Week 2 - The Financial System Flashcards
(32 cards)
The financial system
includes the financial institutions, financial instruments, and financial markets that facilitate the financial decisions of individuals/households, firms, and governments; the flow of funds from suppliers to users is essential for the economy because it allows those with surplus funds to invest in the productive opportunities of users of funds
Functions of the financial system include:
○ Payment Mechanism - clearing and settling payments to facilitate the exchange of goods and services
○ Risk Transfer - insurance companies offer policies for health, life and physical assets & managed funds take your savings and spread them out among the shares and bonds of many companies
○ Liquidity - individuals/households, firms, and government can convert their assets into cash at short notice without loss of value
The Flow of Funds - From those who have surplus funds (suppliers of funds) to those who need funds (users of funds)
Suppliers of Funds are investors, savers or lenders who have surplus funds
○ Funds are supplied mostly as bank deposits, investments and superannuation contributions
They require compensation for forgoing the immediate use of the funds and for the risk the funds will not be returned
Users of Funds
include individuals/households (for housing loans, personal loans), firms (to financne their investment decisions) and the government (both State and Australian) e.g issuer of bonds to finance deficits and infrastructure
Financial Market
is a general term that includes a number of different types of markets (e.g money market, capital market) for the creation and exchange of financial assets such as bonds and shares
Financial Institutions
are entities such as commercial banks, credit unions, insurance companies, finance companies and superannuation funds, which provide financial services to the economy
→ The distinguishing feature of financial institutions is that they employ their funds in financial assets, such as business loans, shares and bonds, rather than investing themselves in real assets such as warehouses and supplies
→ Competition between banks will drive term deposit interest rates up and loan interest rates down
→ The bank gathers loans from you and other consumers in small, dollar amounts, aggregates it, and then makes loans of much larger dollar amounts. Saving by consumers in small amounts is the way many large scale businesses are financed in the economy
→ An important feature of the financial system is to direct money to the best investment opportunities in the economy. If the financial system works, businesses with high rates of return and good credit standing are financed (vice versa)
The flow of funds through the financial system
Direct Financing (no intermediary)
○ Users of funds raise funds directly from suppliers of funds through the issue (sale) of financial instruments in the financial markets
○ Financial Instruments are contracts that specify the obligations of users of funds and the rights of suppliers of funds. Financial instruments are broader than financial assets, they include financial assets such as bank accounts, bonds, and shares and other instruments such as derivative contracts
○ In direct transactions, the lender-savers and the borrower-spenders deal “directly” with one another; borrower-spenders sell securities and bonds to the lender-savers in exchange for money; these securities represent claims on the borrowers’ future income or assets
○ A number of different interchangeable items are used to refer to securities, including financial instruments and financial claims
○ When managers decide to engage in a direct transaction, they often have a specific capital project that requires financing, such as building a new shopping centre
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○ To raise finance, companies can issue their own securities (e.g bonds and shares) in the financial market, particularly the capital market e.g to raise $200 million to finance their project, the Westfield group could issue bonds or shares in the capital market and list those on the ASX - to issue securities to the market a company needs to follow a rigorous process including issuing a public document called a prospectus - typically companies need help from investment banks to organise, issue and sell shares in the market
Investment banks specialise in helping companies sell new debt or equity - when investment bankers help bring new debt or security to the market, they perform two important tasks: origination and underwriting
Origination
is the process of preparing a security issue for sale. During the origination phase, the investment bank may help the client company determine the feasibility of the project being funded and the amount of capital that needs to be raised. Once this is done, the investment banker helps secure a credit rating, if needed, determines the sale date, obtains legal clearances to sell the securities, and gets the securities printed or created. If the securities are to be sold in the public market, the issuer must also lodge a prospectus with ASIC.
