Topic 1 - Lecture (Spr 2023)-1

Topic 1 – Lecture Overview

• Part A: Functions of the financial system

• Part B: Australia’s financial institutions

• Part C: Australia’s financial markets

• Part D: Financial regulators

• Part E: Fundamental Finance Concepts (Workshop only)

• Part F: Learning from History (Workshop only)

• Textbook Reference: Chapter 1

Page 2

• Textbook Information: 8th Edition Financial Institutions + Markets by Ben Hunt & Chris Terry, Copyright © 2019 Cengage Australia Pty Limited.

Page 3: Topics and Chapters

• Topic 1: The Financial System (Chapter 1)

• Topic 2: Direct Financing (Chapter 3)

• Topic 3: Authorised Deposit-Taking Institutions (Chapter 5)

• Topic 4: Money Market (Chapter 7)

• Topic 5: Bond Market (Part I) (Chapter 8)

• Topic 6: Bond Market (Part II) (Chapter 12)

• Topic 7: Shares (Chapter 9)

• Topic 8: Equity Markets (Chapter 10)

• Topic 9: Funds Management & Superannuation (Chapter 4)

• Topic 10: Forwards & Futures (Chapter 13)

• Topic 11: Options (Chapter 15)

• Topic 12: Foreign Exchange & the FX Market (Chapter 11)

Page 4: Definition of a Financial System

• A financial system comprises

  • Financial institutions

  • Markets

  • Instruments

• Functions: Provides financial services crucial for economic functioning.

• Developed financial systems perform five main functions.

Page 5: Components of a Financial System

• Main Components:

  • Financial Institutions:

    • Deposit-taking institutions (make loans)

    • Investment banks (aid companies in accessing funds)

    • Fund managers (manage investments)

  • Financial Markets: Facilitate trading in securities, foreign exchange, and derivatives.

  • Regulators: Ensure oversight of institutions and markets.

Page 6: Functions of the Financial System

• Functions: Critical for economic stability and growth.

Page 7: Major Functions of the Financial System

1. Settlement

2. Flow-of-funds

3. Risk-transfer

4. Promoting efficiency

5. Stability

Page 8: Transaction and Settlement

• Transaction: Agreement between buyer and seller.

• Settlement: Exchange of money for purchased items, including cash and payment instructions.

• Payment Instruments: Facilitate transactions and settlements.

Page 9: Tasks of Money in Settlements

• Three Functions of Money:

  • Medium of Exchange

  • Store of Value

  • Unit of Account

Page 10: Flow-of-Funds Function

• Fund Supply: Provided primarily by surplus units (e.g., bank deposits, super contributions) expecting returns.

• Deficit Units: Households, businesses, and governments seeking funds.

• Financial system allocates funds based on returns and risks involved.

Page 11: Methods of Fund Supply

1. Direct Financing:

   • Deficit units raise funds from surplus units via securities.

2. Indirect Financing:

   • Surplus units deposit funds with institutions that then lend to deficit units.

Page 12: Overview of Flow of Funds

• Direct Financing: Surplus units through financial markets.

• Indirect Financing: Via deposit-taking institutions.

• Objective: Channel funds to their most profitable use.

Page 13: Indirect Financing in Australia

• Indirect Financing: Predominantly used for residential property purchases.

Page 14: Contribution of Direct Financing

• Direct Financing: Enhances wealth through financial asset ownership, reflected in share-price indices.

Page 15: Risk-Transfer Contracts

• Derivatives: Financial instruments for managing risks faced by investors, businesses, and institutions.

Page 16: Types of Financial Risks

• Major Risks:

  • Default Risk: Failure to meet financial obligations.

  • Market Risk: Loss due to fluctuations in market variables (interest rates, exchange rates, share prices).

Page 17: Example of Risk-Transfer

• Qantas Scenario: Uses derivative contracts to hedge against rising fuel prices; gives up potential gains from falling prices.

Page 18: Risk-Transfer Example

• Price of Jet Fuel: Chart depicting profit and loss against risk hedging.

Page 19: Determinants of Financial System Efficiency

1. Mutually Beneficial Decision-Making: No information asymmetry or incentive problems.

2. Pooling Funds: From individual suppliers.

3. New Financial Instruments: Development of reliable services and operating systems.

Page 20: Information Asymmetry

• Definition: Occurs when one party in a contract has more information than the other, potentially leading to unfavorable outcomes.

Page 21: Addressing Information Asymmetry Risks

• Solutions: Financial regulations and restrictions for professional traders to ensure informed transactions.

Page 22: Influence of Financial Contracting Incentives

• Incentives can lead to unethical behavior (e.g., short-term profits over long-term stability).

Page 23: Addressing Problematic Incentives

• Moral Hazard: Individual acts in self-interest at the expense of responsibilities.

• Need for fiduciary duties and adherence to professional ethics.

Page 24: Incompatible Wants Between Surplus and Deficit Units

• Surplus units prefer small, short-term amounts while deficit units require large, long-term funding.

Page 25: Financial System Stability

• Crisis Impact: Unstable financial systems lead to economic crises, affecting employment and wealth.

• Role of Central Banks: Provide last resort lending to solvent banks; guided by international supervision.

Page 26: Australia’s Financial Institutions Overview

Page 27: Dominance of Financial Institutions in Australia

• Major Players by Assets:

  • Four major banks (ANZ, CBA, NAB, Westpac)

  • Credit unions

  • Building societies

  • Investment banks

Page 28: Types of Financial Institutions

• Authorised Deposit-Taking Institutions (ADIs): Accept deposits, make loans; regulated by APRA.

Page 29: Non-Bank Financial Institutions

• Merchant Banks: Provide services to wholesale customers.

• Finance Companies: Offer lease financing.

• Mortgage Originators: Lenders funding mortgage-backed loans.

Page 30: Fund Managers and Other Institutions

• Superannuation Funds: Long-term retirement income schemes.

• Public Unit Trusts: Voluntary investment vehicles.

• Insurance Companies: Manage funds, some with investment purposes.

Page 31: Australia’s Financial Markets Overview

Page 32: Types of Financial Markets in Australia

1. Money Market: Trades short-term debt securities.

2. Bond Market: Trades long-term securities with interest payments.

3. Share Market: Trades shares, paying dividends.

Page 33: Foreign Exchange Market

• Facilitates transactions in different currencies and trades derivatives contracts.

Page 34: Financial Regulators in Australia

Page 35: Key Financial Regulatory Bodies

• APRA: Prudential regulation for ADIs, insurance, and superannuation.

• ASIC: Enforces financial laws to protect consumers and investors.

• Australian Treasury: Influences regulations but does not regulate directly.

Page 36: Functions of RBA

1. Implement monetary policy.

2. Issue bank notes and coins.

3. Act as banker to the government.

Page 37: Further Functions of RBA

4. Monitor financial system stability.

5. Regulate the payment systems.

6. Manage Australia’s foreign exchange reserves.

Page 38: Preparations for Topic 1 Workshop

1. Revise Time Value of Money (FBF).

2. Watch "The Big Short": A true story featuring prominent actors.