From the beginning the speciality of Lloyd’s was marine insurance, helped by the fact that England has traditionally been a great naval power. Like underwriters in the other financial fields we have looked at (bonds, Euronotes and shares), Lloyd’s underwriters accept a commission in return for providing against an unfortunate eventuality. In the case of underwriters of financial instruments, they guarantee to buy the bonds if no one else will, in return for a premium. Early Lloyd’s underwriters agreed to pay shipowners for the damage to, or loss of, their ships and cargo. For a long time, Lloyd’s had the best intelligence on the movements of foreign shipping. Perhaps the most famous occupant of Lloyd’s is the Lutine Bell, which is rung when important news is about to be announced (one ring for bad news, two rings for good).

The Lloyd’s Structure

An elaborate structure has been built on the flimsy edifice of a coffee house. There are now five classes of individual which are involved in Lloyd’s. First and foremost, there are the clients. Merchant shipping has long since passed its peak and Lloyd’s now provides insurance for a wide variety of customers and products, including Betty Grable’s legs, potential kidnap victims and space satellites. Sometimes the clients may be other insurance companies and markets for whom Lloyd’s provides reinsurance.

The second tier in the structure are the brokers. They link client with underwriter in return for a commission. Their business is rather less risky than the underwriters’, since they are not liable to pay out for any claims. But with Lloyd’s challenged by other insurance markets around the world, Lloyd’s brokers have been forced to travel far and wide to drum up business. Not all of it goes to Lloyd’s; indeed the bulk goes to outside insurance companies. However, Lloyd’s still retains the flexibility that encourages brokers to place with it substantial or unusual risks. Brokers provide a service which goes beyond merely broking: they advise clieants on the best kind of insurance protection for their needs and they act for clients by administering their insurance business and by collecting any legitimate claims they may have. The big broking firms have gradually come to dominate the market, in the process buying many underwriting agencies. As we shall see, this has led to many problems.

The next tier up are the underwriters, who actually take on the insurance risk in return for premiums. Many underwriters put up their own capital but it is a business only for those with strong nerves and large wallets. So great are the risks that underwriters club together in syndicates, to spread the costs among many. There are over four hundred underwriting syndicates divided into four main sections: marine, non-marine, UK motor and aviation. Even so, the combination of high taxes and safer alternatives has meant that there is a limit to the numbers of people who can become active underwriters.

To bring in the capital to allow the market to work efficiently, Lloyd’s has been forced to attract outsiders. It is that development which has created the other two tiers of the Lloyd’s structure: the names and the agents.

Both the company which is attempting to make a takeover and the company defending against it usually employ a merchant bank to advise them on tactics. The takeover process is discussed at length in Chapter 10, but it is worth noting here how the same forces which have caused the City revolution have affected the merchant banks and the takeover market.

As outlined earlier, overseas banks have been moving on to the UK market. They were able to back takeover deals with their cash as well as with their advisory skills. This faced the British merchant banks with a great problem since they were effectively dwarfed by their foreign competitors.

A good example of a finance-backed deal was the acquisition by Beazer, the British construction and aggregates group, of the US company Koppers. Shearson Lehman, the US bank, and County Nat West not only advised on the deal, they owned half of the specially created company which was used as a vehicle for the bid. On top of that, they raised much of the $1.7 billion finance needed. The deal also illustrates how merchant banks face competition from the merchant banking subsidiaries of the UK retail banks. Some merchant banks, like S. G. Warburg, have responded by becoming part of new conglomerates. Others, such as Barings, have given up the unequal struggle an concentrated on their skills in niche areas where financial muscle is less important.

It is as yet far from clear which set of merchant banks have adopted the best strategy. After the 1987 Crash, when activity in the City slowed to a trickle, some of the larger banks were forced to lay of staff. The smaller houses, which had not increased their costs so much, were able to ride out the problems.
Fund Management

Another important area of merchant banks’ work is fund management. Many of the investment and unit trusts advertised in the daily papers are run by merchant bankers. In addition, there is a growing trend among companies with large pension funds towards spreading the management of such funds among several banks, rather than manage the funds within the company. The merchant banks, with their reputation for financial expertise, have been ideally placed to take advantage of this trend.

Fund managers are normally paid on a percentage of the assets they manage. Thus the better they perform, the more they earn. This was very good news for managers in the bull market years, when without being particularly brilliant, they could continue to increase their fees. It was of course very bad news at the time of the Crash.

In any case, survey after survey has shown that managers under perform the stock market index. This has led to the increasing popularity of ‘passive’ funds which slavishly follow the index and require little management (and small management fees). It is rather unfair to expect fund managers to beat the index. After all, since institutions constitute the vast majority of equity investors, the index largely reflects the decisions those fund managers take. If all the fund managers perform well, the index will perform well and vice versa. But fund managers will always face dealing costs, so logically they should under perform the index.

Merchant banks’ fund management business should continue to expand. The greater interest of private investors in the equity market, and the growth of personal pensions, is likely to provide more than enough funds for the banks to manage.

Acceptance business is a way of lending a bank’s name rather than its money – the bank is liable only if the client fails to pay up. Although they rarely grant overdrafts, the accepting houses do make loans to businesses, usually for fixed terms. The merchant banks are particularly tied up with the financing of trade and apart from the acceptance credits, they are active in areas like cross-border leasing (a form of international hire purchase, (project finance (where a loan is tied to a particular scheme with the profits from the scheme being used to repay the loan) and factoring (where a company borrow money on the strength of its customer invoices).

The main difference between the retail banks, like Lloyds and Barclays, and merchant banks is that the former have access to a vast pool of customer deposits. The latter’s profits depend on financial expertise – earning fees is as important to them as the traditional banking process of earning more fro investments than is paid for deposits. This makes them considerably smaller than their retail cousins. Merchant banks claim that they uniquely have the skills to pilot through complicated financial deals. So merchant banks are frequently involved in share listings, bond issues and company takeovers.

Merchant banks do not normally seek to attract business or deposits from the general public: you would need to be pretty rich before a merchant bank would think it worthwhile to accept your custom. The most important clients of merchant banks are large companies, government institutions and other banks. The merchant banks obtain their funds from deposits from these clients or by borrowing from other banks in the money markets. Most of these deposits have fairly short maturities (i.e. less than a year, (and as a result, merchant banks prefer to lend money only for short periods.

If a client wishes to borrow funds for more than a year, a merchant bank will normally set up a credit facility. Under such a facility, the maximum amount that can be borrowed will be carefully controlled and the interest rate will vary throughout the lifetime of the loan, according to some agreed formula. Should the borrower wish to borrow more than any one bank would want to lend, the merchant bank will arrange for others to join the facility.

Although these lending activities bring in the bulk of the profits for the merchant banks, the business which brings the bank the most publicity is their corporate finance work. Probably the most important part of this business is handling new issues of company shares on The Stock Exchange. The mechanics of a new issue are described in Chapter 10. The fees involved in arranging a new issue can be substantial –several million pounds for a large issue such as a privatization.

It is very difficult to define exactly what a merchant bank is: one of the main guides to the business says that merchant bankers are now ‘seldom merchants and by no means always bankers’. The other name by which merchant banks have been known is that of accepting houses, referring to their habit of accepting bills of exchange as a means of financing companies’ trading activities. But that term is far too narrow as a definition of their activities.
The Growth of Merchant Banking

Before the development of a world wide banking system, much international trade depended on trust – trust that goods would be delivered and that they would be paid for. It was much easier for overseas clients to trust merchants with whom they had traded before or those with whom their friends had traded. Thus, the larger and well-established merchants found it easier to trade than their smaller and less familiar competitors.

The smaller firms needed some way both of assuring their clients that they were trustworthy, and of raising money to cover the interval between the time goods were delivered and the time they were paid for. The normal method for raising finance in this period was for the exporter to draw up a bill of exchange, whose value was a large proportion of the value of the goods being sold. The exporter could then sell the bill to a local banker at a discount and receive a substantial proportion of the money in advance. The extent of the bank’s discount would represent two elements, a charge equivalent to interest on what was effectively a loan and a charge reflecting the risk of non-payment.

