Financial Service Industry
While some of the details of this outline of ‘financial service industry (FSI)’ may not seem relevant to a basic primer on personal finance; a basic understanding of the key motivation behind this ‘industry’ is important to take on-board, i.e. it is driven by profit. Typically, an individual will make 3 major financial investments in their lives, i.e. buying a house, saving for a pension and buying some form of retirement annuity. All three of these investments represent a money making opportunity to the FSI, such that it is important to remember that you are NOT their first priority, when you enter into any legally binding agreement. Therefore, it can be instructive to understand a little about the scope of the financial service industry and how it makes its profit from millions of individuals. In many ways, it would be nice to provide an initial introduction that simply ignored the issue of inflation, as we tend to intuitively equate the value of money in today’s purchasing power. Unfortunately, removing the effects of inflation would then mask other factors, which are felt important to highlight within the context of the examples to be given. The following graph gives some historical insight to the fact that the rate of inflation has varied considerably from its current low rate in the order of 2.5%.
However, it is possibly more informative to show the effect of inflation running at an average rate of 2.5% over the next 60 years, based on the value of £1, although in practice it will probably be subject to much variation, as reflected in the graph above.
So, in effect, inflation causes the monetary value of £1 to fall over time and the illustrative example above shows the purchasing power of £1 falling to 23% of its present-day value after 60 years; while the historic chart below suggests that the value of £1 has eroded to almost nothing since 1700.
Of course, in practice, the pound in your pocket is normally offset by an equal inflationary increase in wages and interest on savings, at least, in concept. However, there is a knock-on effect associated with interest rates, when applied to savings, which requires consideration in a wider context. While interest rates are linked to inflation within the general economy, they are also a mechanism that allow financial institutions, such as banks, to make money. At a very basic level, a bank is simply a financial service that costs money to operate, which as a business it needs to recover with a profit in mind. Basically, this type of business model operates by lending money at a higher interest rate, which covers its operating costs and the interest paid on its saving accounts. While the following model might be considered to be laughably simplistic, - see Bank, Money & Loans for more details, it may still demonstrate how a bank, in principle, may be established with a ‘total capital’ of £10 billion, where conceptually it must hold 10% as a ‘reserve fund’ with a ‘central bank’, e.g. The Bank of England. This leaves our model bank with a ‘working capital’ of £9 billion that it can offer as loans with an interest charge associated, e.g. 7%, which would return a ‘working profit’ of £630 million. However, this figure must also cover the ‘operational costs’ of the bank plus the ‘ saving interest’ that amounts to £400 million, leaving a final ‘profit’ of £230 million.
So, based on the model above, the ‘total cost’ of maintaining £10 billion of capital is £400 million, which it recoups by lending out its ‘working capital’ at a higher rate, e.g. 7% and results in a final profit of £230 million or a 2.3% return on £10 billion total capital. Today, even quite modest banks may have to ‘access’ to what appears to be very substantial sums of money like £10 billion.
Note: In practice, banks raise their savings capital in a number of ways, e.g. stakeholders, shareholders, market lending and governments. Often the original ‘stakeholders’ are very rich people who see the bank as a long-term investment that will be relatively risk-free, while still providing a good rate of return, i.e. profit. While individual ‘shareholders’ may operate on a similar basis as stakeholder, it is usually on a smaller scale.
It may be worth highlighting that while ‘banking’ is a ‘financial service’ that normally operates as a ‘business’, i.e. it has to make a profit, banks also have a more fundamental role to play in the wider economy. Although the scope of this issue is not the subject of this discussion, banks often act as a broker between ‘investors’ and ‘borrowers’ that is critical to the ‘growth of an economy’. However, within the simplicity of the current model, we are only assuming that banks work by taking a little slice of a very big pie, whereas in practice, it is not against their principles to take a much larger slice, when the opportunity arises or they think they can get away with it. If you check out the profits posted by some of the mortgage banks, you will see that this model is not that far from reality.
Note: Many banks also recoup operational costs associated with setting up a loan by imposing charges and fees, which may not be immediately obvious. In principle, the Annual Percentage Rate (APR) should aggregate these charges into an effective interest rate, although many banks still find ways of imposing additional charges.
So, to summarise, our simple bank model has assumed that all customer savings earn a compound interest of 3%, while the bank uses the same money to earned 7%. In principle, many financial institutions operate by taking money at one rate and lending it at a higher rate, where the difference minus the operational cost becomes their net profit. However, today, there are many types of financial institutions offering what may appear to be a bewildering range of services, both savings and loans, although the underlying principle may still conform to the general description provided, the actual interest rates charged may differ widely.
Note: Since the financial crash of 2008, interest rates paid out to savers as fallen towards zero. As such, the cost of borrowing money has also fallen. However, the basic principle of one rate for savers and another for borrower still applies, although the essential simplicity of this model is rarely obvious in the real world.
As indicated, today, financial services now encompass a broad range of financial business models that manage money, e.g. banks, credit unions, credit card companies, insurance companies, accountancy companies, consumer finance companies, stock brokers, investment fund managers and even some government sponsored enterprises. However, we shall proceed on the basic assumption that most financial services, but not necessarily all, operate on the profit margin between the interest rate given to savers and the rate charged to borrowers. However, it should come as no surprise that the financial services industry is always on the lookout for new ways to maximise profit through new ‘innovative’ services.
So does money really make the world go round?
