Chapter 1

The financial
system

©2019 John Wiley & Sons Australia Ltd

 Learning objectives

After studying this presentation, you should be able to:

1.1 discuss the primary role of the financial system in
the economy, and how fund transfers take place
1.2 describe the primary, secondary and money markets,
and explain why these markets are so important to
businesses
1.3 explain how financial institutions serve consumers
and small businesses that are unable to participate
in the direct financial markets, and describe how
companies use the financial system
 Learning objectives

1.4 discuss the internationalisation of financial markets

and the role played by the BIS in ensuring the global
financial markets remain stable
1.5 explain what an efficient capital market is and why
market efficiency is important to financial managers.
 The financial system

• The financial system consists of financial markets and

financial institutions.
• These markets and institutions provide the structure to
the financial system.
• A well‐developed financial system is critical for the
operation of a complex economy such as that of
Australia.
 The financial system

• The financial system at work:

‒ The financial system is competitive.
‒ The bank gathers money from consumers in small dollar
amounts, aggregates it and then makes loans in much
larger dollar amounts.
‒ Money is directed to the best investment opportunities.
‒ Financial risk is managed and/or transferred to other
parties.
‒ The bank earns a profit.
 The financial system

• How funds flow through the financial system:

─ The system moves money from lender‐savers to
borrower‐spenders.
• Lender-savers = surplus spending units (SSU).
─ For example, households, some businesses and
state and local governments.
• Borrower‐spenders = deficit spending units (DSU).
– For example, businesses and the Commonwealth
Government.
 The financial system

• The flow of funds through financial system:

 The financial system

• Direct financing:
‒ The lender‐savers and the borrower‐spenders deal
‘directly’ with one another.
‒ Borrower‐spenders sell securities, such as shares and
bonds, to lender‐savers in exchange for money.
• Securities can be referred to as financial instruments
and financial claims.
‒ Typical minimum direct transaction size is $1 million.
‒ Provide the lowest possible cost.
 The financial system

• Direct financing:
– Major buyers and sellers are:
• commercial banks
• insurance and finance companies
• large business companies
• the Commonwealth Government
• hedge funds
• some wealthy individuals.
 The financial system

• A direct financing transaction (without using the

market):
– Suppose that the Westfield Group needs $200 million
to build a new centre and decides to fund it by selling
long‐term bonds with a 15‐year maturity.
– Westfield contacts a superannuation fund, which
expresses an interest in buying Westfield’s bonds.
 The financial system

• A direct financing transaction (without using the market):

– The superannuation fund will buy Westfield’s bonds
only after determining that the bonds are priced fairly
for their level of risk and the interest rate they carry.
– Westfield will sell its bonds to the superannuation fund
only after studying the current bond market to be sure
the price offered by the superannuation fund is
competitive.
 The financial system

• A direct financing transaction (without using the

market):
– If a deal is struck the flow of funds will be:
 The financial system

• Direct financing (using the market):

‒ To raise finance:
• companies can issue their own securities in the
financial market
• particularly in the capital market.
– Typically companies need help from experts to
organise, issue and sell securities in the market.
 The financial system

• Direct financing (using the market):

‒ Investment banks and direct financing:
• Investment banks specialise in helping companies
sell new debt or equity.
‒ Origination: the process of preparing a security
issue for sale.
– Underwriting: guarantees that the company will
raise the funds it expects from its new security
issue.
• Stand-by underwriting is most common.
 Financial markets

• In financial markets, people buy and sell financial

instruments, such as:
– stocks
– bonds
– futures contracts
– mortgage-backed securities.
 Financial markets

• Types of financial markets:

‒ Money market: short term market.
‒ Capital market: long term market.
‒ Primary market: where companies initially sell new
security issues (debt or equity).
‒ Secondary market: where owners of securities can sell
them to other investors.
 Financial markets

• Types of financial markets – other terms:

– Marketability: the ease with which a security can be
sold and converted into cash.
– Liquidity: the ability to convert an asset into cash
quickly without loss of value.
– Brokers: market specialists who bring buyers and
sellers together for a sale to take place.
– Dealers: ‘make markets’ for securities and bear risk.
 Financial markets

• Exchanges and over-the-counter markets:

– Financial markets can be classified as either:
• Organised markets (exchanges):
– 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.
– For example, the ASX - all members of the ASX
are broker and only members can use the
exchange.
 Financial markets

• Exchanges and over-the-counter markets:

– Financial markets can be classified as either:
• Over‐the‐counter (OTC) markets:
‒ Securities not listed on an exchange are bought
and sold in OTC markets.
 Financial markets

• Money and capital markets:

‒ Money markets are:
• where short‐term debt instruments, those which
have maturities of less than 1 year, are sold.
• wholesale markets in which the minimum
transaction is $1 million and transactions of $100
million are not uncommon.
• where instruments are lower in risk than other
securities because of their high liquidity and low
default risk.
 Financial markets

• Money and capital markets:

– Capital markets are:
• where intermediate‐term and long‐term debt and
corporate shares are traded.
• where companies raise funds to finance capital
assets, such as property, plant and equipment.
• carry more default risk and have longer maturities.
 Financial markets

• Public and private markets:

– Public markets: are organised financial markets where
members of the general public buy and sell securities
through their stockbrokers.
• For example, the ASX.
– Private markets: involve direct transactions between
two parties.
• Transactions are called private placements.
 Financial markets

• Futures and options markets:

– Often called derivative securities.
– Futures markets:
• New York Board of Trade
• Chicago Board of Trade
• in Australia, the ASX.
 Financial markets

