Financial Institutions and Market

Week 1
An overview of the financial system – Financial Foundations. Navigating the world of money
and markets. If we were to name four pieces of finance and economics that can help us
organise our thoughts and make it easier to understand how financial institutions,
instruments, and markets work, they would be: 1. Risk and rewards, 2. Supply and demand,
3. No arbitrage; and 4. The time value of money. IF the risk is great, the return on investment
is higher.

Learning Objectives:
 Explain the functions of a financial system and main types of financial institutions.
 Define main classes of financial instruments.
 Discuss the flow of funds between savers, borrowers, the financial system and
economy.
 Distinguish between financial structures.
 Analyse flow of funds through the financial system and economy and importance of
stability.

Money and Finance

Money is a medium of exchange of goods and services (four function. Medium of exchange,
store of value (savings). Unit of account. Standard of first payment. Finance is the art
of science of managing the scarce resource of money.
Financial System
Definition: A comprehensive network comprising a variety of financial institutions,
instruments, and markets.

Functions of financial system: SIX functions. 1. Arrange the settlement of commercial

transactions, 2. Promote the flow of funds, 3. Provide opportunities for participants in the
financial system to manage the risks they face, 4. Overcome information symmetry and to
observe incentives, promote the pulling of funds.
Regulations: Operates under the supervision of central banks and prudential supervisors.

Financial Institutions (Is an establishment that conducts financial transactions such as

investment, loans, and deposits): 1. Commercial Banks ANZ, 2. Investment Banks Macquarie
Group 3. Insurance Company - Insurance Australia Group 4. Superannuation Funds -
Australian Super 5. Non-bank Financial Institute - Credit Union 6. Internet Bank ING
Australia.

Reserve Bank of Australia (website).

Flow of funds – Direct & Intermediated

Day-by-day financial positions of households, firms and government and other organisations
abroad when they can supply funds or when they demand funds.
Surplus Units – Suppliers of the funds.
Deficit Units – Users of funds.
In the diagram, the funds are being facilitated by brokers and or dealers. Intermediaries obtain
funding from sellers(*).

Difference between dealer and broker

A dealer is a party that makes a market in a security for their own account. A broker is a
person engaged in the business of buying or selling securities for the account of others.

Direct Finance
Advantages and disadvantages): Avoids costs of intermediation, increases access to diverse
range of markets, greater flexibility. Disadvantages include matching of preferences, liquidity
and marketability of a security, search and transaction costs, risks. Lenders and borrowers
directly do business with each other.
Intermediated Finance (advantages): Assess transformation, maturity transformation, credit
risk diversification and transformation, economies of scale.
Financial Instruments is the name of the money product. Monetary contracts between
parties. They can be created, traded, modified, and settled. They can be cash or currency,
evidence of an ownership interest in entity which is a share, contractual right to receive or
deliver cash which is called bond. Any contract that gives rights to a financial asset of one
entity and any financial liability or financial instrument to another entity. Three major
financial instruments: Equity, Debt and Derivatives.

Financial Market
refers broadly to any marketplace where securities trading occurs, including the stock market,
bond market, forex market, and derivatives. There are two major markets: Money markets,
and Capital markets.

Financial Transactions
Take place in financial markets. Physical assets vs financial assets market > tangible, and
financial claims. Spot versus futures markets > time of the transaction happened. Private
versus public markets > transactions are negotiated between two parties or transactions are
traded on exchanges. purchase

Matching principle: short term asset must be funded with short term liabilities.
Flow of funds, market relationship

Week 2: Commercial Bank Operations

Banks play a major role in channelling funds to borrowers, providing loans to businesses,
helping us finance our college education, purchasing a new home, and providing us with
checking and savings accounts services and so on. Banking, this financial activity is
important in ensuring that the financial system and the economy run smoothly and efficiently.

 Evaluate the functions and activities of commercial banks.

Commercial banks hold more than 50.00 per cent of the total assets of financial institutions in
Australia. The most interesting aspect of the operation of commercial banks is their ability to
create money and liquidity. Commercial banks take deposits from customers and then invest
those deposits by making loans to their customers. Services and products include balance-
sheet transactions and off-balance-sheet transactions. Balance sheets transactions are assets
(e.g. loans), liabilities (e.g. deposits) and shareholders’ funds (equity). Off balance sheet
items are contingent liabilities; that is, they are transactions that do not appear on the balance
sheet. Commercial banks now actively manage their sources of funds (liabilities) to ensure
they have sufficient funds available to meet loan demand and other commitments. Banks
compete in the global capital markets to raise funds in addition to their depositor base. This is
known as liability management, whereby a bank borrows sufficient funds (liabilities) direct
from the capital markets to meet forecast loan demand.

