FINANCIAL INSTITUTIONS, INSTRUMENTS AND MARKETS

The eighth edition of Financial Institutions, Instruments and Markets sees wellregarded authors Christopher Viney and Peter Phillips team up once again to deliver the latest information in financial institutions management.

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2016/3/10 IEB Wireframe

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Many educational institutions today are focused on the notion of assurance of learning, an important element of some

accreditation standards This eighth edition of Financial Institutions, Instruments and Markets is specifically created

to support assurance of learning initiatives designed to draw on and expand key knowledge and skill sets required by

graduates such as: communication, initiative and enterprise, self-management, life-long learning, problem

Chapter learning objectives and pedagogical features throughout the text are developed to directly relate to the

learning outcomes for your course which may assist instructors in making the collection and presentation of assurance oflearning data easier

AACSB STATEMENT

McGraw-Hill Education is a proud corporate member of AACSB International Understanding the importance and value of

AACSB accreditation, Financial Institutions, Instruments and Markets 8e has sought to recognise the curriculum

guidelines detailed in the AACSB standards for business accreditation A variety of pedagogical features in chapters aredesigned to draw on the general knowledge and skill guidelines found in the AACSB standards: communication abilities,use of information technology, ethical understanding, reflective thinking, critical analysis and diversity

The AACSB leaves content coverage and assessment within the purview of individual schools, the mission of the school and

the faculty While Financial Institutions, Instruments and Markets 8e and the teaching package make no claim of specific

AACSB qualification or evaluation, we have geared pedagogical features and online assessment tools towards some of thegeneral knowledge and skills areas

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editor at the address below

National Library of Australia Cataloguing-in-Publication Data

markets / Christopher Viney, Peter Phillips

institutions—Australia—Problems, exercises,etc Financial instruments—Australia

Financial instruments—Australia—Problems,exercises, etc Money market—Australia Moneymarket—Australia—Problems, exercises, etc

Other

Authors/Contributors:

Phillips, Peter John, author

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This book has achieved remarkable acceptance by academics and their students in a significant number of tertiary

institutions throughout Australia, New Zealand and Asia, and by professionals within the financial services industry Inthis eighth edition, Dr Peter Phillips and myself continue to present a finance text for you that is authoritative andscholarly, which at the same time highlights the dynamic, exciting and global nature of financial institutions,

instruments and markets

The recent global financial crisis gradually became apparent from mid-2007 and had a significant adverse effect on thefinancial markets from 2008 As the crisis then rapidly evolved it led to an extended period of continuing financial

market uncertainty and extreme volatility Major global financial institutions had to be bailed out by government or

failed, sovereign debt in a number of countries reached unprecedented levels, economic activity slowed significantly andunemployment rose to very high levels, particularly in the USA and a number of European countries The nature and

contagion effects of this evolving global financial crisis are discussed in detail in various chapters of the book

Within this context, it is important that the eighth edition should encourage new generations of students and industrypractitioners to understand, anticipate and challenge the complex and rapidly evolving structure of the financial

system

As argued by Nobel Laureate and leading economist Professor Joseph Stiglitz, effective financial market regulation

within the context of the integrated global financial markets is required to mitigate future financial crises

Interestingly, the government initiated a review of the Australian financial system in 1997 (the Wallis Report) In

part, structural and regulatory change that was implemented as a result of that report ensured the Australian financialsystem came through the global financial crisis relatively unscathed The government has currently commissioned a new

review of the system (the Murray Report) The final report is due at the end of 2014 and hopefully the government and

regulators will act upon its recommendations of the report to ensure the financial system is made even more efficient

and robust

One thing is certain, change will occur As students of the financial system you must keep yourself informed about thestructure and operation of financial institutions, instruments and markets Importantly, you must think about and

anticipate future directions and change When, as a young boy of sixteen I began working in the industry, it was the

time of pounds, shillings and pence I was required to record all transactions using a nib pen dipped in ink Daily,

weekly, monthly and annual statements were added in my head It was an exciting day when we received a mechanical adding

handle to input each entry into the machine There has been unbelievable change to the insulated environment of those

days In particular, there has been significant deregulation of the financial markets, the development of electronic

information and product delivery systems, new and sophisticated financial products, the integration of domestic

financial systems into a global financial system and, from time to time, major financial and economic crises

To remain relevant in business and finance you must continue to educate yourself and those for whom you may be

responsible in the future You must read the daily press and periodic financial journals to keep yourself up to date Isuggest you add notations of current and proposed future changes to the financial system to your personal copy of thisbook This is not a text that you will sell at the end of a particular unit of study, but rather is an important

reference that you should continue to use for further studies and on into your professional career

I have enjoyed my career working in and teaching about the financial system I encourage you to accept every opportunitythat comes your way and I wish you the best of success

CH R I S T O P H E R VI N E Y

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CH R I S T O P H E R VI N E Y brings to this book a wealth of industry experience and academic knowledge associated with the

international financial markets His appreciation of the nature of both the theoretic and the applied functions and

operations of the global financial system is reflected in the clear and interesting presentation of issues in such a waythat the reader is motivated to learn

Prior to moving into academia Chris spent twenty-seven years in the commercial banking industry including retail

banking, corporate lending, risk management, personnel, property, policy and administration His academic career

included appointments at Monash University and Deakin University, Melbourne, Australia He has taught in the areas of

financial markets, financial institutions management, corporate finance, treasury management and personal financial

planning Chris has also taught in Singapore, Malaysia, Thailand, Indonesia and New Zealand He has received universityawards for contributions to the internationalisation of teaching and learning programs As the director of the financeinternational study programs at Monash and Deakin Universities, Chris has taken select groups of students overseas as

part of their tertiary studies He has also published research papers on the capital markets, operational risk

management, bureau de change, money laundering and education and training

Following the passing of Michael McGrath with the first edition of the text, Chris has guided the evolution of future

editions of the book and it has now become a principal learning and reference source for undergraduate students,

postgraduate students and industry practitioners alike As the text book continues to evolve, a co-author, Peter

Phillips, has joined Chris in writing the seventh and eighth editions

PE T E R PH I L L I P S has been teaching economics and finance at the University of Southern Queensland (USQ) in Toowoomba,

Australia since 1998 Presently, he is an Associate Professor in Finance at USQ He has taught in the areas of financialmarkets and institutions, portfolio management and corporate finance as well as several economics courses, including

macroeconomics and econometrics Peter completed a PhD at USQ in financial economics in 2003 Since then he has

published a number of papers on the topic of Self Managed Superannuation Funds (SMSFs) in which he and his co-authors

explore various aspects of the portfolios chosen by SMSF investors He has recently completed work on a book that

explores SMSFs in more detail

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CH A P T E R 1 A modern financial system: An overview

highlights various aspects of the global financial crisis with a special focus on the importance of regulationfor ensuring financial markets stability

introduces the financial institutions, financial instruments and financial markets that comprise domestic andglobal financial systems and explains why a stable financial system is important for economic growth

provides a concise context that assists the reader to understand the relationships of the material in thefollowing chapters

extended learning—globalisation of the financial markets and the drivers of change in the financial systemextended learning—the impact of the Asian financial crisis on the financial system

CH A P T E R 3 Non-bank financial institutions

an examination of investment banks, managed funds, superannuation funds, cash management trusts, public unittrusts, life and general insurance offices, hedge funds, finance companies, building societies, credit unionsand export finance corporations

extended learning—project finance and structured finance

CH A P T E R 4 The share market and the corporation

considers the management structure of a publicly listed corporationdiscusses the important roles of a stock exchange in facilitating the listing of a corporation's shares on theexchange (primary market role) and the ongoing trading of existing shares (secondary market role) on the sharemarket

examines the managed products and derivative products offered by a stock exchange, including exchange tradedfunds, contracts for difference, real estate investment trusts, infrastructure funds, options, warrants andfutures contracts

examines the interest rate market role, the trading and settlements roles, the information role and theregulatory roles of a stock exchange

CH A P T E R 5 Corporations issuing equity in the share market

introduces the capital budgeting investment decision process; funding issues related to debt and equity;

initial public offerings, stock exchange listing rules and alternative forms of equity issuesextended learning—Australian Securities Exchange (ASX) listing requirements

CH A P T E R 6 Investors in the share market

considers the role of the investor in the share market; risks associated with buying and selling sharesdiscusses taxation; financial performance indicators and the pricing of shares

introduces share market indices and the interpretation of share market information

CH A P T E R 7 Forecasting share price movements

examines fundamental analysis and technical analysis approaches to share price forecasting

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considers the nature and impact of electronic trading on the marketsintroduces the random walk hypothesis and the efficient markets hypothesis (EMH) within the context offorecasting share price movements

introduces behavioural finance as an alternative theoretical framework to the EMH for understanding shareprice movements

CH A P T E R 8 Mathematics of finance: an introduction to basic concepts and calculations

introduces the principles of mathematical calculations that underpin financial market instruments, includingsimple interest, compound interest, present value, future value, yield, annuities and effective rates ofinterest

CH A P T E R 10 Medium- to long-term debt

identifies the main types of longer-term debt available to a corporation, including term loans, fully drawnadvances, mortgage finance, debentures, unsecured notes, subordinated debt and leasing

calculation of prices and yields on fixed interest securitiesextended learning—securitisation

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CH A P T E R 11 International debt markets

explores the structure of the international debt markets, in particular the euromarkets (eurocurrency,euronote and eurobond markets) and the US money and capital markets

examines the main generic products offered in the international debt marketsconsiders the important role of credit rating agencies in the international debt marketsextended learning—novation, subparticipation and transferable loan certificates

extended learning—convertible bonds and warrantsextended learning—US medium-term notes

extended learning—Standard & Poor's credit rating definitions

CH A P T E R 12 Government debt, monetary policy and the payments system

examines why governments issue short-term and longer-term debt securities, the types of securities and thepricing of those securities It also considers the purpose and implementation of monetary policy; theoperation of the payments system, exchange settlement accounts, real-time gross settlement and repurchaseagreements

extended learning—fixed-coupon Treasury bonds: price calculation using the Australian Office of FinancialManagement (AOFM) formula

CH A P T E R 13 An introduction to interest rate determination and forecasting

examines the macroeconomic context and the loanable funds approach to interest rate determination and theimpact of changes in related variables

considers the term structure and risk structure of interest rates within the context of the expectationstheory, the segmented markets theory and the liquidity premium theory

extended learning—the yield curve and expectations theory calculations

CH A P T E R 14 Interest rate risk measurement

identifies methods used to measure interest rate risk and introduces an exposure management systemexamines interest rate risk measurement models, including re-pricing gap analysis, duration and convexityconsiders internal and external interest rate risk management techniques

