Intro to Financial Systems Flashcards
What are the five major functions performed by the financial system?
- The settlement of transactions.
- The flow of funds.
- Risk management
- To be efficient
- To be stable
What is a surplus unit?
A surplus spending unit can be a household, business, or any other entity that makes more than it spends for the purpose of sustaining itself.
What is a deficit unit?
A deficit spending unit, which spends more than it makes and has to borrow from surplus units to sustain itself.
What is direct financing?
Deficit units raise funds directly from surplus units through the issue of securities in the financial markets
What are securities?
Securities are contracts that specify the obligations of deficit units and the rights of surplus units
What is indirect financing?
Funds are supplied as deposits to financial institutions, which in turn supply funds as loans to deficit units
What are derivatives?
A derivative is a security whose underlying asset dictates its pricing, risk, and basic term structure. A risk-transfer contract.
What are the two main risks?
- Default risk (financial obligations are not met)
- Market risk (loss arising from unexpected market changes)
What are the three determinants of financial system efficiency?
- Decision-making that is mutually beneficial to the parties involved.
- The pooling of funds from individual suppliers
- The emergence of new and reliable financial instruments, services, and operating systems.
What is information asymmetry?
When one party to a potential contract has an information advantage over the other party
How are risks to information asymmetry addressed?
- By restricting participation in the market to professional traders.
- Through financial regulations that require the more informed party to provide certain information to the less informed supplier of funds.
What are decision-making incentive problems?
Financial contracting is influenced by the incentives faced by the parties involved
This can be a problem if incentives motivate bad behavior.
How does the system overcome these incentive problems?
- When financial institutions have a fiduciary duty to their customers.
- A practice by professional bodies that require members to adhere to a code of ethics.
What problem does the pooling of funds solve?
- Usually deficit units are seeking large amounts that will take a long time to repay.
- Usually surplus units want to supply small amounts for short periods.
How does the pooling of funds work?
- A bank accepts many small deposits and makes fewer large-value loans.
- A fund manager that pools investments from clients and invests these funds collectively in large value assets
How is stability in financial systems enforced?
- Central banks assist by being ‘lender-of-last-resort’ to solvent but illiquid banks
- International banking supervisions guidelines implemented by APRA
- The RBA is responsible for promoting stability in Australias financial system.
What is the definition of Finance?
Finance refers to the flow of funds function. Funds made available by surplus units for use by deficit units are subject to agreed terms and conditions.
What are the main benefits sought by suppliers of funds?
- Returns
- Liquidity