While this is a well worn adage, it might be argue that it is ‘loans’ and ‘interest’ that really drive the economy, where money is simply an exchange mechanism that is primarily confined to an accounting balance sheet – see Private Bank Money for more details. However, in the context of personal finance, one of the biggest innovation was the introduction of credit cards, back in the 1960’s. Of course, this trend was not something that just happened all by itself, as it was a situation essentially engineered, and possibly later exploited, by financial institutions and governments, which recognised instant credit as another source of both profits and tax revenue that could fuel growth in the economy. Today, following the 2008 financial crisis, bank interest rates offered to many high-street savers is typically in the range of 0-3%, while the cost of a high-street bank loan may range between 5-25% APR depending on the amount and period of payback. In contrast, mainstream credit cards may charge between 15-20% APR, while others on offer to people with lower credit ratings can escalate between 100-1000% APR. At the top end of this market, i.e. the payday loans, interests rate can approach 5000% APR. The justification of such high interest rates is often defended on the basis of administrative overheads, inclusive of higher rates of default, although one might questions why loans carrying such prohibitive interest rates are ever offered to people who clearly cannot afford them.
What about investments as opposed to savings?
Another ‘innovation’ of the last few decades has been the buying and selling of stocks and shares, which is now seen to be within the remit of a personal financial investments. Of course, financial services are happy to facilitate almost any type of investment, especially if offering a higher rate of return and incurs no additional risk to themselves. Today, many financial services will offer different ‘portfolios of investments` across a range of different ‘risk markets’. While this issue is not really the subject of this primer, it is worth stressing that the risk of loss is invariably always placed on the customer, not the financial service provider. There is Latin term for this situation that may be worth committing to memory, i.e. ‘caveat emptor’, which basically means ‘buyer beware’, such that the bottom-line is that many financial services operate to maximise their profits without necessarily giving too much concern towards the potential loss-risk to their customers. Another sector that the financial service industry has also recognised as being another profitable market is associated with mortgages and pensions, especially when accepted as a necessity by the population at large. As this is such an important investment to most people, it might be worth extending the discussion to another illustrative example showing the scale of this aspect of the financial service industry. We might start by assuming there are approximately 60 million people in the UK, where 20% of the population are below 25, 60% are between 25-65 and the remaining 20% are over 65.
Note: The percentage of the population over 65 in 1901 was around 5%. The increase in the percentage number of retired people from 5 to 20% in the last 100 years has caused a big headache for government pensions and spawn a growing need for personal pensions.
The previous approximation equates to about 36 million people of working age, although statistics suggest that only 75% are in full-time employment, i.e. 27 million people. Therefore, we might use this figure as a potential target market for mortgages and personal pensions in order to make some ‘ballpark estimates’ regarding the potential value of these markets to the financial service industry. We will start with the mortgage market by making the assumption that only two-people partnerships acquire mortgages, such that the size of our potential target market would be 13 million. However, by anecdotal evidence suggests that the UK figure is closer to 10 million, where each mortgage might be assigned an average value of £100,000, e.g.
As such, this is potentially a trillion pound industry in the UK, which would return a £30 billion year-on-year profit, if we assume the 3% profit margin of our basic model. Given that each mortgage is secured by a legally binding contract, 10-20% deposit and the equity in the property itself, there is virtually no risk of loss to the lender and, based on the 3% interest assumed, the lender would net £42,263 in interest over 25 years on each average £100,000 mortage, although this figure increases when the payback period is extended to 35 years or, worst still, the interest rate is increased.
This is a little more difficult to estimate as historically many people have relied on a government state pension and some form of earnings related pensions paid for through national insurance (NI) contributions in the UK. Historically, many people also had a ‘works pension’ that was classed as ‘defined benefits (DB)’, where an employee might have originally accrued 1/60th of his final salary for every year employed. As such, this employee would have been guaranteed a pension of 2/3 of their final salary after 40 years (40/60) service. However, this type of pension is now quickly disappearing and being replaced by a pension classed as a ‘defined contribution (DC)’ pension. In a DC pension, each employee has their own pension pot into which they, and possibly their employer, may make contributions throughout their working life. On retirement, the employee invariably takes out an ‘annuity’ to provide a yearly income for the rest of their life. However, for the sake of simplicity, we shall assume that in future all 27 million full-time employees will only have the option of a DC pension and aim to accumulate a pension pot of £100,000 over a 40 year working lifetime. This would required a contribution of £2,500 per year, which is approximately 10% of the current UK average wage. What this size of pension pot might return by way of an annuity payout in retirement will be discussed in later discussions, but 5% per year might be optimistic, e.g. £5,000 per year per for every £100,000.
By way of clarification, although the final value of the pension pot might be £100,000, it must start off being zero and only ends up at the assumed value after 40 year, such that we might estimate an average pot as being half the final value. In contrast, the annuity value must decrease over the assumed 20 years of retirement and be subject to all employees taking a 25% lump sum on retirement. Again, we might assumed that the financial service industry managing the pension and annuity pots can make a 3% profit as shown. In practice, the dynamics of these financial services can appear to be very complex and many people simply end up trusting the financial service industry to provide them with the best advice, which hindsight might suggest was not always wise. However, the only purpose of these illustrative example is to show that we are dealing with very large multi-billion pound industry, which has the power to influence governments and confuse its customers with complexity for, in truth, this is an area that few people understand well and many may start off in almost complete ignorance.