FIN111 Lecture Notes - Lecture 2: Primary Market, Asian Development Bank, Direct Deposit

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31 May 2018

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Week 2 – The Financial System

The Financial System

• The financial system consists of financial markets and financial institutions

• These markets and institutions provide the structure to the financial system

• Role of the financial system is to gather money from people and businesses with

surplus funds and channel the gathered money to those who need it

• A well‐developed financial system is critical for the operation of a complex economy

such as that of Australia

• Financial market → general term that includes a number of different types of

markets for the creation and exchange of financial assets

• Financial institutions → companies that provide financial services to the economy.

Invest funds in financial assets like business loans, shares, bonds

The financial system at work:

• The financial system is competitive → competition among banks for deposits will

drive term-deposit interest rates up and loan interest rates down

• The bank gathers money from consumers in small dollar amounts, aggregates it and

then makes loans in much larger dollar amounts

• Money is directed to the best investment opportunities

• Key role → financial risk is managed and/or transferred to other parties

• The bank earns a profit

How funds flow through the financial system:

The system moves money from lender‐savers to borrower‐spenders

• Lender-savers = surplus spending units (SSU)

- For example, households, some businesses and state and local governments

• Borrower‐spenders = deficit spending units (DSU)

- For example, businesses and the Commonwealth Government

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Direct Financing

• The lender‐savers and the borrower‐spedes deal dietly ith oe aothe

• Borrower‐spenders sell securities, such as shares and bonds, to lender‐savers in

exchange for money

- Securities can be referred to as financial instruments and financial claims

• Transactions of large sums take place in financial markets, typical minimum direct

transaction size is $1 million

• Provide funds at the lowest possible cost

• Major buyers and sellers of securities are:

- commercial banks,

- insurance and finance companies

- large business companies

- the Commonwealth Government

- hedge funds

- some wealthy individuals

• Individuals gain access to financial products produced in these markets through

retail channels at investment banks or financial institutions

The arrows in the figure show that there are two basic mechanisms by which funds flow through the

financial system:

1. Funds can flow directly through financial markets (the route at the top of the diagram), wherein

lender‐savers invest directly in financial securities; and

2. Funds can flow indirectly through financial institutions (the route at the bottom of the diagram),

wherein the financial institutions mediate between lender‐savers and borrower‐spenders.

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A direct financing transaction (without using the market)

• Suppose that the Westfield Group needs $200 million to build a new centre and

deides to fud it y sellig log‐te ods ith a 15‐yea atuity

• Westfield contacts a superannuation fund, which expresses an interest in buying

Westfields ods

• The supeauatio fud ill uy Westfields ods oly afte deteiig that the

bonds are priced fairly for their level of risk and the interest rate they carry

• Westfield will sell its bonds to the superannuation fund only after studying the

current bond market to be sure the price offered by the superannuation fund is

competitive

• If a deal is struck the flow of funds will be:

• So, Westfield sells its bonds and gets to use the $200 million for 15 years. The bonds

are a liability and they pay the bondholders interest for use of the money and pays

back the $200 million on maturity (15 years)

Direct financing (using the market)

• To raise finance:

- companies can issue their own securities in the financial market, particularly in

the capital market

- to issue securities, a company needs to issue a prospectus to the public

• Typically, companies need help from experts to organise, issue and sell securities in

the market

• Investment banks and direct financing:

- Investment banks specialise in helping companies sell new debt or equity. They

perform two important tasks:

1. Origination: the process of preparing a security issue for sale. Help determine

the feasibility of the project being funded and the amount of capital that

needs to be raised. Then helps secure a credit rating, determines a sale date,

obtains legal clearances and gets securities printed or created. If sold in the

public market, a prospectus must be lodged with ASI

2. Underwriting: investment banker guarantees that the company will raise the

funds it expects from its new security issue. Most common type of

underwriting is stand-by underwriting

→

investment banker guarantees to

the company that the funds will be raised by purchasing any securities that

aet sold fo the issue at offe pie.

