Financial System Mod1
Subject Structure and Delivery
The subject is organized into three primary delivery components to ensure a comprehensive understanding of the financial system:
Pre-recorded Lectures: These are accessed weekly on Canvas. It is required to review the lecture slides and listen to the recordings before attending the corresponding workshops.
Lecture Slides: Complement the pre-recorded audio, providing the visual and structural framework for topics.
Workshops: These sessions focus on "index-level" material that is not covered in the pre-recorded lectures. They are held in a face-to-face, in-person environment to facilitate in-depth discussion, Q&A sessions, and detailed exploration of complex contexts.
Specific curriculum division: For Chapter 1 (The Financial System), the pre-recorded lecture covers parts A through D, while parts E and F are reserved exclusively for the workshop to allow for interactive delving into the material.
Essential Resources and Foundations
Core Textbook: The primary reference for the semester is Financial Institutions and Markets by Ben Hunt and Chris Perry, two former professors at UTS. The course utilizes the latest edition of this text.
Pedagogical Focus: The subject emphasizes three core pillars of finance:
Markets: The platforms where financial activity occurs.
Institutions: The organizations operating within those markets.
Instruments: The specific securities or contracts used, including their valuation, pricing, and unique characteristics.
Primary Objective: These three pillars facilitate the flow of money and credit between four key groups: lenders, borrowers, investors, and savers.
Terminology: A major component of the subject involves mastering financial terminology, phrases, and market operation mechanics. Understanding the financial system is the cornerstone and fundamental foundation for all subsequent subjects in a finance major.
The Financial System Core Components
Financial Institutions: These organizations are the "intermediaries" that run the financial system. They provide financial services and act as middlemen between lenders and borrowers. Examples include banks and other financial services organizations.
Financial Markets: These are platforms where buyers and sellers congregate. They allow businesses and individuals to access capital and raise funds for expansion and investment activities (e.g., funding capital budgeting projects).
Regulators: The system must be heavily regulated by governments and dedicated bodies to ensure fairness, transparency, and safety. Regulation is essential to prevent fraud, protect investors, and maintain systemic stability.
The Five Functions of the Financial System
1. The Settlement Function
Definition: The methods and procedures used to transfer funds between buyers and sellers of goods and services to settle commercial transactions.
Mechanism: It enables the transfer of funds when purchasing items online or in person.
Instruments of Settlement: Includes cash, checks, credit cards, debit cards, electronic transfers, and cryptocurrency.
Infrastructure: Financial institutions (banks) and payment processors (e.g., Visa, Mastercard, Afterpay) provide the secure network and equipment necessary to manage and clear settlements while protecting integrity and confidentiality.
2. The Flow of Funds Function
Definition: The mobilization and channeling of money from Surplus Units (those with excess funds) to Deficit Units (those requiring funds).
Economic Impact: The system allocates capital to its most productive use, channeling funds to projects likely to generate a return on investment.
Incentives: Investors require an attractive return to provide funding; they assess risk and potential return to determine where to place their capital.
Direct vs. Indirect Financing:
Direct Financing: Investors deal directly with companies through financial markets (e.g., buying shares). The company knows the identity of the shareholder.
Indirect Financing: Managed via Deposit-Taking Institutions (Banks). A surplus unit deposits money in a bank; the bank then lends it to a company. The borrower and original saver have no direct connection.
Australian Context: The majority of household wealth is held in "dwellings" (property) and superannuation. Banks dominate indirect financing, while the share market and superannuation funds dominate direct financing.
3. The Risk Transfer Function (Risk Management)
Definition: The use of financial markets to transfer risk from one party to another. This is primarily achieved through derivative instruments.
Types of Risk:
Default Risk: The risk that a borrower fails to fulfill financial obligations, resulting in a loss for the lender or investor.
Market Risk: The risk of financial loss resulting from changes in market conditions (e.g., interest rates, exchange rates, asset prices). This is inherent in all financial instruments (shares, bonds, commodities, currencies) and is influenced by economic, political, or social events (e.g., inflation, the war in Ukraine, presidential elections).
