TFS 1 PDF - Introduction to Financial Systems

Module 1 Introduction to Financial Systems What is a Financial System? A financial system consists a complex network that comprises financial institutions, markets and instruments that together, provide financial services for the economy. Developed financial systems perform five financial functi...

Module 1 Introduction to Financial Systems What is a Financial System? A financial system consists a complex network that comprises financial institutions, markets and instruments that together, provide financial services for the economy. Developed financial systems perform five financial functions. These systems facilitate the flow of money and credit between lenders, borrowers, investors and savers. Every country has financial system and every country needs to perform all five systems. The Structure of a Financial System The main components of a financial system include: Financial Institutions - The organisations that provide the financial services, often referred to as intermediaries) between lenders and borrowers through financial instruments, - These organisations help to match the borrowers with the appropriate type of funding and connecting them with investors. - The main types of financial institutions are; - Deposit-taking institutions, that make loans - Investment banks, that assist their large company clients access funds from the financial markets - Fund managers that manage investor’s funds. Financial Markets that arrange trading in securities, foreign exchange and derivative contracts. - Place where buyers and sellers come together. - Provide platform for businesses and individuals to access capital and to raise funds for investment expansion - Financial markets raise funds with help of financial instructions through financial securities to fund capital budgeting projects. Regulators that oversee the institutions and markets. - Regulated by gov and other regulatory bodies to ensure they operate fairly, to ensure transparency and safety in market. - Important to prevent fraud, protect investors, maintain stability in financial system. The 5 Functions of the Financial System Settlement Flow-of-Funds Risk-Transfer Promoting Efficiency Stability 1. The Settlement Function The provision and processing of payment instruments for the settlement of commercial transactions - A commercial transaction is an agreement between a buyer and seller to exchange an item or service for payment. A settlement occurs when a buyer exchanges money for a purchased item - Money includes cash or payment instruction. Banks predominantly participate in settlement function - Afterpay e.g. provide infrastructure and services necessary for secure (encrypted) transfer of funds between parties. Includes managing and clearing of settlement process By providing secure and reliable payment instruments, financial instructions help to reduce risk of fraud and provide a means for buyers and sellers to transact a settlement with confidence. Money performs three tasks as a medium of exchange, a store of value, a unit of account. 2. The Flow of Funds Function The financial system arranges the supply of funds and allocates them among users depending on the returns they pay and the risk they pose to suppliers. Funds are supplied by surplus units mostly as bank deposits and superannuation contributions. - They require compensation for forgoing the immediate use of the funds and for the risk the funds will not be compensated as agreed. The deficit units that require funds include households (money for housing loans), businesses and the government. Between those that have a surplus amount of money (e.g. people with money to invest) and a deficit amount of money (people want you to invest money with them) The financial system globalises and facilitates the flow of funds by bringing together savers and borrowers. The more efficient the financial markets are, the better the financial system is at facilitating this flow of money between surplus and deficit units. The financial systems helps allocate capital and does so by allocating capital to where it’s most productively used and does this by channeling funds to businesses and projects that are most likely to generate a return on investment. Borrowers need a potential, attractive return for them to provide money to deficit units. Funds should be channeled to their most beneficial use. Funds are supplied either: 1.Directly - Deficit units raise funds directly from surplus units through the issue of securities in the mkt - Securities are contracts issued by deficit units to raise funds. They specify their promised payments and can be traded in mkt. - E.g. buying shares directly from market. - Disintermediation. No intermediary. Often has no security 2.Indirectly - Where funds are supplied as deposits to financial institutions, which in turn, supply funds as loans to deficit units. - Where share purchasers deals with intermediary company. DIRECT FINANCING Arranged by financial markets (you) surplus company (needs funds) 3 units Iyanc) 3 Deficit units 1 Arranged by deposit-taking Institutions INDIRECT FINANCING - Called intermediation when there is an intermediary. - Often involves security to ensure the lender gets their money back/is protected. Security is known as collateral. Only direct if they are ADIs or accepting deposit from the public. In Aus, indirect financing makes up the largest component of the flow of funds, with the majority of these funds being used to purchase residential property.  