Introduction to Financial System

Wallace Fan – Adjunct Lecturer

Profession –
•Banking and finance Specialist
•Help corporates solve funding and banking problems
•Corporate governance - Independent non-executive director

Education -
•CFA 2001, MBA (AGSM) 1998, A.B (Economics) 1991
•Member of Omicron Delta Epsilon, International Honour Society, Economics
•2012 Graduate of Australian Institute of Company Directors (GAICD)

Personal –
•A lovely wife and 2 beautiful young daughters (16 & 18)
•Like to stay active with a bit of running, swimming, cycling, guitar, drawing/painting
 What to expect
 Refer to course outline…

– Lecture and tutorial webinars schedules

– Assessments

Any questions?
4
 Learning Objectives
 Explain the functions of a financial system
 Categorise the main types of financial institutions
 Describe the main classes of financial instruments issued
in a financial system
 Distinguish between various types of financial markets
according to function
 Discuss the flow of funds between savers and borrowers,
including primary/secondary markets and
direct/intermediated finance
Then, what is money?
 Money
– Acts as medium of exchange
– Represents a store of wealth
– Facilitates saving
– Solves the divisibility problem
 5 Sector Economy
HOUSEHOLD FIRMS
Sector Sector

FINANCIAL
Sector

GOVERNMENT
Sector

OVERSEAS
Sector
 Flow of Funds
 Sectorial flow of funds
– The flow of funds between business, financial institutions,
government and household sectors and the rest of the world
– Net borrowing and net lending of these sectors of an economy
vary between countries
– Influenced by
• The impact of fiscal and monetary policy on savings and investment
decisions
• Policy decisions like compulsory superannuation
Chapter Organisation

1.1 Functions of a Financial System

1.2 Financial Institutions
1.3 Financial Instruments
1.4 Financial Markets
1.5 Flow of Funds and Market Relationships
1.6 Summary
 What is financial System?

The financial system is part of a country’s

economic system
A financial system comprises a range of financial
institutions, financial instruments and financial
markets which interact to facilitate the flow of
funds
Financial institutions permit the flow of funds
between borrowers and lenders by facilitating
financial transactions
The main functions of financial system

Provide investment products for surplus

economic units – shares, bank deposits
Provide alternative funding sources for
deficit economic units – bank loans
Provide risk management products and
services – insurance products
 The main functions of financial system
Main function is to facilitate the flow of funds
Primary Financial Market -facilitate the transfer of funds
from surplus to deficit economic units by the creation of
new financial assets
Secondary Market – facilitates the transfer of funds by
arranging trades in existing financial assets
Efficient financial system should ensure that savings will
be directed to the most efficient users of those funds
Overseeing the financial system is the Central bank and
the prudential supervisor
Functions of a Financial System (cont.)
 1. Financial Institutions
Financial institutions are classified into five
categories based on the differences between
the institutions’ sources and uses of funds
1.Depository financial institutions
2.Investment banks and merchant banks
3.Contractual savings institutions
4.Finance companies
5.Unit trust
 Depository financial institutions
Commercial banks
obtains a large proportion of their funds from
deposits lodged by savers.
A principal business of these institutions is the
provision of loans to borrowers in the
household and business sectors
E.g.
 Investment banks and merchant banks
Major function is to provide off-balance sheet
advisory services to support their corporate and
government clients
Off balance sheet business includes advising clients
on mergers and acquisitions, portfolio restructuring,
and risk management.
These institutions may provide some loans to clients
but are more likely to advise and assist a client to
raise funds directly in the capital markets.
 Contractual savings institutions
Financial institutions such as life insurance offices,
general insurers and superannuation funds
Their liabilities are mainly contracts which specify that,
in return for periodic payments to the institution, the
institution will make specified payouts to the holder of
the contract if and when the event specified in the
contract occurs.
The periodic cash receipts received by these institution
provide them with a large pool of funds that they invest.
 Finance companies
These institutions raise funds by issuing financial
securities such as commercial paper, medium
term notes and bonds in the money markets and
the capital markets
They use those funds to make loans and provide
lease finance to their customers in the household
sector and the business sector
 Unit trusts
A unit trust is formed under a trust deed and is
controlled and managed by a trustee or responsible
entity
Unit trusts attract funds by inviting the public to
purchase units in a trust. The funds obtained from the
sale of units are pooled and then invested by funds
managers in asset classes specified in the trust deed.
There is a wide range of unit trusts, including equity
trusts, property trusts, fixed interest trusts and
mortgage trust.
1.2 Financial Institutions (cont.)
 Chapter Organisation

1.1 Functions of a Financial System

1.2 Financial Institutions
1.3 Financial Instruments
1.4 Financial Markets
1.5 Flow of Funds and Market Relationships
1.6 Summary
 Financial Assets
 A financial asset is defined as entitlement to
future cashflows
 A financial instrument is the more general
term used in the markets to describe financial
assets and other instruments where there is no
organised secondary market where that
instrument can be traded
 A financial security is a financial asset that can
be traded in secondary market.
 Financial Assets
Attributes of financial assets
–Return or yield
• Total financial compensation received from
an investment expressed as a percentage of
the amount invested
–Risk
• Probability that actual return on an
investment will vary from the expected return
 Financial Assets
Attributes of financial assets (cont.)
–Liquidity
• Ability to sell an asset within reasonable time
at current market prices and for reasonable
transaction costs
–Time-pattern of the cash flows
• When the expected cash flows from a financial
asset are to be received by the investor or
lender
 Financial Assets
 The financial system (financial
institutions, instruments and markets)
provides the potential suppliers of
funds with the combinations of risk,
return, liquidity and cash-flow patterns
that best suit each saver’s particular
needs
 2. Financial Instruments
A financial instrument represents an
entitlement to the holder to a specified set of
future cash flows.

