Financial Institutions

FINANCIAL MARKETS AND INSTITUTIONS

Topic 3
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Overview: Financial Institutions

Characteristics
Main types of
of depository
FIs
institutions

Source of
Uses of funds
funds

Non-bank
financial
institutions

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Main types of financial institutions

Deposit Taking Financial Institutions: attract the

savings of depositors through on-demand deposit and
term deposit accounts.
 e.g. commercial banks, building societies and credit
cooperatives.

Non Deposit Taking Financial Institutions: may

manage funds under contractual arrangements and
provide a wide range of financial services.
 e.g. Investment banks, general insurance companies and
superannuation funds.

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Main types of financial institutions

Insurers
ADIs Non-ADIs
and Funds
Investment banks
Commercial banks and Merchant Managed funds
Banks

Finance Life insurance

Building societies companies and offices and general
and credit general financiers insurance offices
And etc… And etc…

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Institution features
Main types of Financial Institutions in Australia as at June 2020:
Authorised Deposit-taking Institutions (ADIs)
Number of Total assets
Type of institution Main supervisor/ regulator Percentage
institutions ($b)
Banks APRA 98 5410.4 58.83%
Credit unions and building societies APRA 40 54.7 0.59%
Non-ADI Financial Institutions
Money market corporations (broker-
ASIC 6 39.6 0.43%
dealers)
Finance companies (including
general financiers and pastoral ASIC 129 250.8 2.73%
finance companies)
Securitisers – 158.3 1.72%
Insurers and Funds Managers

Life insurance companies APRA 28 91.6 1.00%

General insurance companie APRA 95 219.8 2.39%

Health insurance companies APRA 37 16.6 0.18%
Superannuation and approved
APRA 1818 2523.2 27.44%
deposit funds
Public unit trusts ASIC – 372.6 4.05%

Cash management trusts ASIC – 42.6 0.46%

Common funds State and territory authorities – 10 0.11%
Friendly societies APRA 12 6.2 0.07%

Data source: https://www.rba.gov.au/fin-stability/fin-inst/main-types-of-financial-institutions.html University©

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Main types of financial institutions

Commercial banks
Commercial banks are the largest group of financial
institutions within a financial system.
The core business of banks is often described as the
gathering of savings (deposits) in order to provide loans for
investment.
They also provide a wide range of off-balance-sheet
transactions such a underwriting, issue of derivatives or
execute FX transactions.

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Characteristics of Commercial Banks

 Commercial banks control a significant proportion of the

financial assets within the financial system and provide a
full range of financial services
 In the modern financial system, the activities of commercial
banks are far less regulated than they have been
historically
 In a less regulated environment, commercial banks practise
‘liability management’ whereby shortfalls in loan demand
are borrowed on the capital markets
 The regulation of the banking sector attracted renewed
attention following the Global Financial Crisis (GFC)
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Characteristics of Commercial Banking

Importance of banks
 A high level of regulation prior to the mid-1980s constrained
banks’ development and led to a growth of non-bank
financial institutions
 With deregulation in the period after 1980, banks began to
practise liability management, where demand for loans was
met by borrowing rather than from available deposits or
equity
 Commercial banks hold the largest share of assets of all
institutions
 But even this understates the volume of business that
commercial banks undertake because it does not include
off-balance-sheet transactions
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Characteristics of Commercial Banking

Asset management (before the 1980s)

 Loans portfolio is tailored to match the available deposit
base

Liability management (1980s onwards)

 Deposit base and other funding sources are managed to
meet loan demand
 Borrow directly from domestic and international capital markets
 Provision of other financial services
 Off-balance-sheet (OBS) business
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Sources of funds
Sources of funds appear in the balance sheet as either
liabilities or shareholders’ funds

Banks offer a range of deposit and investment products with

different mixes of liquidity, return, maturity and cash flow
structure to attract the savings of surplus entities
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Sources of funds

Current account deposits

 Funds held in a cheque account
 Highly liquid
 May be interest or non-interest bearing

Call or demand deposits

 Funds held in savings accounts that can be withdrawn on
demand
 Includes passbook account, electronic statement account with ATM and
EFTPOS
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Sources of funds
Term deposits
 Funds lodged in an account for a predetermined period at
a specified interest rate
 Term: one month to five years
 Loss of liquidity owing to fixed maturity
 Higher interest rate than current or call accounts
 Generally fixed interest rate

Negotiable certificates of deposit (CDs)

 Paper issued by a bank in its own name
 Issued at a discount to face value
 Specifies repayment of the face value of the CD at
maturity
 Highly negotiable security
 Short term (30 to 180 days)
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Sources of funds

