The Role of the Financial Sector

What the Financial Sector Is

Financial sector: the banks, building societies, insurers, investment funds and markets that handle money for households, firms and the government.

Unit 1.4.1 introduced banks as go-betweens for savers and borrowers. This page covers the whole sector and the seven roles the spec lists.

Mobilising Savings for Lending

Millions of households each hold a few thousand pounds they do not need yet. On its own, none of that would pay for a factory. Banks, pension funds and other institutions pool it, so it can be lent out in large amounts to firms and individuals.

Savers are paid interest or a return for handing it over. Pooling also spreads their risk: one failed borrower is a small loss across thousands of savers, not a disaster for one.

Lending to Business for Working Capital

Working capital: the money available for a business's day-to-day running, measured as current assets minus current liabilities. It pays for stock, staff and suppliers before customers pay.

A builders' merchant buys timber in spring for summer sales. It pays its supplier now and is paid by its customers weeks later. An overdraft or short-term loan bridges the gap (types of credit are in unit 1.4.3).

Banks also lend for longer-term investment in machinery, buildings and technology. Both kinds of lending let a firm grow faster than its own profits would allow:

• Firms: credit pays for stock and equipment → output and sales rise sooner → higher profit and more jobs.
• When credit dries up: a profitable firm still has bills to pay before its customers pay it → it runs short of cash → it cuts orders or staff, or fails.

Lending to Individuals

Households borrow through mortgages, personal loans and credit cards. A mortgage lets a family buy a home now and pay for it over 25 years, instead of saving for decades first.

Lending to households keeps spending flowing: more credit → more cars, furniture and holidays bought → higher sales for the firms that make them. The risk is debt that grows faster than incomes. If rates rise or jobs are lost, repayments swallow more income and spending falls sharply.

Facilitating the Exchange of Goods and Services

Banks run the payment systems that move money between buyers and sellers: card payments, bank transfers and direct debits. A café owner can take a tap-and-go payment and have the money in their account within a day or two.

Without these systems, trade would mean carrying cash or bartering. Cheap, fast payments let firms sell to customers they will never meet, including online and overseas.

Assessing Creditor Risk

Creditor risk: the risk to a lender that a borrower does not repay what it owes.

Before lending, a bank checks the borrower's credit history, income or cash-flow forecast, and any collateral on offer. It then decides whether to lend, how much, and at what rate. Riskier borrowers pay more interest to cover the greater chance of default.

This matters for the whole economy, because it decides where savings go:

• Done well: money goes to borrowers likely to use it productively and repay → fewer bad debts → banks stay sound and keep lending.
• Done badly: loans go to borrowers who cannot repay → defaults rise → banks make losses and cut lending to everyone, as in 2007-08 (unit 4.5.4).
• Done too cautiously: new firms with no track record or collateral are turned down → good ideas go unfunded → less investment and enterprise.

Forward Markets in Currencies and Commodities

In a forward market, a firm agrees today the price at which it will buy or sell a currency or commodity on a future date. Unit 4.5.1 shows how this works for currencies.

Commodities work the same way. A bakery chain can fix what it will pay for wheat for the next year, and an airline can fix the price of its jet fuel.

Each swaps an unknown future cost for a known one → it can set prices and plan output with confidence. The downside is that it misses out if the market price falls.

Providing a Market for Equities

Equities: shares in a company, each giving its owner part-ownership and a share of any profits paid out as dividends.

A stock exchange such as the London Stock Exchange does two jobs. When a company first sells shares to the public, it raises new money for investment: the primary market. After that, investors buy and sell those shares between themselves: the secondary market.

The secondary market matters even though the company receives nothing from it. Investors know they can sell their shares whenever they want → they are more willing to buy in the first place → companies can raise large sums without taking on debt or paying interest.

Why the Financial Sector Matters

When the financial sector works well:

• Firms: savings are channelled into loans and share issues → firms can fund working capital and investment → higher output, productivity and jobs.
• Households: mortgages and loans let them spread big purchases over time → consumption is steadier → firms' sales are steadier too.
• Trade: fast payments and forward markets cut the cost and risk of buying and selling abroad → more trade and specialisation.

How much it helps depends on:

• Who gets the credit: lending for houses and existing assets raises prices without adding to what the economy can produce. Lending to firms for investment does.
• The size of firm: large companies can issue shares and bonds. Small firms depend on banks, and lose out first when banks become cautious.
• How much risk the sector takes: too much lending to weak borrowers can end in a crisis that cuts credit to everyone. Regulation by the Bank of England tries to prevent this (unit 4.5.3).