How the Financial System Works
Gresham College・2 minutes read
Banks connect depositors with borrowers, earning profits by charging borrowers more interest than they pay depositors. Stock markets provide liquidity for buying and selling shares, while actively managed funds like Baillie Gifford Positive Change focus on sustainable investing.
Insights
- Banks connect depositors with borrowers by lending deposited money for various purposes, charging borrowers more interest than they pay depositors to generate profits and cover operational costs.
- Stock markets provide liquidity by enabling easy buying and selling of shares, with market makers acting as both buyers and sellers, while understanding financial concepts like deposit insurance can mitigate risks in financial crises.
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Recent questions
How do banks make profits?
Banks make profits by charging borrowers higher interest rates than they pay depositors, generating revenue to cover operational costs and generate profits.
What is the purpose of collateral in banking?
Collateral in banking serves as security for loans, mitigating the risk of non-repayment by borrowers. For example, in a mortgage, a house can be used as collateral.
How do banks create money?
Banks create money through fractional reserve banking, where they lend out a portion of deposits and repeat the process with subsequent deposits, enabling individuals to afford expenses they couldn't otherwise.
What is the role of deposit insurance in banking?
Deposit insurance guarantees funds up to a certain amount, helping prevent bank runs by assuring customers of the safety of their savings, providing a sense of security in the banking system.
What is the difference between actively managed and passive funds?
Actively managed funds have specific investment strategies and objectives, aiming to outperform the market, while passive funds, like Vanguard tracker funds, hold entire indexes with lower management fees, tracking market performance rather than trying to beat it.
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Summary
00:00
Banks: Connecting Depositors and Borrowers for Profit
- Banks act as financial intermediaries, connecting depositors (suppliers of money) with borrowers (customers who need money).
- Depositors earn interest by depositing money in banks, similar to how clothes manufacturers earn by selling clothes to retailers.
- Banks lend deposited money to borrowers for various purposes like buying a house, funding education, or renovating a home.
- Banks charge borrowers more interest than they pay depositors, generating profits and covering operational costs.
- Banks screen borrowers to ensure they can repay loans and monitor them throughout the loan term.
- Banks take collateral (security) from borrowers, like a house in a mortgage, to mitigate the risk of non-repayment.
- Banks may sell collateral if borrowers default, but the sale might not recoup the full loan amount due to market conditions.
- Banks practice fractional reserve banking, keeping a fraction of deposits in reserve to reduce the risk of insolvency.
- Through fractional reserve banking, banks create money by lending out a portion of deposits and repeating the process with subsequent deposits.
- Money creation by banks enables individuals to afford expenses they couldn't otherwise, without the bank making a profit from the process.
15:16
Banking and Stock Market Operations Explained
- Multiplying by 10% means creating more money by lending out more than is kept in reserve, leading to a greater money multiplier.
- Banks profit by lending out more than they receive in deposits, at higher interest rates than they borrow.
- Depositors seek liquidity, able to withdraw funds at any time, while borrowers often require long-term loans for projects like mortgages or business development.
- Banks engage in maturity transformation, converting short-term deposits into long-term loans to support customer projects.
- The risk for banks lies in a maturity mismatch, where sudden withdrawals can lead to liquidity issues despite safe lending practices.
- Deposit insurance, guaranteeing funds up to a certain amount, helps prevent bank runs by assuring customers of their savings' safety.
- The stock market facilitates buying and selling shares, representing partial ownership in companies and entitling holders to profits.
- Stock markets provide liquidity by enabling easy buying and selling of shares through multiple sellers and buyers.
- Sellers in the stock market quote ask prices for shares, while buyers can also post prices, distinguishing it from traditional markets.
- Understanding financial concepts and mechanisms, like deposit insurance and stock market operations, can mitigate risks and prevent unnecessary panic in financial crises.
30:30
Understanding Stock Market Trading and IPO Process
- At a farmer's market, buyers and sellers post prices for goods, unlike in the stock market where both sides post prices, leading to trades when prices are accepted.
- In the past, open outcry was used for trading signals, but now electronic trading is prevalent due to deregulation in 1986.
- Market makers in the stock market act as both buyers and sellers, quoting bid and ask prices, creating two-sided markets like currency exchanges.
- Stockbrokers facilitate trading with market makers, like Hargreaves Lansdown, by placing orders on behalf of clients for a commission.
- Market orders allow trading at current prices, while limit orders set maximum prices for buying or selling shares, offering flexibility in trading strategies.
- Ex-dividend dates determine entitlement to future dividends, affecting share prices as they become cheaper when ex-dividend.
- Start-up businesses initially raise private equity from partners, angel investors, and venture capitalists before considering public listing.
- Seed funding is the initial financing for start-ups, followed by series A, B, C, etc., rounds of private financing to expand the business.
- Going public involves listing shares on the stock market, allowing primary equity for new financing and secondary equity for existing investors to cash out.
- Companies can go public through an IPO, issuing new shares, or a direct listing, where existing shares are sold without creating new ones.
45:39
"Ethical Investing: Analyzing CEOs for Profit"
- Financial analyst analyzes company's financials and identifies good CEOs to invest in.
- Actively managed funds have specific investment strategies and objectives.
- Baillie Gifford Positive Change fund focuses on sustainable and ethical investing, aiming to outperform the world index.
- Fund invests globally in companies making a positive impact on society or the environment.
- Investors give money to fund manager who selects ethical companies to invest in.
- Initial charge for investing in the fund is 5%, but brokers like Hargreaves Lansdown often refund this charge.
- Ongoing charges for fund management are around 0.8-1% per year.
- Actively managed funds allow investors to cash in at any time without going to the market.
- Passive funds, like Vanguard tracker fund, hold entire indexes like the FTSE 100 and have lower management fees.
- Exchange traded funds are a hybrid between mutual funds and shares, investing in multiple companies and traded on the market.
00:00
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