CH A P T E R 15 Foreign exchange: the structure and operation of the FX market

examines the structure, participants, operation and conventions in the global FX markets

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discusses and calculates spot and forward FX quotationsconsiders the impact of the Economic and Monetary Union of the European Union (EMU)

CH A P T E R 16 Foreign exchange: factors that influence the exchange rate

introduces different exchange rate regimes used by various nation-states

in the context of a floating exchange rate, considers factors that affect the determination of an equilibriumexchange rate, including relative inflation rates, national income growth rates, interest rates, expectationsand central bank intervention

considers the application of regression analysis in the measurement of exchange rate sensitivityextended learning—purchasing power parity

CH A P T E R 17 Foreign exchange: risk identification and management

recognises FX risk and presents an organisational FX risk policy structurediscusses the measurement of transaction FX exposures

examines internal and external market-based hedging techniques using derivative products

CH A P T E R 18 An introduction to risk management and derivatives

introduces the fundamentals of understanding risk and risk managementprovides a concise introduction to generic derivative products and markets, in particular futures, forwards,option and swap contracts

CH A P T E R 19 Futures contracts and forward rate agreements

examines the purpose, structure and operation of a futures market, including structuring and calculating riskmanagement strategies

considers forward rate agreement contracts and the use of an FRA to manage interest rate risk exposures

CH A P T E R 20 Options

examines the purpose, structure and operation of options marketsintroduces option contract strategies that may be applied in a wide range of risk exposure scenarios

CH A P T E R 21 Interest rate swaps, cross-currency swaps and credit default swaps

examines the purpose of interest rate swaps (including facilitating speculation) and considers theconstruction of a swap to manage an interest rate risk exposure

in the context of international markets, considers the construction of a currency swap to manage both aninterest rate exposure and an FX risk exposure

introduces the credit default swap and discusses the structure of, and parties to, a CDS

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PART INTRODUCTIONS Introducing each of the six parts is a short overview of the material covered in the following

chapters These openers are a helpful introduction to how the key concepts, institutions or instruments work together

and how they fit within the larger picture

CHAPTER OPENERS Each chapter begins with a short overview of the information contained in the chapter, providing notonly an introduction to the chapter, but also a useful study reference

LEARNING OBJECTIVES These numbered points clearly outline what each reader should know and be able to do by the end ofthe chapter They will also assist in exam revision Each learning objective notes the numbered section in which the

learning objective appears in the chapter They are directly linked to the end-of-chapter summary, which systematicallyworks through each learning objective

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KEY TERMS, MARGIN DEFINITIONS AND THE KEY TERMS LIST Each key term or concept is highlighted in the text at itsfirst appearance, and the definition provided in the corresponding margin A boxed list of these key terms appears at

the end of each chapter and each entry is followed by the page on which it first appeared (thus linking to the margin

definition) as well as providing the context for the definition A full list with definitions appears in the glossary

FINANCIAL NEWS CASE STUDY Found at the end of every chapter, each financial news case study contains excerpts fromfinancial articles that provide real-world examples of concepts discussed within the chapter They are followed by

related discussion questions providing the opportunity for self-assessment and putting into practice what you've

learned!

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REFLECTION POINTS Located after every major section within each chapter, the reflection points highlight the most

significant material covered as well as providing regular summaries and a useful tool for revision, which will help

students identify areas requiring further study

CHAPTER SUMMARIES The chapter summaries comprehensively review the topics covered in each chapter and are linked

directly to the learning objectives, listing each learning objective and a summary of the relevant material

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EXTENDED LEARNING The extended learning sections provide an additional resource for self-assessment and a variety ofactivities designed to address the more complex aspects of the chapter These sections are accompanied by extended

learning questions which test students' understanding of the material

END OF CHAPTER QUESTIONS Each chapter contains a number of different question types useful to test student recall andunderstanding of the material covered in the chapter The True or false questions test your recall and the answers arehelpfully contained at the end of the book, an excellent tool for exam revision These true or false questions can also

be used as short answer questions to test students' ability to provide more information

The Essay questions provide the opportunity to put the concepts that have been learnt into practice, highlighting

students' ability to analyse and evaluate the material

The Extended learning questions relate to the in-depth extended learning sections and require students to demonstrate adeeper understanding of the concepts and theories presented in the chapter

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EXPLORING FINANCE ON THE WEB This updated resource provides a comprehensive list of useful finance websites includingcentral banks, financial institutions, government sites, exchanges and markets It also provides online learning toolssuch as financial newspapers and magazines, currency converters, background reading and suggested databases

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CAREERS IN FINANCE Introduces students to the enormous career opportunities that exist in both local and internationaleconomics A list of web addresses of select employers of finance graduates is a source of organisation-specific careerinformation A useful guide to preparing on-line application is also presented

GLOSSARY This useful list of definitions contains all of the key terms and concepts as they appear in the margin notes.FINANCIAL ABBREVIATIONS This comprehensive list covers all the major financial abbreviations used both in the text

and in the financial world, providing a quick, easy-to-use reference point It is helpfully located on the inside frontcover to make looking up terms easy!

WORLD CURRENCIES Located on the inside back cover for ease of reference, this handy, updated table lists the

currencies of all the world's major countries, as well as their common abbreviations

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McGraw-Hill Connect is a digital teaching and learning environment that improves performance over a variety

of critical outcomes; it is easy to use and proven to be effective

score on each attempt, the date you started and submitted the assignment, and the date the assignment was scored

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The following websites have been selected as useful and interesting sources of information relevant to financial

institutions, instruments and markets As you continue your search of the internet you will find many more sites; this

is just the beginning! See your library's subject page on finance/economics/business where there will be listings of

search terms for the library catalogue and for databases, lists of subject-specific dictionaries and resources available

to use/borrow, often with their call numbers and the general call numbers to look for your subject These pages may alsolist significant journals in your field as well as databases and newspapers

BACKGROUND READING

Both Yahoo! and Google provide good entry points for the latest news, facts and figures as well as providing a gateway

FINANCE GLOSSARIES

This text includes a glossary of the main financial market words referred to in the book As you extend your

links It is the biggest financial glossary on the web

DATABASES

This is a list of some of the suggested databases your library may have access to that contain finance articles and

information If your institution does not have access to all the databases you may be able to get access through anotherinstitution, so check with your library about borrowing rights at other universities

Proquest: Academic research library Covers finance, has full text articles

Connect4: Annual report collections Business provides full text annual reports from various Australian companies

including some company financial statements

APA Full Text (Australian Public Affairs full text) Lists a large range of Australian periodicals with some access to

full text

Proquest: Banking Information Sources International database, full text article access Covers banking and industry andthe financial services industry

Expanded Academic ASAP Full text articles available, international

Factiva Full text available, covers most Fairfax publications including Business Review Weekly, The Australian Financial

Review and The Age.

Science Direct Full text, international Includes access to journals such as Journal of Financial Markets, Journal of

International Money and Finance and Journal of Banking and Finance.

You can find these databases by selecting your subject (finance, business, economics) and searching the library subjectpages for relevant journal listings Alternatively, look them up in alphabetical order through the online library

catalogue to check for access You may need a password when accessing them off campus

Although not all of these may be available from your library (either in hard copy or through online access with a

password) it is worth investigating the possibilities of interlibrary loans Ask your subject librarian for informationabout accessing the catalogues of other libraries

Wall Street Journal

http://online.wsj.com/public/asia

The Wall Street Journal has great information available online without subscription.

MSN Money

www.money.msn.com

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A useful site that has good coverage of financial events in the ‘news’ section including video clips

The Financial Times

www.ft.com/home/uk

Online access to full text articles from either the UK, US or Asian editions of the paper

Fortune Magazine

http://www.fortune.com

Fortune Magazine home, access to full text articles.

AUSTRALIAN AND INTERNATIONAL INSTITUTIONS AND AUTHORITIES

central banks

EMEAP members

other international organisations

Australian government departments and authorities

Australian legislation

Australian financial sector organisations

AUSTRALIAN MAJOR BANKS

SELECT INTERNATIONAL FINANCIAL INSTITUTIONS

CREDIT RATING AGENCIES

INFORMATION PROVIDERS

EXCHANGES AND MARKETS

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CLEARING, SETTLEMENTS AND CUSTODIAN SERVICES

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have saved him from many of the financial pitfalls he experienced over the years Within the context of careers in

finance, this true story highlights that a career in finance can be established in any country, economic sector,

industry sector, business or government

The range of career opportunities is enormous For example, commercial banking provides an enormous range of options

including retail finance, corporate lending, international banking, treasury and information technology, to name but afew Investment banking also offers specialist finance opportunities including mergers and acquisitions, project

finance, securitisation, underwriting and venture capital Funds management or personal financial planning are also

other career opportunities Small, medium and large businesses all require people skilled in finance to manage their

assets, liabilities and cash flows Government departments and authorities also require finance graduates to assist withthe financing of capital or recurrent expenditures Stock-broking is yet another career opportunity

Finance is a global market and therefore there are possibilities for working in a range of developing and advanced

financial markets In particular, you may wish to work in London or New York While visiting many of the global

financial markets, I have encountered many people from different countries who have made the transition from their localmarket to the international financial markets

During your studies you may find certain areas of finance that particularly excite and interest you Research the types

of organisations that provide career opportunities in your areas of interest; understand the structure and culture of

the organisations and carefully consider the organisation's guidelines for graduate employment Most large employers

include a link to this information on their website Some examples include:

Tips for online applications

Before you start

Allow yourself plenty of time as each application can take between two and four hours at a minimum! Read the

application instructions carefully, to determine whether you:

have the appropriate/minimum software and hardware to undertake this processhave the option of downloading a copy of the application form to assist you in preparing all relevantinformation and in filling out the form

have to fill out the form in one sitting, or whether you have the option of saving, exiting out and returning

to the form when you are readyPage xxv

know what information you will be required to include in the application form (course/unit details, resultsetc.) so you can have this handy when you are completing the forms

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know whether additional information (cover letters, etc.) can be attached if desired

Obtain a copy of your academic transcript

Collect all the information you require, for example course/unit details Also have electronic access to your

résumé to cut and paste into the application form

If you need to use computer labs or library computers, book ahead of time

Working on the application

Print out the application form to use as a draft Complete responses offline and cut and paste into the

application

Remember to fill out all the fields

Save regularly as you progress through the application form if possible

Proofread your applications—not all online application forms have spell checks

Leave plenty of time to submit the applications electronically Typically, employer websites experience a huge rushtowards the application deadlines You may experience delays or be unable to submit due to technical problems if

sites are overloaded

Make sure your email address and mobile phone numbers are correct! All too often students record these inaccurately

—it is vital that you are contactable, particularly if employers wish to schedule you for testing/interviews Ifthey can't reach you, they won't bother trying again, given the numbers of applications they will be processing

If you don't receive acknowledgment, or you are unsure whether your application has been received, contact the

relevant recruitment coordinator to confirm receipt of your application

If you are having any problems with the technology or have questions regarding the form, contact the graduate

recruiter in that organisation as soon as possible

Print out a copy of the application for your records (and make a note of any contact you have with the

organisation)—it will help if and when you are invited to an interview

In addition to proofreading, reread your application before you hit the ‘send’ button Does it present you in thebest possible way? You will not get another chance to revise it!

