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Lecture 1: Chapter 1

A Modern Financial System

Presented By
Dr Sarod Khandaker

Presented by Dr Sarod Khandaker

THE ROLE OF THE FINANCIAL SYSTEM

The financial system consists of financial


markets, institutions and money.

The roles of the financial system are:

To facilitate the flow of funds


To provide the mechanism to settle transactions
To generate and disseminate information
To provide the means to transfer and manage risk
To provide ways of dealing with incentive problems

Presented by Dr Sarod Khandaker

THE FLOW OF FUNDS


The financial system allows the flow of funds
from surplus spending units (SSUs) to
deficit spending units (DSUs).

Figure 1.2 Flow of funds

Presented by Dr Sarod Khandaker

SSUs and DSUs

Economic units can be classified as:

Households
Businesses
Governments

A surplus unit is a unit whose income exceeds


planned expenditure.
A deficit unit is a unit whose expenditure
exceeds its receipts.
The flow of funds from SSUs (mainly
households) to DSUs (mainly business firms
and governments) is a fundamental function of
the financial system.
Presented by Dr Sarod Khandaker

DIRECT FINANCING

SSUs lend money to DSUs and accept a


financial claim in return.

In direct financing, this exchange takes place


directly without an intermediary.

The limitations of direct financing create a role


for financial intermediaries to intervene
between DSU and SSU.

Presented by Dr Sarod Khandaker

INDIRECT FINANCING

Direct financing requires DSUs to find SSUs


that want direct claims and the denominations
involved are usually very large.

These problems are resolved through the


involvement of a financial intermediary.

Financial intermediaries purchase direct claims


from DSUs, transform them into indirect
claims and sell them to SSUs.

Presented by Dr Sarod Khandaker

BENEFITS OF FINANCIAL
INTERMEDIATION
When intermediaries transform direct claims
into indirect ones, they perform five services:

Denomination divisibility
Currency transformation
Maturity flexibility
Credit risk diversification
Liquidity

Presented by Dr Sarod Khandaker

TYPES OF INTERMEDIARIES
Australian financial intermediaries include:
i.
ii.
iii.
iv.
v.

vi.
vii.

Banks, building societies and credit unions


Foreign bank representatives
General and life insurers
Friendly societies
Money market corporations, finance
companies and securitises
Licensed trustees
Superannuation entities.
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AUSTRALIAN FINANCIAL INTERMEDIARIES

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GROWTH OF FINANCIAL INTERMEDIARIES

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COMMERCIAL BANKS

Commercial banks are the largest and most diversified


intermediaries.
Australian-owned commercial banks hold more than
$2.85 trillion in financial assets (end 2013).
These assets consist of loans to consumers,
businesses and governments.
Commercial banks liabilities consist of deposit
accounts and other sources of funds.
Commercial banks might also be engaged in other
activities such as underwriting.

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NONBANK FINANCIAL
CORPORATIONS
1.

NBFCs provide many of the same services and


products that commercial banks provide.

2.

NBFCs may be classified into four groups:


I.
II.
III.
IV.

Building Societies
Credit Unions
Money-market Corporations
Finance Companies

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AUSTRALIAN OWNED BANK ASSETS

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OTHER FINANCIAL INSTITUTIONS


I.

Several groups of other financial institutions


operate in the financial system.

II.

These include:
I.
II.
III.
IV.
V.

Life insurance companies


General insurance companies
Superannuation funds
Managed Funds
Securitisers

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INTERNATIONAL ORGANISATIONS
In addition to domestic institutions, there are
a number of important international
organisations.
These

include:

The
The
The
The

Bank of International Settlements


World Bank
International Monetary Fund
Asian Development Bank

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PRIMARY AND SECONDARY


MARKETS

Primary markets are where financial claims


are initially sold by DSUs.

This might take place through an initial public


offering of shares to the public.

Secondary markets are where previously


issued financial claims are exchanged among
investors.

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ORGANISED AND
OVER-THE-COUNTER MARKETS
I.

II.

III.

IV.

Once issued, the exchange of claims can take


place on an organised exchange.
In Australia, an example is the Australian
Stock Exchange (ASX).
Financial claims can also be exchanged
over-the-counter. (OTC)
OTC markets have no central location.

Presented by Dr Sarod Khandaker

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OTHER MARKETS
Other types of financial markets include:

The futures market


The options market
Foreign exchange markets
International markets

For example: the eurocurrency markets and


eurobond markets where domestic or
overseas firms can borrow or lend Australian
dollars deposited in overseas banks.

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MONEY MARKETS
1.

We usually sort financial markets into either


money or capital markets.

2.

Money markets are where a certain type of


financial claim are traded.

3.

Specifically, a wholesale short term to maturity


(less than 12 months) claim is classified as a
money market transaction.

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MONEY MARKETS

Banks and businesses adjust their liquidity positions by


borrowing and lending for a short time on the money
market.

The RBA also conducts monetary policy on the money


markets.

The money market consists of a collection of markets


each trading a different financial instrument.

All of instruments have characteristics very similar to


money: high liquidity and low default risk.

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MONEY MARKET INSTRUMENTS


Treasury

notes
Commercial paper
Commercial bills
Negotiable certificates of deposit
Secured and unsecured notes

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CAPITAL MARKETS

Capital markets: where longer term


(greater than 12 months) securities are traded.

On capital markets, capital goods are financed


with stock or longer-term debt instruments.

Capital market instruments are less


marketable, have varying default levels and
have maturities ranging from five to thirty
years.

Presented by Dr Sarod Khandaker

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CAPITAL MARKET INSTRUMENTS


The instruments traded on the capital
market include:
I.
II.
III.
IV.

Shares
Corporate bonds
Government bonds
Mortgages

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INTERNATIONAL ASSETS AND LIABILITIES OF

AUSTRALIAN BANKS

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RISKS FACED BY FINANCIAL


INSTITUTIONS
Financial institutions are exposed to a variety of
risks. These include:

Credit risk
Interest rate risk
Liquidity risk
Foreign exchange risk
Political risk
Reputational risk
Environmental risk

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MANAGING RISK
The risks faced by financial institutions is
managed by:
a.
b.
c.
d.

Diversification of loans and investments


Careful credit analysis of borrowers
Careful monitoring of borrowers over time
The undertaking of appropriate hedging
strategies on the financial markets.

Presented by Dr Sarod Khandaker

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SUMMARY
You should now be able to:

Explain the role of the financial system and why it is


important.
Explain the function of direct and indirect financial
markets.
Describe the different types of financial intermediaries.
Describe the various types of financial markets.
Explain the economic function of money and capital
markets.
Identify the risks that financial institutions face and
describe how these risks are managed.

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THANK YOU

Presented by Dr Sarod Khandaker

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