Topic 1: The Financial System
Chapter 1: The Financial System Course Objectives • Strengthen understanding of financial system • Integrate technical content into discussion • Preparation for competitive and dynamic field • Understanding about managing risk
Topic 1: The Financial System Financial System - consists of financial markets, institutions and money Roles of Financial System: • To facilitate the flow of funds (savers to the borrowers) • Provide the mechanism to settle transactions (cash, cards, phones) • To generate and disseminate information (ensure both parties have the same amount of information) • To provide the means to transfer and manage risk (loans from banks) • To provide ways of dealing with incentive problems Money - means of exchange • The financial system allows the efficient allocation of funds throughout the economy Flow of Funds • The financial system acts as intermediary for the flow of funds from surplus spending units (SSUs, people who save) to deficit spending units (DSUs, people in debt)
Financial Market Efficiency Allocational Efficiency - finds are allocated to their highest value use (those who pay the highest interest rate need the money the most Informational Efficiency - allows households and firms to make intelligent decisions (ensuring everyone has enough information about the business) Operational Efficiency - where the costs of conducting transactions are as low as possible Managing Risks and Incentive Problems Information Asymmetry - when the buyer or seller has more information then the other party Adverse Selection - market process that produces sub-optimal outcomes due to parties having asymmetrical information (people with high risk of danger needing life insurance)
Moral Hazard - tendency of people and/or organizations to change their behavior once they become party to a contract (the ability to be bailed out by government, reserve bank, because banks know they will bail them out) Two Methods of Financing: Direct Financing • SSUs exchange money to DSUs and accept a financial claim (IOU or Direct Claim) in return • Absence of a financial intermediary • Brokers, dealers, Investment bankers Indirect Financing • When a financial intermediary (banks) is present and aid in the purchase of goods and services
Benefits of Financial Intermediation • Denomination divisibility (different amounts of money) • Currency Transformation (changing currency for importers/exporters) • Maturity Flexibility (supplying loans for consumers) • Credit Risk Diversification (whether or not the DSU will pay back loans) • Liquidity (ability to turn assets into cash) Types of Financial Intermediaries Australian Financial Intermediaries • Banks, credit unions • Foreign bank representatives • General and life insurers • Finance companies and securitizes • Approved trustees • Superannuation entities Commercial Banks
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largest banks and most diversified and cannot be bought by outside parties (ANZ, CBA, NAB, WBC)
Non Bank Financial Corporations • NBFC provide many of the same services and products as commercial banks • The four groups that NFBCs are classified in are Building societies, Credit Unions, MoneyMarket Corporations and Finance Companies Other Financial Institutions include: • Life insurance companies • General insurance companies • Superannuation funds • Managed funds International Organizations • The Bank of International Settlements • The World Bank • The International Monetary Fund • The Asian Development Bank Types of Financial Markets Primary Markets - are where financial claims are initially sold by DSU's which can take place through an initial public offering of shares to the public or bond issue Secondary Markets - when previously issued financial claims are exchanged among investors Organised Markets - Once issued claims can be exchanged on an organised exchange such as the Australian Securities Exchange Over-the-Counter Markets - Financial claims can also be exchanged 'over the counter' usually by telephone conversation (OTC markets have no central location) Other Markets Include: • Futures Markets • Options Markets • Foreign Exchange Markets • International Markets Money Markets - a wholesale short term to maturity (less than 12 months) claim • Banks and businesses can adjust their liquidity positions by borrowing and lending for a short time on the money market which consists of a collection of markets each trading a different financial instrument (high liquidity and low default risk Money Market Instruments Include: • Treasury Notes • Commercial Paper • Commercial Bills • Negotiable Certificates of Deposit • Secured and Unsecured Notes Capital Markets - where longer term (greater than 12 months) securities are traded • Capital goods are financed with stock or longer term debt instruments
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Capital market instruments are less marketable, have varying default levels and have maturities ranging from 5 to 30 years Capital Market Instruments Include: • Common Stock • Corporate Bonds • Government Bonds • Mortgages
Risk in Business Risks Faced by Financial Institutions: • Credit Risk • Interest Rate Risk • Liquidity Risk • Foreign Exchange Risk • Political Risk • Reputational Risk • Environmental Risk • Operational Risk Companies can Manage Risk By: • Diversifying their loans and investments • Analysis of impact of climate change and environmental ligation on the company • Careful credit analysis and monitoring the borrowers over time • Undertaking appropriate hedging strategies in financial markets • Good internal processes to manage operational risks