Distinguish yourself from other applicants

Employers advise that the best way to make your application stand out are the simple things:

Fill out all the fields

Proper business language should be used as you would for a paper-based application Just because it is an online

form doesn't mean that you should use more informal or text language, or insert symbols, for example smiley faces.Check your spelling, or get others to check it for you—spell checks don't pick up everything

Answers to in-depth questions should be carefully thought out and tailored to each employer, not a generic paste answer Use proper paragraphs, not just a list of dot points

cut-and-These tips may seem obvious, but you'd be amazed at the number of applications which are not successful because they

haven't followed this advice!

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Front Matter

PART 1.FINANCIAL INSTITUTIONS

Chapter 1.A modern financial system: an overview

Chapter 2.Commercial banks

Chapter 3.Non-bank financial institutions

PART 2.EQUITY MARKETS

Chapter 4.The share market and the corporation

Chapter 5.Corporations issuing equity in the share market

Chapter 6.Investors in the share market

Chapter 7.Forecasting share price movements

PART 3.THE CORPORATE DEBT MARKET

Chapter 8.Mathematics of finance: an introduction to basic concepts and

calculations

Chapter 9.Short-term debt

Chapter 10.Medium- to long-term debt

Chapter 11.International debt markets

PART 4.GOVERNMENT DEBT, MONETARY POLICY, THE PAYMENTS SYSTEM AND INTEREST RATES

Chapter 12.Government debt, monetary policy and the payments system Chapter 13.An introduction to interest rate determination and forecasting Chapter 14.Interest rate risk measurement

PART 5.THE FOREIGN EXCHANGE MARKET

Chapter 15.Foreign exchange: the structure and operation of the FX market Chapter 16.Foreign exchange: factors that influence the exchange rate

Chapter 17.Foreign exchange: risk identification and management

PART 6.DERIVATIVE MARKETS AND RISK MANAGEMENT

Chapter 18.An introduction to risk management and derivatives

Chapter 19.Futures contracts and forward rate agreements

Chapter 20.Options

Chapter 21.Interest rate swaps, cross-currency swaps and credit default swaps End Matter

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Page 1

Financial institutions

Chapter 1 A modern financial system: an overview

Chapter 2 Commercial banks

Chapter 3 Non-bank financial institutions

Page 2

Part 1

FINANCIAL INSTITUTIONS

Career opportunities in finance are enormous and they are available to you if you dedicate yourself to learning and

understanding how the financial institutions, instruments and markets work You should be excited that one day you may,for example, work in a commercial bank in Hong Kong or Sydney, or an investment bank in London or New York, or a

multilateral government organisation in Paris or Washington, or a multinational corporation anywhere in the world

Further, it does not matter where you live or study; financial institutions, instruments and markets are essentially thesame in all developed countries What you learn from this textbook will be relevant in the world of finance no matter

where your travels take you

This textbook discusses the structure, functions and operations of a modern financial system; that is, you are going tolearn about financial institutions, financial instruments and financial markets Each nation-state is responsible for

the structure and operation of its own financial system; however, they form an integrated global financial system

Although institutions, instruments and markets are fundamentally alike, they may be differentiated by size, terminology,the level of government regulation and prudential supervision For example, in the UK the main type of financial

instrument issued on the stock exchange is called an ordinary share, whereas the same instrument issued in the USA is

known as common stock

Internationalisation of the financial markets has, in part, occurred because of the development of sophisticated

technology-based information systems and product delivery systems This has allowed new products and markets to evolve,and an enormous increase in the volume and speed of the flow of funds through the international financial markets As

will be seen, the combination of globalisation, deregulation, technology and competition has encouraged enormous

innovation and change within financial institutions, instruments and markets

Much of what you will learn from this text is international in nature, but it will be necessary at times to focus on thefinancial system of a particular nation-state It is not possible to look at the variations that occur in the financialsystems of all nation-states Therefore, when necessary, reference will be made to the Australian financial system as ithas a modern, efficient and stable financial system that operates effectively within the global financial system

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Think of a financial system as being a number of financial institutions and markets through which funds move between

lenders and borrowers The institutions and markets that facilitate this flow of funds develop the financial instrumentsand techniques that encourage savings and investment The financial system also provides the framework through which

central banks and prudential regulators influence the operations of participants in the financial system Most

importantly, a central bank, through its monetary policy initiatives, affects the level of interest rates, economic

activity and business performance

A financial system is essential in facilitating economic growth and future productive capacity in a country The

provision of finance to business allows economic growth to occur, which should lead to increased productivity, increasedemployment and a higher standard of living A modern, sound and efficient financial system encourages the accumulation

of savings that are then available for investment in productive capital within an economy

Chapter 1 presents an overview of a modern financial system and provides a context for the more detailed studies that

occur throughout the textbook It introduces the main categories of financial institutions, discusses the functions offinancial markets and provides an overview of the types of instruments that are created within the markets At the end

of Chapter 1, two extended learning sections are provided: ‘Globalisation of the financial markets’ and ‘The impact

of the Asian financial crisis on the financial system’

Chapter 2 provides a detailed analysis of the roles and functions of the commercial banks Commercial banks are the

largest financial institutions providing savings, lending and a wide range of other financial services for their

customers The assets, liabilities and off-balance-sheet business of commercial banks are analysed in detail At the end

of the chapter three extended learning sections are provided: ‘The standardised approach to credit risk’, ‘Businesscontinuity risk management’, and ‘Corporate governance and ethics’

Chapter 3 extends the discussion of financial institutions further and looks at the operations and significance of othertypes of financial institutions In particular the chapter considers investment banks, managed funds, superannuation

funds, cash management trusts, public unit trusts, life insurance offices, general insurance offices, hedge funds,

finance companies, general financiers, building societies, credit unions and export finance corporations At the end of

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the chapter an extended learning section is provided: ‘Project finance and structured finance’

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1.1 Financial crises and the real economy

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

Learning objectives

1 LO 1.1 Understand the effects and consequences of a financial crisis on a financial system and a real economy

2 LO 1.2 Explain the functions of a modern financial system and categorise the main types of financial institutions,including depository financial institutions, investment banks, contractual savings institutions, finance companiesand unit trusts

3 LO 1.3 Define the main classes of financial instruments that are issued into the financial system, that is, equity,debt, hybrids and derivatives

4 LO 1.4 Discuss the nature of the flow of funds between savers and borrowers, including primary markets, secondarymarkets, direct finance and intermediated finance

5 LO 1.5 Distinguish between various financial market structures, including wholesale markets and retail markets, andmoney markets and capital markets

6 LO 1.6 Analyse the flow of funds through the financial system and the economy and briefly discuss the importance of

‘stability’ in relation to the flow of funds

Extended learning

1 LO 1.7 Appreciate the importance of globalisation of the international financial markets

2 LO 1.8 Appreciate the effects, consequences and relevance of the Asian financial crisis

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Introduction

The real economy where goods and services are exchanged is connected to the financial markets where financial securitiesare exchanged Each affects the other The development of financial markets has made the exchange of value for goods andservices much easier The introduction of money into the exchange process increases the speed and efficiency with whichtransactions take place The use of monetary value also makes it easier to save surplus funds In order to attract thesesurplus funds for use in capital projects or consumption spending, businesses and governments issue financial securitiessuch as shares and bonds that entitle investors to a share of business profits or periodic interest payments These

securities change hands on the financial markets at prices that reflect the prevailing business conditions, risk and

uncertainty and expectations of future returns

Ups and downs are to be expected in the normal course of the business cycle However, financial markets are sometimes

characterised by high levels of volatility These periodic bursts of volatility send market participants running for

cover as the capital values of investments suddenly appear to have been overestimated The ensuing liquidation and

crisis is the market's remedial action to correct the miscalculations of the preceding economic boom In the modern

financial system, this liquidation can take place at terrifying speed Although the particular circumstances of each

crisis are unique, we can be sure that at the depths of a crisis there will be calls for a review of the ways in whichthe financial system is regulated We start our study of the financial system with a discussion of the ways in which

financial markets and the real economy interact during periods of financial crisis

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1.1Financial crises and the real economy

LEARNING OBJECTIVE 1.1Understand the effects and consequences of a financial crisis on a financial system and a real economy

The most recent crisis was the global financial crisis (GFC) The GFC has been described as the most significant

economic crisis since the Great Depression in the 1930s In 2007, realisation that house prices in America had begun tofall and mortgage defaults were increasing, particularly in sub-prime mortgages which had been issued to low-incomeindividuals who were sometimes without a documented ability to meet the monthly repayments, initiated a liquidation oftrading positions in the mortgage markets which quickly evolved into a banking crisis Uncertainty about the value of

assets posted as collateral and the solvency of counterparties significantly disrupted the financing arrangements uponwhich financial institutions relied to fund their activities Uncertainty about the solvency of financial institutionsflowed through the financial system Unable to fund their activities through the usual channels, some financial

institutions were forced to seek equity capital injections from investors or obtain emergency funding from central

banks Some were bailed out by their sovereign government Others were forced to sell themselves to stronger financialinstitutions Many others were forced to file for bankruptcy

GLOBAL FINANCIAL CRISIS (GFC) the global financial crisis (GFC) refers to the financial crisis of 2008 that has beentraced to the collapse of the housing market in the United States and the consequences of that collapse for the marketfor mortgage-related securities

SUB-PRIME MORTGAGES loans to borrowers that under normal credit assessment standards would not have the capacity torepay

The effects of the crisis flowed into the ‘real’ economy Economic growth in the USA slowed considerably According to

experienced four consecutive quarters of negative economic growth (falling gross domestic product or GDP) Contributing

to this were severe declines in private investment, including back-to-back declines of 36 per cent and 42 per cent in

doubled from 5 per cent in 2007 to just over 10 per cent in 2009 Amid the uncertainty and economic turmoil, financialmarkets continued to reel Share markets in most of the advanced economies experienced precipitous falls and at the

depths of the crisis had recorded losses of more than 50 per cent The American stock market alone experienced losses in

