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TOPIC 1: INTRODUCTION TO FINANCIAL MARKETS Aim The aim of this topic is to provide an introduction to, and framework for examining, the nature and operation of the financial system. The two main methods of financing are distinguished along with the different types of financial assets that are create...

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TOPIC

1: INT FIN

R O D U C T I O N T O A N C I A L M A R K E T S

Aim The aim of this topic is to provide an introduction to, and framework for examining, the nature and operation of the financial system. The two main methods of financing are distinguished along with the different types of financial assets that are created. In addition, the relationship between the financial system and the economic system and the role of government with respect to the financial system are considered.

Learning objectives After working through this topic, you should be able to: 1. Describe the main features of the financial system. 2. Distinguish between direct and indirect financing and the characteristics of each. 3. Explain the relationship between the financial system and the economic system. 4. Outline the main reasons for, and methods of, government intervention into financial markets.

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After working through this section you should be able to describe the main features of the financial system.

1.1 The financial system To understand the nature of financial markets it is first necessary to understand the overall financial system that comprises, inter alia, financial markets. The main functions of a nation’s financial system are to facilitate the: 

transfer of funds from surplus to deficit economic units, in primary financial markets, by the creation of new financial assets



trade of existing financial assets in secondary financial markets

A nation’s financial system comprises surplus economic units (lenders), deficit economic units (borrowers), financial institutions, financial markets and financial assets.

1.1.1 Surplus economic units These are individuals or small groups (eg individual households or business firms) who have more funds available than they require for immediate expenditure. That is, they represent savers and potential lenders of their surplus funds.

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1.1.2 Deficit economic units These are individuals or groups (eg individual households or business firms) who require additional funds to meet their expenditure plans. That is, they represent potential borrowers of funds. 1.1.3 Financial institutions These are organisations whose core business involves the borrowing and lending of funds (financial intermediation) and/or the provision of financial services to other economic units. 1.1.4 Financial assets Financial assets, also called financial instruments, represent a claim or right that a surplus economic unit holds over a deficit economic unit. Issued by the party raising funds, it acknowledges a financial commitment and entitling the holder to specified future cash flows. For the party issuing the financial assets, the assets represent a liability or obligation. Whenever, funds are lent and borrowed, financial assets are created. Primary market financial transactions involve an exchange as funds are exchanged for financial assets. Lenders of funds are also buyers of financial assets and borrowers of funds are sellers of financial assets. All financial assets have four different attributes which can provide a basis for comparison between different types of financial assets: 

return or yield

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risk

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liquidity

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time pattern of return or cash flow

Note that expected return or yield has a positive relationship with risk and inverse relationship with liquidity. The higher the level of risk and the lower the liquidity, the higher the return on investment required by lenders of funds (surplus economic unites). Lenders of funds are able to satisfy their own personal preferences by choosing various combinations of these attributes. The financial assets that are created and exchanged can be divided into the following four broad types: 

Debt: Debt instruments represent an obligation on the part of the borrower to repay the principal amount borrowed and interest in a specified manner over a defined period of time or when a specified event occurs. Some examples are: 

Deposits - eg bank deposits

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Contractual savings- eg life insurance, superannuation

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

Discount securities - eg commercial bills

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Fixed interest securities - eg bonds, debentures

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Equity: Equity differs from debt in that it represents an ownership claim over the profits and assets of a business. The main example is ordinary shares.

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Hybrid: Hybrid financial assets comprises securities that combine features of both debt and equity. Two examples are preference shares and convertible notes.

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Derivatives: Derivative instruments are financial assets whose value is derived from another type of financial asset. Two examples are options and futures

Whatever form financial assets take they represent a claim (or right) which a surplus economic unit holds over a deficit economic unit. Likewise they also represent an obligation of deficit economic units. 1.1.5 Financial markets An economic market comprises a mechanism which brings together, not necessarily to a single location, sellers and buyers for the purpose of exchange. Financial markets are where financial assets are created and/or exchanged. Every nation’s financial system comprises a number of different financial markets which can be classified in different ways for different purposes. One type of classification is between primary and secondary financial markets. In the former, new financial assets are created and traded in exchange for borrowed funds: eg a household (surplus economic unit) lends funds to a corporation (deficit economic unit) in exchange for debentures (a financial asset). In the latter, existing financial assets are traded which results in a change of ownership but not the lending of funds: eg the holder of debentures sells his financial asset to another person. The term financial security is used to describe financial assets that can be traded in a secondary market. Another type of classification is between money markets , where funds are lent for a period of less than one year, and capital markets, where funds are lent for one year or longer. Other types of classification distinguish between financial markets for the different type of financial assets that are traded. This is the basis on which we will be examining different financial markets in Australia. Specifically, we will examine the following separate Australian financial markets in turn:     

The Money Market (topic 3) The Debt-Capital Market (topic 4) The Foreign Exchange Market (topic 5) The Equity Market (topic 6) The Derivatives Market (topic 7)

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After working through this section you should be able to distinguish between direct and indirect financing and the characteristics of each.

