chapter 1. a modern financial system: an overview

ĐCTC

1. Chapter 1 A modern financial system: an overview Websites: www.rba.gov.au www.treasury.gov.au www.bis.org www.ny.frb.org www.asx.com.au www.ft.com/asia/

2. Learning objectives LO 1.1 Understand the basic frameworks that underlie the facts that characterise financial institutions, financial instruments and financial markets. LO 1.2 Explain the functions of a financial system and main types of financial institutions. LO 1.3 Define the main classes of financial instruments. LO 1.4 Discuss the flow of funds between savers, borrowers, the financial system and the economy. LO 1.5 Distinguish between financial structures. LO 1.6 Analyse the flow of funds through the financial system and economy and the importance of ‘ stability ’ .

3. Chapter outline 1.1 Theory and facts in finance 1.2 The financial system and financial institutions 1.3 Financial instruments 1.4 Financial markets 1.5 Flow of funds, market relationships and stability

4. 1.1 Theory and facts in finance (cont.) Finance can seem like a complex field to study In a financial markets course, students are asked to develop their understanding of many different types of financial instruments exchanged on different markets There are some underlying principles that hold everything together: Risk and reward Supply and demand No arbitrage The time value of money

5. 1.1 Theory and facts in finance Risk and reward: all financial instruments yield some amount of return while being characterised by some amount of risk Supply and demand: the price of financial instruments is determined by supply and demand, although different factors influence supply and demand in different markets No arbitrage: all market prices are held together in a coherent structure by the principle of no arbitrage. The same thing cannot sell for two different prices Time value of money: the value of $1 today is higher than the value of $1 later. Where financial instruments represent a claim of future cash flows, their current price must be the present value of those cash flows

6. 1.1 Theory and facts in finance Financial markets and flow of funds relationship: like our other principles, the flow of funds relationship is a way to represent the core features of the financial system without the complexity: (cont.)

7. 1.2 Financial system and financial institutions A financial system comprises a range of financial institutions, financial instruments and financial markets facilitating the flow of funds Under the supervision of the central bank and the prudential supervisor Surplus units Savers of funds available for lending Deficit units Borrowers of funds for capital investment and consumption Attributes of financial assets Return, risk, liquidity and timing of cash flows (cont.)

8. 1.2 Financial system and financial institutions Most people have used the services of a financial institution at some stage, even if the service was simply a basic bank account Financial institutions may specialise in: taking deposits, providing advice to corporate and government clients or offering financial contracts such as insurance Financial institutions are essential to the operation of the modern financial system Financial institutions permit the flow of funds between borrowers and lenders by facilitating financial transactions Institutions may be categorised by differences in the sources and uses of funds (cont.)

9. 1.2 Financial system and financial institutions Categories of financial institutions Depository financial institutions Investment banks Contractual savings institutions Finance companies and general financiers Unit trusts (cont.)

10. 1.2 Financial system and financial institutions Apart from facilitating the flow of funds from savers to borrowers, the financial system also facilitates portfolio restructuring and monetary policy Facilitation of portfolio restructuring: A portfolio is a combination of assets and liabilities characterised by return, risk, liquidity and timing of cash flows An investor, for example, may want to invest for the long term but is unwilling to bear a great deal of risk. The financial system can facilitate this strategy through the bond market Implementation of monetary policy The central bank’s monetary policy consists of actions taken to influence interest rate levels to achieve certain economic outcomes. If the central bank wants to increase interest rates for example, it can soak up the supply of money by selling bonds. As supply goes down, the price (interest rates) goes up (cont.)

11. 1.3 Financial instruments Equity Ownership interest in an asset Residual claim on earnings and assets Dividend Liquidation Types Ordinary share Hybrid (or quasi-equity) security Preference shares Convertible notes (cont.)

12. In mid-2018, the AFR asked top equity strategists for their tips on beating the market in 2019 Here’s what they said: Buy shares in resources (mining) companies Be wary when buying shares in the major banks Be extra wary of shares in growth companies that had great runs during 2017 and 2018 How well did the experts forecast the overall market? On average, most of the strategists predicted that the ASX200 would be sitting somewhere around 6500 points by the end of 2019 For more see Sarah Turner’s AFR article Talking markets and strategy

13. 1.3 Financial instruments Debt Contractual claim to: periodic interest payments repayment of principal Ranks ahead of equity Can be: short term (money market instrument) or medium to long term (capital market instrument) secured or unsecured negotiable (ownership transferable, e.g. commercial bills and promissory notes) or non-negotiable (e.g. term loan obtained from a bank) (cont.)

14. 1.3 Financial instruments Derivatives A synthetic security providing specific future rights that derives its price from: a physical market commodity gold and oil financial security i nterest-rate-sensitive debt instruments, currencies and equities Used mainly to manage price risk exposure and to speculate (cont.)