Direct financing also contributes to wealth creation through the ownership of financial assets, the success of these investments is reflected through share price indices. If we combine direct and indirect financing, the two biggest components will be the property we own and the superannuation. 3. The Risk-Transfer Function Investors, businesses and financial institutions need ways to manage risk that arise in the financial system. Risk-transfer contracts (derivatives) are provided by financial institutions and markets Markets can be used for individuals and companies who want to transfer risk they have. Do this through financial market through a collective of derivative instruments. Main risks; - Default Risk; chance that financial obligations will not be met such as loan payment defaults. Resulting in risk for lender by borrower. - Market Risk; Possibility of loss arising from unexpected changes in market variables or conditions (int rate, exchange rate, share price) Effects all financial instruments; shares, bonds, commodities, derivatives. Market risk is inherent on fluctuations on financial markets. - Can be caused by economics, politics, etc. Risk Transfer: An Example (INSERT) - Most companies are more concerned about hedging price increasing than missing price decreases. - Example 2: Insurance, paying for insurance but not having to use it. Save cost for if crash were to occur as forgoing expenses alone would supersede this cost but lose on the fact no crash occurred and expenses did not need to be made. Risk Transfer Graph Risk Hedge PROFIT (derivative central) · price goes up rish exposure loss made If price you down profit made If ,. · $0 LOSS Price of jet fuel Turrent US Risk Exposure price $0 894 P/L. Risk neage , , Cancels risk exposure 4. Promoting the Efficiency of the Financial Systems Three determinants of financial systems efficiency are; 1.Decision making that is mutually beneficial to the parties involved, and which is not impeded by: - Information asymmetry: - Arises when one party to a potential contract has an information advantage over the other party. - E.g. potential borrower knows more about their capacity to repay then the lender does. - Can lead to not mutually beneficial financial agreements at expense of the uninformed party, or to agreements not being made because of reluctance of the uninformed party to enter contract with informed party. - Can cause uninformed party to lose trust, not complete settlement. - One party knowing more info can lead to unethical behaviour. - Can occur between lenders and borrowers, investors and companies or buyers and sellers of financial assets - E.g. don’t disclose to bank that you have trouble repaying but want to get a loan or business doesn’t disclose full financial statements but individual wants to invest in company that they think is well performing. - More informed party may do this for the purpose of forgoing increased cost of perceived risk. - More efficient the market is = lower cost of borrowing - professional : lesschance ente ↳ o Des s g e ungs -.. - Incentive problems - Financial contracting is influenced by the incentives faced by the parties involved - Problematic if incentives motivate unethical behaviour; - E.g. - Remuneration arrangements - reward ST profits without considering LT consequence - Financial advisor receive commission from suppliers of investment products and directs clients to products which pay the advisor the highest commission. - Incentives offered to participants in financial system are problematic if encourage unethical behaviour - Individual faces moral hazard by acting on their own incentive rather than other party who they owe duty of care - E.g. of moral hazard; if no insurance, overprotecting house from burglary but with insurance, person behaves recklessly with not protection as they can say they will always have fallback of insurance. This is inefficient because it means they’re taking on risk - In context of financial system, moral hazard is crucial. Lenders and borrowers can have expectation that they’ll be bailed out if their investments fail. Borrowers take on more debt because they expect to be saved. Can be mitigated by regulatory oversight. Regulators may impose penalties or restrictions on financial instructions that engage in this risk behaviour. - System needs to ensure incentives are overcome or removed - One approach is where institutions have fiduciary duty to their customers - Another is practice of professional bodies that require members to adhere to code of ethics. - (all parties, surplus units, deficit units, investors, banks, institutions, insurance companies, all parties in financial systems should have access to accurate information and the incentives should align to ensure fair and efficient decision making.) 