Small exporters found the banks would often charge a very large discount to advance money on their bills, if they agreed to do so at all. So the smaller merchants began to ask their larger brethren to guarantee (or accept) their bulls. In the event that the small merchant failed to pay up, the large merchant would be liable. In return for the service, the large merchants charged an acceptance commission, based on a percentage of the size of the bill.

Eventually, some of these large merchants found that they could earn more money from their finance activities than from their trading and became full-time merchant banks or accepting houses. For a long time, their business was centred around the financing of trade but gradually, as they developed a reputation for financial acumen, they increased the corporate finance side of their activities.

Asset Liabilities
Cash ?200 Customer deposits ?1,000
BT shares ?800
TOTAL ?1,000 ?1,000

To find out the total amounts of deposits that can be created form the original cash base, divide 100 by the percentage which the bank needs to hold as cash (known as the cash ration). Then multiply the result by the amount of the original deposit. Thus, in this example, dividing 100 by the cash ration of 20 per cent gives 5, and multiplying that by the original deposit equals ?1,000

The cash ratio is therefore very important. If, in the example, the ratio had been only 10 per cent, the amount of deposits created from the original deposit would have been ?2,000 and not ?1,000. In practice, banks find that they need to keep around 8 per cent of their deposits in the form of cash.

This relation between the money which banks need to hold in liquid form and the amount which they can lend has been used by the Bank of England to control the level of credit in the economy.
Defining the Money Supply

As money has become increasingly sophisticated, so it has become more and more difficult to define exactly what it is. This issue assumed particular importance with the prominence of the monetarist school of economics, which believed that the level of inflation is closely related to the rate of increase of the money supply. In the late 1970s and early1980s many Western governments, including the UK’s, were strong adherents of the monetarist school and attempted to base economic policies on its theories. Accordingly, they needed to define the money supply before they could control it.

The Bank of England published several definitions of money. M1 is defined as notes and coins in circulation with the public, plus sterling current accounts held by the private sector. M2 is M1 plus private-sector sterling deposit accounts held with the deposit (commercial) banks and the discount houses. A broader definition, M3, includes virtually all the deposits held by the private and public sectors in both sterling and foreign currencies. Sterling M3, which was for many years the government’s principal monetary target, is M3 minus the foreign currency element. As something of an afterthought, the Bank devised a very narrow definition of money, M0, which consists purely of notes and coins.

By defining money solely by reference to deposits held in banks, the Bank of England realized that it was failing to take into account other deposits which might be substitutes for those in banks. For example, building society deposits are not strictly compatible with bank deposits. Traditionally it has not been possible to write a cheque on a building society account, although this too is changing. However, if building society rates are more attractive than those offered by the banks, depositors will switch their money from their bank accounts to a building society. Most society accounts will let their depositors withdraw cash instantly, and many creditors will accept a building society cheque as payment. To call bank deposits money and building society accounts non-money would be to paint an inaccurate picture of credit levels in the economy.

The Bank of England accordingly established a new set of definitions of money, the Private Sector Liquidity (PSL series). PSLI includes notes and coins, sterling bank deposits, certificates of deposits, Treasury and bank bills and similar instruments. PSL2 adds in building society deposits and shares and deposits with similar institutions like the Trustee Savings Bank (TSB). Eventually, a broad definition along these lines was named M4. However, the PSL definitions have attracted little attention from economic analysts.

In the middle of 1985 the Chancellor of the Exchequer effectively abandoned sterling M3 as a target figure for his monetary policy. It had been growing at 20 per cent a year at a time when inflation was falling. It was announced that M0 would continue to be watched (along with short-term interest rates and the exchange rate), but it seemed that the difficulty of defining money had defeated the best efforts of the monetarists.

The next stages of the development of money – banknotes and cheques are dealt with in Chapter 4, on the banks. It is sufficient to point out here that banknotes were, in origin, claims on gold and silver. Now money depends on the confidence of its users in the strength of the economy. When economies break down (as they occasionally do in wartime) money disappears and is replaced by some other commodity such as cigarettes.

At money has grown more sophisticated, so it has grown farther away from its origins. For large sums, payment by cheque is far easier and safer than payment by notes and coins. The money is debited from the payer’s bank account and credited to the payee’s. Even if someone presents a cheque for cash at a bank, he or she will be paid in banknotes, which are, in origin, only a claim on the real assets, gold and silver. The system depends on the confidence of all those concerned. Shopkeepers accept cheques because banks will honour them. Bank accounts are therefore money in the same sense as notes and coins are, since they can be used instantly to purchase goods.

Banks can thus create money. This is because only a small proportion of the deposits they hold is needed to meet the claims of those who want to withdraw cash. Much of the need is met by those who deposit cash. Simple way for a bank to lend money is to create a deposit (or account) in someone’s favour.

Gradually precious metals and, most notably, gold and silver were used as payment and became the first money. Precious metals had several advantages. Money had toe be scarce. It was no good basin a monetary system on the leaf. Everyone would soon grab all the leaves around and the smallest payment would require a wheel barrowful. Money had also to be easy to carry and in divisible units –making the goat a poor monetary unit. Gold and silver wee sufficiently scarce and sufficiently portable to meet society’s requirements.

Of course, it soon became inconvenient to carry gold and silver ingots. Coins were created by the kings of Lydia in the eighth century BC. From the days of Alexander the Great the custom began of depicting the head of the sovereign on coins.

There are a variety of functions which money serves. It is a measure of value. Sheep can be compared with goats and chalk with cheese by referring to the amount of money one would pay for each product. Money is also a store of value. It can be saved until it is needed, unlike the goods it buys, which are often perishable. Creditors will accept money as a future payment, confident that its value will remain stable in the meantime.

Of course, today’s money is made from neither gold nor silver. Coins are made from copper or nickel, and the most valuable monetary nits are made of paper. There are two main reasons for this. The first is that supplies of gold and silver were outstripped by the demands of society. If money is scarce, it is difficult for the economy to expand and for us to get richer. The second reason is the so-called Gresham’s Law that ‘bad money drives out good’. When money was in the form of gold coins, it was tempting for those with a large number of coins to shave off a tiny fraction of each coin. The resulting shavings could be melted down to make new coins. Gradually some coins contained less gold than others. Anyone who had a coin with the maximum amount of gold would have been foolish to spend it least the received a coin with less gold in return. So the best coins were hoarded and the worst coins circulated. Bad money drove out good.

It is possible for both the advising bank or broker and the stags to overestimate the likely demand for a company’s shares. If that happens, the price of the company’s shares will drop below the issue price. If that happens, the stag will have to sell the shares and take the loss or hand on to them in the hope that the price will rise. As some stags will have borrowed money to purchase the shares (planning to repay the loan with the help of the profits), a failed issue can hit them particularly hard.

Stags only really emerge for offers for sale; placings and tenders give them little chance for profit. But it would be wrong to suggest that stags are unpopular with new issue sponsors. By pushing up demand for an issue, they ensure its success. The same is true of multiple applicants: people who apply for several parcels of shares or addresses. Keith Best, the Member of Parliament who was convicted of making multiple applications for British Telecom shares, was rather unfortunate. The practice had been quietly condoned for years on the reasoning that it was better to have multiple applicants than no applicants at all.

It was only the sensitive nature of a privatization issue, where profits seemed certain, that caused attention to be focused on multiple applications. Even then, it took a Labour Party researcher to discover Mr. Best’s offence. Later on, when it was discovered that some people had made more than one application for the phenomenally unsuccessful British Petroleum issue, it was suggested that the offenders’ best bet was to plead insanity.

In a conventional offer, investors are told the share price in advance; in a tender offer, they pick the price themselves (although a minimum price is usually set). When all the tenders are in, the highest will be awarded shares, then the next highest and so on down until all the shares are allocated.

Tenders are unpopular with institutional investors, since they reduce the chance of an increase in price (premium) when the shares start trading. Private investors also are not inclined to apply for tender offers. As a result, tenders are comparatively rare and only tend to be used when an issue looks certain to be popular.

