Course Notes Topic 1-1-1.docx

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...

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 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. **[\ Objective 1]{.smallcaps}** **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: 1. **transfer of funds** from surplus to deficit economic units, in primary financial markets, by the creation of **new financial assets** 1. 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 **1.1.1 Surplus economic units** These are individuals or small groups (e.g. 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. **\ 1.1.2 Deficit economic units** These are individuals or groups (e.g. 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: 1. return or yield 1. risk 1. liquidity 2. time pattern of return or cash flow Note that expected return or yield has a positive relationship with risk and an 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 units). 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**: 1. 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: 1. 1. 1. 3. 1. 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. 1. Hybrid: Hybrid financial assets comprises securities that **combine features** of both **debt and equity**. Two examples are preference shares and convertible notes. 4. 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: e.g. 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: e.g. 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 on 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 based on **asset class**. 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 - The Debt-Capital Market - The Foreign Exchange Market - The Equity Market - The Derivatives Market  Source: [Eikon](file:///C:%5CUsers%5CDownloads%5CEikon) Thomson Reuters 2018\ Source: [Eikon](file:///C:%5CUsers%5CDownloads%5CEikon) Thomson Reuters 2018\ Source: [Eikon](file:///C:%5CUsers%5CDownloads%5CEikon) Thomson Reuters 2018 **[Objective 2]{.smallcaps}** **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 lenders to borrowers 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 are the ultimate **lenders who 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. 1-4 **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.  The financial institution acts as a **financial intermediar**y 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. - 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. - 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. - 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. - 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: 1. **Increased cost** of funds for borrowers 5. **Reduced return** from lending for savers. In addition to this, there is a further disadvantage in that, as a general rule: 6. It is **less likely for secondary financial assets to be securitised** (i.e. 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. **[\ Objective 3]{.smallcaps}** **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 a 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 on-demand 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 manage funds under a 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. **Main Types of Financial Institutions as at June 2017** ------------------------------------------------------------------------------------------------------------------------------------------------------- ------------------------------------------------------------------------------------------------------------------ ---------------------------------------------------------------------------------------------------------------------- ---------------------------------------------------------------------------------------------------------------------- ---------------------- **Type of institution** **Main supervisor/ regulator** **Number of institutions** **Total assets (\$b)** **Percentage share** Banks APRA 83 [[4,187.30]](http://www.rba.gov.au/fin-stability/fin-inst/main-types-of-financial-institutions.html#fn2) 59.01% Building societies APRA 4 13 0.18% Credit unions APRA 54 37.6 0.53% **Non-ADI Financial Institutions** 0.00% Money market corporations (broker-dealers) [[ASIC]](http://www.rba.gov.au/fin-stability/fin-inst/main-types-of-financial-institutions.html#fn3) [[9\[4\]]](http://www.rba.gov.au/fin-stability/fin-inst/main-types-of-financial-institutions.html#fn4) 31.3 0.44% Finance companies [[ASIC]](http://www.rba.gov.au/fin-stability/fin-inst/main-types-of-financial-institutions.html#fn3) [[112\[4\]]](http://www.rba.gov.au/fin-stability/fin-inst/main-types-of-financial-institutions.html#fn4) 140.6 1.98% Securitisers -- 125.3 1.77% **Insurers and Funds Managers** 0.00% Life insurance companies [[APRA]](http://www.rba.gov.au/fin-stability/fin-inst/main-types-of-financial-institutions.html#fn5) 29 [](http://www.rba.gov.au/fin-stability/fin-inst/main-types-of-financial-institutions.html#fn6) 2.44% [[General insurance companies]](http://www.rba.gov.au/fin-stability/fin-inst/main-types-of-financial-institutions.html#fn7) [[APRA]](http://www.rba.gov.au/fin-stability/fin-inst/main-types-of-financial-institutions.html#fn5) 104 170.4 2.40% Health insurance companies APRA 37 13.8 0.19% [[Superannuation and approved deposit funds]](http://www.rba.gov.au/fin-stability/fin-inst/main-types-of-financial-institutions.html#fn8) APRA 2,338 1,865.10 26.28% Public unit trusts ASIC -- 290.2 4.09% Cash management trusts ASIC -- 34 0.48% Common funds **State and territory authorities** -- 9.3 0.13% Friendly societies APRA 12 [[5.5]](http://www.rba.gov.au/fin-stability/fin-inst/main-types-of-financial-institutions.html#fn9) 0.08% Source: http://www.rba.gov.au/fin-stability/fin-inst/main-types-of-financial-institutions.html\#fn3 From this table, a number of observations can be made concerning the institutional structure of the Australian financial system. These include: 1. 