2008 of $8 trillion Currency markets were not immune from the volatility The Australian dollar experienced

depreciations of more than 30 per cent against the major currencies

During the crisis, a number of prestigious Wall Street firms lost their independence or failed completely Bear Stearnswas purchased by JPMorgan Chase & Co for just $10 per share in March 2008, after trading at $150 per share a year

earlier In July, the mortgage broker IndyMac was placed in ‘conservatorship’ by the US government In September, twogovernment-chartered mortgage lenders, Freddie Mac and Fannie Mae, were similarly placed in the care of the US

government Lehman Brothers collapsed in mid-September At the same time that Lehman Brothers tried in vain to arrange abailout or takeover, Merrill Lynch sold itself to Bank of America to avoid a Lehman-style collapse Lehman Brothers'

collapse created enormous market volatility as market participants struggled to predict the effects of the investment

bank's failure on the intertwined network of trades that characterises the financial markets Governments and central

banks desperately tried to stabilise the markets Meanwhile, other financial institutions found themselves under

tremendous pressure Washington Mutual was placed in receivership Wachovia was purchased by Wells Fargo AIG was

effectively taken over by the Federal Reserve

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FEDERAL RESERVE the central bank of the USA

Banks and other financial institutions are always vulnerable to ‘runs’ These are situations where all at once many

customers demand their money back from a financial institution Financial institutions do not operate with 100 per centreserves and cannot possibly meet all of these demands Before the GFC, financial institutions became more vulnerable

because of maturity mismatching in their financing arrangements Most financial institutions had become reliant on veryshort-term or overnight financing to finance their operations Repurchase agreements or ‘repos’ are very short-term

funding arrangements and financial institutions had come to rely heavily on overnight repo financing in the decade

before the crisis During the crisis, when financial institutions became wary about the solvency of their counterparties(and themselves), repo financing became either increasingly expensive or impossible to secure Without the overnight

repo markets, financial institutions did not have the capital to sustain their operations for any length of time Thiswas exacerbated by the redemption and withdrawal requests being received from investors and depositors Bear Stearns,

for example, found that it was unable to secure repo financing once doubts surfaced about its solvency Although Bear

Stearns had more than $18 billion in capital, this fell far short of what was required to finance its day-to-day

operations Bear Stearns was taken over by JPMorgan Chase & Co just a few days after its repo financing evaporated

With Bear Stearns gone, the financial markets awaited the next ‘domino’ to fall

When the crisis hit, information about the market value of the securities traded among financial institutions and the

magnitude of financial obligations of particular institutions was difficult or impossible to obtain Collateralised debtobligations (CDOs), which are portfolios of mortgages and other loans arranged into ‘tranches’ according to levels ofrisk, are complex by nature because it is very difficult to determine the quality of the numerous individual loans in

each of the tranches This complexity and the absence of liquid secondary markets for the securities led to large downs in the estimated values of these securities when financial institutions realised that there were no buyers willing

to engage in transactions at prices even close to the previously recorded selling prices With prices falling,

write-downs in the value of positions in these markets spiralled downwards Uncertainty about which institutions held the

riskiest CDO tranches contributed to financial institutions' unwillingness to extend financing to their counterparties

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To make matters even worse, buyers of CDOs had usually entered into credit default swaps (CDSs) with other financial

institutions CDSs were designed to insure their buyers against default on bonds, tranches or by institutions As CDOsfell rapidly in value and financial institutions reeled, the large outstanding liabilities potentially facing the

‘sellers’ of CDSs and the uncertainty over how much insurance had been sold by which institutions contributed further

to the spiral in valuations, balance sheet write-downs and the viability of financial institutions

Although most of the drama and many of the popular accounts of the crisis focused on Wall Street and its ‘blue-blood’banking establishments, as time has passed the GFC has come to be thought of as having two main parts The first, which

we have just described, was the initial liquidation of assets due to the trouble emanating from and engulfing the WallStreet banks The second was what has come to be known as the eurozone crisis or the sovereign debt crisis This

second instalment of the GFC emanated from and engulfed the central banks of a number of European countries That is, in

‘part two’ it was country or government debt, otherwise known as sovereign debt, that became ground zero as the crisisevolved

EUROZONE CRISIS or SOVEREIGN DEBT CRISIS the economic and international financial crisis that followed the GFC,

which saw multiple European governments seek bailouts from the European Central Bank (ECB) and other stronger Europeancountries

The eurozone crisis can be traced to late 2009 when the new Greek government announced that its deficit, understood bythe world financial community to already be an astronomical 113 per cent of the country's national income, was actuallytwice as large, or more than 220 per cent of the country's gross domestic product There was a very great possibility

that Greece would fail to meet its obligations to investors in Greek sovereign debt (Greek government bonds) This

immediately precipitated panic in the international bond markets

Like any market, investors need to have confidence that they will receive the cash flows they are entitled to and the

issuer of the debt, whether it is a corporation or a government, will not default on its obligations It looked like

Greece might do just that The panic in the international bond markets led to a collapse in bond prices and a spike inthe cost of borrowing for governments suspected of being in a similar position to Greece, especially Ireland, Spain,

Portugal and Italy Government services and welfare programs became the victims of harsh austerity measures As the

government sector of these economies was curtailed, national incomes fell rapidly and other economic indicators

deteriorated

The economic booms in these now troubled countries had been fuelled by money coming from banks in other European

countries, particularly in northern Europe These banks held trillions of dollars in Greek, Irish, Spanish and Italiandebt, which were consequently trading at substantially lower prices The trouble had spread north and west, like a

virus This had disastrous and far-reaching economic consequences National incomes fell precipitously in the worst

affected countries and unemployment soared Most of the Eurozone, including relatively strong economies such as Franceand Germany, soon found itself amid an economic malaise that has shown no real signs of abating And so, the GFC

continues to ripple through the global economic and financial system

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A number of explanations for the GFC have been proposed These include greed, irrationality, fraud, the inherent

instability of capitalism, the disproportionate size of the financial sector compared to the manufacturing or ‘real’sector of the economy, shadow banking, lax lending standards, deregulation and free-market policies, over-reliance on

badly designed mathematical models for measuring risk, inappropriate incentives structures within financial

institutions, ‘captured’ ratings agencies that were too lenient in rating mortgage debt, out-of-control financial

innovation and misguided government or central bank policy There are many different points of view and strong and

convincing arguments can be made for each of the possible explanations for the GFC Whatever role each of these factorsmight have played, the fundamental explanation for the GFC is quite straightforward Throughout the early 2000s, centralbanks, particularly the US Federal Reserve, set interest rates at very low levels This created a boom in consumption,housing and other asset prices driven by easy credit available throughout the economic system In the absence of

increasingly intense credit expansion, sooner or later the credit-driven boom had to come to an end The larger and

longer the boom, the more catastrophic must be the ensuing recession or depression Despite the unique circumstances ofeach individual case, all economic crises can be traced to this same root cause

Following the onset of the crisis, governments and central banks around the world undertook unprecedented interventions

in the financial and economic systems In America, for example, the federal government arranged a $700 billion bailoutplan and, as we have seen, even took ownership of some financial institutions In Australia, the federal government

implemented a guarantee on deposits with banks, building societies and credit unions to prevent ‘runs’ on these

institutions by their customers As the banking crisis gave way to concerns about economic growth, governments turned

their attention to fiscal stimulus to encourage economic activity and prevent recession In Australia, the government

implemented two stimulus packages totalling more than $50 billion in late 2008 and early 2009 Various factors

contributed to greater stability in Australia during the crisis and a mitigation of its effects on the real economy

However, the effects of the GFC continue to be felt in most parts of the developed world and, although Australia managed

to navigate the crisis better than other countries, dealing with the legacy of the GFC will present a challenge for manyyears to come

Many lessons might be learned from the GFC A stable financial sector is vital to the health of the overall economy

Perceived mistakes by regulators, including allowing interest rates to remain at very low levels for long periods of

time, as well as perceptions that the crisis was caused by a financial sector that is out of control, have sparked callsfor strong regulatory reforms Innovative financial products and securities, such as CDOs and CDSs, present a challenge

to regulators New products do not always fall within the scope of existing regulations The incentive arrangements andgovernance within financial institutions is another factor that attracted the attention of critics before, during and

after the GFC Regulations that limit compensation packages within the financial sector or realign incentive structuressuch that they do not encourage large amounts of risk taking represent attractive options to those who are critical ofperceived excesses within the financial sector Finally, the way that risk is managed within financial institutions hasemerged as a very prominent subject Risk is intertwined and interrelated The existence of one risk will change the

dynamics of other risk exposures With the GFC, it appears that there was a lack of understanding of who was ultimately

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holding risk and the impact on the markets if the ultimate risk holder failed For example, CDOs simply moved the riskexposure from one party to another party Everyone made money along the way, including the mortgage brokers, the banks,the credit rating agencies and the fund managers, but the risk was still in the financial system The process of risk

shifting was also often made easier by implicit or explicit guarantees given by governments, often with limited or no

regulatory oversight

To ensure the soundness and stability of a financial system, governments establish legislation and regulatory

authorities responsible for the prudential supervision of the financial system The soundness and stability of the

financial system and the role of financial regulation are issues that have acquired even more significance following theGFC The GFC produced a number of regulatory and policy responses Some of these were directed to the problem of

managing the ensuing economic recession while others were directed at specific parts or activities of the financial

system The response of governments and their regulators to the GFC will be a topic of ongoing discussion for many

years Anyone who doubts that this will be the case need look no further than the recent intense focus on the role of

central bankers' responses to the collapse of the dot-com boom in 2000 in sowing the seeds for the GFC almost a decadelater The reduction of interest rates and their maintenance at very low levels following the dot-com collapse has beencriticised for inflating values in the real estate market The subsequent decline in real estate prices from these over-inflated levels is widely viewed as the proximate cause of the GFC

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It would be wishful thinking to believe that another crisis will not eventually strike the financial system If that

happens any time soon, there is no doubt that the US Federal Reserve's years of ‘quantitative easing’ (credit easing),designed to encourage economic activity by pumping billions of dollars into the financial sector following the GFC, will

be heavily scrutinised Of course, if speculative banking practices once again lie at the heart of any such event,

questions will be raised about whether the response of regulators to the GFC was strong enough or whether the bailouts

of so many financial institutions, directly or indirectly, sent the wrong signals to market participants and sowed theseeds for another crisis