Bill acceptance liabilities

 Bill of exchange
 A security issued into the money market at a discount to the face value.
The face value is repaid to the holder at maturity

 Acceptance
 Bank accepts primary liability to repay face value of bill to holder
 Issuer of bill agrees to pay bank face value of bill, plus a fee, at maturity
date
 Acceptance by bank guarantees flow of funds to its customers without
using its own funds

(cont.)
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Sources of funds

Debt liabilities
 Medium- to longer-term debt instruments issued by a bank
 Debenture
 A bond supported by a form of security, being a charge over the assets of the
issuer (e.g. collateralised floating charge)
 Unsecured note
 A bond issued with no supporting security

(cont.)
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Sources of funds

Foreign currency liabilities

 Debt instruments issued into the international capital
markets that are denominated in a foreign currency
 Allows diversification of funding sources into international markets
 Facilitates matching of foreign exchange denominated assets
 Meets demand of corporate customers for foreign exchange products

(cont.)
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Sources of funds

Loan capital and shareholders’ equity

 Sources of funds that have characteristics of both debt and
equity (e.g. subordinated debentures and subordinated
notes)
 Subordinated means the holder of the security has a claim on interest
payments or the assets of the issuer after all other creditors have been
paid (excluding ordinary shareholders)
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Uses of funds
Personal and housing finance
 Investment property
 Fixed-term loan
 Credit card
 Housing finance
 Mortgage
 Amortised loan

(cont.)
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Uses of funds

Commercial lending
 Involves bank assets invested in the business sector and
lending to other financial institutions
 Fixed-term loan
 A loan with negotiated terms and conditions
 Period of the loan
 Interest rates
• Fixed or variable rates set to a specified reference rate (e.g. BBSW)
 Timing of interest payments
 Repayment of principal

(cont.)
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Uses of funds

Commercial lending
 Overdraft
 A facility allowing a business to take its operating account into debit up to an
agreed limit
 Bills of exchange
 Bank bills held
 Bills of exchange accepted and discounted by a bank and held as assets
 Commercial bills
 Bills of exchange issued directly by business to raise finance
 Rollover facility
 Bank agrees to discount new bills over a specified period as existing bills
mature
 Leasing
(cont.)
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Uses of funds
Lending to government
 Treasury notes
 Short-term discount securities issued by the Commonwealth Government
 Treasury bonds
 Medium- to longer-term securities issued by the Commonwealth
Government that pay a specified interest coupon stream
 State government debt securities
 Low risk and low return

Other bank assets

 Include electronic network infrastructure and shares in
controlled entities
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Non-bank financial institutions

Operating alongside commercial banks are a range of non-
bank financial institutions. These include:

• Investment banks
• Managed funds
• Life insurance and general insurance offices
• Finance companies and general financiers
• Building societies and Credit unions
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Investment bank and merchant

banks (MM Corp)
Investment banks are innovators at the cutting edge of
developments in the financial system, often using the latest
theoretical work produced by finance scholars
The organisation of an investment bank is interesting:
 front office, middle office and back office
In Australia, investment banks or money market
corporations do not control a large share of the total assets
of financial institutions
However, they remain important as innovators and deal-
makers (cont.)
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Main types of financial institutions

Investment banks and merchant banks
(MM Corp)
Mainly provide off-balance-sheet (OBS) advisory services to
support corporate and government clients, e.g.:
 advice on mergers and acquisitions, portfolio restructuring,
finance and risk management
May also provide some loans to clients but are more likely to
advise on raising funds directly in capital markets.
They also execute FX transactions

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Investment banks

Sources of funds
 Mainly securities issued into international money markets
and capital markets

Uses of funds
 Limited lending to clients, usually on short-term basis
 These loans tend to be sold into the secondary market
 Primarily focused on off-balance-sheet advisory services
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Main types of financial institutions

Managed Funds
Attract the savings from individual investors and invest in both
money and capital market.
Funds normally managed by professional investment managers
with extensive investment knowledge and skills.
Managers seek to maximise the return on investment portfolios at
given level of risk.
Provide access to wholesale markets (not an intermediary).
Investors in the fund obtain a right to the assets of the fund or the
income derived from those assets.
George Soros and the Quantum Fund
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Main types of financial institutions

Managed Funds (cont’d)

The main types of managed funds are
 cash management trusts, public unit trusts, superannuation
funds (also a contractual institution), statutory funds of life offices,
common funds and friendly societies.
 The large pool of funds is then used to purchase both primary and
secondary market securities
Managed funds may be categorised by their investment risk
profile, being capital guaranteed funds, capital stable funds,
balanced growth funds, managed or capital growth funds.