1.2 Direct and indirect finance The flow of funds in primary financial markets can either be direct from lender to borrower or indirectly through a financial intermediary. The alternative methods of financing are illustrated in the diagram below; 1.2.1 Direct finance With direct finance the surplus economic units who are the ultimate lenders provide funds directly to the deficit economic units who are the ultimate borrowers. In exchange for the funds, the deficit economic units issue financial assets that are primary securities held by the surplus economic units and represent a direct claim over the ultimate borrower. In direct finance financial institutions frequently provide financial services to the parties, particularly the borrowers. These services include financial advice, financial management and security documentation, marketing, sales negotiation, provision and arrangement of underwriting facilities. In providing such services financial institutions are paid commission or fees.

1.2.2 Indirect finance Indirect financing is also known as intermediated financing because it involves financial institutions performing the role of financial intermediary. With indirect financing, the surplus economic units, the ultimate savers, lend their funds initially to a financial institution who then lends the funds to the deficit economic units who are the ultimate borrowers.

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The financial institution acts as a financial intermediary and performs the role of both borrower and lender. This is the basis of the legal relationship that financial intermediaries have with surplus and deficit economic units. In performing this role financial intermediaries earn income in the form of a net interest margin and fees. The net interest margin represents the difference between the average cost (interest paid) of funds and average return (interest earned) from lending. In indirect financing, deficit economic units issue primary securities which are held by financial intermediaries who issue secondary securities to surplus economic units. Surplus economic units do not have a direct claim on deficit economic units. You should not become confused between primary and secondary financial markets and primary and secondary financial assets (securities). The terms “primary” and “secondary” are used in different contexts for each of the above which are not related. Primary and secondary securities are both created in primary financial markets and can be traded in secondary financial markets. 1.2.3 Advantages of financial intermediation In carrying out the role of intermediation financial institutions provide a number of benefits to borrowers, lenders and the economy as a whole. The main advantages of financial intermediation are: 

Asset value transformation: financial intermediaries are able to create secondary securities that differ in value from the primary securities that are issued by deficit economic units. In this way they can tap small individual savings and pool them together for the purpose of making larger loans.

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Maturity transformation: financial intermediaries are able to borrow for different time periods than for what they lend. In doing this they are able to match the maturity preferences of borrowers and lenders. As a general rule, lenders require greater liquidity than borrowers are prepared to provide.

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Credit risk reduction and diversification: financial intermediaries are able to reduce the risk of lending to borrowers who are unable to meet their loan commitments as a result of their expertise and knowledge. In addition, as a result of their size and diversification of loans, they are able to spread a small percentage of bad loans across their total loan portfolio.

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

Liquidity provision: Ability to convert financial assets into cash. Financial intermediaries, due to their size and specialisation in borrowing and lending are able to provide their customers with a high degree of liquidity eg. cheques, ATM, EFTPOS facilities.

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Increased quantity of national savings: As a result of the above advantages the existence of indirect financing will tap a greater quantity of national savings and hence increase the supply of funds available to finance real investment and promote economic growth.

1.2.4 Disadvantages of financial intermediation There is no doubt that financial intermediation provides a number of advantages. However, it does not come without cost as both borrowers and lenders must pay for the benefits they receive. This generally means: 

Increased cost of funds for borrowers

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Reduced return from lending for savers.

In addition to this, there is a further disadvantage in that, as a general rule: 

It is less likely for secondary financial assets to be securitised ( ie financial securities) in that they can be traded in a secondary market.

Over recent years there has been increased reliance by large borrowers on direct rather than indirect (intermediated) finance. Hence the term disintermediation is used to describe this process.