A placing is by far the most common, and also the most prosaic, means by which a company joins the stock market. The sponsoring bank or broker contacts key investment institutions and asks them to take some shares; individual investors are unlikely to be approached. The placing method is cheaper than an offer for sale and tends to ensure that the shares are held in the hands of a few, supportive institutions.

The success of all these new issue methods depends on setting the right price for the shares. The higher the price, the more money flows into the company. But the sponsor will not want to set the price too high, for fear that it will fall when dealings commence. The ideal is a modest price rise on the first day. That reflects will on the company and pleases the shareholders – in the long run that will be better for the company than squeezing the last penny out of the issue price. The sponsor’s problems in setting the price will be exacerbated by the presence of stock market investors called stags, who are eager to make a profit out of new listings when the price is set too low.

Since the Financial Services Act was implemented in 1988, there is no real forum for trading shares outside The Stock Exchange. However, there is at least a choice of three tiers for companies wishing to float – the main market, the Unlisted Securities Market (USM) and the Third Market.

There are different rules of entry on the different tiers. For a full listing, the company will need to have a five-year trading record and at least 25 per cent of its shares in public hands. On the USM, the trading record can be only three years and the proportion of shares in public hands falls to 10 per cent. On the Third Market, only one-year’s trading record is required ant there is no minimum percentage of equity that needs to be in public hands.

Certain banks and stockbrokers specialize in bringing companies to market and the name of the sponsoring house may be very important in ensuring investors’ confidence in the issue. The sponsor will also advise on the timing and the terms of the issue. After Black Monday, for example, several companies withdrew their issues, on advice from their banks or brokers, until the stock market was more settled. When they returned, they were able to raise less money than they had originally planned.

There are a variety of methods by which a company can join the market. If the company is particularly large – like British Telecom or Eurotunnel – it will make an offer for sale. This is the most expensive method of making a new issue since it requires a large amount of publicity and also the underwriting of the offer by institutions. Underwriters guarantee, in return for a commission, to buy shares if no one else will. When issues go well, and investors flock to buy them, it sometimes seems as if underwriting is money for old rope. But the British Petroleum issue in late 1988 illustrated that a poorly-received offer can cost underwriters millions of pounds.

For amounts over 80 per cent of the value of the house, the building society will demand that the buyer insures against default by paying a one-off premium to an insurance company. Note that the building society will offer a loan, based on their valuation of the house, or the agreed sale price, whichever is the lower.

If the price of the house is over ?30,000, stamp duty of 1 per cent is payable, a particular penalty on London house buyers where even broom cupboards cannot be bought for under ?30,000.

There are different types of mortgage agreement – the best-known being the repayment mortgage, under which the monthly payments are structured over the lifetime of the loan so that at the end of the period both interest and capital have been repaid. Over the first few years of the mortgage, very little of the capital is repaid. This can surprise home buyers who sell their houses after a few years.

An alternative to the repayment mortgage is the endowment mortgage. At the same time as the borrower takes out the mortgage, he or she takes out a life insurance policy with a monthly premium payment. At the time that the mortgage ends, the insurance policy matures and repays the full amount of the loan. In the meantime, the borrower has paid interest but not capital each month to the building society. The tax benefit is thus retained throughout the life of the loan. There are two further advantages of endowment mortgages. One is that if the borrower dies, the loan will be repaid in full. The second is that the policy can be transferred from house to house as the borrower moves. Some endowment schemes offer a bonus in addition to the amount needed to repay the mortgage, but the premium payments on such a policy are somewhat higher. And there is always the risk that the life assurance company will prove to be a bad fund manager, and thus the final bonus may be disappointing.

A pension mortgage is similar in principle to an endowment mortgage. In return for extra payments, not only is the house price repaid, but a sizeable income is accumulated. This is a particularly useful scheme for those people who are self-employed and who do not benefit from an occupational pension scheme.

House buyers should be cautions before choosing an institution just because it offers the lowest rate. The lender has no obligation to keep the rates competitive for the full twenty-five years. If they decide they do not like the market, they may no longer undercut their rivals. In contrast, building societies will always have to be competitive because their main business is mortgage lending.

Although the attractions of home ownership seem obvious, it is well to remember that house buyers are, in fact, making a complex calculation. The alternative to house buying is, of course, renting. Mortgage repayments are at first considerably more expensive than rents and to the payments must be added the rates bill. However, mortgage payments go up and down with the rate of interest and not, like rents, with the rate of inflation. After a couple of years, the mortgage payment normally becomes competitive with rents.

Of course, most people see the benefits of property investment in terms of the increase in house prices. However, as one house’s price is increasing, so are the prices of all the others. When the house is sold, the next house may be even more expensive. The costs of moving are also high. Estate agents normally take 1.5 per cent of the price, solicitors a further 1 per cent and stamp duty 1 per cent more, making 3.5 per cent in all. On top of those costs are the charges of removal men and the inconvenience involved.

Just to illustrate the complexities, suppose a young married couple buy a flat for ?40,000 with a deposit of ?4,000. Previously they had paid rent of ?30 a week each or ?3,120 a year. The monthly mortgage payments, after tax relief, are ?300 a month, making ?3,600 a year to which rates of ?500 are added to make a total of ?4,100 in all. Added to that are several extra payments – ?400 stamp duty, ?400 solicitor’s fees and, say, ?200 for surveys, making ?1,000 in all (first-time buyers pay no estate agent’s fees). So, in the first year, the couple pay out ?1,980 more than they would have, had they rented. To that must be added the loss of interest on the ?4,000 deposit. At 10 per cent a year, say, that makes an extra ?400. So, the total income loss is ?2,380. Assume that house prices have increased at the end of a year by 10 per cent. They have gained ?4,000 but if they moved, they would have to pay another ?1,000 in moving expenses plus ?600 in estate agent’s fees. That is an effective capital gain of ?2,400, leaving them even in the first year but that does not allow for costs of repair to the house or of payments on furniture, neither of which are paid by a tenant.

House buying is expensive. The 1980s boom in prices was exceptional; normally buying a house requires a fairly long-term approach to investment. However, a tenant will pay rent for ever, while most home owners will have paid off their mortgages by the time they have retired and their earnings have been cut. The worst time for house buyers is soon after their purchase, but, as the salary increases, the burden of a mortgage is reduced.

Whether or not all house buyers have made the sort of complex calculations described above, investing in property has posed an extremely good investment over the last few years. The growth in home ownership, rising incomes and the limited supply of housing have fuelled a phenomenal house-price boom. But in all the euphoria, one should remember prices can fall. In the USA, prices in certain areas have fallen drastically leaving many people with a house worth less than their mortgage. Some have been known to vanish without trace, choosing to abandon their homes rather than face the mortgage payments.

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A curve can be drawn which links the different levels of rates with the different maturities of debt. If long-term rates are above short-term ones, this is described as a positive or upward-sloping yield curve. If short-terms rates are higher, the curve is described as negative or inverted.

What determines that shape of the yield curve? The three main theories used to explain its structure are the liquidity theory, the expectations theory and the market-segmentation theory.

The liquidity theory, which has already been outlined, states simply that investors will demand an extra reward (in the form of a higher interest rate) for investing their money for a long period. They may do so because they fear that they will need the funds suddenly but will be unable to obtain them, or they may be worried about the possibility of default. Borrowers (in particular, business) will be prepared to pay higher interest rates in order to secure long-term funds for investment. Thus, other things being equal, the yield curve will be upward-sloping.

The expectations theory holds that the yield curve represents investors’ views on the likely future movement of short-term interest rates. If one-year interest rates are 10 per cent and an investor expects them to rise to 12 per cent in a year’s time, he will be unwilling to accept 10 per cent on a two-year loan. It would be more profitable for him to lend for one year and then re-lend his money at the higher rate. A two-year loan will therefore have to offer at least 11 per cent a year before the investor will be attracted. Thus if interest rates are expected to rise, the yield curve will be upward-sloping. If investors expect short-term interest rates to fall, however, they will seek to lend long-term. That will increase the supply of long-term funds and bring down their price (i.e. long-term interest rates). Thus the yield curve will be downward-sloping.

