Topic 1 - Introduction To The Financial System

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This article is a topic within the subject Capital Markets and Institutions.

Contents

Required Reading

Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 4-45.

Money

  • Acts as a medium of exchange, increases speed & efficiency of transactions in markets – no need for barter
  • Store of wealth - Facilitates saving
  • Solves the divisibility problem, (e.g. if cake = half a cow) & removes the double coincidence of wants requirement

Functions Of The Financial System

[1] Finance is the art & science of managing the scarce resource of money. The Financial System comprises a range of financial institutions, instruments & markets & is overseen by the Government (fiscal, super & regulations), central bank (monetary) & prudential supervisors (APRA – Banks, ASIC – Markets, ACCC – Competitiveness).

  • The Financial System functions to facilitate the flow of funds between deficit & surplus units through the interaction of financial institutions, instruments & markets.

Surplus units have an excess of current funds while deficit units have a shortage of current funds. For the financial system to fulfill its function of facilitating the flow of funds, it provides:

  • Investment products for surplus units, (creation of instruments in the primary market to facilitate flow of funds)
    • Allow for trading of existing instruments in secondary markets
  • (Alternative) sources of funding for deficit units - BUT must ensure savings are directed to most efficient users
  • Risk management products & services

Financial Institutions

[2]

There are a range of financial institutions in our financial system. They can be classified by their "USES" & "SOURCES" of funds.

  1. Depository Financial Institutions (DFI’s) – Requires APRA License
    • Sources funds from deposits & Use funds to provide loans. For example, a commercial bank – ANZ.
  2. Investment/Merchant Banks (I.B)
    • Source funds from providing off balance sheet advisory services (M&A, restructuring, risk mgmt) & Uses funds to pay labour. This still facilitates the flow of funds as they link deficit & surplus units. They assist & advise clients to raise funds directly from capital markets
    • IPO - I.B advises company/deficit unit on IPO’s (prospectus etc.) & markets the securities to surplus units
  3. Contractual Savings Institutions (CSI’s)
    • Sources funds from premiums collected, Uses float to earn a return through investing. E.g. Insurer
    • Clients (surplus units) pay premiums for the return of claim benefits if & when the ‘event’ occurs. The CSI invests these funds (lends to deficit units) in order to attain a return.
  4. Finance Companies
    • Source funds from wholesale markets, Use funds to provide loans in the retail market, e.g. RAMS
  5. Unit Trusts
    • Sources funds from public who buy ‘units’, Uses – pooled funds are invested by managers (in asset classes) according to the trust deed. Controlled & managed by a trustee or responsible entity

Financial Assets

[3] Financial Assets are issued by the party raising funds that entitles the holder to future cash flows. A financial security is a financial asset that can be traded on a secondary market.

The financial system encourages savings by offering a range of instruments (which facilitates portfolio restructuring) & providing accurate & timely information. These savings are invested to expand productive capacity - economic growth

Attributes of financial assets:

  • Return/Yield – total financial compensation from the investment
  • Risk – Probability that actual return of an investment will vary from the expected return
  • Liquidity – Ease of which it can be sold at current market prices
  • Time Pattern of Cash Flows – When the cash flows are expected to be received by investor/lender

Financial Instruments

Represents an entitlement to the holder to a specified set of future cash flows. When a user of funds obtains finance, the user must prepare a legal document (or financial instrument) defining the contractual arrangement.

  • Equity – An ownership interest in an asset, e.g. ordinary share, hybrids (preference shares, convertible notes)
    • Don’t mature, infinite life. Receives dividends & capital gains, voting rights
  • Debt – A contractual claim to defined periodic interest repayments & the repayment of principal, e.g. debentures
    • Ranks above equity in claim to future cash streams
    • Short term (<1 yr – money market) or long term (capital market)
    • Unsecured debt or Secured debt – specifies the assets of the borrower that are pledged as collateral
    • Can be negotiable – (transferable ownership e.g. commercial bills) or non negotiable (term loans)
  • Derivative – Facilitates management of certain risks & speculation, don’t provide funds to borrower
    • Future – an exchange traded agreement to buy/sell a specified amount of a commodity at a price determined today for delivery or payment at a future date. They are standardised & traded through a futures exchange.
    • Forward – An OTC agreement that locks in a price that will apply at a future date. Similar to a future, but more flexible & negotiated OTC with a commercial or investment bank.
    • Option – The right, but not the obligation to buy/sell a commodity or security at a predetermined exercise price. The buyer pays the premium to the option writer.
    • Swap – An agreement between 2 parties to swap future cash flows, e.g. interest rate or currency swaps
  • Hybrid – Incorporates characteristics of debt & equity
    • e.g. preference shares have a specified fixed dividend for a defined period

Financial Markets

[4] The Matching Principle states that short (long) term assets be funded with short (long) term liabilities (equity). This issue worsened GFC.