• Foreign exchange markets:

– where foreign currencies are bought and sold.
– are traded on organised exchanges such as the ASX,
New Zealand Futures and Options Exchange (NZFOX)
and Hong Kong Stock Exchange (HKE).
 Financial institutions

• Financial intermediation:
– When financial institutions convert financial
instruments with one set of characteristics into
instruments with another set of characteristics.
– Intertwined with indirect financing.
– Benefits include:
• Denomination divisibility, currency transformation,
maturity flexibility, credit risk diversification and
liquidity.
 Financial institutions

• Financial institutions and their services:

– Commercial banks:
• offer the widest range of financial services to
businesses.
– Life and general insurance companies:
• provide funding to companies through the purchase
of shares and bonds in the direct finance markets.
• also fund private companies through private
placement financing.
 Financial institutions

• Financial institutions and their services:

– Superannuation funds:
• invest contributions in financial market securities
on behalf of the employees.
– Investment funds:
• sell shares to investors and use the funds to
purchase a wide variety of direct and indirect
financial instruments.
 Financial institutions

• Financial institutions and their services:

– Finance companies:
• sell short‐term debt, called commercial paper, to
investors in direct credit markets.
– Financial planning practices:
• assist individuals and corporations to meet their
long‐term financial goals by analysing each client’s
financial status and setting a program to achieve
their goals.
 Financial institutions

• Risks faced by financial institutions:

‒ Credit risk:
• The possibility that the borrower will fail to make
either interest or principal payments in the amount
and at the time promised.
‒ Interest rate risk:
• The risk of fluctuations in a security’s price or
reinvestment income caused by changes in market
interest rates.
 Financial institutions

• Risks faced by financial institutions:

– Liquidity risk:
• The risk that a financial institution will be unable to
generate sufficient cash inflow to meet required
cash outflows.
– Foreign exchange risk:
• The fluctuation in the earnings or value of a
financial institution that arises from changes in
exchange rates.
 Financial institutions

• Risks faced by financial institutions:

– Political risk:
• The risk of fluctuation in the value of a financial
institution resulting from the actions of Australian
or foreign governments.
 Financial institutions

• Risks faced by financial institutions:

– Reputational risk:
• The potential for negative publicity regarding an
institution’s business practices to cause a decline in
the customer base, costly litigation or revenue
reduction.
 Financial institutions

• Risks faced by financial institutions:

– Environmental risk:
• Issues, such as climate change and environmental
litigation, are increasingly being recognised as key
risk factors for financial institutions and their
clients.
 Financial institutions

• Risks faced by financial institutions:

– Operational risk:
• Complexity and scale of large businesses create a
risk of loss due to the failure or inadequacy of
internal systems, people and processes that should
ensure the effective and efficient operation of a
financial institution.
 Financial institutions

• Risks faced by financial institutions:

– Contagion risk:
• The risk of financial difficulties in one organisation
spreading to others due to the complex
interrelationships between institutions and the
nature of the exchange settlement systems.
 Financial institutions

• Companies and the financial system:

– Cash flows relate to some of the key decisions that the
financial manager must make.
– These decisions involve three major areas:
• capital budgeting
• financing
• working capital management.
 Financial institutions

• Cash flows between a company and the financial system:

 International financial markets

• Financial markets can be classified as either domestic or

international.
• The most important international financial markets for
Australian firms are the:
‒ short‐term US market
‒ eurocurrency market
‒ long‐term eurobond market.
 International financial markets

• Internationalisation of financial markets:

– Domestic financial markets are part of a global financial
system.
– Intermediating borrowing and lending between the
local nation and the rest of the world.
– Necessitated by expanding international trade and
production, and the development of multinational
corporations.
 International financial markets

• International organisations:
‒ play a significant role in the global financial markets.
‒ examples are:
• The Bank for International Settlements (BIS)
• The World Bank
• The International Monetary Fund (IMF)
• The Asian Development Bank (ADB).
 International financial markets

• International assets of Australian institutions:

– In the Australian financial system, Australian banks
have accumulated significant offshore assets and
liabilities.
• Figures are not large as a percentage of GDP.
• Australia’s reliance on international funding is more
apparent when the net liability position of
Australian banks is considered.
– Necessary to consider aspects of the international
financial system and the importance of globalisation.
 Capital market efficiency

• Efficient capital markets:

– fully reflect the knowledge and expectations of all
investors at a particular point in time.
• Overall efficiency depends on:
– Operational efficiency: focuses on bringing
buyers and sellers together at the lowest
possible cost.
– Informational efficiency: market prices reflect
all relevant information about securities at a
particular point in time.
 Capital market efficiency

• Efficient market hypotheses:

– Strong-form efficiency:
• the idea that all information about a security is
reflected in its price.
– Semi-strong-form efficiency:
• holds only that all public information
• information available to all investors
• is reflected in security prices.
 Capital market efficiency

• Efficient market hypotheses:

– Weak-form efficiency:
• holds that all information contained in past prices
of a security is reflected in current prices, but there
is both public and private information that is not.
 Summary

• The primary role of the financial system in the economy,

and how fund transfers take place.
• The primary, secondary and money markets, and explain
why these markets are so important to businesses.
• How financial institutions serve consumers and small
businesses that are unable to participate in the direct
financial markets, and describe how companies use the
financial system.
 Summary

• The internationalisation of financial markets and the role

played by the BIS in ensuring the global financial markets
remain stable.
• What an efficient capital market is and why market
efficiency is important to financial managers.