What determines investors’ expectations of future interest-rate movements? Much may depend on future inflation rates. If inflation is set to rise, then price rises will absorb much of an investor’s interest income. So investors will demand higher rates when they think inflation is set to increase.

Keynes constructed a more elaborate theory which depended on the yield of securities. If people expect interest rates to rise, Keynes argued, they will hold on to their money in the form of cash, in order to avoid capital loss. But if they expect rates to fall, they will invest their money to profit from capital gains. Of course, this principle applies to bonds rather than to interest-bearing accounts. As we have seen, if interest rates rise, the price of previously issued bonds falls until investors earn a similar yield from equivalent bonds. Thus a bond investor who expected rates to rise will sell his bonds before the rise in rates and the resultant fall in the bond price occurs. The investor will hold the funds in the most liquid form available so that he can reinvest them as soon as rates rise. If the same investor expects interest rates to fall, the will hold on to the bonds because their price will rise as rates fall.

The third theory of the yield curve is the market-segmentation theory. This assumes that the markets for the different maturities of debt instruments are entirely separate. Within each segment interest rates are set by supply and demand. The shape of the yield curve will be determined by the different results of supply/demand trade-offs. If a lot of borrowers have long-term financing needs and few investors want to lend for such periods, the curve will be upward-sloping. If borrowers demand short-term funds and investors prefer to lend for longer periods, the curve will be downward-sloping.

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First, let us look at the determinants of specific rates. One of the principal elements is risk. There is always the chance, whomever money is lent to, that it will not be repaid. That risk will be reflected in a higher interest rate. This is one of the general principles of finance. The riskier the investment, the higher the return demanded by the investor. It is a principle which can be ignored, mainly because investors do not always assess risk adequately. Nevertheless, it is a useful principle to bear in mind, especially when it is stood on its head. Those investors who seek extremely high returns would be wise to remember that such investments normally involve extremely high risk.

Governments are usually presumed to be the least risky debtors of all, at least by lenders in their own country. (Other countries’ governments are a different matter, as many banks who lent to Brazil and Argentina have discovered.) But the government of a lender’s country can always print more money to repay the debt if necessary. In any case, if the government does not repay debt, it is reasonable for investors to presume that no one else in the country will.

Banks and building societies have traditionally been rated next on the credit ladder. Nowadays, however, as we noted in Chapter 2, because of banks’ exposure to the international debt crisis, many large corporations are considered better credit risks than even the biggest banks. For the benefit of potential investors, some agencies have devised elaborate rating systems to assess the credit worthiness of banks and corporations.

At the bottom of the ratings come individuals like you and me. Individuals have a sad tendency to lose jobs, get sick, over-commit themselves and default on their loans. Unless they are exceptionally wealthy, individuals thus pay the highest interest rates of all.

One of the other main elements involved is liquidity. The house buyer with a mortgage has to pay a higher rate than is received by the building society depositor because the society needs to be compensated for the loss of liquidity involved in tying up its money for twenty-five years. The society faces the risk that it will at some point need the funds that it has lent to the house buyer but will be unable to gain access to them. As I mentioned in the introduction, this is another of the basic principles of finance. The more liquid the asset, the lower the return. The most liquid asset of all, cash, bears no interest at all.

Logical though the above arguments are, it often happens that long-term interest rates are below short-term rates. To understand why, we must look at the yield curve.

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There are two alternative methods of calculating interest: simple and compound.

Simple interest can be easily explained. If a deposit of ?100 is placed in a building society and simple interest of 10 per cent per annum is paid, then after one year the deposit will be ?110, after two years ?120 and so on. Nearly all interest is paid, however, so a compound basis.

Compound interest involves the payment of interest on previous interest. In the above example the depositor would still receive ?10 interest in the first year. In the second year, however, interest would be calculated on ?110, rather than on ?100. The depositor would thus earn ?11 interest in the second year, bringing his deposit to ?121. In the third year he would earn ?12.10 interest and so on. The cumulative effect is impressive. The same ?100 deposit would become ?350 after twenty-five years of simple interest but ?1,083.50 with compound interest. Most saving accounts operate on the principle of compound interest, but most securities pay only simple interest. A bond may pay 5 per cent a year but only on the principal amount borrowed. That amount does not increase over the bond’s lifetime.

When dealing with a bond or with a share, it is more important to talk of the yield than merely of the interest rate or dividend.

Yield

A deposit account in a building society carries an annual interest rate. The money deposited will always be returned in full with the accumulated interest, but the lump sum (capital) will not grow. Other investment like shares, bonds and houses, are not as safe as a building society account but offer the potential for capital growth. Shares, bonds and property can all increase in price as well as provide income in the form of dividends, interest or rent. Since the price of these securities can alter, the interest rate or dividend will be more or less significant as the price falls or rises. The interest rate or dividend, expressed as a percentage of the price of the asset, is the yield. A security with a price of ?80 that pays interest of ?8 a year has a yield of 10 per cent. If the value of the security rises to ?100, the yield will fall to 8 per cent. In assessing the profitability of various assets, calculating their yield is very important; articles in the financial press will talk about equity yields and bond yields as much as about dividends and interest rates.

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The mistake that many people make when worrying about the national debt is to draw an analogy between a nation and a family. The proper comparison is with a business. The UK is one enormous and extremely complicated business and like other businesses it has to borrow to expand. Borrowing to finance investment is perfectly acceptable in a business provided that in the long term, the return on the investment is greater than the cost of the borrowing. For a nation, the problem is deciding how to calculate the return on the investment.

The proportion of national income which constitutes debt is considered by some economists to be the most important factor. If it is steadily increasing, that would indicate that the cost of borrowing is greater than the return on our investments and that the government has been borrowing too much (or investing in the wrong things). If the wisely and increasing national wealth. Those who propound this argument argue that money spent on the so-called infrastructure (investments in roads, railways or airports) is wise expenditure which is increasing our wealth. Debt in such circumstances is not a burden to future generations but a contribution to their standard of living.

In opposition to this argument, many economists would point out that the majority of government expenditure is used for consumption rather that for investment. The biggest element of the public expenditure bill is the salaries of its employees and the benefits paid to the sick and unemployed. The cost of paying these wages and benefits is subtracted from the incomes of the private sector of the economy. Less expenditure by government would mean more money for the private sector to invest.

Whatever the merits of the opposing arguments, the evidence seems to be that debt, though increasing in nominal terms, has been steadily falling, as a proportion of national income, since World War II. (Remember, debt is not the same as public expenditure.) On that basis, it could be argued that the country has been investing wisely rather than recklessly.

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The most serious scandal concerned allegations of impropriety at one of Lloyd’s biggest broking firms, Alexander Howden, involving one of Lloyd’s most successful underwriters, Ian Posgate, known as Goldfinger because of his Midas touch. The details, which involved the placing of reinsurance business, were complicated and need not concern us. What was of importance were the doubts that developed over the capacity of Lloyd’s to regulate itself. Much of Lloyd’s business was earned overseas, particularly in the US. Doubts about the market could lead to US customers withdrawing their business and turning to US-based insurers.

In response to the scandals, Parliament passed the Lloyd’s Act in 1982, which reorganized the workings of the market. A new committee was appointed on which representatives from outside the market were introduced. Brokers were told to divest them selves of their underwriting interests. At the same time, all members were asked to declare their outside interests. Special attention would be paid to the reinsurance interests of underwriting syndicates. To strengthen the market’s self regulation, Ian Hay Davison, formerly with accountants Arthur Andersen, was brought in by the Bank of England is 1982 as Chief Executive of Lloyd’s. He had a mandate to reorganize and reform.

Davison resigned at the end of 1985 after rumors of internal conflicts over policy. He had carried through a series of reforms but failed to satisfy Lloyd’s critics. Few people seemed to have been disciplined or prosecuted over the scandals and many called for Lloyd’s to be included in the scope of the 1986 Financial Services Act. The government resisted those cries, arguing that the Lloyd’s Act of 1982 had not had time to be judged, but it may yet be forced to tighten up the regulations further.