Primary And Secondary Markets

A Primary Market Transaction occurs when firms, government or individuals issue/create new financial instruments in the money & capital markets. Funds are obtained by the issuer. A Secondary Market Transaction is the buying/selling of existing financial instruments, facilitating the transfer of ownership (before maturity) & liquidity, whilst the issuer gains no extra funds. This enhances the marketability & liquidity of primary-issue instruments.

Wholesale And Retails Markets

Wholesale Markets involve large sums of money & usually direct financial flows between institutional investors & borrowers. Cost of funds is determined by levels of liquidity, interest rate expectations & maturity structures. In contrast, the Retail Market involves smaller amounts of funds & directs flows between intermediaries, households & small to medium businesses.

Direct And Indirect Finance

Direct Finance

The raising of funds in the primary market can either as Direct Finance or Indirect Finance. For Direct Finance the contractual agreement is between the provider & user of the funds. There is no intermediary, but a broker who arranges the transaction may receive a commission, e.g. stockbroker. Generally, this is for corporations or government with a good credit rating.

The Advantages of Direct Finance include:

  • Avoid costs of intermediation
  • Allows the borrower to diversify funding sources, reducing exposure to a single funding source or market + Flexibility
  • Enhance firms reputation through doing transactions in international financial markets

The Disadvantages of Direct Finance include:

  • Matching of preferences between lenders & borrowers is required (amount, maturity structure etc.)
  • Liquidity & marketability of the security, does it have a liquid secondary market?
  • Search & transaction costs associated with a direct issue (advisory/legal/taxation fess, prospectus)
  • Assessment of risk (default risk), accounting standards vary, information may be limited

Indirect Finance

Intermediated Finance is a financial transaction conducted with a financial intermediary, who has an active role in the relationship between savers & borrowers. Intermediaries obtain funding from savers by issuing financial instruments & lend funding to deficit units in return for financial instruments (2 separate contractual agreements).

The Advantages of Intermediated Finance include:

  • Asset Transformation – Resolves conflicting preferences between surplus & deficit units
    • Ability of intermediaries to offer customers on both sides of the balance sheet a range of financial products
    • They can incentivise savings for small surplus units.
  • Maturity Transformation – Savers/borrowers offered products with a range of terms to maturity
    • Pool many small short term deposits and lend out as long term loans – economies of scale
    • Unlikely savers would withdraw deposits at the same time, withdrawals are usually matched by new deposits
      • Liability Management – actively manage sources of funds to meet future loan demand
  • Credit Risk Diversification – A saver’s credit risk exposure is limited to the intermediary, while the intermediary is exposed to the credit risks of all its borrowers. Intermediaries tend to have expertise in assessing risk of borrowers.
  • Liquidity Transformation – Ability to convert a financial asset into cash (benefits the saver – offer ‘at call’ accounts)
    • Savings & expenditure vary (don’t coincide)
    • Intermediaries have the ability to lower transaction fees by spreading fixed costs (+ time)
  • Economies of Scale – Create cost efficient distribution systems (e.g. Banks & ATM’s, online etc.), spreading overhead

Money Markets

Money Markets are wholesale markets (institutional) in which short-term securities are issued & traded. The securities are highly liquid with maturities of less than 1 year & are standardised. It enables participants to manage liquidity & short term financing to bridge the gap between cash expenditures & receipts.

The Money Market is comprised of a number of submarkets:

  • Central Bank: System liquidity & monetary policy - alter liquidity by buying/selling CGS’s to attain targeted cash rate
  • Inter-Bank: for the management of the short term liquidity needs of commercial banks - Settle transactions & ESA’s
  • Bills: Short term discount securities, no interest, but sold at less than face value
  • Commercial Paper: Promissory notes are like ‘bills’ but are usually unsecured & issued by firms with good credit rating
  • Negotiable Certificates of Deposit: Discount securities issued by a bank

Capital Markets

Capital Markets are those which long term securities are issued & traded, it includes:

  • Equity: Funds are given in return or an ownership interest in the form of a share
  • Corporate Debt: Longer term debt, e.g. – term loans, debentures, unsecured notes, commercial property (mortgage)
  • Government Debt: Borrowing for short term liquidity (T-Notes) or long term capex (Treasury Bonds – deficit)
  • FOREX: Facilitate buying/selling of foreign currency
  • Derivatives: Synthetic risk management products  futures, forwards, options, swaps

End

This is the end of this topic. Click here to go back to the main subject page for Capital Markets and Institutions.

References

Textbook refers to Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill.

  1. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 7-8
  2. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 9-11
  3. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 12-14
  4. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 15-30
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