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, the share of financial assets fell, however, following deregulation it did increase. 1. 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. 2. **Life offices and superannuation funds**, as a group, have experienced 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. 3. Other forms 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. 4. **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. **1.3.3.3 Other institutions** **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 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. **Finance companies and general financiers** Finance companies derive the largest proportion of their funding from the sale of debentures (Debt). They provide loans to individuals and businesses, including lease finance, floor plan financing and factoring. Deregulation of commercial banks has resulted in a significant decline in finance companies. Many finance companies are now operated by manufacturers, such as car companies, to finance sales of their product. i.e. AGC, CBFC and ESANDA **[\ ]{.smallcaps}** **[Objective 4]{.smallcaps}** **After working through this section, you should be able to explain the relationship between the financial system and the economic system.** **1.4 The financial and economic systems** In the study of economics, it is normal to treat the financial system as a component part of the larger economic system. The economic system is seen as comprising, inter alia, real output markets (for goods and services), resource markets and financial markets. The role of the financial system is to facilitate the operation of the overall economic system and in particular the output markets for goods and services. **1.4.1 The economic system** A nation's economic system is concerned with the production and distribution of goods and services. In performing this function, a nation's economic performance is normally assessed in terms of the following economic objectives: **1.4.2 The financial system and economic objectives** A nation's financial system will affect its performance with respect to each of the economic objectives listed below: - Economic growth - Full employment - Price stability - External balance - Efficient allocation of resources - Equitable distribution of income and wealth **1.4.2.1 Economic growth** Historically, there is a well-established relationship between the development of a nation's financial system and economic development. The establishment of a well developed financial system is seen as a necessary prerequisite for a country to raise sufficient funds, to finance the necessary infrastructure projects required for sustained economic development. For developed economies, the cost and availability of funds, determined in the financial system, are significant determinants of aggregate demand, particularly private investment demand. The level and rate of growth of aggregate demand, in turn, has a major impact on a nation's economic growth rate. **1.4.2.2 Full employment** The demand for resources, including labour, is derived from the demand for final goods and services. Thus, the level of employment in the economy is directly related to aggregate demand and the rate of economic growth. As the cost and availability of funds is a significant determinant of aggregate demand, it is also a significant determinant of the level of employment. **1.4.2.3 Price stability** The rate of inflation is also significantly determined by the growth of aggregate demand. Consequently, the cost and availability of funds in the financial system will have some bearing on whether a nation is experiencing inflation or relative price stability. A nation's monetary policy normally involves Central Bank intervention into the financial system in pursuit of macroeconomic objectives, particularly price stability. In Australia, at the present time, the Reserve Bank of Australia has set an inflation target of 2 - 3% per annum for determining the conduct of monetary policy. **1.4.2.4 External balance** External balance refers to a desirable position in terms of a nation's international transactions, as reflected in that country's balance of payments, and exchange rate value of its currency. Both the balance of payments and the exchange rate will be significantly affected by the financial system. The cost and availability of funds will affect the level and rate of change of the export and import of goods and services. In addition, borrowing from overseas (capital inflow) and overseas investment of funds (capital outflow) are directly affected by conditions in financial markets both domestically and globally. Thus, both current and capital account transactions of a nation's balance of payments will be significantly determined by domestic and international financial market conditions. As international transactions determine the demand and supply for a nation's currency, financial market conditions will also have a significant effect on the foreign exchange value of that nation's currency. **1.4.2.5 Efficient allocation of resources** An efficient allocation of resources is where a nation's limited resources are allocated to produce that output mix of particular goods and services that maximise the satisfaction of