In the meantime, Lloyd’s was faced with other problems – the growing size of damage settlements in the US courts was causing claims from clients who had reinsured their excess risks at Lloyd’s. However, as settlements rose, overcapacity in the insurance industry worldwide limited Lloyd’s ability to increase premiums to meet the extra risks. Some syndicates made large losses, causing alarm to the ‘names’. In 1988 for the first time in nearly twenty years, the number of Lloyd’s members was set to decline.

The total amount that most governments have had to borrow has increased in post-war years, because of the growth of welfare economies in the West with the resulting inbuilt increases in expenditure. Few governments have been willing to take the unpopular step of raising taxes to cut the deficit. The expenditure side of the equation has suffered accordingly. The result in the UK has been continuous battles over cuts in spending between those ministries with escalating budgets (particularly the Departments of Health, Social, Environment and Defence) and the Treasury.

The difference between the government’s total revenue and its expenditure is known as the public-sector borrowing requirement (PSBR), and it is the size of the PSBR that has been one of the central points of the Conservative government’s financial strategy. (Indeed so frequent was the mention of this acronym in the speeches of Sir Geoffrey Howe that one wag suggested that he was ‘unable to tell his PSBRs from his elbow’.)

In the early days of Mrs. Thatcher’s administration, the economic rationale behind the government’s desire to reduce the PSBR was that a fall in government borrowing would stimulate the economy. If the PSBR is too high, it was reasoned, the available funds for investment will flow to the government (a safe credit) rather than to industry. Companies will be able to borrow only by offering investors penally high rates of interest, discouraging them from investing in new plant and machinery. Without new investment, the economy will not grow. The government will effectively have ‘crowded out’ private-sector borrowing. A low PSBR, the government argues, will result in low interest rates. Businesses will be encouraged to invest and the economy will grow.

However, in the later part of Mrs. Thatcher’s administration, interest rates were increasingly used by the government as a weapon in two other policy areas, combating monetary growth and supporting sterling. By 1988, broader economic policy required the government to push up interest rate, even though the government had been successful in eliminating the PSBR. So it is far from clear what effect the government’s borrowing actually has on interest rates. In the US, a combination of President Reagan’s tax cuts, increased defence spending and Congressional reluctance to cut programmers elsewhere have brought record budget deficits, yet interest rates have consistently been below those in the UK.

Timing the issue is very important – if the stock market is strong, then a company can raise a lot of money by issuing fewer new shares. However, shareholders may be unwilling to take up new shares which are highly priced. If the share market is weak and a company’s share price is low, then a rights issue to raise a large amount will involve issuing a large number of shares. This can dilute the control of its shareholders.

The proportion of a company’s total profits, dividends and assets held by existing shareholders is unaffected by the price at which new shares are issued under a rights issue or the number of shares issued – it is the proportion of equity raised which is important. A one-for-four issue will create 25 per cent more shares, in other words there will be five shares in issue for every four that existed before. If existing shareholders do not take up their rights, they will own four-fifths of the enlarged company, regardless of whether the shares were issued at 50 pence or ?2 each. The important question for existing shareholders to decide is whether to exercise their rights to the issue or whether to sell them to a more willing buyer. That decision may depend on whether or not they have the cash available to pay for the new share, whether they have an interest in controlling the company and what they see as its future prospects.

How much would their rights be worth? Assume that the company offered one million shares at ?2 each and that its 4 million existing shares were trading at ?2.50 (a one-for-four issue). The theoretical value of the rights can be calculated as follows:

4 million existing share at 250 pence ?10 million
1 million new share at 200 pence ?2 million
5 million shares in total ?12 million

Dividing the total value of the company by the number of shares, ?12 million ? 5 million = ?2.40p. Subtracting the rights issue price of ?2.00 gives a theoretical price for the rights of 40 pence. In fact, this theoretical value is rarely attained but it is a rough guide for investors.

Many of the early bankers misjudged their ability to absorb ‘runs’ – times of financial panic when investors rushed toe claim back their gold. In such cases, bankers had insufficient funds to meet the claims of depositors upon them and thus became ‘bankrupt’ (literally ‘broken bench’). Such runs could easily become self-fulfilling. As soon as depositors feared that a bank might become bankrupt, they would flock to the banks in order to demand their money back, thus accelerating the bank’s deterioration into ruin. Because of the nature of banking, no bank could stand a determined run. Some tried ingenious methods to do so. One bank arraigned for a few wealthy depositors to arrive by carriage at the front of the bank and withdraw their gold ostentatiously. The queuing small depositors were impressed. Meanwhile, the wealthy depositors sent their footmen round the back to re-deposit the gold, so it could be used to meet the claims of the other depositors.

Bankruptcies did not reduce the total number of banks. The seeming ease with which it was possible to make money from banking soon attracted others to take the places of the institutions that had failed. Gradually, depositors regained confidence in the trustworthiness of the banks. Thus began a regular banking cycle of boom and bust. Professor Galbraith explains that the length of these cycles ‘came to accord roughly with the time it took people to forget the last disaster – for the financial geniuses of one generation to die in disrepute and be replaced by new craftsmen who the gullible and the gulled could believe had, this time but truly, the Midas touch’.

In the UK Charles I, that unlikely saint, gave banking an unwitting boost in 1640 by seizing ?130,000, which merchants had unwisely committed to his safe-keeping by placing it in the Royal Mint. Merchants decided that in future it would be rather safer to deposit their funds with the bankers in the City. It was not until 1694 that the government’s financial reputation could be restored and the Bank of England established: by that time, the crown was on the head of the sober and respectable Dutchman, William of Orange.

The traditional means of raising new equity is a rights issue. Shares are offered to existing shareholders in production to their holdings – a typical offer might be one share for every four owned. The shareholder may then take up the rights and pay for the new shares or sell his rights to do so to another investor.

Rights issues are a fairly expensive way of raising new money. They have to be underwritten and the shares usually have to be offered at a substantial discount to the market price. Such are the costs that some companies have tried to find alternatives to the rights offer. But the institutions have stood firm in defence of their rights. It is a general principle of UK companies’ legislation that existing shareholders should have a pre-emptive right to subscribe to any new shares on offer. Without that right, the original shareholders’ stake in the company would be eroded. So except for quite small issues, UK companies can still only place shares with new investors if the existing shareholders agree.

Some companies make so money acquisitions, using shares as their means of payment, that constant rights issues are out of the question. A compromise method is called a ‘vendor placing with claw back’. It works like this. Company A wants of buy Company B and would rather pay in shares than in cash. But Company B’s shareholders want cash rather than shares. So Company A issues shares to Company B and then immediately arranges for the shares to be placed with outside investors. Thereby getting Company B its cash. To protect the rights of Company A’s shareholders, they are given the entitlement to apply (to ‘claw back’) any or all of the placed shares.

However, for companies wanting to raise large amounts of equity, the rights issue is the only practicable method. Blue Arrow, the employment agency, raised ?837m via a rights issue when it wanted to buy US group Manpower in 1987. That was around twice as much as the market valued the whole of Blue Arrow before it launched the bid.

When considering a rights issue, the main questions facing the company and the bank or broker advising it are when to make the issue and at what price. The shares will normally have to be offered at a discount to the market price for the company’s existing shares, otherwise those shareholders who want more shares will simply buy existing ones on the market. The bigger the proportion of new shares on offer (say, one to four), the heavier the discount will have to be, in order to attract the amount of funds needed.

The receipts were the first banknotes. The legacy of those early receipts is visible today in the form of the confident statement on banknotes: ‘I promise to pay the bearer on demand the sum of…’.

Despite having the image of the Queen to back it up, that statement is of no value today and anyone attempting to redeem a five pound note for gold at his local bank will be disappointed.

Smart goldsmiths were able to take the development of banking one stage further. They noticed that of the gold stored in their safes, only a small quantity was ever required for required for withdrawal and that amount was roughly matched by fresh deposits. There was therefore a substantial quantity of money sitting idle. The money could be lent (and interest earned) in the knowledge that the day-to-day requirements of depositors could still easily be covered.

Such a system will be good for the banks, which will no longer have to process millions of payments for small accounts. It will also be good for the retailers, by helping them make their queues shorter and receive their funds more quickly. But it will not necessarily be good for the customer since he or she will lose the credit period granted by a credit card or a cheque.

