Chapter 1

A Financial System

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Learning Objectives
• Explain the functions of a financial system
• Categorise the main types of financial institutions
• Describe the main classes of financial instruments
issued in a financial system
• Discuss the flow of funds between savers and
borrowers, including primary - secondary markets and
direct/intermediated finance
• Distinguish between various types of financial markets
according to function

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Chapter Organisation

1.1 Functions of a Financial System

1.2 Financial Institutions
1.3 Financial Instruments
1.4 Financial Markets
1.5 Flow of Funds and Market Relationships
1.6 Summary

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1.1 Functions of a Financial System

(cont.)
• Role of markets
– Facilitate exchange of goods and services by
▪ Bringing opposite parties together
▪ Establishing rates of exchange, i.e. prices

• Surplus units
– Savers of funds available for lending

• Deficit units
– Borrowers of funds for capital investment and
consumption

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1.1Functions of a Financial System (cont.)
• Financial instrument
– Issued by a party raising funds, acknowledging a financial
commitment and entitling holder to specified future cash
flows

• Double coincidence of wants satisfied

– A transaction between two parties that meets their mutual
needs

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1.1 Functions of a Financial System

(cont.)
• Flow of funds
– Movement of funds through the financial system between
savers and borrowers giving rise to financial instruments

• Financial system
– Comprises financial institutions, instruments and markets
facilitating transactions for goods and services and
financial transactions

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1.1 Functions of a Financial System
(cont.)

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1.1 Functions of a Financial System

(cont.)
• Attributes of financial assets

– Return or yield
▪ Total financial compensation received from an investment
expressed as a percentage of the amount invested

– Risk
▪ Probability that actual return on an investment will vary from
the expected return

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1.1 Functions of a Financial System
(cont.)
• Attributes of financial assets (cont.)

– Liquidity
▪ Ability to sell an asset within reasonable time at current
market prices and for reasonable transaction costs

– Time-pattern of the cash flows

▪ When the expected cash flows from a financial asset are to
be received by the investor or lender

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1.1 Functions of a Financial System

(cont.)
• Facilitation of portfolio restructuring
– The combination of assets and liabilities comprising the
desired attributes of return, risk, liquidity and timing of
cash flows

• Implementation of monetary policy

– Actions of a central bank taken to influence interest rate
levels to achieve certain economic outcomes

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1.1 Functions of a Financial System
(cont.)
• An efficient financial system
– Encourages savings
– Directs savings to the most efficient users
– Implements the monetary policy of governments by
influencing interest rates
– Is a combination of assets and liabilities comprising the
desired attributes of return, risk, liquidity and timing of
cash flows

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1.2 Financial Institutions

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1.2 Financial Institutions
• 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

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1.2 Financial Institutions (cont.)

• Categories of financial institutions
– Depository financial institutions
– Investment banks and merchant banks (money market
corporations)
– Contractual savings institutions
– Finance companies
– Unit trusts

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Categories of financial institutions
Depository financial institutions

• Mainly attract the savings of depositors through on-demand

deposit and term deposit accounts, e.g.
– Commercial banks, building societies and credit cooperatives

• Mainly provide loans to borrowers in household and business

sectors

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Categories of financial institutions (cont.)

Investment banks and merchant banks
(money market corporations)

• Mainly provide off-balance-sheet (OBS) advisory services to

support corporate and government clients, e.g.
– Advice on mergers and acquisitions, portfolio restructuring,
finance and risk management

• May also provide some loans to clients but are more likely to
advise on raising funds directly in capital markets

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Categories of financial institutions (cont.)
Contractual savings institutions
• The liabilities of these institutions are contracts that specify, in
return for periodic payments to the institution, the institution
will make payments to the contract holders if a specified
event occurs, e.g.
– Life and general insurance companies and superannuation
funds
• The large pool of funds are then used to purchase both
primary and secondary market securities
• Payouts are made for insurance claims and to retirees

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Categories of financial institutions (cont.)

Finance companies

• Funds are raised by issuing financial securities, such as

commercial paper, medium-term notes and bonds, directly
into money markets and capital markets

• Funds are used to make loans and provide lease finance to

customers in the household and business sectors

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Categories of financial institutions (cont.)
Unit trusts
• Formed under a trust deed and controlled and managed by a
trustee
• Funds raised by selling units to the public. Investors
purchase units in the trust
• Funds are pooled and invested by fund managers in a range
of asset classes specified in the trust deed
• Types of unit trusts include equity, property, fixed interest
and mortgage trusts

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1.2 Financial Institutions (cont.)

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1.3 Financial Instruments

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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

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1.3 Financial Instruments (cont.)
• 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)

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1.3 Financial Instruments (cont.)

• Derivatives
– A synthetic security providing specific future rights that
derives its price from
▪ A physical market commodity
• Gold and oil
▪ Financial security
• Interest rate-sensitive debt instruments, currencies and
equities
– Used mainly to manage price risk exposure and to
speculate

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1.4 Financial Markets

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1.4 Financial Markets

• Matching principle
• Primary and secondary market transactions
• Direct and intermediated financial flow markets
• Wholesale and retail markets
• Money vs Capital markets

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Matching principle
• Short-term assets should be funded with short-
term (money market) liabilities, e.g.
– Seasonal inventory needs funded by overdraft

• Longer-term assets should be funded with equity

or longer-term (capital market) liabilities, e.g.
– Equipment funded by debentures

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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

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Primary and secondary market transactions
(cont.)
• Secondary market transaction
– The buying and selling of existing financial securities
▪ No new funds raised and thus 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

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Direct and intermediated financial flow

markets

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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

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Money markets
• Wholesale markets in which short-term securities
are issued (primary market transaction) and traded
(secondary market transaction)
– Securities highly liquid
– No specific infrastructure or trading place
– Enable participants to manage liquidity

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Money markets (cont.)

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Money markets (cont.)

• 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

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

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1.6 Summary
• The financial system is composed of financial
institutions, instruments and markets facilitating
transactions for goods and services and financial
transactions

• Financial instruments may be equity, debt (or

hybrid), Derivatives.

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1.6 Summary (cont.)
• Categories of financial institutions
– Depository financial institutions
– Investment banks and merchant banks (money market
corporations)
– Contractual savings institutions
– Finance companies
– Unit trusts
• Categories of Financial markets
– Primary and secondary transactions
– Direct and intermediated flows
– Wholesale and retail markets
– Money markets and capital markets

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