Topic 1: The Financial System Financial System - consists of financial markets, institutions and money Roles of Financial System: • To facilitate the flow of funds (savers to the borrowers) • Provide the mechanism to settle transactions (cash, cards, phones) • To generate and disseminate information (ensure both parties have the same amount of information) • To provide the means to transfer and manage risk (loans from banks) • To provide ways of dealing with incentive problems Money - means of exchange • The financial system allows the efficient allocation of funds throughout the economy Flow of Funds • The financial system acts as intermediary for the flow of funds from surplus spending units (SSUs, people who save) to deficit spending units (DSUs, people in debt)
Financial Market Efficiency Allocational Efficiency - finds are allocated to their highest value use (those who pay the highest interest rate need the money the most Informational Efficiency - allows households and firms to make intelligent decisions (ensuring everyone has enough information about the business) Operational Efficiency - where the costs of conducting transactions are as low as possible Managing Risks and Incentive Problems Information Asymmetry - when the buyer or seller has more information then the other party Adverse Selection - market process that produces sub-optimal outcomes due to parties having asymmetrical information (people with high risk of danger needing life insurance)
Moral Hazard - tendency of people and/or organizations to change their behavior once they become party to a contract (the ability to be bailed out by government, reserve bank, because banks know they will bail them out) Two Methods of Financing: Direct Financing • SSUs exchange money to DSUs and accept a financial claim (IOU or Direct Claim) in return • Absence of a financial intermediary • Brokers, dealers, Investment bankers Indirect Financing • When a financial intermediary (banks) is present and aid in the purchase of goods and services
Benefits of Financial Intermediation • Denomination divisibility (different amounts of money) • Currency Transformation (changing currency for importers/exporters) • Maturity Flexibility (supplying loans for consumers) • Credit Risk Diversification (whether or not the DSU will pay back loans) • Liquidity (ability to turn assets into cash) Types of Financial Intermediaries Australian Financial Intermediaries • Banks, credit unions • Foreign bank representatives • General and life insurers • Finance companies and securitizes • Approved trustees • Superannuation entities Commercial Banks
•
largest banks and most diversified and cannot be bought by outside parties (ANZ, CBA, NAB, WBC)
Non Bank Financial Corporations • NBFC provide many of the same services and products as commercial banks • The four groups that NFBCs are classified in are Building societies, Credit Unions, MoneyMarket Corporations and Finance Companies Other Financial Institutions include: • Life insurance companies • General insurance companies • Superannuation funds • Managed funds International Organizations • The Bank of International Settlements • The World Bank • The International Monetary Fund • The Asian Development Bank Types of Financial Markets Primary Markets - are where financial claims are initially sold by DSU's which can take place through an initial public offering of shares to the public or bond issue Secondary Markets - when previously issued financial claims are exchanged among investors Organised Markets - Once issued claims can be exchanged on an organised exchange such as the Australian Securities Exchange Over-the-Counter Markets - Financial claims can also be exchanged 'over the counter' usually by telephone conversation (OTC markets have no central location) Other Markets Include: • Futures Markets • Options Markets • Foreign Exchange Markets • International Markets Money Markets - a wholesale short term to maturity (less than 12 months) claim • Banks and businesses can adjust their liquidity positions by borrowing and lending for a short time on the money market which consists of a collection of markets each trading a different financial instrument (high liquidity and low default risk Money Market Instruments Include: • Treasury Notes • Commercial Paper • Commercial Bills • Negotiable Certificates of Deposit • Secured and Unsecured Notes Capital Markets - where longer term (greater than 12 months) securities are traded • Capital goods are financed with stock or longer term debt instruments
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Capital market instruments are less marketable, have varying default levels and have maturities ranging from 5 to 30 years Capital Market Instruments Include: • Common Stock • Corporate Bonds • Government Bonds • Mortgages
Risk in Business Risks Faced by Financial Institutions: • Credit Risk • Interest Rate Risk • Liquidity Risk • Foreign Exchange Risk • Political Risk • Reputational Risk • Environmental Risk • Operational Risk Companies can Manage Risk By: • Diversifying their loans and investments • Analysis of impact of climate change and environmental ligation on the company • Careful credit analysis and monitoring the borrowers over time • Undertaking appropriate hedging strategies in financial markets • Good internal processes to manage operational risks
