From the City to your doorstep

Deals made in the City already affect your life every day - The Gateway explains how

"Apart from the sanitation, medicine, education, wine, public order, irrigation, roads, the fresh water system and public health, what have the Romans ever done for us?" asks John Cleese in cult film, Monty Python's Life of Brian. Investment banks too often suffer from a lack of understanding of the positive effects that they can have on the workings of everyday life. We think that it's worth looking on the bright side, and exploring why the activities of investment banks matter.

Here are some examples of how, whether or not you're heading for a job in the City, what happens on trading floors and Bloomberg screens is already a big part of your world.

08:00

You stumble out of bed, throw on a jumper over your pyjamas, and put a couple of slices of your housemate's granary bread in the toaster.

Ever notice much change in the cost of a loaf of Hovis? No, The Gateway didn't think so. Even if you're the one who buys the food, you might be surprised to learn that the wholesale prices of the commodities such as wheat, milk and sugar that make up your breakfast have been extremely volatile in recent years. But, although consumers may well see an increase of a few percentage points in the price of food products, price fluctuation is significantly greater in the wholesale market. So why are prices in the supermarkets so little affected by changes in the prices at which consumable commodities trade?

Food manufacturers, often with the help of traders at investment banks, are able to protect themselves against variation in commodity prices using derivatives available through the financial markets. Bread is not produced using wheat bought at the market price available on the day the wheat changed hands. Instead, the price of that wheat will have been agreed perhaps twelve months in advance using the futures market. The wheat producer and the purchaser enter into a derivative called a futures contract in which the purchaser agrees to buy the wheat from the producer at a particular price on a particular day a few months hence. Doing so is beneficial for food companies because their costs become more predictable. It's also beneficial for the commodity producers who have the certainty that their product will be bought on a certain day at a certain price. And, because the use of the futures contract means that the price of a loaf of bread is stabilised, it's beneficial for end consumers - that is, you (and your housemate).

11:00

You try to withdraw £20 from your campus ATM. Unfortunately, you seem to be experiencing "liquidity issues" - that is, you've got too many days left at the end of the money.

Cashflow problems and budgeting difficulties are everyday parts of student life. Correct - and they are also experienced by banks and governments. Take student loans. How difficult must it be for the government to budget for all the repayments coming in and loans going out, all from and to different individuals and happening over a number of years? Also, paying out all that money at once every year puts a very large hole in the government budget. On a larger scale, the government confronts the same weighing up of incomings against outgoings that you do every month. Wouldn't it be easier if all the repayments could come in one lump sum, and preferably now, instead of in bits over the coming years?

Since student loans first became a feature of higher education in the UK, the government has experimented with using the financial markets to convert the variable income streams due to them from multiple student loan repayments into single payments of money that they can have right now. The technique used is called securitisation, which entails selling the right to receive loan repayments to a company set up specially for this purpose. This company raises the sum to fund the purchase by issuing bonds (tradeable slices of debt) guaranteed by the income it will receive as the repayments trickle in. Investment banks give specialised advice on securitisations and structure their implementation for their clients.

Admittedly, only a handful of securitisations of UK student loans have taken place. It has been more common for other kinds of loan, particularly mortgages, to be treated in this way, and doing so became very popular in the boom years of the early to mid 2000s. However the quantity and, often, instability of the bonds produced, known as mortgage-backed securities, have been cited as factors in precipitating the problems in the US housing market which led to the 2008/9 financial crisis. The bad reputation of mortgage securitisations put a damper on the usage of the technique for student loans, and a planned deal of this kind worth £8 billion was shelved in 2007 as the credit crunch hit.

But securitisation is likely to play a larger role in the future in the provision of funds for those studying in the UK - the technique hasn't been scrapped, just put on hold for the time being. And further securitisation of UK student loans seems especially likely when you consider the incoming increases in tuition fees.

But whether your loan is for books and beer, or for your first flat, the point is the same: securitisation ideally gives lenders more stability and flexibility, which enables individuals, including students, to have access to the sums they need when they want them. But that's probably no consolation if you've spent all of your loan already.

16:00

When you come out of your afternoon lecture you discover that your bike has been stolen! You have no money to afford a new one at the moment, but need to be able to get around. What can you do?

"Claim on my insurance," you're probably thinking.

But how does that work? Do insurance companies just collect their premiums, and hope they'll have enough cash under the mattress if someone asks for a payout?

Insurance companies need to hold large amounts of assets that they can access at any time to meet potential obligations to the holder of an insurance policy. They have the cash they receive in exchange for issuing insurance policies, but these funds kept as cash deposits won't necessarily be enough to cover their obligations - and make the insurance company a profit. And what happens if someone makes a very big claim?

The financial markets - and investment banks - can provide a solution. Investment banks advise insurance companies where in the financial markets to put their money, and how to manage it. The aim is to ensure that these institutions always have the funds to meet their obligations. Insurance companies often invest the premiums they receive in large amounts of very short-term liquid assets that will generate a good return, and which can be sold very quickly if the insurance company needs funds to meet a claim. Alongside these, they are also likely to make some long-term investments.

But what if, instead of your bike getting stolen, a tidal wave devastates the city in which you study, or a biological agent is released in the vicinity by terrorists? How can home, car, travel or life insurance companies ever expect to fulfill all the claims which would then be made on them?

The answer is that insurers pass on some of their insurance obligations to a reinsurance company, effectively obtaining insurance themselves. If the worst happens, an insurance company will simply claim on their own insurance, that is, their reinsurance policy, and through this policy will be granted the funds to guarantee that it stays solvent and meets all its obligations under its customers' insurance policies. Like insurance companies, reinsurance firms also benefit from the financial advice and services provided by investment banks. All of which means you have a good chance of being able to replace your wheels!

How are investment banks involved in the real economy?

Financing businesses

Investment banks arrange and provide financing for businesses, allowing them to grow and create revenue benefitting the wider economy through the payment of corporation taxes and by creating jobs.

Facilitating arts and research

Investment banks are involved in the financing of films, art, theatre - and more. On the research side, many pharmaceutical companies and university endowments, among many other similar organisations, benefit from assistance and cash from the banking sector.

Energy and infrastructure

Investment banks advise on the financing of, and often play a role in funding, the construction of power stations, transport networks and public facilities, such as schools and hospitals.

Shipping and aviation

The asset finance activities of investment banks are crucial to the functioning of shipping companies, airlines and other businesses that need to use very expensive assets such as tankers and planes.

Emerging markets

Through the provision of economic advice and funds to sovereign and commercial entities, investment banks play an important role in the economic development of emerging market nations.

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