Underwriting
is the process by which the investment banker guarantees it will raise the funds it expects from its new security issue. In the most common type of underwriting arrangement, called stand-by underwriting , the investment banker guarantees to the company that the total funds that a company plans to raise by issuing new securities will be raised. Under a “stand by agreement” the investment banker will purchase any shares that are not sold at the initial offer price. The difference between the net price of the security and the gross price is the “underwriting spread”
Indirect Finance (intermediated finance)
○ Funds are supplied as deposits to financial institutions, which in turn supply funds as loans to users of funds
Allows firms who are too small and/or without the expertise and reputation to raise finance in the financial market to approach a financial institution to act as an intermediary
Financial Institutions and Indirect Financing
→ The premise of indirect financing is that a financial institution - intermediary - stands between the lender-saver and the borrower-saver
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→ The bank raises money by selling financial instruments such as cheque accounts, savings accounts, term deposits and various securities and then uses the money to make loans to businesses and consumers.
→ On a smaller scale, both superannuation funds and insurance companies also provide a significant portion of the long-term financing in the Australian economy through the indirect finance market. Insurance companies also invest into debt and equity securities issued by companies, using the funds that they receive when they sell insurance policies to individuals and businesses
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→ Contrary to the direct market, in the in-direct market securities flow between lenders-savers and borrowers-spenders they are repackaged and the form is changed. By repackaging securities, financial intermediaries tailor-make a wide range of financial products and services that meet the needs of consumers, small businesses and large companies. Their products are particularly important for small businesses that do not have access to direct financial markets.
→ Commercial banks are the most prominent and large financial intermediaries in the economy and offer the widest range of financial services to businesses. Nearly every business, small or large, has a significant relationship with a commercial bank - usually a cheque or transaction account or some type of loan arrangement. For businesses the most common type of bank transaction is a “line of credit” (often called an overdraft). A line of credit is a commitment by the bank to lend a company an amount up to a pre-determined limit, which can be used as needed.
→ The two types of insurance companies that are important are life insurance companies and general insurance companies, which sell protection against loss of property from theft, fire, accidents and other predictable causes. The cash flows for both types of companies are fairly predictable. As a result, they are able to provide funding to companies through the purchase of shares and bonds in the direct finance markets as well as funding for companies through private placement financing.
→ Superannuation is Australia’s retirement savings scheme whereby employers are required to contribute 9.5% of an employees’ salary to a complying superannuation fund. Superannuation funds then invest these contributions in financial market securities on behalf of employees. Because of the predictability of these cash flows, superannuation fund managers invest in money market securities, capital market securities (bonds and shares) and also in private placement market
→ Investment funds are pools of money collected from multiple investors, which are then used to purchase a variety of financial assets. These funds help individuals diversify their investments while providing businesses with funding; diversification reduces risk by spreading investments across different assets
→ Finance Companies (non-bank financial institutions) obtain the majority of their funds by selling short-term debt, called commercial paper to investors in direct credit markets. These funds are used to make a variety of short and intermediate term loans and leases to individuals and small businesses. The loans are often secured by accounts receivable or inventory. Finance companies are typically more willing than commercial banks to make loans and leases to companies with higher levels of risk default. Finance companies are important as they often provide loans to less individuals and businesses who would not qualify for bank loans
Companies and the Financial System
Debt
○ Borrowed funds, also known as “credit”
○ Commits the borrower to make the agreed interest and loan repayments
○ Provided indirectly by financial institutions (known as a loan) and directly by financial markets (known as a bond)
○ Failure to make repayments can result in bankruptcy
○ Sometimes specifies that lender can take possession of an asset if failed to repay loan e.g. mortgagee in possession (asset used as collateral)
○ Lower interest rate when asset is used as security
Equity
○ Equity capital is funds invested in a firm or investment by its owners; companies raise equity through the sale of ordinary shares
○ This is a source of “permanent” capital as the funds are not repayable