2.The pooling of funds from individual suppliers. - important to achieving economies of scale - Pooling is where we go from surplus to deficit units - Efficient for people to pool money together at same time and buy shares together. Bank play crucial role in pooling funds and allocating them to different borrowers or investments. 3. The emergence of new and reliable financial instruments, services and operating systems. - Important to have continuing renewal and reliable instrument services to increase efficiency and competitiveness of financial system - Cheque; inefficient, easy for fraud where as electronic payment, mobile payment, efficiency and security is higher. - New technology increases everyone’s access to financial services and decrease cost of services and provides new investment opportunities for organisations. Pooling of Funds Usually deficit units are seeking large amounts that will take a long period to repay where as surplus units normally want to supply small amounts for short periods So surplus ad deficit units have incompatible wants This can be overcome by the pooling of funds such as - A bank that accepts many small deposits and makes fewer larger value loans - A deficit units who issues many securities to many investors to raise a very large amount of funds. 5. The Financial System Stability Unstable financial systems experience crisis which disrupts flow of funds and activity in the economy, resulting in greater unemployment and loss of wealth Central banks assist with system stability by being ‘lender of last resort’ to solvent but illiquid banks There are international supervision guidelines, which aim to establish internationally consistent supervision arrangements and that are implemented by APRA The RBA (Reserve Bank of Aus) has responsibility for promoting stability in Australia’s financial system. Ensuring financial stability = ensuring there is no crisis in the financial system Stability keeps interest rates in check, inflation, money supply, growth of economy in check. Australia’s Financial Institutions Banks and funds managers (superannuation funds e.g.) dominant in terms of their assets. Basically in terms of who has the most money, funds in Australia. 1. Banks (authorised deposit taking institutions) - Banks are financial institutions authorised by ARPA to undertake banking businesses in.e accept deposits, loans, provide financial services - They include; - Four major banks (ANZ, CBA, NAB and Westpac) that provide services such as; - Credit unions and building societies that mainly serve households and - Investment banking services to large businesses 2. Shadow Banks - Non bank financial institutions that compete with big four - Merchant Banks; provide financing services to wholesale customers (businesses, particularly in areas of corporate finance e.g. if businesses borrow money for corporate financing) their role has largely been taken over by banks. E.g. JP Morgan - Finance Companies; mainly provide lease financing for motor vehicles and business equipment - Mortgage Originators; are lenders who fund loans from the proceeds of mortgage-backed their activities were curtailed by GFC. 3. Fund Managers - Fnud managers provide investment management services for their clients in return for fees - Super funds are long-term investment schemes for the purpose of generating income in retirement - Public unit trusts are voluntary investment vehicles that sell ‘units’ in their trust and then invest their funds. - Insurance companies manage funds as [art of their operations and some of their policies have an investment purpose. Australia’s Financial Markets Following 3 markets arrange direct financing Money Market; Trades short term debt securities that pay a single amount at maturity and are known as ’discount securities’. - E.g. certificates of deposit, treasury bills, commercial paper, repurchase agreements - Low risk, low return, amongst the most liquid assets available - Important for overall finance system for business and governments - Plays key role in management of monetary policy by RBA and RBA uses various tools in money market to influence interest rate and availability of credit rate in the economy. (RBA moves up or down its interest rates and does so in ST money market which impacts on broader economy)  Bond Market; Trade long term debt securities that make regular interest payments and then repay their face value - Where companies and governments get money form - Issue and trade debt securities