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After working through this section you should be able to outline the main institutional and regulatory features of the Australian financial system

1.3.1 Nature and role of financial institutions A financial institution is a business organisation whose core business is financial intermediation and/or the provision of financial services to other sectors of the economy. In indirect financing, a financial institution performs the function of financial intermediation by borrowing from surplus units and lending to deficit units. Revenue is generated by net interest margin and fees. In direct financing, a financial institution provides financial services by performing the function of broker, agent, financial advisor, etc. Revenue is generated by fees and commission. Although there is a great deal of overlap between the services offered by different financial institutions, it is common practice to categorise non-bank financial institutions on the basis of how they raise the majority of their funds. We can identify two main types of institutions: •

Deposit taking financial institutions: They attract the savings of depositors through ondemand deposit and term deposit accounts. They provide loans to borrowers in household and business sectors. e.g. commercial banks, building societies and credit cooperatives.

•

Non Deposit taking financial institutions: They generally do not provide laons or take deposits but they may managed funds under contractual arrangement (superannuation) and provide a wide range of financial services. e.g. Investment banks, general insurance companies and superannuation funds.

1.3.2 Current Institutional features The Australian financial system comprises a range of different types of financial institutions providing financial intermediation or other financial services.

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Total Assets (Percentage Share) of Financial Institutions

From this table a number of observations can be made concerning the institutional structure of the Australian financial system. These include: 

The dominant role of banks with the commercial banks, as a group, comprising more than 50% of the total assets of all financial systems. During the period of regulation banks share of financial assets fell however, following deregulation it did increase.



Both building societies and credit unions are very small in terms of percentage share of financial assets. However, there are a large number of individual institutions with approximately 30 building societies and 320 credit unions. The decline in percentage share of financial assets owned by building societies has been particularly due to the conversion of a number of building societies into banks.



Life offices and superannuation funds, as a group, have experience a significant increase in the share of financial assets they control. The percentage share of life offices has declined in recent years while superannuation funds have represented one of the fastest growing sectors of the financial system. This is particularly due to government wages and taxation policy.

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Other form of managed funds, particularly public unit trusts , have also grown significantly as retail investors have turned toward equity and other types of managed investments and away from traditional forms of investment such as bank deposits.

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

Mortgage originators and securitisation vehicles have only become recognised as a type of financial institution in recent years. Officially, the Reserve Bank did not collect statistics on them until December 1996. Mortgage originators have experienced considerable recent growth in the 90’s but shrank following the Global Financial Crisis. Mortgage originators make housing loans and then sell these loans to securitisation vehicles set up as separate entities by financial institutions. Funds are raised through the issue of mortgage backed securities by the securitisation vehicles.

1.3.3.1 Commercial banks Commercial banks are the largest group of financial institutions within a financial system and therefore they are very important in facilitating the flow of funds between savers and borrowers. The core business of banks is often described as the gathering of savings (deposits) in order to provide loans for investment. The traditional image of banks as passive receivers of deposits through which they fund their various loans and other investments has changed since deregulation (for deregulation see topic 8). For example, banks provide a wide range of off-balance-sheet transactions such a underwriting where for instance the bank will commit to purchase unsold share after the share were issued to the market. The bank can also act as guarantor on some financial products such as money market bills (“bank bills”). A wide range of non-bank financial institutions has evolved within the financial system in response to changing market regulation and to meet particular needs of market participants. 1.3.3.2 Building societies and credit unions The majority of building society funds are deposits from customers. Residential housing is the main form of lending. Credit unions funds are sourced primarily from deposits of members. Housing loans, personal loans and credit card finance is available to their members. A defining characteristic of a credit union is the common bond of association of its members, usually based on employment, industry or community. 1.3.3.3 Investment banks and merchant banks Investment banks and merchant banks play an extremely important role in the provision of innovative products and advisory services to their corporations, high-net-worth individuals and government. Investment and merchant banks raise funds in the capital markets, but are less inclined to provide intermediated finance for their clients; rather, they advise their clients and assist them in obtaining funds direct from the domestic and international money markets and capital markets. Investment banks specialise in the provision of off-balance-sheet products and advisory services, including operating as foreign exchange dealers, advising clients on how to raise funds in the capital

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markets, mergers and acquisitions, acting as underwriters and assisting clients with the placement of new equity and debt issues, advising clients on balance-sheet restructuring, evaluating and advising on corporate mergers and acquisitions, advising clients on project finance and, providing risk management services. 1.3.3.4 Managed funds The main types of managed funds are cash management trusts, public unit trusts, superannuation funds (pension funds), statutory funds of life offices, common funds and friendly societies. Managed funds may be categorised by their investment risk profile, being capital guaranteed funds, capital stable funds, balanced growth funds, managed or capital growth funds. Managed funds are a significant and growing sector of the financial markets due, in part, to deregulation, ageing populations, a more affluent population and mo...