Managing financial risk
A London International Financial Futures and Options Exchange case study

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Page 2: Change in a competitive market

During the 1980s, however, there was a considerable change when the Conservative government encouraged increasing competition in the Financial Services markets. Prior to the 1980s, financial service organisations had tended to specialise so that:

  • if you wanted a loan you went to a finance house or bank
  • a mortgage - to a building society
  • an insurance policy - to an insurance broker, or insurance company.

London International Financial Futures And Options 2 Diagram 2Today, however we have seen the development of “integrated providers” of financial services, who set out to offer the customer a complete package of financial services. The term “Bancassurance” has been coined to describe these integrated providers. There is now a blurring of the edges between sectors and products, with everyone trying to diversify and expand their market share.

One particular area of competition has seen the emergence of banks into the mortgage market, offering fixed rate mortgages i.e. the rate of interest remains fixed for a specific period of time. You can see why this is attractive to customers. It provides them with a lot more security and predictability. They know exactly how much they will need to pay out - not just this year, but on a given period, normally up to five years. In a competitive environment, it is necessary to rival competitors’ offers. Building Societies have, therefore, moved into fixed rate mortgages.

An increased element of risk

With fixed rate mortgages, Building Societies are now exposed to the risk of interest rates rising. You can see how this risk arises in our illustration (above). In the top half of the diagram you can see that a Building Society is paying five and a half per cent interest to depositors. At the same time it is receiving 6% interest rate from mortgages whether they have a variable (floating) or fixed rate mortgage.

But look what happens if interest rates in the economy rise by 1%. In this new situation the building society will be paying out 6.5% in interest to depositors (they are paid a variable rate). Under the old system, this would have been covered by mortgagees having to pay 7% in interest (floating). However, in the new competitive environment, the Building Society that chooses to offer a fixed 6% mortgage is disadvantaged. As a result, the money they are taking in from lending operations (fixed at 6%) does not cover what they are paying out on borrowing operations (6.5%). Building Societies therefore needed a way to reduce their risk if interest rates rose. This is because they could not increase the rates of existing fixed rate mortgages.

The solution

This is where the London International Financial Futures and Options Exchange helps out. By using the services of LIFFE, Building Societies are able to take the risk out of their activities - i.e. the traditional risk aversion strategy.

LIFFE has quickly established itself as one of the world’s leading futures markets. Futures are contracts - that are legally binding agreements - to buy/sell or borrow/lend “something” in the future. In the context of this case study that “something” is a contract to secure a future interest rate.

London International Financial Futures and Options Exchange | Managing financial risk