in form of bonds Share Market; Arrange trading in shares, which are perpetual equity securities that commonly pay dividends Foreign Exchange Market (FX); Enables transactions to be made in different currencies because it arranges trading in foreign currencies Derivative Contracts; (Such as futures and options) trade contracts that can be used to manage forms of financial risk and for speculation. The Financial Regulators APRA; Australian Prudential Regulation Authority - Prudential regulator of ADIs, insurance companies and superannuation fund trustees. - Seek to ensure an institutions is able to meet it’s obligations to it’s customers - Sets the rules RBA; Reserve Bank of Australia - Australia’s central bank (gov does not have influence on RBA) and has 6 main functions 1 Implementing monetary policy; RBA influences ST interest rates to contribute to it’s stability objective for inflation, unemployment and economic wellbeing 2 Issuing bank notes and coins 3 Acting as banker to the Commonwealth Government 4 Monitoring stability of the financial system; RBA work with other regulators and global agencies to avoid financial crisis, and monitors data to help identify threats to stability. 5 Regulating the payment system; through its Payments System Board, RBA is responsible for ensuring the payments system is safe and efficient. 6 Managing Australia’s reserves of foreign exchange ASIC; Australian Securities and Investments Commission - Enforces company and financial service laws to protect customers, investors and creditors (ASIC regulates conduct) - Enforcer of the rules - Investigators of fraud These bodies together with The Treasury (representing the government) form the Council of Financial Regulators The Treasury is where the government uses the treasury to buy and sell its money market and bond market instruments. - Not a regulator but as the government’s main economic department, it influences the framework for regulation Fundamental Concepts Forms of Finance; - Funds can be supplied as debt or equity form surplus to deficit. Companies usually deficit - Debt; - Borrowed funds = Credit - Commits borrower to make agreed interest and loan repayments - Provided indirectly by financial institutions and directly in security markets - Failure to repay loan = liquidation - Bank would be creditor to company - Amortising = principal and interest. - Equity - Eqiupty capital = funds invested in firm by owners - Raise equity through ordinary shares - source of permanent capital as funds are not repayable - Owners of ordinary shares can vote on board of directors and can receive dividends - Perpetuity, never expires Leverage - Use of debt by a firm is a form of leverage. Amount of leverage indicated by debt to equity ratio - Higher DtoE = greater leverage - Leverage can increase return on equity as debt is cheaper than equity - Leverage increases risk as increased debt - increase likelihood of insolvency (ability to pay debts when they fall due) & variability of returns. Company can stop paying dividends to prevent inso - Impact on investor risk and return: - increase risk and return to owners because of their cost represented by the interest payments - Leverage will make returns in good times better and returns in bad worse (increased variability) ROEprofit Minimal profit = average ROE, Good profit = Increased ROE, Break Even = Bad ROE We  Return - Returns earned from supplying funds; - Periodic, int, cash payments (bank deposits, loans, bonds, money market instruments) - Periodic PMT of dividends - Change in value of financial assets (Cap gains and losses) - Returns usually expressed as yields - annual rate of growth r( 1) - r : I/ 3. 5% Liquidity - Efficiency or ease with which an asset or security can be converted into ready cash without affecting its market price. - Indirect Financing; Bank deposit accounts offer suppliers of funds liquidity, but often little or no interest - Direct Financing; Provides liquidity when secondary markets enable the transaction of securities. - Why is liquidity valued? What happens to returns? - Indicates fair market value access suppliers of funds have to their money. Indicates the level of access lenders have to their money once it is invested. - Bank deposit accounts - Suppliers of funds place high value on liquidity and are willing to accept little to no interest as the cost of that liquidity. - Investments that lack liquidity - less attractive and riskier. Investors require higher compensation in form of increased expected returns in order to consider supplying funds. - Liquidity in shares shows by bid and offer range buyers want $44.45 and offers want $44.480. Someone is willing to bid for $44.45. This is called the spread and in this case, the spread is narrow by 3c. Shows this is high liquidity. Smaller spread encourages trades of securities and this promotes liquidation. Risk - Investment returns are exposed to risk - possibility that actual