We have already introduced some very important issues The GFC demonstrated the vast interconnectedness of global

financial markets This global financial system grew from relatively humble beginnings Its development began the momentthat people first started to use money The use of money has many advantages For one, it makes it easier for

individuals to save their surplus earnings Saving may be defined as deferring consumption into the future The funds

saved by surplus units—those savers with current excess funds—can be put to use by those whose current demand for

goods and services is greater than their current available funds Such users of funds are called borrowers or deficit

units

Just as the exchange of goods and services can be carried out more efficiently through organised markets, so too can theexchange of money or value between surplus units and deficit units Financial institutions and markets facilitate

financial transactions between the providers of funds and the users of funds

When a financial transaction takes place it establishes a claim to future cash flows This is recorded by the creation

of a financial asset on the balance sheet of the saver The financial asset is represented by a financial instrument

that states how much has been borrowed, and when and how much is to be repaid by the borrower For example, if you

invested money in a term deposit with a bank, the bank would issue a term deposit receipt to you This is a financial

instrument The receipt would specify how much you had invested, the rate of interest to be paid, when interest paymentsare due and when the amount invested had to be repaid by the bank The interest payments and principal repayment are

claims to future cash flows

Buyers of financial instruments are lenders that have excess funds today and want to invest and transfer that purchasingpower to the future The sellers of the instruments are those deficit units that are short of funds today, but expect tohave a surplus amount in the future that will enable the repayment of the current borrowing

A principal role of financial institutions and markets is to bring together providers of funds (savers) with users of

funds The flow of funds and the relationship between savers and users of funds, and the place of the financial markets

in the flow, are shown in Figure 1.1 Once it is understood why financial markets have evolved, it is possible to

consider the major functions served by a modern financial system

Figure 1.1Financial markets and flow of funds relationship

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REFLECTION POINTS

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A financial system encourages savings, provides funds for investment and facilitates transactions for goods and

services The financial system and the financial markets are inextricably connected with the real economy

Historically, financial markets have exhibited periods of extraordinary volatility The GFC is a recent and

prominent example of the volatility that can characterise the financial markets and the consequences that

volatility can have in the real economy

The GFC is now viewed as having two parts or phases The first was concentrated in the mortgage derivatives marketsand brought down a number of US-based institutions The second was a sovereign debt crisis emanating from severaltroubled European countries that eventually engulfed much of the eurozone

The GFC, in both its parts, initiated a severe economic contraction in many countries, especially the USA and parts

of Europe

The modern financial system began humbly when people first started using money Economic and financial transactionsare valued in money terms Money is a universally acceptable medium of exchange and a store of value

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1.2The financial system and financial institutions

LEARNING OBJECTIVE 1.2Explain the functions of a modern financial system and categorise the main types of financial institutions, including

depository financial institutions, investment banks, contractual savings institutions, finance companies and unit trusts

A financial system comprises a range of financial institutions, financial instruments and financial markets whichinteract to facilitate the flow of funds through the financial system Overseeing the financial system, and sometimestaking a direct role, is the central bank and the prudential supervisor

FINANCIAL SYSTEM comprises a range of financial institutions, instruments and markets; overseen by central bank;

supervised by prudential regulator

FINANCIAL INSTRUMENTS issued by a party raising funds, acknowledging a financial commitment and entitling the holder

to specified future cash flows

FLOW OF FUNDS movement of funds through a financial system

The decision to save allows surplus units to transfer some of today's income to the future when it can be used for

consumption Therefore, savings allow consumption in the future to be independent of future levels of earned income

Surplus entities invest their savings through the purchase of financial instruments which are expected to improve theiroverall wealth

SURPLUS UNITS savers or providers of funds; funds are available for lending or investment

The expectation of the saver is to earn a positive rate of return However, there are other factors that savers shouldconsider; otherwise all savers would only purchase financial instruments that offered the highest rate of return

Providers of funds should consider their own particular needs when they purchase or invest in assets This will affectthe expected rate of return It is useful to think of an asset, whether it is a real asset such as an investment

property or a financial asset such as a bank term deposit, as being a package of four main attributes:

return or yield

risk

liquidity

time-pattern of cash flows

RATE OF RETURN the financial benefit gained from investment of savings; expressed in percentage terms

RETURN OR YIELD the total financial benefit received (interest and capital gain) from an investment; expressed as a

percentage

RISK the possibility or probability that an actual outcome will vary from the expected outcome; uncertainty

LIQUIDITY access to cash and other sources of funds to meet day-to-day expenses and commitments

TIME-PATTERN OF CASH FLOWS the frequency of periodic cash flows (interest and principal) associated with a financialinstrument

With a real asset such as an investment in a residential unit, return is the regular rental or lease payments received,plus any increase in the value of the property over time (capital gain) Risk relates to uncertainty and probabilitiessuch as the failure of the tenant to make rental payments or the possibility that the property may be burnt down The

liquidity of the residential unit is the ease with which it can be sold Finally, the time-pattern of the cash flows

will vary depending on the frequency of the rental payments, the cost of maintenance and the payment of other expensessuch as insurance and rates

In the case of a financial asset, such as the purchase of shares in a corporation, return consists of the dividends

received and the capital gains or losses made through movements in the share price on the stock exchange Note that a

dividend is the portion of corporation profits periodically paid to the shareholder; a stock exchange is where

corporation shares are bought and sold Risk is measured by the variability of the expected returns and, in the extreme,the possibility that the corporation may fail

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The liquidity of the shares relates to the ease with which they can be sold on the stock exchange at the current marketprice Finally, the time-pattern of the cash flows expected from the shares depends on the profitability and dividend

policy of the corporation Typically, a profitable corporation will pay dividends to shareholders twice a year

It is reasonable to assume that the average person likes return and liquidity, dislikes risk and prefers reliable cashflows Fortunately, the preferences of savers with regard to these four attributes are not identical If they were, allsavers would seek to place all of their savings with very few borrowers Since preferences are not identical, financialinstitutions and markets provide an enormous range of investment opportunities that have different levels of return,

risk, liquidity and timing of cash flows

Individuals and businesses may be categorised as being risk averse, risk neutral or risk takers More risk averse

individuals will accept lower expected returns for bearing lower levels of risk If the level of risk increases, they

expect to be compensated with higher expected returns It is usual to assume that individuals and businesses are risk

averse to some degree They do not avoid risk entirely but they do demand a higher return for bearing higher risk

Furthermore, savers will accept various levels of liquidity or different timings of cash flows associated with financial

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instruments Participants in the financial markets are therefore able to alter the composition of their financial assetportfolio by changing their preferences in relation to the four attributes of return (yield), risk, liquidity and thetiming of cash flows An asset portfolio is the list of assets held by a saver

ASSET PORTFOLIO a combination of assets, each comprising attributes of return, risk, liquidity and timing of cash

To support decisions taken by both the providers of funds and the users of funds, the financial system is also a

provider of financial and economic information to market participants Information affects price and investment

decisions; therefore the provision of timely and accurate information is essential for an efficient financial system

If a financial system is successful in creating a range of financial instruments that possess different combinations ofthe four attributes valued by savers, this will encourage an increased flow of savings By encouraging savings, the

financial system is important to economic growth, as the savings are available for investment capital which can be usedfor the improvement of the productive capacity of an economy

Not only can it be expected that a well-functioning financial system will increase the flow of savings, but it can also

be argued that an efficient financial system should ensure that savings are more likely to be directed to the most

efficient users of those funds This outcome further enhances the rate of economic growth Since typical savers will

seek to maximise their return, subject to their preferred level of risk, liquidity and the time-pattern of cash flows,they should be expected to invest their funds with users that show a high probability of meeting those expectations, forexample by investing in corporations that use funds to produce goods and services that are in demand in the marketplace.Another important function of a financial system is its role in the implementation of monetary policy Monetary policyrelates to the actions of a central bank that are taken to influence the level of interest rates in the financial

system The current monetary policy stance of central banks in developed countries is to maintain the level of inflationwithin a specified level Inflation is the increase in the price for goods and services within an economy By targetingthe level of inflation, a central bank seeks to achieve a range of economic objectives such as increased employment andthe stability of the exchange rate of the currency

MONETARY POLICY actions of a central bank that influence the level of interest rates in order to achieve economic

outcomes; primary target is inflation

INFLATION an increase in prices of goods and services over time; measured by the consumer price index (CPI)

REFLECTION POINTS

A financial system comprises financial institutions, financial instruments and financial markets Overseeing a

financial system are the central bank and prudential supervisor

A financial asset incorporates four main attributes: return, risk, liquidity and time-pattern of cash flows

The wide range of financial products available in a financial system facilitates portfolio structuring

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A financial system provides economic and financial information to the markets; that information should be timely

and accurate

An efficient financial system rapidly absorbs and reflects new information into the price of financial instruments

A financial system encourages savings and allocates those savings to the most efficient users of funds

The central bank uses the financial system to implement monetary policy in order to target the level of inflationand achieve certain economic objectives

Most of you have carried out transactions with one or more financial institutions For example, you may have opened a

deposit account with your local bank, applied for a loan from that bank or obtained a credit card facility Also, you

may have entered into an insurance contract for motor vehicle insurance, medical insurance, travel insurance or life

insurance with an insurance office

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There is a very wide range of financial institutions operating in the financial system While some institutions offer

similar products and service, typically institutions tend to specialise in areas where they have greater expertise Wewill discuss the different types of institutions in detail in Chapters 2 and 3 In this chapter we simply classify

financial institutions into five categories based on the differences between the institutions' sources of funds and uses

of funds

1 Depository financial institutions obtain a large proportion of their funds from deposits lodged by savers

Examples include deposits placed in demand deposit accounts or term deposit accounts with commercial banks,

building societies and credit cooperatives A principal business of these institutions is the provision of loans toborrowers in the household and business sectors

2 Investment banks generally focus on the provision of advisory services for their corporate and government

clients This includes advising clients on mergers and acquisitions, portfolio restructuring and financial risk

management These institutions may provide some loans to clients but are more likely to advise and assist a client

to raise funds directly from the capital markets

3 Contractual savings institutions are financial institutions such as life insurance offices, general insurersand superannuation funds Their liabilities are mainly contracts which specify that, in return for periodic

payments made to the institution, the institution will make specified payouts to the holder of the contract if andwhen an event specified in the contract occurs The periodic cash receipts received by these institutions providethem with a large pool of funds that they invest Payouts made by these institutions include payments for claims

made on an insurance policy, or payment to a superannuation fund member on their retirement from the workforce

4 Finance companies and general financiers raise funds by issuing financial instruments such as commercial

paper, medium-term notes and bonds in the money markets and the capital markets They use those funds to make loansand provide lease finance to their customers in the household sector and the business sector

5 Unit trusts are formed under a trust deed and are controlled and managed by a trustee or responsible entity Unittrusts attract funds by inviting the public to purchase units in a trust The funds obtained from the sale of unitsare pooled and then invested by funds managers in asset classes specified in the trust deed Trusts generally

specialise in certain categories of investments, including equity trusts, property trusts, fixed-interest trusts

and mortgage trusts

DEPOSITORY FINANCIAL INSTITUTIONS accept deposits and provide loans to customers (e.g commercial banks, credit

unions)

INVESTMENT BANKS specialist providers of financial and advisory services to corporations, high-net-worth individualsand government

CONTRACTUAL SAVINGS INSTITUTIONS offer financial contracts such as insurance and superannuation; large investors

FINANCE COMPANIES AND GENERAL FINANCIERS borrow funds direct from markets to provide loans and lease finance to

customers

UNIT TRUSTS investors buy units issued by the trust; pooled funds invested (e.g equity trusts and property trusts)

Table 1.1 shows the total assets of the various Australian financial institutions in June 1990, June 2008 and

September–December 2013 The Australian financial system has rapidly evolved over this period in response to

significant changes that have occurred, including regulatory change, internationalisation of the financial markets andthe application of technology to the development of new financial products and information systems As can be seen,

there has been an enormous growth in assets held within the financial system This is not restricted to the Australianmarket, as international markets have also shown considerable growth Some generalisations that emerge from Table 1.1

include:

SOURCE: Reserve Bank of Australia, RBA Bulletin, various issues.