The retail sector has its own financial plans. Several stores have set up their own credit card systems which take some business away from the banks. Others have set up in-store share shops and Marks and Spencer has launched its own unit trust.

As the banks have expanded into other areas themselves – like mortgages and insurance – so they are now facing challenges from outside. In twenty years, the conventional definition of a bank – as just a depository for funds – may seem very old-fashioned indeed.

Assets and Liabilities

Banks’ assets are the loans and investments which they make with the deposits provided and which earn them interest. Those assets are held in a variety of forms. A substantial proportion is lent out shout-term – either at call (effectively overnight) with a special set of institutions called the discount houses, or in the form of short-term deposits in the money markets. The bulk of banks’ assets is held in the form of loans – to individuals and to business. Individuals and companies both borrow mainly in the form of overdrafts which have advantages for the banks since they can, in theory, recall them overnight. That gives the flexibility in case of a sudden drop in their funds.

The banks also lend longer-term, both domestically and internationally. In the UK, the loans are vital to the development of industry. Most companies start with the help of a bank loan, usually secured on the assets of a company. That means that if the firm folds, the bank has a claim on the firm’s fixed capital such as machinery or buildings. Internationally, the banks’ lending activities exploded in the seventies and as we saw in Chapter 1, many of them now regret it.

The proportion of the banks’ assets which they need to hold in the form of cash is known as the cash ration. The ratio has from time to time been set by the Bank of England to ensure hat banks remain sound. It determines to some extent the total amount banks can lend. However, there are other factors involved.

One of he most important is the supply of creditworthy customers. Banks are normally cautious about the people to whom they grant overdrafts. If we assume that the number of people who are good credit risks (i.e. they have a steady job, good references, a good financial record) remains fairly constant, that puts a limit on banks’ expansion.

The general state of the economy will also affect the growth of bank lending. If the economy is healthy, more businesses will be seeking to borrow funds to finance their investment plans. If the economy is in recession, however, few industries will be prepared to invest and therefore to borrow. Banks might seek to attract more borrowers by lowering their interest rates, but there is an obvious limit to such a process. The banks cannot afford the return from their lending to fall below the cost of their borrowing. The return from lending must always be significantly higher, because of the substantial costs involved in running a branch network.

At the core of the market are the banks. Most commercial banks have their own foreign-exchange room. Although banks could not deal if they were not providing a service for their corporate clients who need foreign exchange as part of their everyday business, the majority of any bank’s deal are done with other banks. One bank has estimated that 95 per cent of its foreign-exchange business is done with other banks and only 5 per cent with outside customers.

There are three major dealing time zones, all of which have more than one centre. London was considered the most important centre, although New York has now probably taken over that role. The market begins each day at 1 a.m. Greenwich Mean Time (GMT), when Tokyo opens. The Far Eastern tome zone holds sway until 9 a.m. GMT, by which time London, Frankfurt, Paris and Zurich have begun the European time zone trading. By 2 p.m. GMT, New York has opened trading in the American time zone. The market does no close in New York until 10 p.m. GMT. Those dealers who are still awake can trade in San Francisco and Los Angeles until Tokyo opens the next day.

With so many markets to keep track of, the pace of a dealer’s life is often frenetic. Most are young, and some are burnt out by their middle thirties. How do they operate?

Suppose so dealer gets a commercial request to buy or sell a large volume of currency. He has several choices. He can satisfy the request himself or ask one of his colleagues to do so. If his colleague cannot, he can ring up a dealer in another bank and hope that he will be able to sell on the currency to his counterpart. But this can be time –consuming. His alternative is to contact a foreign-exchange broker, whose job is to find a willing counterparty to the deal. In return for this service, the broker charges a commission, which can be as small as one-hundredth of 1 per cent. However, one-hundredth of 1 per cent of deals worth ?1 million a time can quickly add up to a lot of money.

The broker will always attempt to cover his position; in other words, he will ensure that he is selling and buying the same amount of currency, so that he is safeguarded against fluctuation. Dealers will usually do the same, although they are allowed, within limits, to leave surplus funds in currencies which they believe will appreciate.

An exchange of currencies for immediate delivery is conducted at the spot rate. Dealers will quote two exchange rates for each currency, one at which they will buy the currency and one at which they will sell. The difference between the two is one way in which a bank makes money and is called the spread. So if you wanted to buy dollars in exchange for sterling, the bank might offer $1.4850/?1. If you had wanted to buy sterling in exchange for dollars, the rate would have been $1.4870/?1. (For brevity the sterling/dollar rate would be given by a dealer as 50/70.) The 0.2 cent difference between the two rates is the spread. These rates are displayed and continually updated throughout the day in foreign-exchange dealing rooms and on Reuters and Telerate screens, and they appear every day in the Financial Times. The faster an exchange rate is moving, the wider the spread, since the dealer will not want to be committed to dealing at an unfavourable rate.

Tourists buying foreign currencies will find that the spread is very wide, often several percentage points. Banks can afford to charge each other a narrow spread because the deals are large and frequent and because the competition is intense. The tourist, by comparison, has little bargaining power, and the bank’s costs in supplying the small amounts of currencies involved are proportionately higher.

The Bank’s most important supervisory activities, however, relate to the banking system. As we have already seen, the Bank has often used its powers to regulate the asset portfolios of banks. It is also concerned to ensure that bank depositors are protected from collapse. This role was brought into the public eye in 1984 when the Bank was forced to step in and buy the Johnson Matthey Bank, for the nominal sum of ?1, to save it from insolvency.

The Johnson Matthey scandal forced the Bank to revise totally its supervisory functions. After deputy governor Kit McMahon left the bank, George Blunden, the man who guided the banking system through the secondary banking crisis of 1974-5, came out of retirement to take on McMahon’s post. The Bank was faced with dealing with two problems: the prevention of fraud and the avoidance of bank failures.

It was clear that the 1979 Banking Act, which divided banks into two tiers – top-rank banks and licensed deposit-takers – had proved unsuccessful. The new system created a Board of Banking Supervision which included independent members as well as the Bank’s supervisory team. The Board will be responsible for advising the Governor on a wide variety of issues, including the development and evolution of supervisory practice, the administration of banking legislation and the structure, staffing and training of the Banking Supervision Division.

The two-tier supervisory system was abolished and to cope with the greater workload, the staff of the Bank’s supervisory department was substantially increased. Under the new system, authorized institutions will need to have minimum net assets of ?1 million and issued capital of at least ?5 million to be able to call themselves a bank. They will need to report certain information about their lending patterns to the Bank. It will be a criminal offence ‘knowingly or recklessly to provide information to the supervisor which is false or misleading in a material particular.

One of the most tricky areas in banking supervision is the role of bank auditors. The Bank of England had hinted that auditors might be required to report to it directly – a breach of the time-honoured tradition of confidentiality between auditors ad audited. After some debate, a compromise was reached under which auditors were required to inform the Bank of potential disasters such as the possibility of fraud. In addition, the Bank will have powers to appoint a second firm of accountants if dissatisfied with the work of the first group.

The Bank of England must be notified of any exposure to an individual customer in excess of 10 per cent of a bank’s capital (equity and near-equity). Exposures of over 25 per cent will require prior notification to the Bank. (As mentioned in the Introduction, Johnson Matthey Bank lent 115 per cent of its capital to just two borrowers.) In addition, anyone who buys a stake of more than 5 per cent in a bank must report it to the Old Lady; anybody wishing to control a bank would have to be declared ‘a fit and proper person’ by the Bank.

These powers give the Bank real teeth to cope with potential scandals. The old Bank would not have needed them, but the modern financial system is less of a gentleman’s club. As the Johnson Matthey case illustrated, one cannot rely on bankers to be prudent wit their depositors’ money.

Probably the best way of showing the importance of yields is to cite the bond market. Suppose that in a year of low interest rates the Jupiter Corporation issues a bond with a face value of ?100 and an interest rate (normally called the coupon) of 5 per cent. In the following year interest rates rise and bond investors demand a return of 10 per cent from newly issued bonds. Those investors who bought Jupiter bonds are now stuck with bonds which give them only half the market rate. Many of them will therefore sell their Jupiter bonds and buy newly issued bonds.