returns will be less than expected. - Suppliers of funds are risk-averse and so require higher returns to be induced into accepting risk - r = r(risk free) + r(risk premium) - 10 year treasuries are 10 year treasury bonds - Credit spread is difference in yields between Triple A bonds and US treasury bonds. This shows relative to 10 year treasury bonds, Triple AAA corporates are fairly narrow. - Trimble B rated debt, credit worthiness declines, risk premium increases. Credit spread would be higher. Credit spread gives idea of risk premium for different rated securities and is used as a measure of returns required on different securities. - How can risk and risk premiums be measured? Market values may indicate relative riskiness, risk assessments by rating agencies, credit spreads meaning the margin between the market yield for risky bonds and those of safe bonds. Time Value of Money - PK-PMT() PAT = 200000 (0. 0 +. 015 & 16 N : (1) 015) + 2000 o # = 500 Learning From History Stability and Financial Regulation - 1st half 20th century - financial regulations introduced to reduce crises - 1980s - Deregulation (loosening of regulations) to increase efficiency of financial services - lowered cost, improve convenience - Global Financial Crisis triggered reevaluation of need for regulations Mortgage-Backed Securities (MBS) - MBS are financial instruments created by pooling together large numbers of individual mortgage loans into single security - Then sold to investors, who receive portion of cash flows generated by underlying mortgages - Value of MBS is derived from value of underlying loans, and is directly tied to performance of underlying mortgages. Global Financial Crises (GFC) - GFC arose from subprime loan crisis in US 2007 - Banks pooled and assigned MBS but underestimated risk - Loans are subprime when they are made to borrowers with questionable repayment capacity like no loan deposit, falsified applications, low/irregular income, poor credit history. - They were assisted by rating agencies that inflated their ratings of MBS in order to increase their own fee income. - Assumptions: Defaulting loans would not produce losses because they were secured mortgages & property prices never decrease. - Subprime financed building boom and sales of reposed properties caused fall in property prices. - US Gov took measures to bail out their financial institutions to protect economy. - Crisis became global because of sharp contraction in flow of funds internationally. Example of asymmetric info - Mortgage brokers don’t explain loans and fact that repayments would increase substantiality to loan applicants. - Wall Street banks continued to market securities at low risk even after default rates rose in order to get them off their records - MBS/ Collateralised Debt Obligation (CDO) investors were unaware that underlying mortgages were high risk/subprime, they thought they were low risk. Example of Incentive Problems - Mortgage brokers fail to assess and verify borrowers repayment capacity. Big bonuses offered on adjustable loans - Wall Street banks willingness to buy any loans regardless of risk because of the intention of reselling them - Rating agencies “selling ratings for fees”, applying MBS ratings the banks want knowing that they would lose business otherwise - Investment advisors were meant to represent investors but were paid by someone to sell their securities. The Royal Commission - Royal Commission into misconduct in the banking, superannuation and financial services industry was established in Dec 2017 to investigate malpractice in Aus financial institutions. - Revealed a culture that fails to deal with moral hazard and information asymmetry and that has eroded public’s trust Tutorial Bigger companies can go direct to financial markets because the buyers of these bonds, will be well received by the market. Can measure trustworthiness through risk. But Apple have lower risk which means less chance a bond will default. Greater confidence that these coupon payments will be repaid Need to know measure of credit rating to guarantee security of investment repayments. Strong credit rating companies can go directly to the financial markets. Can forgo intermediaries as they can get strong pricing in financial markets. As credit rating decreases, need to go to ADIs or NBFI to raise capital. Credit Spread; Related to bonds market and risk associated with bonds. Yield = return - The spread is the gap is the difference of comparison of percentages or basis points between the different yield of economic bond markets. - The greater the spread of yield, the greater the risk. The faster the spread widens, the faster the momentum is of risk. - The yield can be shifted up as investors their bonds if the rate is becoming too high. As more are sold, the rate increases. The yield is shifted down when more people buy bonds in a specific economic market. Basis point is 0.01 percent, 100 basis points = 1%