 Identify the main sources and uses of funds for commercial banks.
Where does the bank obtain the funds that it lends? Sources of funds appear on a bank
balance sheet with as liabilities that the bank will eventually repay or as equity funds
provided by shareholders. To attract the savings of surplus entities, commercial banks offer a
range of instruments with different terms to maturity, liquidity, rates of return and cash-flows
attributes. The main sources of commercial bank funds considered in this section are current
account deposits, call or demand deposits, term deposits, negotiable certificates of deposits,
bill acceptance liabilities, debt liabilities, foreign currency liabilities, loan capital and
shareholders’ equity.

Call Deposits
Are held in accounts other than a cheque account where the funds are available on demand.
Savings account. Term deposits are funds lodged in an account with a bank for a specified
period. Such funds receive a fixed rate of interest for the period of the investment.

Negotiable certificates of deposits are referred to in the market as the CD. The CD is a
certificate issued by a bank undertaking to pay to the bearer the face value of the CD at the
specified maturity date. Negotiable security is a financial instrument that can easily be sold
into a deep and liquid secondary market.
A business may seek to raise funds through the issue of a bill exchange. A bill is a discount
security; that is, it is issued today and sold at price that is less than the face value. The bill
does not pay interest.
Commercial banks are highly leveraged organisations; that is, a large percentage of their
funds is on the form of debt liabilities that must be repaid; the remainder is different types of
equity.
Loan capital are sources of funds that have the characteristics of both debt and equity.
Current account deposits are liquid funds held in cheque account; a cheque is written
instruction to the bank to pay the specified sum to the payee shown on the cheque. Businesses
use cheque accounts as their operating accounts.

One of the most liquid instruments offered by a bank is a current account deposit. Deposits in
a cheque account provide liquidity in that they can be used directly in a payment for goods
and services. The current account holder can write an order on a cheque that instructs its bank
to pay funds to the named payee.

Users Of Funds
Funds used by commercial banks appear as assets on their balance sheet. The majority of
bank assets are financial assets that create entitlement to future cash flows; for example, if a
bank gives a customer a loan, then the amount outstanding on the loan will appear as an asset
on the bank’s balance sheet. The bank is then entitled to receive periodic interest payments
plus repayment of the principal in accordance with the terms and condition of the loan
contract. A bank will also accumulate other assets, such as branch premises and electronic
systems.
PERSONAL AND HOUSING FINANCE
Banks are the principal providers of finance to individuals. In Australia, for example, the
largest form of bank lending is for owner-occupied housing. Other forms of personal finance
include investment property finance, fixed-term loans, personal overdrafts and credit card
finance. Housing finance where the bank registers mortgage over the property as security for
the loan, is an attractive form of lending as the risk of default by the borrower is normally
low. Borrowers will try and meet their housing loan commitments because if they don’t, the
bank will take possession of the house and sell it to recover the amount owing. Both
mortgage originators and commercial banks often use the process of securitisation to finance
their lending activities. Briefly, a lender may seek to obtain additional funds to provide new
housing loans by selling existing housing loans.

Commercial Lending
Commercial lending represents bank assets invested in the business sector plus lending to
other financial institutions. Bank lending to business is essential if economic growth is to be
achieved within a nation-state. Economic growth generates benefits such as increased
production, higher levels of employment and better living standards within a country.

Reference Interest Rate

A benchmark interest rate published daily and used for pricing variable-rate loans.

BBSW
The average mid-point of banks’ bid and offer rates in the bank bill secondary market.

Overdraft
An arrangement a bank allows a business to place its operating account into debit up to an
agreed limit.

Commercial Bills
A bill of exchange issued direct to raise finance for a business; discount security; may be sold
in the money market.

Bank bills held.

Bills that have been accepted and discounted by a bank and are held as a balance-sheet.