15. 1.3 Financial instruments Four basic derivative contracts Futures contract (Chapter 18 and 19) Forward contract (Chapters 17, 18 and 19) Option contract (Chapters 18 and 20) Swap contract (Chapters 18 and 21)

16. 1.4 Financial markets A study of the financial markets, which are a key part of the financial system, can be organised into the following categories: Matching principle Primary and secondary market transactions Direct and intermediated finance Wholesale and retail markets Money markets Capital markets (cont.)

17. Matching principle The matching principle says that short-term assets should be funded with short-term (money market) liabilities, for example: seasonal inventory needs funded by overdraft Longer term assets should be funded with equity or longer term (capital market) liabilities, for example: equipment funded by debentures lack of adherence to this principle accentuated effects of frozen money markets with the ‘ sub-prime ’ market collapse

18. Talking markets and strategy Following the global financial crisis (GFC), it became clear that one of the key reasons financial institutions got themselves into so much trouble was that they had not following the matching principle Lehmann Brothers was one of the most prominent failures of the GFC and its collapse worsened the crisis Lehmann had borrowed very short term with many of its loans having maturities of as little as one day. It used the funds to fund its enormous balance sheet With $600 billion in assets, $572 billion in borrowings (i.e. just $28 billion in shareholder equity) and with most of its borrowings needing to be renewed each day, is it any wonder that Lehmann collapsed?

19. Primary and secondary market transactions Primary market transaction The issue of a new financial instrument to raise funds to purchase goods, services or assets by: businesses company shares or debentures governments Treasury notes or bonds individuals mortgage Funds are obtained by the issuer (cont.)

20. Primary and secondary market transactions Secondary market transaction The buying and selling of existing financial securities No new funds raised and therefore no direct impact on original issuer of security Transfer of ownership from one saver to another saver Provides liquidity, which facilitates the restructuring of portfolios of security owners

21. Direct and intermediated finance Direct finance Users of funds obtain finance through primary market via direct relationship with providers (savers) Advantages Avoids costs of intermediation Increases access to diverse range of markets Greater flexibility in range of securities users can issue for different financing needs Disadvantages Matching of preferences Liquidity and marketability of a security Search and transaction costs Assessment of risk, especially default risk (cont.)

22. Direct and intermediated finance (cont.)

23. Direct and intermediated finance Intermediated financial flow markets A financing arrangement involving two separate contractual agreements whereby the saver provides funds to an intermediary and the intermediary provides funding to the ultimate user of the funds (cont.)

24. Direct and intermediated finance (cont.)

25. Direct and intermediated finance Advantages Asset transformation Borrowers and savers are offered a range of products Maturity transformation Borrowers and savers are offered products with a range of terms to maturity Credit risk diversification and transformation Saver ’ s credit risk limited to the intermediary, which has expertise and information Liquidity transformation Ability to convert financial assets into cash Economies of scale Financial and operational benefits of organisational size and business volume

26. Wholesale and retail markets Wholesale markets Direct financial flow transactions between institutional investors and borrowers Involves larger transactions Retail markets Transactions conducted primarily with financial intermediaries by the household and small- to medium-sized business sectors Involves smaller transactions (cont.)

27. Wholesale and retail markets

28. Money markets The money markets are wholesale markets in which short-term securities are issued (primary market transaction) and traded (secondary market transaction) Securities highly liquid Term to maturity of one year or less Highly standardised form Deep secondary market No specific infrastructure or trading place Enable participants to manage liquidity (cont.)

29. Money markets Money market submarkets exist for: central bank—system liquidity and monetary policy inter-bank market bills market commercial paper market negotiable certificates of deposit (CDs) market

30. Capital markets Markets in which longer term securities are issued and traded with original term-to-maturity in excess of one year Equity market Corporate debt market Government debt market Also incorporate use of foreign exchange markets and derivatives markets Participants include individuals, business, government and overseas sectors

31. 1.5 Flow of funds, market relationships and stability When we introduced the flow of funds as a picture of the financial system, we said that the flow was from savers to borrowers. We can imagine, also, funds flowing between the sectors of the economy: Funds flow between business, financial institutions, government and household sectors and the rest of the world Net borrowing and net lending of these sectors of an economy vary between countries The flow of funds can be influenced by: the impact of fiscal and monetary policy on savings and investment decisions policy decisions like compulsory superannuation, which increased the flow of funds between businesses, households and financial institutions dramatically (cont.)

32. 1.5 Flow of funds, market relationships and stability The flow of funds between deficit and surplus units is an important contributor to economic growth For these benefits to be fully realised, the flow of funds must be characterised by relative stability The role of regulators is to balance the benefits of a free financial system against the costs of instability

33. Summary Studying the financial markets can be intimidating because there seems like such a lot to cover Remembering that everything is held together by a few fundamental principles will help you avoid feeling overwhelmed Primarily, the financial system is organised to facilitate the flow of funds from savers to borrowers It has evolved, also, to facilitate portfolio composition according to particular needs and to facilitate the operation of a central bank’s monetary policy