○ Shares are financial instruments that represent part-ownership in a firm; right to cash flows, future dividends, ownership if company goes bankrupt
○ Share value depends of the share’s expected future returns
○ Equity is referred to as risk capital because its returns (dividends and capital gains) are uncertain
Shareholders have the lowest payment priority. That is, they have a residual claim on earnings because debt payments are paid first
Financial Institutions
○ Authorise deposit-taking institutions that accept deposits and make loans
○ Fund managers that manage investors’ funds
○ Investment banks that assist their large company clients in accessing funds from the financial markets
Financial Markets
that arrange trading in financial instruments
Regulators
that oversee the institutions and markets
Authorised deposit taking institutions (ADIs)
authorised by Australian Prudential Regulation Authority (APRA) to accept deposits, make loans and provide other financial services. Including, the major banks, foreign banks, credit unions and building societies
Fund Managers = institutions
○ Pool and manage the money of many investors
○ They have the advantage of large-scale trading and portfolio management
○ Investors are assigned prorated share of the total funds according to the size of their investment
○ They include superannuation funds, public unit trusts, insurance companies
Investment Banking Activities
○ Advising and assisting corporates in obtaining financing in equity and debt markets
○ Advising large companies on takeovers, mergers and acquisitions
○ Managing investment portfolios for both individual and institutional investors
Trading in financial markets such as equity, dent, derivatives and commodities
Financial Markets
→ Primary Markets deal with issuing (selling) new financial instruments e.g., Guzman Y Gomez issuing shares in an initial public offering (IPO)
→ Secondary Markets trade existing instruments, e.g. an investor buying Guzman Y Gomez shares from an existing shareholder through a broker
→ Brokers are market specialists who bring buyers and sellers together in secondary markets; dealers are market-makers assuming risk on their own accounts
→ Liquidity is an important consideration in financial instruments traded in financial markets - financial instruments can be traded quickly at a fair price when a market has numerous buyers and sellers
→ Financial instruments are traded on organised exchanges (ASX, NYSE) or over the counter
→ The money market includes short-term debt instruments with maturities less than -year - instruments include Treasury notes, bank-accepted bills and commercial paper
→ The bond market includes medium and long-term debt instruments issued by:
○ Australian government (treasury bonds)
○ State governments (semi-government bonds)
○ Banks and corporates (corporate bonds)
Equity Markets are for issuing (selling) new shares in the primary market and trading existing shares in the secondary market e.g ASX
Financial Regulators
→ RBA’s task is to manage inflation -> by increasing interest rates, funds suppliers will save more rates than spepnd
→ Secondary markets for securities are important as they enable investors to buy and sell securities as often as they want
→ Marketability is the ease in which a security can be sold and converted into cash. A security’s marketability depends on whether the buyers of the security are readily available, and also on the costs of trading and search for information, so called transaction costs. The lower the transaction cost, the greater a security’s marketability. Because secondary markets are easier to trade securities, their existence increases a securities’ marketability
→ Liquidity is the ability to convert an asset into cash quickly without loss of value. Liquidity implies that when a security is sold, its value will be preserved; marketability does not carry this implication
→ Brokers are market specialists who bring buyers and sellers together for a sale to take place in the secondary market. They execute a transaction for their clients and charge an intermediary fee. Contrary to investment bankers, they bear no risk of ownership ; their service is only that of a “matchmaker”. In Australia, ComSec is a well known broker.
→ Dealers in contrast, “make markets” for securities and do bear risk. They make a market for a security by buying and selling from an inventory of securities they own. Dealers make their profit, just as merchants do, by selling securities at a price above what they paid for them. The risk dealers bear is a “price risk” which is the risk that they will sell the security for less than they bought it.
Exchanges and Over-the-Counter Markets
→ Financial markets can either be classified as organised (commonly known as exchanges) or over-the-counter (OTC) markets.
→ Traditional exchanges such as the ASX, provide a platform and facilities for members to buy and sell securities or other assets (such as commodities) under a specific set of rules and regulations. All members of the ASX are brokers
→ Securities not listed in the exchange can be bought in the OTC market.
→ The OTC differs from organised exchanges in that the ‘market’ has no central trading location. Instead, investors can execute OTC transactions by visiting or telephoning an OTC dealer or by using a computer based-electronic trading system linked to an OTC dealer
