Lecture 1: Chapter 1

A Modern Financial System

Presented By
Dr Sarod Khandaker

Presented by Dr Sarod Khandaker

THE ROLE OF THE FINANCIAL SYSTEM

The financial system consists of financial

markets, institutions and money.

The roles of the financial system are:

To facilitate the flow of funds

To provide the mechanism to settle transactions
To generate and disseminate information
To provide the means to transfer and manage risk
To provide ways of dealing with incentive problems

Presented by Dr Sarod Khandaker

THE FLOW OF FUNDS

The financial system allows the flow of funds
from surplus spending units (SSUs) to
deficit spending units (DSUs).

Figure 1.2 Flow of funds

Presented by Dr Sarod Khandaker

SSUs and DSUs

Economic units can be classified as:

Households
Businesses
Governments

A surplus unit is a unit whose income exceeds

planned expenditure.
A deficit unit is a unit whose expenditure
exceeds its receipts.
The flow of funds from SSUs (mainly
households) to DSUs (mainly business firms
and governments) is a fundamental function of
the financial system.
Presented by Dr Sarod Khandaker

DIRECT FINANCING

SSUs lend money to DSUs and accept a

financial claim in return.

In direct financing, this exchange takes place

directly without an intermediary.

The limitations of direct financing create a role

for financial intermediaries to intervene
between DSU and SSU.

Presented by Dr Sarod Khandaker

INDIRECT FINANCING

Direct financing requires DSUs to find SSUs

that want direct claims and the denominations
involved are usually very large.

These problems are resolved through the

involvement of a financial intermediary.

Financial intermediaries purchase direct claims

from DSUs, transform them into indirect
claims and sell them to SSUs.

Presented by Dr Sarod Khandaker

BENEFITS OF FINANCIAL
INTERMEDIATION
When intermediaries transform direct claims
into indirect ones, they perform five services:

Denomination divisibility
Currency transformation
Maturity flexibility
Credit risk diversification
Liquidity

Presented by Dr Sarod Khandaker

TYPES OF INTERMEDIARIES
Australian financial intermediaries include:
i.
ii.
iii.
iv.
v.

vi.
vii.

Banks, building societies and credit unions

Foreign bank representatives
General and life insurers
Friendly societies
Money market corporations, finance
companies and securitises
Licensed trustees
Superannuation entities.
Presented by Dr Sarod Khandaker

AUSTRALIAN FINANCIAL INTERMEDIARIES

Presented by Dr Sarod Khandaker

GROWTH OF FINANCIAL INTERMEDIARIES

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COMMERCIAL BANKS

Commercial banks are the largest and most diversified

intermediaries.
Australian-owned commercial banks hold more than
$2.85 trillion in financial assets (end 2013).
These assets consist of loans to consumers,
businesses and governments.
Commercial banks liabilities consist of deposit
accounts and other sources of funds.
Commercial banks might also be engaged in other
activities such as underwriting.

Presented by Dr Sarod Khandaker

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NONBANK FINANCIAL
CORPORATIONS
1.

NBFCs provide many of the same services and

products that commercial banks provide.

2.

NBFCs may be classified into four groups:

I.
II.
III.
IV.

Building Societies
Credit Unions
Money-market Corporations
Finance Companies

Presented by Dr Sarod Khandaker

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AUSTRALIAN OWNED BANK ASSETS

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OTHER FINANCIAL INSTITUTIONS

I.

Several groups of other financial institutions

operate in the financial system.

II.

These include:
I.
II.
III.
IV.
V.

Life insurance companies

General insurance companies
Superannuation funds
Managed Funds
Securitisers

Presented by Dr Sarod Khandaker

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INTERNATIONAL ORGANISATIONS
In addition to domestic institutions, there are
a number of important international
organisations.
These

include:

The
The
The
The

Bank of International Settlements

World Bank
International Monetary Fund
Asian Development Bank

Presented by Dr Sarod Khandaker

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PRIMARY AND SECONDARY

MARKETS

Primary markets are where financial claims

are initially sold by DSUs.

This might take place through an initial public

offering of shares to the public.

Secondary markets are where previously

issued financial claims are exchanged among
investors.

Presented by Dr Sarod Khandaker

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ORGANISED AND
OVER-THE-COUNTER MARKETS
I.

II.

III.

IV.

Once issued, the exchange of claims can take

place on an organised exchange.
In Australia, an example is the Australian
Stock Exchange (ASX).
Financial claims can also be exchanged
over-the-counter. (OTC)
OTC markets have no central location.

Presented by Dr Sarod Khandaker

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OTHER MARKETS
Other types of financial markets include:

The futures market

The options market
Foreign exchange markets
International markets

For example: the eurocurrency markets and

eurobond markets where domestic or
overseas firms can borrow or lend Australian
dollars deposited in overseas banks.

Presented by Dr Sarod Khandaker

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MONEY MARKETS
1.

We usually sort financial markets into either

money or capital markets.

2.

Money markets are where a certain type of

financial claim are traded.

3.

Specifically, a wholesale short term to maturity

(less than 12 months) claim is classified as a
money market transaction.

Presented by Dr Sarod Khandaker

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MONEY MARKETS

Banks and businesses adjust their liquidity positions by

borrowing and lending for a short time on the money
market.

The RBA also conducts monetary policy on the money

markets.

The money market consists of a collection of markets

each trading a different financial instrument.

All of instruments have characteristics very similar to

money: high liquidity and low default risk.

Presented by Dr Sarod Khandaker

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MONEY MARKET INSTRUMENTS

Treasury

notes
Commercial paper
Commercial bills
Negotiable certificates of deposit
Secured and unsecured notes

Presented by Dr Sarod Khandaker

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CAPITAL MARKETS

Capital markets: where longer term

(greater than 12 months) securities are traded.

On capital markets, capital goods are financed

with stock or longer-term debt instruments.

Capital market instruments are less

marketable, have varying default levels and
have maturities ranging from five to thirty
years.

Presented by Dr Sarod Khandaker

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CAPITAL MARKET INSTRUMENTS

The instruments traded on the capital
market include:
I.
II.
III.
IV.

Shares
Corporate bonds
Government bonds
Mortgages

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INTERNATIONAL ASSETS AND LIABILITIES OF

AUSTRALIAN BANKS

Presented by Dr Sarod Khandaker

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RISKS FACED BY FINANCIAL

INSTITUTIONS
Financial institutions are exposed to a variety of
risks. These include:

Credit risk
Interest rate risk
Liquidity risk
Foreign exchange risk
Political risk
Reputational risk
Environmental risk

Presented by Dr Sarod Khandaker

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MANAGING RISK
The risks faced by financial institutions is
managed by:
a.
b.
c.
d.

Diversification of loans and investments

Careful credit analysis of borrowers
Careful monitoring of borrowers over time
The undertaking of appropriate hedging
strategies on the financial markets.

Presented by Dr Sarod Khandaker

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SUMMARY
You should now be able to:

Explain the role of the financial system and why it is

important.
Explain the function of direct and indirect financial
markets.
Describe the different types of financial intermediaries.
Describe the various types of financial markets.
Explain the economic function of money and capital
markets.
Identify the risks that financial institutions face and
describe how these risks are managed.

Presented by Dr Sarod Khandaker

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THANK YOU

Presented by Dr Sarod Khandaker

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