Rollover facility
An arrangement whereby a bank agrees to discount new securities over a specified period as
the existing securities mature

Lease
An arrangement in which the owner of an asset, the lessor, allows a lessee to use the asset in
return for periodic lease payments.

Lending to Government
Government generally borrows direct from the markets. Commercial banks lend to
government directly by investing in government-issued securities, such as Treasury notes,
Treasury bonds and other public sector securities. Banks may also provide some loans to
government agencies in the form of term loans and overdraft facilities. Government needs to
manage their short-term and longer-term cash flows. Short-term funds are required to meet
regular commitments such as social security benefits and the salaries of government
employees. Longer-term funding is required for capital expenditures such as building
hospitals and water storage facilities.

Other Bank Assets

Bank lending is the core business of commercial banks and the largest allocation of their
assets. Banks are highly dependent on their information systems and product delivery
systems. Therefore, they invest heavily in technology, property, plant, and equipment.

Personal finance includes housing loans, term loans and credit card facilities.

Housing finance is the provision of loans to purchase residential property. AS security, the
bank will register a mortgage over the property.

Banks are providers of lease finance, whereby the bank purchases an asset that is leased to a
customer.

 Outline the nature and importance if banks off balance-sheet business.

Volume of Off-Balance-sheet-business
There are two outstanding features of the banks’ off-balance-sheet (OBS) business. The first
is the magnitude of the notional face value of the OBS contracts written by banks.
It is mainly market-rate-released contract.

A balance sheet is a statement of the financial position of a business which states the assets,
liability, and owner’s equity at a particular point in time.

OBS items are commitments to add an asset or a liability to the balance sheet if a contingent
event occurs. For example, loan commitment (asset): A bank commits to give a company a
loan in the future.

OBS Items: Direct credit substitutes, commitment (forward purchases, underwriting), Trade-
and-performance-related (Documentary letters of credit, performance, guarantees etc),
Foreign exchange, interest rate and other related are typically derivative contracts, such as
futures, forwards, options and swaps, used to manage risk exposure (Futures, options,
currency, swaps, forward rate agreements etc).

The notion value of the OBS business of banks is much greater than the value of OBS

 Consider the regulations and prudential supervision of banks.

Australian Prudential Regulation Authority- Authorised Deposit-taking Institutions. These
include banks, credit union, building societies, insurance companies, superannuation funds.

Banking Regulations
Constraints on banking activities through prescriptive legislation and prudential supervision

Prudential Supervision
The imposition and monitoring of standards designed to ensure the soundness and stability of
a financial system.

Bank Asset Management

Loan portfolio tailored to available deposit base, restricted loans, highly regulated
environment, high-interest rate return from loans, and less default, investment into securities
with high return and low returns, diversification.

Bank Liability Management

Deposit base and other funding sources tailored to loan demand, less regulated environment,
the bank borrow direct from capital markets to meet forecast loan demand.

Australia Financial System – Australian Regulatory Structure – RBA – Reserve Bank of Aus.
System stability and payments system, APRA – and supervision of deposit-taking institutions,
ASIC – Australian Securities and Investment Commission and market integrity and consumer
protection, ACCC – Australian Competition and Consumer Commission Competition Policy.

 Understand the background and application of Basel II and Basel III

Basel I
Focus: Introduced to standardised capital requirements among internationally active banks
and to minimise credit risk. Main components – Minimum Capital Requirements: required
banks to hold capital equal to at least 8% of ther risk-weighted assets. – Credit Risk
Assessment: Introduced a risk-weighting system for different types of assets

Basel II
Focus: Aimed at improving the Basel I framework particularly in response to the evolving
complexity of financial products and risk management practices. Main components – Three
Pillars: 1. Capital Requirements: Refined the risk-weighting approach for credit risk and
introduced new standards for operational and market risks. 2. Supervisory Review Process:
Focused on regulatory oversight and internal risk assessment processes of banks. 3. Market
Discipline: Empathised the need for transparency and disclosure to strengthen market
discipline. Basel III Focus: Developed in response to the deficiencies in financial regulation
revealed by the 2007-2008 global financial crisis. Main components – Higher Capital
Requirement: Increases the quality and quantity of capital, with a greater emphasis on
common equity. Leverage Ratio: Introduce a non-risk-based leverage ratio to curb excess
leverage in the banking sector. Liquidity requirement: introduced the Liquidity Coverage
Ratio (LCR) and Net Stable Funding Ration (NSFR) to ensure long-term liquidity.
Countercyclical Measures: Included buffer for systemic risk and countercyclical capital
buffers.