Hedging Example (Qantas): Qantas faces the risk of fuel/oil price increases. They use derivative contracts (options, forwards, or futures) to "lock in" a price. While they give up the benefit of potential price drops, they are protected against price spikes. This is analogous to insurance premiums; the cost of the hedge provides security and cancels out exposure.
4. Promotion of Efficiency
Determinants of Efficiency:
Information Asymmetry: A situation where one party in a transaction has more or better information than the other. This leads to unfair advantages and unethical behavior (e.g., a car dealer hiding a defect). Reducing asymmetry lowers the cost of borrowing and increases market trust.
Incentive Problems: Occur when parties receive short-term rewards without long-term consequences.
Moral Hazard: The risk that an organization acts more recklessly because they are protected from the consequences of their actions (e.g., an insured party taking more risks, or financial advisors prioritizing commissions over client benefits).
Pooling of Funds: Bringing together surplus and deficit units increases efficiency.
Innovation: The emergence of new technologies and financial products lowers transaction costs and provides new investment opportunities.
5. Financial System Stability
Definition: Ensuring the absence of crises within the financial system.
Regulator Roles: Stability involves keeping interest rates, inflation, and money supply in check to support economic growth and full employment.
Australian Financial Markets and Regulators
Key Financial Markets
Money Market: Deals with short-term (typically low-risk, low-return) instruments such as Certificates of Deposit (CD), Treasury bills, Commercial Paper, and Repurchase Agreements (Repos). It is central to the Reserve Bank of Australia's (RBA) monetary policy.
Bond Market: Focuses on longer-term debt instruments and the return of principal at maturity.
Share Market (Stock/Equity Market): Facilitates the buying and selling of company ownership units.
Foreign Exchange Market: Deals with currency trading.
Derivative Markets: Focuses on risk management instruments like forwards, futures, and options.
Major Regulators
APRA (Australian Prudential Regulatory Authority): The "prudent regulator" responsible for overseeing banks, insurance companies, and superannuation funds to ensure they are financially sound.
ASIC (Australian Securities and Investments Commission): Manages market integrity and consumer protection. It is the Australian equivalent of the United States SEC (Securities and Exchange Commission).
RBA (Reserve Bank of Australia): Australia's central bank. Its roles include managing inflation (target targets), promoting full employment, ensuring financial system stability, and managing exchange rates.
The Treasury: Advises the government on economic policy and manages the issuance of government money market and bond instruments.
Preparation for Workshop One
Academic Review: Students must revise "Time Value of Money" (TVM) concepts from prior studies (e.g., FPF or APF).
Purpose: Strong TVM skills are essential for the complex calculations required throughout the semester, particularly regarding financial instruments.
Case Study Assignment: Preparation involves watching the film The Big Short, which illustrates the Global Financial Crisis (GFC) and the impacts of moral hazard and incentive problems.
MORAL HAZARDS
Moral hazard refers to a situation in which one party in a transaction can take risks because they do not bear the full consequences of those risks. This often occurs when one party is insulated from risk due to a form of insurance or a safety net provided by another party. It leads to behaviors that are more reckless or riskier than would occur if the individual bore the full brunt of the consequences.
Two circumstances that pose moral hazards include:
Insurance Coverage: When individuals or businesses have health or property insurance, they may take greater risks, knowing that their losses will be covered by the insurer. For example, a person with full auto insurance may drive less cautiously because they believe they will be reimbursed for damages in case of an accident.
Financial Institutions and Bailouts: During financial crises, banks and other financial institutions may engage in risky investments believing that they will be bailed out by the government if their ventures fail. For instance, the behavior of banks leading up to the 2008 financial crisis exhibited moral hazard, as they undertook high-risk lending practices, confident that public funds would cover their losses.
Moral hazard is when someone takes risks because they don't have to face the full consequences. This often happens when they have insurance or support that protects them from the negative results of their actions.
Two examples of moral hazard are:
Insurance Coverage: When people have insurance, like car insurance, they might drive less carefully because they know any accident costs will be covered by the insurance company.
Financial Institutions and Bailouts: Banks might take big risks when investing if they believe the government will bail them out if they fail. This was seen during the 2008 financial crisis when banks made risky decisions thinking that the government would step in to help them if things went wrong.