Who will they sell the bonds to? Potential buyer s of Jupiter bonds will be no more willing to accept a yield of only 5 per cent than the sellers. Bonds sellers will therefore have to accept a reduced price for the Jupiter bonds. The price will have to fall until the returns from Jupiter and other bonds are roughly equal. If the bond price fell from ?100 to ?50, then each year bondholders would still receive ?5 on a bond which cost them ?50 – a return, or yield, of 10 per cent. The Jupiter bond would be as attractive as a bond priced at ?100 with a 10 per cent coupon, which would also yield 10 per cent.

Calculating the yield on a bond is not quite that easy, however. The bond will be repaid at some future point. Say, for example, it has a nominal value of ?100, sells for ?96, pays ?5 interest a year and has one year to go before it is repaid. Over the next year the bondholder will receive ?5 interest and ?4 capital – the difference between the ?96 it sells for and the ?100 which will be repaid. So the bond yields ?9 on a price of ?96, just under 10 per cent. A yield which is calculated to allow for capital repayment is called the grow yield to redemption. Going back to the Jupiter issue, the bonds would not have to fall in price as low as ?50 to keep their yields in line. If they had a five-year maturity, they would have to fall only to around ?83 to have a gross yield to redemption of about 10 per cent. Bond trading depends on quick and sophisticated calculation of yields and exploitation of anomalies in the market.

This process of adjusting prices to bring yields in line gives bond investors the prospect of capital gain (or loss) on their holdings. An investor who buys Jupiter bonds at ?100 would lose ?25 if the price fell to ?75 because of the yield adjustment. That would more than wipe out any interest earned on the bond. However, if the interest rate offered on other bonds fell back to 5 per cent again, then Jupiter’s bonds would climb back to their face value of ?100. An investor who bought at the low of ?75 would have made a capital gain of 33 per cent and still earned interest in the process.

Because of the yield factor, bond prices have an inverse relationship with interest rates: bond markets are generally euphoric when interest rates are falling, depressed when they are rising.

The big retail banks have faced increasing competition for the deposits of ordinary individuals. The challenge of the building societies has already been mentioned. There are other long-standing competitors of which perhaps the most important is the Trustee Savings Bank (TSB). Trustee Savings Banks were set up in the nineteenth century to collect the savings of small depositors who did not have enough money to be attractive to the larger banks. The banks were run by ‘honorary trustees’ who invested the depositors’ funds in gilt-edged securities and paid the interest thus earned to the depositors. In the 1860s, there were over 600 banks but this number fell to 20 in the mid-1970s as the banks merged.

In 1982, their organization was changed from a federal structure into a holding company (TSB Group plc) with subsidiaries. Thanks to the Trustee Savings Bank Act of 1976, they no longer have to invest all their money in government securities and can now lend to private customers. The new TSB is pushing hard to rival the traditional banks, helped by its long-standing hold on the savings of the working classes.

The TSB went public in 1986, after a lengthy legal dispute over who actually owned the bank. Once floated, it splashed out buying a find manager (Target) and a merchant bank (Hill Samuel), and was quickly beginning to resemble the other major banks, both in its activities and in its ambitions.

Post Office

It occurred to nineteenth-century governments that small savers (some of whom are depositors at the Trustee Savings Banks (were a very useful source of funds for the National Debt (the gap between the government’s revenue and expenditure). At the time, the nation’s private banks served only a very select band of customers. The government accordingly opened up the Post Office Savings Bank to tap these funds. It soon became the nation’s largest repository for savings, thanks to the advantage of a large number of branches. Not always the most competitive of banks, it paid a standard interest rate of 2.5 per cent from around 1900 until 1970.

Following a change of name to the National Savings Bank, the government had offered a wide variety of savings schemes from Index-linked SAYE (Save As You Earn) to Granny bonds. Although these were rather more competitive than the Post Office used to be, the government’s healthy finances (and a general fall in private saving) kept National Savings out of the limelight.

In Post Offices, customers can also get access to many banking services through the Girobank, which at the time of writing was in the process of being sold to the private sector.

Finance Houses

The finance houses have traditionally been involved in the financing of hire-purchase agreements between customers and retailers. The interest on such agreements is quite high and the business potentially profitable. However, over the years, successive governments have placed increasing restrictions on consumer credit as an anti-inflationary measure. Many consumers have switched to credit cards as a means of financing large purchases. As a result, finance houses have become less significant in the consumer market and have concentrated on lending to companies, through techniques like leasing and factoring.

The main problem for individuals in equity investment is the risk. As the Crash amply illustrated, share prices can fall dramatically in a single day. Even if the market as a whole does not collapse, individual shares can fall very sharply and the smallest investors are usually the last to hear the news that sparks the drop. It may be bad news about an individual company that causes its share price to plunge or bad news about a sector of the economy that causes a group of share prices (e.g. computer companies) to fall.

The best way of dealing with the risk of individual price falls is to spread shareholdings over a wide range of companies. This is a matter for careful judgment; obviously, buying five separate oil stocks will not protect you against a fall in the price of oil.

The problem is that the costs of dealing – the commission paid to stockbrokers, the stamp duty, and the spread between the buy and sell prices – mean that shares have to rise by several per cent just for the investor to break even. Of course, the wider the portfolio, the greater the costs. Since one should really have a portfolio of 10 to 12 stocks, the investor ought to have at least 10,000 to 12,000 to spend. He or she should also be ready to invest long term. Also, individual sectors may be more risky than others. Investing in diamond mining may give you a chance to make your fortune but you are also far more likely to lose your stake than if you had bought shares in ICI.

Tips and rumours can be misleading. Many investors rashly seize on a newspaper report. A story about booming coffee prices in Brazil will have been known of others long before, and the share price of coffee producers will already reflect the new. The tips given by financial journalists are often useful but, not alas, always right.

If there is a hope of a quick killing for the small investor, it may only come through new issues. Everyone who bought shares in British Telecom did well at first. By no means all new issues are no successful but it may well be that the publicity which surrounds further privatization issues will ensure their success. The investor should read the financial press carefully before such issues. If enough publicity is favourable, then it is likely that plenty of other investors will be willing to buy. That will mean that the issue will be over-subscribed and those investors who do not get the shares they want will try to buy the shares on The Stock Exchange, bidding up the price in the process.

Experts have a further rule of thumb – take profits and cut losses. It is luck and not judgement that allows a shareholder to sell at the highest possible price. Better to be sure of a 50 per cent gain, than lose all the gain trying to get 60 per cent. On the loss side, if a share price starts plummeting experts do not hand on in the Micawberish hope that ‘something will turn up’.

A large number of people belong to company pension schemes which ‘contract out’ of SERPS, offering instead a private scheme, part funded by employers, part by the employees themselves. Such funds must be approved by the Inland Revenue and are set up as independent trusts. They provide a very good benefit for those who retire after a long period of service for on firm. The maximum benefit available is generally retirement on two-thirds of the final salary, and there are guaranteed benefits for widows (whether the staff member dies in or out of service). The majority of schemes allow employees to take part of the pensions as a tax-free lump sum. Contributions from both employers and employees are free of tax and the fund itself can accumulate tax-free.

Company-run schemes do not offer a good deal to those who move jobs frequently. Those who are 26 or over and have worked for five years or more must have a pension right preserved by law; the amount is determined by dividing the years of service by the years which could have been served if the employee had worked through until retirement. So if an employee joins at 25 and leaves at 30, and could have worked till 65, he will receive an eighth of his entitlement.

If your service is just under five years, you can opt to take a lump sum in lieu of the final pension but if you do you will be taxed. Your contributions had been exempt of tax only because they were going towards a final pension. So the lump sum you receive will be less than you expect. It often would have been much more profitable to invest the money in a building society. However, few companies allow employees to opt out of making contributions.

There are reasons for the onerous provisions outlined above. If companies had to give all people who worked for them a decent pension, no matter how short their period of employment, and if employees could opt out of contributing, pension schemes would never fund themselves. However, the economic effect of such pension provisions is surely bad. It encourages workers not to be mobile but to stick with one job. An efficient economy is one where there are no barriers on labour movement.

