A Modern Financial System: An Overview: Websites: WWW - Rba.gov - Au WWW - Treasury.gov - Au

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/
Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 1-1

Viney & Phillips, Financial Institutions, Instruments and Markets, 9e
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’.

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

• 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
(cont.)

• 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

• 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.)

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.)

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.)

institutions
• Categories of financial institutions
– Depository financial institutions
– Investment banks
– Contractual savings institutions
– Finance companies and general financiers
– Unit trusts
(cont.)

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.)

• 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.)

Talking markets and strategy
• 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

• 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.)

• 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
(cont.)

• Four basic derivative contracts
1. Futures contract (Chapter 18 and 19)
2. Forward contract (Chapters 17, 18 and 19)
3. Option contract (Chapters 18 and 20)
4. Swap contract (Chapters 18 and 21)

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.)

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

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?

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.)

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

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.)

(cont.)

• 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.)

(cont.)

• 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

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.)

Wholesale and retail markets

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.)

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

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

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.)

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

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


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Chapter 1

A modern financial system:

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• Implementation of monetary policy

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– Ranks ahead of equity

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– Used mainly to manage price risk exposure and to speculate

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– Funds are obtained by the issuer

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• Increases access to diverse range of markets

• Greater flexibility in range of securities users can issue for different

• Liquidity and marketability of a security

• Search and transaction costs

• Assessment of risk, especially default risk

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– Credit risk diversification and transformation

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– No specific infrastructure or trading place

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