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Document Summary

The system moves money from lender savers to borrower spenders: lender-savers = surplus spending units (ssu) For example, households, some businesses and state and local governments: borrower spenders = deficit spending units (dsu) Direct financing: the lender savers and the borrower spe(cid:374)de(cid:396)s deal (cid:858)di(cid:396)e(cid:272)tly(cid:859) (cid:449)ith o(cid:374)e a(cid:374)othe(cid:396, borrower spenders sell securities, such as shares and bonds, to lender savers in exchange for money. Individuals gain access to financial products produced in these markets through retail channels at investment banks or financial institutions. If a deal is struck the flow of funds will be: so, westfield sells its bonds and gets to use the million for 15 years. The bonds are a liability and they pay the bondholders interest for use of the money and pays back the million on maturity (15 years) Investment banks specialise in helping companies sell new debt or equity. They perform two important tasks: origination: the process of preparing a security issue for sale.

Related Questions

Position A: Financial Institutions' role as specialists in risk measurement and management is reduced.

Position B: Financial Institutions' role as specialists in risk measurement and management is increased.

Required:

Read the âbackgroundâ below. After reading, select the position you agree with and write a position paragraph supporting either Position A or Position B.

Background: A major event that changed and reshaped the financial services industry was the financial crisis of the late 2000s. As Financial Institutions adjusted to regulatory changes brought about in the 1980s and 1990s, one result was a dramatic increase in systemic risk of the financial system, caused in large part by a shift in the banking model from that of âoriginate and holdâ to âoriginate to distribute.â In the traditional model, banks take short-term deposits and other sources of funds and use them to fund longer term loans to businesses and consumers. Banks typically hold these loans to maturity, and thus have an incentive to screen and monitor borrower activities even after a loan is made. However, the traditional banking model exposes the institution to potential liquidity, interest rate, and credit risk. In attempts to avoid these risk exposures and generate improved return-risk trade-offs, banks shifted to an underwriting model in which they originated or warehoused loans, and then quickly sold them. Indeed, most large banks organized as financial services holding companies to facilitate these new activities. More recently activities of shadow banks, nonfinancial service firms that perform banking services, have facilitated the change from the originate-and-hold model of commercial banking to the originate-and-distribute banking model. In the shadow banking system, savers place their funds with money market mutuals and similar funds, which invest these funds in the liabilities of other shadow banks. Like the traditional banking system, the shadow banking system intermediates the flow of funds between net savers and borrowers. However, instead of the bank serving as the middleman, it is the non-bank financial service firm, or shadow bank, that intermediates. Further, unlike the traditional banking system where the complete credit intermediation is performed by a single bank, in the shadow banking system, it is performed through a series of steps involving many non-bank financial service firms. These innovations remove risk from the balance sheet of financial institutions and shift risk off the balance sheet and to other parts of the financial system. Thus, the financial institutions, acting as underwriters, are not exposed to the credit, liquidity, and interest rate risks of traditional banking.

In your own words, explain what is meant by business and financial risk. Suppose Firm A has greater business risk than Firm B. Is it true that Firm A also has a higher cost of equity capital? Why or Why not? Explain.

What are the economic functions that financial intermediaries and markets perform that benefit society? In your answer, discuss the relationships of financial intermediaries and financial markets to the savings investment process within an economy and to each other. In addition, provide in your discussion an analysis of the differences in preferences among economic agents as an explanation for the wide variety of primary and secondary securities found in financial markets and the reasons for federal and state regulation of depository institutions and other financial intermediaries. In this regard, consider what role asset-backed securities, securitization and the secondary markets for these instruments play in the efficiency of the financial intermediation process. For example, the mortgage-backed securities secondary marketsâ development and the funds flows to finance home ownership. In this discussion consider the role of interest rates in determining the demand for current and future consumption and the relationship of this to individual and aggregate saving.

1 a) Compare ETFs (Electronic / Exchange Traded Funds) with Mutual Funds studied in the class. Specifically look at the (i) common features, such as ownership and the financial assets involved; and differences between the funds.

b) How or in what way is the ETF connected to the Financial System. Specifically, think about the assets, involvement in financial institution or financial market with the justification (that is reasons) in mind.

2 . In the recent past, small business lenders (for example 'biz2credit', 'kabbage', 'CANCapital', and 'LendingClub') have become popular. Their major function is to provide loans to small businesses to carry on the day-to-day business operations. You may not need to do research in order to answer the following questions. But most definitely you would have to use your analytical mind and make connections to the material learned in the class.

a) Why are these lenders important to the financial system? Include the competition from the financial institutions (such as commercial banks, shadow banks) discussed in the class.

b) What do you think about the long run sustainability of these lenders? Think about what does it take to survive as lenders and what may be major hurdles for their survival.

FIN111 Lecture Notes - Lecture 2: Primary Market, Asian Development Bank, Direct Deposit

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