Accordingly, the government now allows individuals to opt out of company pension schemes. Instead they can take out personal pensions, whereby they pay monthly instalments to a financial services group. The financial group then invests that money, so that by retirement time is has grown to a size sufficient to pay out in pension.

There are disadvantages to such schemes. If the fund is managed badly, or stock markets deteriorate, there is no guarantee that the eventual pension will be adequate. Also, there are no employer’s contributions under personal pensions. However, the advantage of a personal pension is that, however many times the individual move jobs, the fund keeps growing.

Like Barclays, Nat West has built up an integrated securities house, County Nat West. CNW has had its problems – it lost ?116m in the year of the Crash, causing its two top executives to resign.

The big four banks are retail banks with a built-in advantage over their rivals – the current accounts of ordinary like you and me. Such accounts traditionally paid no interest whereas the banks could charge as much as 20 per cent on overdrafts – a fairly hefty profit margin. Banks without retail deposits have to borrow at market rates in the money market in order to obtain funds. It can be said in justification of the retail banks that the costs of such a large network of branches, in terms of buildings, staff and paper work, take a substantial slice of that margin. Nevertheless, in inflationary years, when overdraft rates have risen well above 20 per cent, the major retail banks have been able to announce record annual profits.

This so-called endowment effect is disappearing. Competition from institutions like building societies means that banks now have to offer interest-bearing accounts keep their hands on depositors’ funds. But the banks’ millions of private customers still give them immense strength. They can sell their customers a whole range of other products – from life assurance to unit trusts – while keeping a constant check on their creditworthiness.

The Credit Card

Retail banks were also at the forefront of one of the most striking developments in personal finance over the last twenty years – the credit card. Barclays was the first with the Barclaycard (Visa); the other three banks then responded with Access (Mastercard). However, all four banks have now applied to issue both sets of cards.

Using a credit card is an extremely expensive form of borrowing with an interest rate of around 25 per cent per annum. But a card is very easy to obtain – there are very few forms to fill in. It is also convenient to use for the shopper.

Credit card companies rely for profit on the fact that consumers do not pay off the balance at the end of the month. The sum outstanding is very small but the interest rate is high. There are surprisingly few bad debts among credit card holders – fraud is much more of a problem. The fact that large items can be bought with a card (unlike a cheque which normally can be used only to cover items 0f under ?50) makes credit cards very attractive to the sneak thief who can run up a bill of several thousand pounds in the course of a few hours. However, the problem of the forgery of the cards themselves seems to have been solved by the incorporation in the design of holograms and computer codes.

If, for example, a company wanted to buy an option to borrow at 8 per cent at a time when interest rates were 10 per cent, there would be automatic potential for profiting from the option. As a result, the premium for the option would be at least 2 per cent and would be much larger than the premium for an option to borrow at 12 per cent in the same circumstances. An option to lend at, say, 12 per cent when interest rates were 10 per cent would carry a large premium, however, since it would have built-in profit potential.

Options which run for longer periods will also carry larger premiums. This is because the probability is greater that, over a long period, rates will move in such a way that the option will become more profitable to exercise. The option seller will charge a larger premium to reflect this extra risk.

How quickly interest rates will move is the hardest of the three elements for the option seller to assess. If the rate has shown a tendency to fluctuate violently in the past, it will obviously carry a higher premium than a rate which has shown a tendency to be stable.

An example will help to clarify the point. A company buys a three-month option to borrow at 10 per cent for three months, based on a nominal principal sum of ?1 million. At the time the option is sold, interest rates are 10 per cent and the option seller charges a premium of 1 per cent (?2,500).

Outcome 1 At the end of the three-month period interest rates are 12 per cent. The company exercises the option, thus borrowing at a rate of 2 per cent cheaper than if it had not bought the option (this is equivalent to a saving of ?5,000). However, the premium cost 1 per cent (?2,500), and the savings that the company makes (compared with its borrowing costs if it had not bought the option) are ?2,500.

Outcome 2 At the end of the three-month period interest rates are 8 per cent. The company lets the option lapse but is free to borrow at the cheaper rate available. Its extra costs are ?2,500, the cost of the premium, but its borrowing costs are less than it might have expected at the time when it bought the option.

It is much easier now to raise such large amounts because there is a highly developed secondary market in Eurobonds. A primary market if one in which bonds are sold for the first time; a secondary market is one in which existing bonds are traded. Traders sit in vest dealing rooms, surrounded by electronic screens displaying the current prices of bond issues, the latest moves in interest rates and the trends in the economy. They look for bond yields which have moved out of line with the rest of the market and can therefore be bought or sold for profit. They also try to anticipate whether interest rates will fall (and bond prices will rise) or rise (and bond prices will fall). If they make the right decision, they can earn their companies a lot of money; in consequence, they are some of the most highly paid men and women in the country.

London is the centre of the Eurobond market. The Americans have tried, without much success, to switch the market to New York by setting up international banking facilities, which allow banks to treat some of their New York offices as being off the US mainland. And in 1984 it was feared that the abolition of the US withholding tax (a tax on the investment by US citizens in bonds issued abroad) would lead to the Eurobond market drifting across the Atlantic. However, London retains the advantage of sitting between the time zones of New York and Tokyo, and it seems likely that the Eurobond market will remain focused on the City.

The location of the Eurobond market may still be London, but it is the American rather than the British banks who now have the lion’s share of the business of Eurobond arranging. The early lead of the European bankers evaporated when US banks set up London-based subsidiaries to recapture their hold over the dollar bond market. According to a table compiled by International Financing Review, the top five international bond managers in the first nine months of 1988 were Nomura, CSFB, Deutsche Bank, Daiwa and Nikko. There of the five are Japanese.

Although we have referred to the Eurobond market in the analysis above, it is a term which is becoming less and less appropriate. The capital controls and banking restrictions which spurred the start of the market have largely disappeared, and it is now more correct to refer to an international bond market in which international borrowers issue bonds and notes to international investors via international securities houses. Borrowers can now issue bonds in very sophisticated forms, some of which are described in the rest of this chapter.

Barclays Bang was originally an amalgamation of Quaker family banks. Although it can claim credit for being the first to introduce such ideas as the credit card and the automated teller machine, it was dogged for years by its reputation for being heavily involved in South African investment. Periodically, Barclays’ annual meetings were disrupted by dissident shareholders and its branches picketed by protesters. During the South African riots in 1985, Barclays took the opportunity to reduce its presence in the country and it took a tough line on the repayment of South African loans.

In recent years, Barclays has regained some lost ground. It made perhaps the biggest investment of all the big four in the new securities revolution, joining a stockbrokers’ and jobbers’ firm to its investment banking arm in a new group, Barclays do Zoete Wedd. BZW is generally considered to be one of the more successful securities houses. And under it new executive chairman, John Quinton, Barclays has increased its profits and capital base with the aim of regaining its status as the largest UK bank.

Lloyds has had its problems overseas, with its subsidiary, Lloyds Bank International, disappearing amid rumour of fraud and of dissension between executives. It also failed to acquire Standard Chartered, a bank with substantial overseas interests. However, Lloyds is generally given credit for not splashing out on expensive purchases of stockbroking firms in the years before ‘Big Bank’. It has preferred to concentrate on developing in-house expertise. And it has also been successful in the property field, thanks to the establishment of the Blach Horste estate agency.

Midland Bank committed perhaps the biggest folly of all the UK banks in recent years, by taking a share in the California- based Crocker Bank. Crocker soon resembled a bottomless pit down which Midland was forced to pour more and more money and it was eventually sold in early 1986. Midland’s star has waned somewhat since the days before 1947 when it was the world’s largest bank. However, Sir Kit McMahon, former deputy governor of the Bank of England and now Midland Bank’s Chairman and Chief Executive, is battling to restore the Midland Bank’s Chairman and Chief Executive, is battling to restore the Midland Bank’s fortunes, selling off peripheral businesses and bringing in the Hong Kong & Shanghai bank as an equity partner.