Week 3
Equity markets
The market for shares (stocks) is undoubtedly the one that receives the most attention and
scrutiny around the world. Great gains and losses are made as investors attempt to anticipate
the market’s ups and down.
Banks help us finance our cars and homes and provide with savings and checking accounts.
Balance sheets for banks are available online as it is by law.
Assets=liability + Equity (Capital).
Plus500 is a stock exchange where a range of listed financial assets is bought and sold. The
share market refers to that part of the stock exchange where companies are listed on the
exchange and are known as public corporations.
Three major types of firms: Corporate Life Cycle.

1. Sole Proprietorship
A sole trader, A business owned and operated by a single individual.
Advantage: Ease of formation, subject to few regulations, no corporate income taxes.
Disadvantages: Limited lifespan, unlimited liability, difficult to raise capital to
support growth
2. Corporation
A corporation is a legal entity separate from its owners and managers.
Advantages: unlimited life, easy transfer of ownership, limited liability, ease of
raising capital.
Disadvantages: Double taxation (not in AUs). Cost of set-up and report filing
separation of ownership control.
3. Partnership
A partnership has roughly the same advantages and disadvantage as a sole
proprietorship.
Advantages: Easy to formate, more resources, shared responsibilities, tax advantages.
Disadvantages: Joint liability, potention for conflict, divided authority

 Understand the structure of corporations and reasons for public

listing.

The shares of a publicly listed corporation are listed on a stock exchange and the
main source of equity funding, the ordinary share, is quoted in the share market.
There are several features that distinguish a corporation. Shares issued by a
company can be readily bought and sold in the share market without directly
affecting continuing existence of the business. Shareholders are owners of a
company but do not have the right to participate directly in daily operations and
management of the business. Directors have a legal resposibilitiy to ensure that
the corporation operates in the best interest of the shareholders.

 Consider the origins and purpose of a stock exchange.

 The origins of the modern stock exchange can be traced back to as long
as 1553 within the establishment in England of the Muscovy Company.
The company was established to find the north-east trade route to China
and the Orient. The venture was a ‘joint stock’ company. Shares a freely
transferrable. By the end of the 17th century there was a substantial
dealing in the shares about 140 joint stock companies in London. The
 merchant of owned shares or their agents met in the coffee houses of
London to carry out their transactions. It evolved into formal stock
exchanges, as rules were developed to govern share transactions and the
behaviour of businesses seeking to raise funds through the sale of shares,
indeed, the London Stock Exchange, believed to be the world’s first stock
exchange, was opened in 1700 in Johnation’s Coffee Hourse near Change
Alley in London.
 Establishment of markets in a range of financial securities.

 Provision of a securities trading system

 Operation of a clearing and settlements system
 Regulation and monitoring of the integrity of the exchanges market
 Provision of a well-informed market, to secure the confidence of the
market.

The development of the stock exchange was necessary to facilitate the

formation of the publicly listed corporation and the creation of a deep and liquid
share market.

 Discuss different roles that a stock exchange may serve.

Primary market role, secondary market role, the managed products and
derivative products roles, the interest rate market roles, the trading and
settlement’s role, the information role and the regulatory role of a stock
exchange. A deep and liquid share market is important to a corporation.

The primary market role of a stock exchange is to ensure the efficient and
orderly sale of new-issue securities, and includes all of the support facilities that
are required to enable this to happen. The secondary market role of a stock
exchange involves the buying and selling of existing financial securities,
principally ordinary shares (pg. 140). It provides a market structure for the
buying and selling of existing listed securities. By and sell orders are lodged
through a stockbroker that has access to the exchange’s trading and settlement
platform. In support of their primary and secondary market roles relating to the
issue of ordinary shares and hybrid securities, stock exchanges may provide a
market for the trade of specific equity-based managed products and derivate
products. These products derive their value from the value of an underlying
security group of securities listed on SX. The interest rate market is a market
that facilitates the issue of debt securities and the subsequent trading of those
securities on a formal exchange.

 Identify the principal regulators that affect participants in the

Australian share market.