D

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Total assets of the financial institutions increased more than sevenfold over the period, to $5622.2 billion

Commercial banks account for the largest share of the assets of financial institutions, at 57 per cent However,

this figure does not fully represent the full extent of commercial banks' influence, as these institutions also

participate in a range of activities that are not recorded directly on the banks' balance sheets (e.g their

managed funds activities)

The importance of building societies significantly declined as changes in regulation allowed most of the larger

societies to become commercial banks

The percentage share of financial assets of investment banks declined This reflects the change in focus of theirbusiness activities Much of their business is based on the provision of off-balance-sheet advisory services to

their corporate and government clients

Finance companies contracted as the impact of financial deregulation, greater competition and the absorption of

some finance companies into their parent banks took effect

The percentage of life insurance offices' share of total assets declined over the period However, this was offset

by significant increases in their managed funds business, particularly superannuation products

The percentage share of superannuation assets increased to 22 per cent Factors influencing this growth were an

ageing population saving for retirement, the introduction of compulsory superannuation and the introduction of

taxation incentives for superannuation savings

Another growth area was in managed funds, specifically in unit trusts This sector of the market increased tenfoldover the period Managed funds provide investors with the opportunity to use the specialist skills of funds

managers, particularly in investment categories which are more difficult for the individual investor to access, forexample the international equity markets

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Securitisation vehicles showed enormous relative growth up until the onset of the GFC The ensuing severe

tightening of the availability of credit in the capital markets resulting, in part, from problems with securitisedassets that were backed by sub-prime mortgage assets, has seen new securitisation issues subsequently almost

disappear and the percentage share of securitised assets decline to just 2.20 per cent Securitisation is discussed

in the extended learning section at the end of Chapter 10, but can be briefly described as a process whereby an

organisation, such as a bank, sells existing balance-sheet assets, for example housing loans, thereby generating

new cash flows

SECURITISATION non-liquid assets are sold into a trust; the trustee issues new securities; cash flows from the

original securities are used to repay the new securities

REFLECTION POINTS

Financial institutions may be classified into five categories based on their sources of funds and uses of funds

Depository financial institutions, such as commercial banks, gather savings from depositors and provide loans to

customers (Commercial banks also provide a wide range of other financial services.)

Investment banks do not have a depositor base; they specialise in the provision of advisory services to clients

(e.g merger and acquisition advice)

Contractual savings institutions, such as insurance offices and superannuation funds, gather savings from the sale

of insurance contracts and from superannuation contributions respectively, and make payouts on the occurrence of

specified events (e.g a car accident or retirement from the workforce)

Finance companies raise funds directly from the money markets and capital markets and provide loans and lease

finance to customers

Unit trusts sell units in a trust and invest those funds in assets specified in the trust deed; for example, an

equity trust would invest in certain types of shares

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1.3Financial instruments

LEARNING OBJECTIVE 1.3Define the main classes of financial instruments that are issued into the financial system, that is, equity, debt,

hybrids and derivatives

When a user of funds obtains finance from the provider of funds, the user must prepare a legal document that clearly

defines the contractual arrangement This document is known as a financial instrument and acknowledges a financial

commitment and represents an entitlement to future cash flows The financial instrument becomes a financial asset on thebalance sheet of the provider of funds If the financial asset represents debt that will be repaid then it also appears

as a liability on the balance sheet of the borrower; however, if it represents equity it will appear as part of

shareholder funds

For example, if a bank customer deposits funds in a term deposit, the bank will acknowledge this deposit and issue a

receipt that will specify the amount of funds provided, the maturity date when the funds will be repaid, the rate of

interest to be paid and the timing of interest payments The terms and conditions specified in a financial security canvary significantly For example, a loan agreement may include an interest rate that is fixed for the term of the loan,while another loan may have a variable rate of interest that can change on certain dates One loan may require monthlypayments of interest and principal, while another loan may require half-yearly interest payments with principal only

repaid at maturity Savers, as the providers of funds, will purchase financial assets that have attributes of risk,

return, liquidity and cash flows that meet their particular needs In the financial markets, the saver is said to buy

the ‘paper’ of the issuer

Financial instruments may be divided into three broad categories: equity (including hybrid instruments), debt and

derivatives These three categories reflect the nature and main characteristics of financial instruments

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1.3.1Equity

Equity can take a number of forms For example, if you buy a new car by paying a deposit from your own funds and

borrowing the remainder from a bank, your equity in the car is the amount of the deposit paid As you progressively

repay the loan to the bank, your level of equity in the car will increase Equity can therefore be described as an

ownership interest in an asset

EQUITY the sum of the financial interest an investor has in an asset; an ownership position

Within the context of the discussions in this text, equity in a business corporation is represented through the

ownership of shares issued by a corporation The principal form of equity issued by a corporation is an ordinary share

or common stock As we will discuss in detail in Part 2, larger corporations list their shares on the stock exchange.Ordinary shares have no maturity date; they continue for the life of the corporation However, as the shares are listed

on the stock exchange they may be sold to other investors at the current market price

ORDINARY SHARE or COMMON STOCK the principal form of equity issued by a corporation; bestows certain rights to theshareholder

An ordinary shareholder is entitled to share in the profits of the business Shareholders generally receive a portion ofthe profits of the company in the form of dividend payments (This is discussed in Part 2.) The value of a

corporation's shares may increase over time, representing a capital gain In the event of the failure of a corporation,however, shareholders are entitled to the residual value of the assets of the corporation (if any remain), but only

after the claims of all other creditors and security holders have been paid

DIVIDEND that part of a corporation's profit that is distributed to shareholders

The owners of ordinary shares have the right to vote at general meetings, in particular for the election of members ofthe board of directors of the company

Another form of equity is known as a hybrid security A hybrid security may be described as having the characteristics

of both equity and debt (see below) Preference shares are an example of hybrid securities Preference shares, while

being a form of equity finance, have many characteristics in common with debt instruments For example, the holders areentitled to receive a specified fixed dividend for a defined period, similar to a fixed-interest payment The fixed

dividend must be paid before any dividend is made to ordinary shareholders Preference shareholders also rank ahead ofordinary shareholders in their claim on the assets of the corporation should the company be wound up or placed into

liquidation

HYBRID SECURITY a financial instrument that incorporates the characteristics of both debt and equity (e.g preferenceshares)

LIQUIDATION the legal process of winding up the affairs of a company in financial distress

The issue of hybrid securities, or quasi-equity instruments, has become an increasingly important means by which

corporations raise additional equity funding These instruments are discussed in detail in Chapter 5

The equity markets are discussed in much more detail in Part 2

1.3.2Debt

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A debt is a loan that must be repaid Debt instruments represent a contractual claim against an issuer, and require theborrower to make specified payments, such as periodic interest payments and principal repayments, over a defined period.The types of debt instruments issued by a corporation include debentures, unsecured notes, term loans, commercial bills,promissory notes, overdrafts and mortgage loans These types of debt instruments are discussed in detail in Part 3 of

the text However, when we discuss the financial markets later in this chapter, we will introduce the money markets andthe capital markets Debentures and unsecured notes are longer-term debt instruments issued into the capital markets,

while commercial bills and promissory notes are short-term instruments issued into the money markets Term loans,

mortgage loans and overdrafts are generally provided by financial institutions

Government debt instruments are Treasury bonds and Treasury notes (T-notes); these are examined in Part 4

Debt instruments entitle the holder to a claim (ahead of equity holders) to the income stream produced by the borrowerand to the assets of the borrower if the borrower defaults on loan repayments Debt can be divided into two sub-

categories on the basis of the nature of the loan contract: secured debt and unsecured debt A secured debt contractwill specify the assets of the borrower, or a third party, pledged as security or collateral If the borrower defaults

on the loan the lender is entitled to take possession of those assets to recover the amount owing In other cases a loanmay be made on an unsecured basis

DEBT INSTRUMENTS specify conditions of a loan agreement; issuer/borrower, amount, return, timing of cash flows,

maturity date; debt must be repaid

SECURED DEBT a debt instrument that provides the lender with a claim over specified assets if the borrower defaults

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Another subdivision of debt is based on the transferability of ownership of the instrument Negotiable debt

instruments are those that can easily be sold and transferred from one owner to another Commercial bills are an

example of negotiable debt instruments that can be sold in the money markets (Chapter 9) Non-negotiable instruments areinstruments that cannot be transferred from one party to another A term loan obtained through a bank is generally non-negotiable

NEGOTIABLE DEBT INSTRUMENT a debt instrument that can be sold by the original lender through a financial market

Corporate debt is discussed in Part 3 and government debt in Part 4

1.3.3Derivatives

A third class of instrument has become significant in the financial markets: the derivative instrument

DERIVATIVE INSTRUMENT a synthetic security that derives its price from a physical market commodity or security; mainlyused to manage risk exposures

Derivatives contracts are primarily used to manage an exposure to an identified risk For example, a borrower might beconcerned that interest rates on existing debt funding may rise in the future The borrower can accept this forecast

risk, or seek to reduce that risk exposure by locking in an interest rate today One way the borrower can lock in an

interest rate is through the use of derivative contracts

There is a wide range of derivatives contracts for the management of risk exposures related to commodities (such as goldand oil) and financial instruments (such as interest-rate-sensitive debt, currencies and equities) Therefore, financialderivatives may be used to manage risk exposures related to both equity and debt

There are four basic types of derivatives contracts: futures, forwards, options and swaps:

