FIN80004 Lecture1

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
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
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.
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.
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.
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
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.
AUSTRALIAN FINANCIAL INTERMEDIARIES
GROWTH OF FINANCIAL INTERMEDIARIES
10
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.
11
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
12
AUSTRALIAN OWNED BANK ASSETS
13
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
14
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
15
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.
16
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.
17
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.
18
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.
19
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.
20
MONEY MARKET INSTRUMENTS

Treasury
notes
Commercial paper
Commercial bills
Negotiable certificates of deposit
Secured and unsecured notes
21
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.
22
CAPITAL MARKET INSTRUMENTS

The instruments traded on the capital
market include:
I.
II.
III.
IV.
Shares
Corporate bonds
Government bonds
Mortgages
23
INTERNATIONAL ASSETS AND LIABILITIES OF
AUSTRALIAN BANKS
24
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
25
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.
26
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.
27
THANK YOU
28

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What are the roles of the financial system?

What are the roles of the financial system?

What is the difference between direct and indirect financing?

What is the difference between direct and indirect financing?

Lecture 1: Chapter 1

A Modern Financial System

Presented by Dr Sarod Khandaker

THE ROLE OF THE FINANCIAL SYSTEM

The financial system consists of financial

The roles of the financial system are:

To facilitate the flow of funds

Presented by Dr Sarod Khandaker

THE FLOW OF FUNDS

Figure 1.2 Flow of funds

Presented by Dr Sarod Khandaker

SSUs and DSUs

Economic units can be classified as:

A surplus unit is a unit whose income exceeds

SSUs lend money to DSUs and accept a

In direct financing, this exchange takes place

The limitations of direct financing create a role

Presented by Dr Sarod Khandaker

Direct financing requires DSUs to find SSUs

These problems are resolved through the

Financial intermediaries purchase direct claims

Presented by Dr Sarod Khandaker

Presented by Dr Sarod Khandaker

Banks, building societies and credit unions

AUSTRALIAN FINANCIAL INTERMEDIARIES

Presented by Dr Sarod Khandaker

GROWTH OF FINANCIAL INTERMEDIARIES

Presented by Dr Sarod Khandaker

Commercial banks are the largest and most diversified

Presented by Dr Sarod Khandaker

NBFCs provide many of the same services and

NBFCs may be classified into four groups:

Presented by Dr Sarod Khandaker

AUSTRALIAN OWNED BANK ASSETS

Presented by Dr Sarod Khandaker

OTHER FINANCIAL INSTITUTIONS

Several groups of other financial institutions

Life insurance companies

Presented by Dr Sarod Khandaker

Bank of International Settlements

Presented by Dr Sarod Khandaker

PRIMARY AND SECONDARY

Primary markets are where financial claims

This might take place through an initial public

Secondary markets are where previously

Presented by Dr Sarod Khandaker

Once issued, the exchange of claims can take

Presented by Dr Sarod Khandaker

The futures market

For example: the eurocurrency markets and

Presented by Dr Sarod Khandaker

We usually sort financial markets into either

Money markets are where a certain type of

Specifically, a wholesale short term to maturity

Presented by Dr Sarod Khandaker