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Life and general insurance

The liabilities of these institutions are contractual. They
provide a contract that require, in return for periodic
payments to the institution, the institution to make payments
to the contract holders if a specified event occurs, e.g.:
 life and general insurance companies
The large pool of funds is then used to purchase both
primary and secondary market securities
Payouts are made for insurance claims and to retirees

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Life insurance offices

Uses of funds
 Outflow of funds quite predictable and stable and therefore
invest mainly in long-term securities
 Statutory funds invested in:
 equities and unit trusts
 long-term securities
 cash and short-term securities
 Overseas

Regulation
 Supervised by APRA, which applies the same capital and
liquidity management requirements as for banks
 Life Insurance Act 1995 (Cwlth)—licensing and control
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General insurance offices

Insurer pays the insured a predetermined amount if some
prespecified event occurs
Sources of funds
 Contractual premiums paid in advance for:
 house and contents
 co-insurance, public liability insurance
 motor vehicle insurance
 comprehensive; third party, fire and theft; third party; compulsory third party
 other risk insurance policies to individuals in retail market and businesses
in the commercial market.

 Inflow of funds not as stable as life offices

(cont.)
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General insurance offices

Uses of funds
 Generally shorter term, highly marketable securities, owing
to the less predictable nature of the risks underwritten
 Examples
 Money market securities, such as bills of exchange, commercial paper
and certificates of deposit

Share of total assets declined from 4.4% in 1990 to 3% in

2018
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Finance companies and general financiers

Borrow in domestic and international financial markets and

make loans to small business and individuals
 They emerged largely owing to previously highly regulated
banking sector to circumvent restrictions on interest rates
and lending.
 The sector can be classified into:
 diversified finance companies
 manufacturer-affiliated companies (e.g. Ford Credit)
 niche specialists (e.g. motor vehicle and lease financing).

 The sector share of total assets has declined from 7.5% in

1990 to less than 2% in 2018 as commercial banks are
more competitive in deregulated environment (cont.)
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Finance companies and general financiers

Sources of funds
 Issue of debentures and unsecured notes
 Borrowings from related corporations and banks
 Borrowing direct from domestic and international money
and capital markets

Uses of funds
 Loans to individuals, possibly higher risk
 Lease financing
 Loans to small- and medium-sized businesses (e.g. bills
finance, term loans, floor plan financing, factoring and
accounts receivable financing)
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Building societies
Authorised deposit-taking institutions mainly lending for
residential property
During period of regulation, building societies gained market
share at the expense of savings banks
Since deregulation, the sector share of total assets declined
from 3.1% in 1990 to less than 1% in 2018. In response
some building societies have:
 merged to rationalise costs
 become banks (e.g. Challenge Bank, Advance Bank and
Heritage Bank)
 improved technology for service and cost reasons
(cont.)
 diversified activities and products offered to savers and
borrowers
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Building societies

Sources of funds
 Mainly deposits from customers
Uses of funds
 Personal finance to individual borrowers
 Mainly housing finance
 Term loans and credit card finance

Regulation
 As they are ADIs (i.e. authorised by APRA to accept retail
deposits), regulation is by APRA with the same prudential
and reporting standards as banks
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Credit unions

Common bond of association often exists between members

owing to employment, industry or community (e.g. Shell
Employees’ Credit Union)
Share of total financial institutions assets remained relatively
stable, only declining from 1.2% in 1990 to less than 1% in
2018
Sources of funds
 Mainly deposits from members (payroll deductions)
 Other credit unions and the issue of promissory notes and
other securities (cont.)
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Credit unions

Uses of funds
 Primarily personal finance to members
 Residential housing loans
 Personal loans and credit card facilities
 Limited commercial lending

Regulation
 As ADIs, they are regulated by APRA, which applies the
same prudential and reporting standards as for banks and
PBSs
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Summary
Banks are the dominant financial institution and have moved to liability
management
 Sources of funds include deposits (current, call and term deposits) and non-
deposit sources (bill acceptances, debt and foreign currency liabilities, OBS
business and other services)
 Uses of funds include government, commercial and personal lending
Non-bank financial institutions can be classified according to their assets and
liabilities and the type of services provided
 Investment banks provide advisory services to corporations and government
 Life insurance and general insurance offices are contractual savings institutions
that generate funds mainly on the receipt of premiums for insurance policies
 Finance companies issue debentures and unsecured notes and lend to
individuals and businesses
 Building societies and credit unions receive deposits from individuals and lend
for residential housing
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