 Examine the flotation and listing (IPO) process and equity-funding

alternatives available to newly listed corporations.

 Consider important compliance requirements of listing a business.

 Explore equity-funding alternatives available to an established listed

corporation.

Corporations fund their business operations with a combination of equity and debt. It has
already been noted that the principal function of a stock exchange is to facilitate primary and
secondary market transactions in shares of listed corporations.

Shareholders may receive dividends and/or capital gains (or losses).

Week 4 Interest Rate Determination and Forecasting

Interest rates are the price of money. Yields on investments and the cost of borrowing are
measured in interest rates. Any changes in interest rates will affect return received on
investments and the cost of borrowing.
There are two parties. A borrower and a lender. The interest rate is the price paid by a
borrower (or debtor) to a lender (or creditor) for the use of resources during some interval.
The price is typically expressed as a percentage of the principal per unit of time (generally a
year).
The central bank of a country is typically for the implementation of monetary policy. In
Australia, as in many other countries, monetary policy is directed towards maintaining
inflation within a defined band or range to achieve desired economic outcomes. In most
developed economies monetary policy actions are directed at influencing interest rates. By
understanding what motivates a central bank in its implementation of interest rates policy:
financial market participants can anticipate changes in a government’s interest rate policy.
Lenders and borrowers can make better-informed decisions.
Inflation target in Australia is between 2.00 and 3.00 per cent, on average, over the economic
or business cycle.

Federal Government prints and lends money by buying bonds.

A central bank will generally increase interest rates if:
 The rate of inflation over the business cycle is above its target range.
 The of growth in gross domestic product is excessive.
 The current account of the balance of payments is significantly in deficit.
 Credit growth within the financial system and associated debt levels are expanding
too rapidly.
 There are ongoing and unsustainable price increases in major economic sectors such
as the property sector or the mining sector.
 The currency is under excessive downward pressure in the foreign exchange markets.

Monetary policy changes in interest rates are said to have three effects over time: the
liquidity effect, the income effect, and the inflation effect. The liquidity effects relate to
changes in funds available for lending within the financial system. The income effect relates
to changes in economic activity and therefore future income levels. The inflation effects
relate to the eventual impact on inflation of the liquidity and income effects. Changes in the
money supply will affect the level of interest rates.

 Explain the loanable funds approach to interest rate determination,

including supply and demand variables for loanable funds, equilibrium
and the effect of changes in variables on interest rates.

The loanable funds approach to explaining and forecasting interest rates is often preferred by financial
market analysts. The loanable funds approach looks at lending. It proposes that interest rates are
determined by the supply of, and demand for, loanable funds. In the loanable funds approach, there is
a downward-sloping demand curve and an upward-sloping supply curve. The equilibrium interest rate
is at the intersection of the demand and supply curves.

The downward slope of the demand curve implies that the demand for loanable funds will fall as
interest rates rise; conversely, the upward-sloping supply curve shows that an increase in the supply of
loanable funds will allow interest rates to fall. Changes in the positions of the demand curve and the
supply curve will result in changes in the rate of interest. The increase in demand from D1 to D2 has
resulted in an increase in interest rates.

Financial experts often like using the loanable funds approach to understand and predict interest rates.
This approach focuses on lending and suggests that interest rates depend on how much money is
available to lend (supply) and how much people want to borrow (demand). In this approach, there’s a
curve showing how demand for loans goes down as interest rates rise and a curve showing how the
supply of available funds goes up as interest rates rise. The point where these curves meet is the
balance point or equilibrium.
Demands for loanable funds is determined by firms, government, and households. This demand is
negatively related to the interest rate.

 Understand yields, yield curves and term structures of interest rates,

and apply the expectations theory, segmented markets theory and
liquidity premium theory.

 Explain the risk structure of interest rates, the risk-free interest rate
and the impact of default risk on interest rates.

Week 5 Time Value of Money

Explain what the time value of money is and its importance in the field of finance.

Financial decision-making – borrowing or lending money (investing).

The time value of money is based on the idea that people prefer to consume goods today
rather than tomorrow. It depends critically on how interest is calculated. Focus is on the
mathematical technques for calculating the cost of borrowing and the return earned on an
investment.

Explain the concepts of present value, and future value, including the meaning of the terms
such as principal, simple interest, compound interest, and effective rates.