Equity
Debt
Derivatives
Hybrid
 Equity
Equity can be described as an ownership
interest in an asset
Types
• Ordinary share
• Hybrid (or quasi-equity) security
– Preference shares
– Convertible notes
 Debt
 Debt
– Contractual claim to:
• periodic interest payments
• repayment of principal
– Ranks ahead of equity
– Can be:
• short-term (money market instrument) or medium- to long-term
(capital market instrument)
• secured or unsecured
• negotiable (ownership transferable, e.g. commercial bills and
promissory notes) or non-negotiable (e.g. term loan obtained
from a bank
 Debt Finance
Short-term debt is a financing arrangement for a
period of less than one year with various
characteristics to suit borrowers’ particular needs
–Timing of repayment, risk, interest rate structures
(variable or fixed) and the source of funds
Long term debt has a maturity of more than one
year
 Derivatives
Derivative instruments are different from equity and debt in
that they do not provide actual funds for a borrower, but
rather facilitate the management of certain related risks.
Used mainly to manage price risk exposure and to
speculate
4 different types of derivative instrument
– A futures contract
– A forward contract
– An option contract
– A swap contract
 HYBRID
 A hybrid security incorporates the
characteristics of both debt and equity
 E.g. preference share
 Chapter Organisation

1.1 Functions of a Financial System

1.2 Financial Institutions
1.3 Financial Instruments
1.4 Financial Markets
1.5 Flow of Funds and Market Relationships
1.6 Summary
 3. Financial Markets
 Matching principle
 Primary and secondary market transactions
 Direct and intermediated financial flow
markets
 Wholesale and retail markets
 Money markets
 Capital markets
 Financial Markets
 Financial market within the economic system is vital
for the country
 Financial markets are characterised by
– Lending and borrowing of funds
– Creation and trading of financial assets
 financial market is distinguished from other
economic markets such as the market for final
goods – real assets
 The markets are categorised according to the types
of transactions that occur
 Matching principle
 Short-term assets should be funded with short-
term (money market) liabilities, e.g.
– Seasonal inventory needs funded by overdraft
 Longer-term assets should be funded with equity
or longer-term (capital market) liabilities, e.g.
– Equipment funded by debentures
 lack of adherence to this principle accentuated
effects of frozen money markets with the ‘sub-
prime’ market collapse
Primary and secondary market transactions

 Primary market transaction

– The issue of a new financial instrument to raise funds to
purchase goods, services or assets by
• Businesses
– Company shares or debentures
• Governments
– Treasury notes or bonds
• Individuals
– Mortgage
– Funds are obtained by the issuer
Direct and intermediated finance (cont.)

1-
37
 Primary and secondary market transactions (cont.)
 Secondary market transaction
– The buying and selling of existing financial securities
• No new funds raised and thus no direct impact on
original issuer of security
• Transfer of ownership from one saver to another
saver
• Provides liquidity, which facilitates the restructuring
of portfolios of security owners
Direct Finance and Intermediated Finance

 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
– Direct relationship from the provider of funds to the user of funds
– Indirect relationship from the provider of funds to the user of funds
i,e, financial intermediary is involved
 Direct and intermediated financial flow markets
 Direct financial flow markets - Users of funds obtain finance
directly from savers
 The contractual agreement is between the provider of funds
and the user of funds
 Direct finance is generally available only to corporations and
government authorities that have established a good credit
rating (investment-grade credit rating)
Direct finance con’t

 Advantages
– Avoids costs of intermediation
– Increases range of securities and markets
 Disadvantages
– Matching of preferences
– Liquidity and marketability of a security
– Search and transaction costs
– Assessment of risk, especially default risk
Direct and intermediated financial flow markets (cont.)
Direct and intermediated financial flow markets (cont.)

 Intermediated financial flow markets

– A financing arrangement involving two
separate contractual agreements whereby
saver provides funds to intermediary and
the intermediary provides funding to the
ultimate user of funds
Direct and intermediated financial flow markets (cont.)
 Direct and intermediated financial flow markets (cont.)
 Advantages
– Asset transformation
• Borrowers and savers are offered a range of products
– Maturity transformation
• Borrowers and savers are offered products with a range of terms to
maturity
– Credit risk diversification and transformation
• Saver’s credit risk limited to the intermediary
– Liquidity transformation
• Ability to convert financial assets into cash
– Economies of scale
• Financial and operational benefits of organisational size, expertise
and business volume
 Wholesale and retail markets
 Wholesale markets
– Direct financial flow transactions between institutional
investors and borrowers
• Involves larger transactions

 Retail markets
– Transactions conducted primarily with financial
intermediaries by the household and small- to
medium-sized business sectors
• Involves smaller transactions
Wholesale and retail markets (cont.)

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 Money markets
 Wholesale markets in which short-term securities
are issued (primary market transaction) and traded
(secondary market transaction)
– Securities highly liquid
• Term to maturity of one year or less
• Highly standardised form
• Deep secondary market
– No specific infrastructure or trading place
– Enable participants to manage liquidity
Money markets (cont.)
 Capital markets
 Markets in which longer-term securities are issued and
traded with original term-to-maturity in excess of one
year
– Equity markets
– Corporate debt markets
– Government debt markets
 Also incorporate use of foreign exchange markets and
derivatives markets
 Participants include individuals, business, government
and overseas sectors
 1.6 Summary
 The financial system is composed of financial
institutions, instruments and markets facilitating
transactions for goods and services and financial
transactions
 Financial instruments may be equity, debt or hybrid
 Financial markets may be classified according to
– Primary and secondary transactions
– Direct and intermediated flows
– Wholesale and retail markets
– Money markets and capital markets