1 A futures contract is a contract to buy (or sell) a specified amount of a commodity or financial instrument at aprice determined today for delivery or payment at a future date Futures contracts are standardised contracts thatare traded through a futures exchange Futures contracts are discussed in Chapters 18 and 19

2 A forward contract is similar to a futures contract but is typically more flexible and is negotiated over the

counter with a commercial bank or investment bank A forward foreign exchange contract establishes a foreign

currency exchange rate that will apply at a specified date A forward rate agreement is used to lock in an interest

rate today that will apply at a specified date Forward contracts are discussed in Chapters 17, 18 and 19

3 An option contract gives the buyer of the option the right—but not an obligation—to buy (or sell) the

designated asset at a specified date or within a specified period during the life of the contract, at a

predetermined price The fact that the buyer is not obliged to proceed with the contract is valuable, and thereforethe buyer must pay a premium to the writer of the option Option contracts are discussed in Chapters 18 and 20

4 A swap contract is an arrangement to exchange specified future cash flows With an interest rate swap there is an exchange (swap) of future interest payments based on a notional principal amount A currency swap is denominated in

a foreign currency and fixes the exchange rate at which the initial and final principal amounts are swapped

Ongoing interest payments are also swapped at the same exchange rate Swap contracts are discussed in Chapters 18and 21

FUTURES CONTRACT an exchange-traded agreement to buy or sell a specific commodity or financial instrument at a

specific price at a predetermined future date

FORWARD CONTRACT an over-the-counter agreement that locks in a price (interest rate or exchange rate) that will apply

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Derivative instruments are different from equity and debt in that they do not provide actual funds for the issuer Fundsneed to be raised in either the equity or debt markets Risks associated with equity or debt issues may be managed usingderivative contracts For example, an investor might be concerned that the value of shares held in an investment

portfolio might fall The investor might enter into a derivative contract that gives the investor the option to sell

shares at a specified date at a price that is agreed today If the share price does fall, the investor will exercise theoption and sell at the agreed higher price

REFLECTION POINTS

The principal form of equity issued by a publicly listed corporation is the ordinary share or common stock

Ordinary shares entitle the shareholder to share in the profits of the company, either through the receipt of

dividends or through capital gains, and provide certain voting rights

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A hybrid security, such as a preference share, incorporates the characteristics of both debt and equity

The basic characteristic of debt is that is must be repaid The debt holder is entitled to receive cash flows

specified in the debt instrument (e.g interest payments and principal repayment) Debt may be secured or

unsecured

A derivative contract is designed to facilitate the management of risk (e.g interest rate risk) Types of

derivative products are futures, forwards, options and swaps

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1.4Financial markets

LEARNING OBJECTIVE 1.4Discuss the nature of the flow of funds between savers and borrowers, including primary markets, secondary markets,

direct finance and intermediated finance

We now introduce the third component of a financial system, being the financial markets You gained a basic

understanding of the financial institutions and instruments earlier in the chapter; now, once you understand the

structure of the financial markets, you should have a good grasp of the integrated functions of the markets and the

importance of the financial system to economic growth within a country In this chapter we begin by categorising the

markets according to the types of transactions that occur within each market Later in the textbook we will discuss indetail the institutions and instruments that prevail in each of the financial markets This section considers:

the matching principle

primary and secondary markets

direct and intermediated financial flow markets

wholesale and retail markets

MATCHING PRINCIPLE short-term assets should be funded with short-term liabilities; longer-term assets should be fundedwith longer-term liabilities and equity

OVERDRAFT FACILITY a fluctuating credit facility provided by a bank; allows a business operating account to go intodebit up to an agreed limit

The matching principle goes on to state that longer-term assets should be funded with equity and long-term liabilities.For example, a company may purchase a new factory and manufacturing equipment, and it is expected that these assets willgenerate income for the next 10 years To fund the purchase, the company should issue equity and/or long-term debt such

as bonds (see Chapter 10)

BONDS a long-term debt instrument issued directly into the capital markets that pays the bond-holder periodic interestcoupons and the principal is repaid at maturity

The money markets and capital markets trade short-term and long-term financial instruments respectively, and thereforeallow borrowers to apply the matching principle in relation to funding A borrower is able to match the cash flows

associated with a source of funds (liabilities) closely with the cash flows generated from the use of funds over the

life of a particular asset

While the matching principle may be regarded as a fundamental principle of finance, it is interesting to note how oftenthis principle is disregarded For example, at the onset of the GFC, short-term finance available through the money

markets virtually ceased as a result of uncertainty in relation to risk deriving from the so-called sub-prime market

collapse Quite a number of financial institutions had been funding longer-term instruments with short-term finance inthe money markets When this source of finance was suddenly no longer available the institutions experienced a

significant liquidity problem and some institutions failed or were taken over They forgot the fundamentals!

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1.4.2Primary and secondary market transactions

The concept of primary markets and secondary markets is quite simple, but their role in ensuring the efficiency of thefinancial markets is very important indeed

A primary market transaction occurs when businesses, governments and individuals issue financial instruments in themoney markets and capital markets For example, when a corporation issues additional ordinary shares to raise equity

funding for a proposed investment project, it is conducting a primary market transaction in the capital markets

Similarly, if the government sells new long-term bonds in order to finance spending on capital works, health or

education, this is a primary market transaction Individuals who borrow money from a bank to finance the purchase of ahouse are also participating in a primary market transaction The distinguishing characteristic of a primary market

transaction is that it creates a new financial instrument Primary market flows and relationships are illustrated in

Figure 1.2

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PRIMARY MARKET TRANSACTION the issue of a new financial instrument; funds are obtained by the issuer

Figure 1.2Primary market transactions

MONEY a commodity that is universally accepted as a medium of exchange

In contrast, secondary market transactions involve transactions with existing financial instruments Instruments

traded in the secondary markets are those that were initially created in primary market transactions For example,

consider an investor who buys shares (equity) issued by a corporation These primary market flows are shown in Figure

1.2 If the holder of those shares now decides to sell them, the sale of the shares is regarded as a secondary market

transaction Figure 1.3 illustrates the flows involved in secondary market transactions

Figure 1.3Secondary market transactions

SECONDARY MARKET TRANSACTION the buying and selling of existing financial securities; transfer of ownership, no newfunds raised by issuer

Secondary market transactions have no direct impact on the amount of funding raised or available to the company that wasthe initial issuer of a financial instrument; that is, the company receives no extra funds from the secondary market

transaction A secondary market transaction is simply a transfer of ownership from one party to another party

However, the existence of well-developed secondary markets has important impacts on the marketability of new primary

market financial instruments or securities

Secondary market transactions help overcome two potential obstacles that may stand in the way of savers providing fundsfor the financing of long-term capital investment These are the savers' preferences for liquidity and their aversion torisk Without an active secondary market, purchasers of new-issue instruments would be required to hold those long-terminstruments until they mature In the case of equity, the problem would be even greater as there is generally no

maturity date A deep and liquid secondary market solves this problem by providing markets where these instruments can

be bought and sold A deep and liquid secondary market is one where there are many buyers and sellers in the market

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Economic growth (and the benefits, such as increased employment, that flow to the community from that growth) is

critically reliant on the existence of strong primary markets Primary market transactions allow corporations and

government to raise new funding that leads to increased capital and productive investment Secondary markets, while notdirectly involved in the process of channelling funds from savers to users of funds, encourage both savings and

investment because they enhance the marketability and liquidity of primary-issue instruments, thus making them more

attractive to savers

It will be useful to introduce and explain some market terminology at this stage A financial asset has already been

defined as an entitlement to future cash flows A financial instrument is the more general term used in the markets todescribe instruments where there is no organised secondary market where that instrument can be traded

The market also describes a number of financial instruments as securities A security is the term used to describe a

financial asset that can be traded in an organised secondary market such as a stock exchange or a futures exchange Anexample of a financial instrument is a bank term deposit, and an example of a security is an ordinary share in a

publicly listed company Both are financial assets

SECURITIES financial assets that are traded in a formal secondary market (e.g stock exchange)

1.4.3Direct finance and intermediated finance

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The issue of new financial instruments generates a flow of funds through the primary markets from the provider of funds

to the user of those funds This flow can occur in two ways:

The funds may flow through a direct relationship from the provider of funds to the user of funds

The flow of funds may occur through a financial intermediary such as a bank

Within the financial markets each form of financial flow is an important source of finance

Direct finance

When funds are raised in the primary markets using direct finance, the contractual agreement is between the provider

of funds and the user of funds The funds are not provided by a financial institution The relationships that exist

between savers and the users of funds in the provision of direct finance are shown in Figure 1.4

Figure 1.4Direct financial flows

DIRECT FINANCE funding obtained direct from the money markets and capital markets

The ‘brokers and dealers’ included in Figure 1.4 may act as agents through which the instructions of the providers offunds and users of the funds are carried out The broker does not provide the finance, but receives a fee or commissionfor arranging the transaction between the two parties The broker has no rights to the benefits that may flow from thepurchase of the security It is not necessary for a broker or dealer to be involved at all in the transaction

BROKER an agent who carries out the instructions of a client

DEALER makes a market in a security by quoting both buy (bid) and sell (offer) prices

An investor seeking to purchase shares in a company will generally arrange the transaction through a stockbroker The

stockbroker acts only as an agent to the transaction and, on behalf of a client, facilitates the direct purchase or sale

of shares by accessing the electronic share trading systems of the stock exchange

Examples of direct financing include share issues, corporate bonds and government securities These securities are

discussed further in various chapters of the text

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The benefits and disadvantages of direct finance

Direct finance is generally available only to corporations and government authorities that have established a good

credit rating A credit rating is an assessment of the creditworthiness of an issuer of paper As the contractual

relationship in direct finance is directly between the provider of funds and the issuer of paper, the risk that the

issuer may default is an important consideration Therefore, borrowers that do not have an established good credit

rating generally are not able to borrow direct The credit rating process is discussed in Chapter 11

CREDIT RATING the assessment by a credit rating agency of the creditworthiness of an obligor to a financial obligationThe main advantages of direct finance are as follows:

It removes the cost of a financial intermediary If a borrower obtains a loan from a financial institution, the

borrower will pay a profit margin to the intermediary Should a corporation or government authority have an

investment-grade credit rating (e.g Standard & Poor's BBB and above), it may well be able to raise funds directlyfrom the domestic or international markets at a lower total cost than borrowing through a bank

It allows a borrower to diversify funding sources by accessing both the domestic and international money and

capital markets This reduces the risk of exposure to a single funding source or market Economic and financial

conditions change from time to time, and a user of funds may suddenly find that a traditional source of funds is nolonger willing to provide further funding For example, this situation was evident in Thailand and Indonesia as aresult of the Asian financial crisis of 1997–98, and was repeated in Argentina after the collapse of the country'sfinancial and economic systems in 2002 Following the onset of the GFC, large increases in default rates associatedwith so-called sub-prime market securities made raising funds in the global money markets and capital markets verydifficult

