FINC2011 Lec 2 Financial System Flashcards
What is the “FINANCIAL SYSTEM”?
- Comprises of a range of (1) financial institutions, (2) financial instruments, and (3) financial markets.
- Overseen by central bank (RBA), and supervised by a prudential regulator.
What are the functions of the “financial system”? (4)
- Allows surplus units to transfer from today’s income to the future which can be used for consumption.
- Timely provision of financial info to market participants.
- Important component of monetary policy.
- Creation of financial instruments to match up the risk and return requirements of borrowers and savers. (e.g. rich uncle unwilling to loan $20M to just you vs. $1 from 20M strangers).
How can you encourage an increased flow of SAVINGS into the financial system.
By creating a range of financial instruments that possess diff combinations of the 4 attributes valued by savers.
Why is it important to encourage savings into the financial system?
Important to economic growth: the savings in the financial system will be available for investment capital, i.e. can be used by companies to improve the productive capacity of the economy.
What are the 4 ATTRIBUTES of an asset?
- Return / yield: total financial benefit (interest + capital) received from an investment expressed in %.
- Risk (Uncertainty): probability actual outcome will vary from expected.
- Liquidity: ability to convert to cash as most transactions require cash payment.
- Time-pattern of cash flows: important because of the time value of money.
What are the 5 types of financial INSTITUTIONS?
- Depositary financial institution.
- Investment banks.
- Contractual savings institutions.
- Finance companies and general financiers.
- Unit Trusts.
Describe DEPOSITARY FINANCIAL INSTITUTIONS?
- Accepts deposits and provide loans to customers (e.g. bank).
- Connects retail borrowers to savers and earns off the difference in interest.
Describe INVESTMENT BANKS?
- Specialist financial advisory services for large corporations - breaks up loan into small units (e.g. bonds, notes) and sells off to different institutions.
- Any single bank will be unwilling to loan such a large sum as the risk will be too high with just 1 client.
Describe CONTRACTUAL SAVINGS INSTITUTIONS?
- Offers financial contracts (e.g. insurance, super).
- Periodic payments, insurance / super company invests that money, payout only on certain conditions (e.g. accident, retirement). (Similar to savings account, but cannot withdraw).
Describe FINANCE COMPANY / GENERAL FINANCIERS?
- Borrows funds then provides loans at a higher % rate.
- More willing to lend to higher risk clients.
- Diff from retail bank is that it is not DEPOSIT TAKING.
e. g. Loan sharks, OZ home loans.
Describe UNIT TRUSTS?
- Investors buy units issued by trust, funds are pooled together and then invested.
- A type of structure, rather than a corporation. (thus high 90+% payouts).
e. g. real estate = stable investment, however high barrier to entry. REIT’s overcome this.
Describe the 4 types of financial INSTRUMENTS?
claim, lifespan, interest
- Equity: residual claim, going concern, ownership interest + voting rights. (e.g. common shares).
- Debt: first claim, finite life, contractual obligation (interest + principle). (e.g. bonds).
- Hybrid: e.g. preference shares fixed dividends, convertible bonds (used for high risk start up companies).
- Derivative: value derived from an underlying asset, for risk management or speculation. (e.g. forward contracts).
What is the advantages / disadvantages of equity and debt securities?
- Equity: unlimited upside, however no guaranteed cash flows.
- Debt: contractual cash flows provide certainty, however no potential to earn more.
What is the MATCHING PRINCIPLE and why do we have it?
ST assets - ST liabilities.
LT assets - LT liabilities.
- to maintain company liquidity.
What happens if we break the matching principle?
ST assets - LT liabilities: will be paying extra interest than ST liability, will be paying after asset has stopped being productive / generating returns.
LT assets - ST liabilities: risky! have to repeatedly borrow, market conditions may change (e.g. GFC) so lender may become unwilling to lend.
What is a PRIMARY MARKET transaction?
- new financial instrument issued so NEW CAPITAL is raised. (e.g. Snapchat IPO).
What is a SECONDARY MARKET transaction?
- simply the transfer of existing financial instruments so no new capital is received by the company.
What are the 2 major benefits of having a secondary market?
- Liquidity: large pool of traders in 1 location (ASX), in turn makes shares more attractive to investors bc you can more easily exit whenever.
- Price Discovery: constantly updates value, valuable info for investors (to base forecasts), and companies (to set price for new share offerings).
What is DIRECT finance?
- When you obtain funding directly from money / capital markets (+ brokers, dealers).
What is INTERMEDIATED finance?
- When financial transaction conducted with intermediary, characterised by 2 separate contractual arrangements.
What are the benefits of direct finance? (4)
- Removes intermediary cost
- Enhanced profile: being listed on ASX makes company better known.
- Personal diversification of funding sources: you don’t know where a intermediated funding is coming from).
- Flexibility: can better control capital structure, timing of incremental payments etc.
What are potential disadvantages of direct finance? (4)
- Mismatch of attributes, maturity (ST, LT) structure etc.
- Liquidity of marketability of direct finance instrument.
- Higher search and transaction costs. (e.g. to find out client’s credit risk).
- Difficult to assess default risk.
What are benefits of intermediated financing? (5)
- Asset transformation (e.g. provides shares –> debt loan).
- Maturity transformation (e.g. weekly savings –> mortgage). This makes liability management crucial for retail banks.
- Liquidity transformation: savers want liquidity in their bank accounts to make everyday payments, however borrowers want certainty in their loans.
- Credit risk diversification: lower exposure to consequences of default as larger portfolio vs. 1 person.
- Economies of scale.
What is the WHOLESALE market?
- DIRECT financial flow transactions between INSTITUTIONAL investors and borrowers.
- Large scale transaction.
What is the RETAIL market?
- Transactions conducted with INTERMEDIARIES mainly by individuals and small businesses.
- PRICE TAKERS - % determined by bank.
What are MONEY markets?
- Wholesale markets in which ST securities are issued and traded.
e. g. Inter-bank market.
What are CAPITAL markets?
- Markets for LT funding for companies, individuals, government.
e. g. ASX, FX, Gov debt market.