society. This is best achieved by competitive markets where the allocation of resources is determined by demand and supply for individual goods and services. Any non-market distortions that influence the levels of demand or supply will reduce the efficient allocation of resources. Non-market distortions can result from factors in resource markets, finance markets or in the markets for goods and services themselves. The efficient allocation of resources requires that factors in finance markets do not distort the pattern of demand for individual goods and services from that which would otherwise take place. Allocative efficiency requires that the financial system directs funds to the highest yielding forms of expenditure. This is best achieved by competitive financial markets with a minimum of government intervention and controls. **1.4.2.6 Equitable distribution of income and wealth** Non-market distortions that affect the cost and flow of funds not only reduce allocative efficiency but have effects that are not spread evenly over the community. For example, ceilings on particular interest rates mean some groups receive benefits, or an effective subsidy, while other groups are required to pay a higher cost for funds than would otherwise be the case. As a result, the distribution of income between different groups in the community is affected. At different times, governments have intervened into finance markets for the main purpose of altering the distribution of income to one that it views as more socially desirable or equitable. **[\ Objective 5]{.smallcaps}** **After working through this section you should be able to outline the main reasons for, and methods of, government intervention into finance markets.** **1.5 The government and finance markets** Over the past fifty years, the Australian government and government bodies, such as the Central Bank, have significantly altered both the extent and methods, of intervention into financial markets. Similar changes have been experienced in financial markets around the world. In general terms, we can divide the past 50 years into the following three periods: - Regulation (pre 1980's): During this period the Australian financial system was characterised by an extensive array of direct controls, particularly over banks. - Deregulation (the 1980's): During the first half of this decade the direct controls and other types of government regulation were progressively removed, and the financial system took on the features of a competitive market. - Post-deregulation (the 1990's): During the first half of this decade, the role of government changed again with a strengthening of government intervention. However, this was different in nature from the regulations that existed in the pre-1980 period. These three periods are outlined in more detail in the next objective. **1.5.1 Reasons for government intervention** All government policy actions are aimed at the achievement of particular objectives. In particular, the following objectives have been important reasons for government intervention into finance markets: - Macroeconomic objectives of economic growth, full employment, price stability and external balance. The previous section outlines how the financial system can affect a nation's performance with respect to these objectives. Achieving these objectives has always been a major rationale for government intervention. - An efficient, fair and competitive financial system. - The promotion of financial safety. The diagarm below on "the channels of transmission of monetary policy" show how changes in interest rate and the cost of funding overall can influence the government ecomonic objective in the "real economy". Figure: Channels of the transmission of monetary policy Source: RBA, **1.5.2 Methods of government intervention** There are numerous ways in which government actions can affect conditions in finance markets either directly or indirectly. This includes the main arms of economic policy as well as direct legislation. The main methods are: 1. **Fiscal policy** 1. 1. 1. **Monetary policy** 1. 7. 1. **External policy** 1. 1. 8. 1. **Wages policy** e.g. superannuation requirements. 1. **Competition policy** e.g. attitude of the Australian Consumer and Competition Commission towards bank mergers. 1. **Consumer protection** - voluntary and legislative. 9. **Direct legislation** - e.g. aspects of corporations law, superannuation legislation. **[\ TOPIC 1: Summary]{.smallcaps}** In this introduction to finance markets the emphasis has been on the nature and characteristics of the financial system and its relationship to the larger financial system. The financial system comprises both primary and secondary markets, each of which performs a different role. The primary markets are concerned with mobilising the savings of surplus economic units and transferring the surplus funds, either by means of direct or indirect finance, to deficit economic units in exchange for newly created financial assets. The secondary markets are concerned with the trade of existing financial assets. There are many different financial assets that are created and traded in financial markets. Financial assets can be classified as debt, equity, hybrid or derivatives and can be distinguished from each other on the basis of return, risk, liquidity and time pattern of return. Conditions in finance markets will have a significant influence on the overall economic system, and the achievement of economic objectives have always been main reasons for explaining government intervention into finance markets.