It enables greater flexibility in the types of funding instruments used to meet different financing needs More

sophisticated funding strategies may be used to raise funds For example, a corporation may obtain a US dollar

(USD) loan in the international capital markets and then use USD export income to repay the loan

An organisation may enhance its international profile by carrying out transactions in the international financialmarkets An increased profile in the financial markets may be beneficial in establishing a reputation in the

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markets for the firm's goods and services

There are some disadvantages that may, at times, be associated with direct financing These include:

There can be a problem of matching the preferences of lenders and borrowers For example, a lender may have a

certain amount of funds available for investment, but this amount may not be sufficient for the needs of the

borrower, who would then need to seek out and enter into funding arrangements with additional suppliers of funds.There may also be a mismatch in the maturity structure of the funding as the borrower may need to borrow for a

longer period than the risk-averse investor is willing to lend

The liquidity and marketability of a direct finance instrument may be of concern How easy is it for the holder of

an instrument issued by direct finance to sell at a later date? Is there a deep and liquid secondary market in thatinstrument? Not all financial instruments have an active secondary market through which they may be sold

The search and transaction costs associated with a direct issue can be quite high These might include advisory

fees, the cost of preparing a prospectus, legal fees, taxation advice, accounting advice and specific expert advice(such as a geologist's report) On very large direct finance transactions the fees and costs may run into the

millions of dollars

It can be difficult to assess the level of risk of investment in a direct issue, particularly default risk

Accounting and reporting standards may vary between nation-states, and information about an issuer may be limited

to the prospectus and the issuer's credit rating

DEFAULT RISK the risk that a borrower may not meet financial commitments such as loan repayments when they are due

and the repayment of principal On the other hand, a significant risk accepted by the intermediary is default or creditrisk—that is, the risk that the borrower may not make all loan repayments

Figure 1.5Intermediated financial flows

INTERMEDIATED FINANCE financial transaction conducted with a financial intermediary (e.g bank deposits and bank

loans); separate contractual agreements

funds from the borrower does not change the contractual relationship the bank has with its depositor

The benefits of financial intermediation

Very often the portfolio preferences of savers and borrowers differ For example, a risk-averse lender may be prepared

to receive a lower rate of return in exchange for maintaining funds at call On the other hand, a borrower may be

prepared to pay a higher rate of return, but may want to have the funds available for a number of years It is likely

that many savers and borrowers would find it difficult to meet their investment and funding needs if only direct financewas possible

An intermediary is able to resolve this problem and satisfy the preferences of both parties, and at the same time make aprofit An intermediary is able to transform short-term deposit funds into longer-term loan funds An essential economicrole of an intermediary is to resolve the conflicting preferences of surplus units and deficit units, and thus encourageboth savings and productive capital investment

In carrying out the role of offering instruments with varying financial attributes (risk, return, liquidity, timing ofcash flows), intermediaries perform a range of functions that are important to both savers and borrowers These are:

asset transformation

maturity transformation

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Financial intermediaries engage in asset transformation by offering their customers a wide range of financial products

on both sides of the balance sheet, including deposit, investment and loan products

ASSET TRANSFORMATION the ability of financial intermediaries to provide a range of products that meet customers'

portfolio preferences

Without intermediation, surplus units that could generate only small levels of savings would not have any incentive tosave; and users of funds, such as individuals and small businesses, would find the cost of obtaining loans too great to

be worthwhile Intermediaries specialise in the gathering of savings and can achieve economies of scale in their

operations They can profitably receive small amounts from many savers, pool them into larger amounts and make them

available as loans to borrowers

Financial intermediaries provide a range of deposit products which meet the varying preferences and need of their

customers These include demand deposit accounts, current accounts, term deposits and cash management trusts At the

same time, financial intermediaries provide a range of loan products, including overdraft facilities, term loans,

mortgage loans and credit card facilities

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Maturity transformation

Most frequently, savers prefer great liquidity in their financial assets, while borrowers tend to prefer a longer-termcommitment in the funds they borrow By managing the deposits they receive, intermediaries are able to make loans of alonger-term nature while satisfying savers' preferences for shorter-term savings This is referred to as maturity

transformation

MATURITY TRANSFORMATION financial intermediaries offer products with a range of terms to maturity

Banks provide a good example of the maturity transformation function of intermediaries The deposits they receive are

generally quite short term in nature (typically less than five years), yet a large proportion of their lending is for

home loans that frequently have a maturity of 30 years The banks therefore have a mismatch between the terms to

maturity of a large proportion of their sources of funds and their loan liabilities

Financial intermediaries are able to perform such extremes of maturity transformation for two reasons First, it is

unlikely that all savers would choose to withdraw their deposits at the same time Deposit withdrawals during any

particular period are generally more or less matched by new deposits Second, and more importantly, financial

intermediaries that engage in maturity transformation rely on liability management

LIABILITY MANAGEMENT where banks actively manage their sources of funds (liabilities) in order to meet future loan

demand (assets)

Should a bank's deposit base (liabilities) begin to decline below the level necessary to fund their forecast loan

portfolio (assets), then the bank may adjust the interest rates that it offers in order to attract the necessary

additional deposits More probably, the bank will issue further securities (liabilities) directly into the money or

capital markets to raise the additional funds required

Credit risk diversification and transformation

Credit risk transformation occurs through the contractual agreements of intermediation A saver has an agreement withthe financial intermediary, and therefore the credit risk exposure of the saver is limited to the risk of the

intermediary defaulting The financial intermediary has a separate loan agreement with the borrower and is exposed to

the credit risk of the borrower

CREDIT RISK TRANSFORMATION a saver's credit risk exposure is limited to the intermediary; the intermediary is exposed

to the credit risk of the ultimate borrower

Financial intermediaries have two advantages over most individual savers in managing investments First, intermediariesspecialise in making loans and therefore develop an expertise in assessing the risk of potential borrowers This

expertise comes from the technical skills of the employees and systems in assessing and monitoring loan applications,

and also from the information that is acquired through prior dealings with the borrower

Liquidity transformation

Savers generally prefer more, rather than less, liquidity in their investments One reason for this is that the timing

of a saver's income and expenditure flows will not perfectly coincide There are times when income is higher than

expenditure and savings are available for investment purposes On the other hand, there are times when expenditure

exceeds income In order to try and manage this timing problem, savers will tend to hold at least some of their

financial assets in a very liquid form that can easily be converted to cash

Liquidity transformation is measured by the ability to convert financial assets into cash at something close to thecurrent market price of the financial instrument However, liquidity has another dimension: the transaction costs

associated with acquiring and disposing of the financial asset Transaction costs can often be quite high However, a

financial intermediary may have the capacity to lower transaction fees by spreading fixed costs across a large number of

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transactions The time involved in carrying out a transaction may also be an important component of the total

transaction cost

LIQUIDITY TRANSFORMATION measured by the ability of a saver to convert a financial instrument into cash

Many intermediaries provide highly liquid accounts in which individuals may store some of their wealth For example, ademand (at-call) account with a bank represents complete liquidity The depositor has the right to withdraw funds

without notice There is zero risk that the value of the asset, when it is converted into cash, will be less than the

value of the deposit in the demand account In addition, the transaction costs associated with converting the credit

balance into cash are limited to transaction fees imposed by the bank Intermediaries such as commercial banks can offerhighly liquid assets to savers, which the ultimate users of funds would be most unlikely to be able to do

Banks have further extended liquidity arrangements by adopting systems such as electronic networks: automatic teller

machines (ATMs) and electronic funds transfer at point of sale (EFTPOS) arrangements

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Economies of scale

Financial intermediaries gain considerable economies of scale due to their size and the volume of business transacted,and therefore have the resources to develop cost-efficient distribution systems Banks maintain extensive branch

networks as their primary distribution mechanism At the same time they also provide extensive technology-based

distribution systems such as ATMs, EFTPOS, telephone banking and internet banking

ECONOMIES OF SCALE financial and operational benefits gained from organisational size, expertise and volume of

business

The cost of the sophisticated computer and communication systems required to support such distribution networks is

spread over the millions of transactions processed

Intermediaries also obtain cost advantages through effective knowledge management and the accumulation of financial,

economic and legal expertise For example, a bank will typically use standardised documentation for its deposit and

lending products The bank knows that these documents will comply with regulatory and legal requirements Other cost

advantages include a reduction in search costs for both savers and borrowers; that is, savers do not need to investigatethe creditworthiness of the ultimate borrower; the intermediary will have that data available before making a loan

decision

In a competitive market, financial intermediaries should pass on efficiency gains in the form of reduced interest

margins and fees

1.4.4Wholesale and retail markets

LEARNING OBJECTIVE 1.5Distinguish between various financial market structures, including wholesale markets and retail markets, and money

markets and capital markets

Direct financial transactions between institutional investors and borrowers are described as wholesale market

transactions Institutional investors include commercial banks, insurance offices, superannuation funds, investment

banks, fund managers, finance companies, building societies, credit unions, government authorities and large

corporations Transactions conducted in the wholesale markets typically range from the tens of thousands of dollars tothe millions of dollars For example, a portfolio manager may purchase a $50 000 wholesale managed fund for a client

while a financial institution might sell $10 million worth of commercial bills into the money market

WHOLESALE MARKET direct financial flow transactions between institutional investors and borrowers

The cost of wholesale funds is determined by a range of factors, such as the level of liquidity (surplus funds) withinthe financial system, future interest rate expectations and the maturity structure of investment opportunities For

example, large amounts of short-term funds are invested overnight in the money markets Generally, wholesale investorsare able to accumulate large quantities of surplus funds and use their market power and investment skills to obtain

higher returns than would normally be available in the retail market At the same time, wholesale market borrowers areable to use their good credit standing in the markets to obtain access to those funds

The retail market, on the other hand, comprises transactions primarily of individuals and small to medium-sized

businesses Transactions are principally conducted with financial intermediaries Market participants are price takers;that is, the financial intermediary is able to set both deposit and lending rates of interest Retail market

participants are not totally excluded from the wholesale markets They are able to gain indirect access to the wholesalemarkets through managed investment products such as cash management accounts and unit trusts These are discussed in

Chapter 3

RETAIL MARKET financial transactions conducted with financial intermediaries mainly by individuals and small to sized businesses

medium-1.4.5Money markets

The financial markets may be categorised according to the characteristics of the financial instruments that are traded

in the markets Within the debt and equity markets, the two main market classifications are the money markets and the

capital markets The money markets and the capital markets include a number of submarkets (see below) Other markets,

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