal to potential
investors.
Case Study: Razak Inc

Razak Inc is already a large global player in technology that

supports smartphones. Razak uses the advice of Coldman
Jones, an investment bank. Coldman’s M&A team
recommends that Razak should buy a minor competitor
company to gain access to the Japanese market. The
Japanese company will cost around $100 million.

The cost of the purchase needs to be raised by Razak and,

again on the advice of the investment back, Razak uses
Coldman Jones to raise the required funds by selling bonds
to investors.
 The Role of an Investment Bank
The World’s Top 10 Investment Banks

Companies

Advisors Capital Raising

Corporate Finance

Listing & Mergers &

Bond Issues Acquistions

Stock Markets
The Role of the Central Bank
• UK Central Bank – Threadneedle Street, London, Founded in 1694

• Since 1694 – banker to the government

– The government gathers tax receipts, spends on defence, welfare etc.

• Since the late 18th Century – banker to the banking system

– Banks hold accounts with the central bank

• Manages the UK foreign exchange and gold reserves

– Many governments also hold money in other currencies – foreign exchange reserves

• Regulatory role
– Many central banks regulate other banks
– Set interest rates in accordance with government policy
The Role of the Central Bank

• It does NOT :
• manage the National Debt (This is the Debt
Management Office in the UK)
• provide a depositors protection scheme (This is
the Financial Service Compensation Scheme in the
UK)
Plenary

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