Lecture 1.2
An overview of the financial system
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Source: Mishkin Ch 2
Learning Objectives
Compare and contrast direct and indirect finance
Identify the structure and components of financial markets
List and describe the different types of financial market instruments
Recognize the international dimensions of financial markets
Learning Objectives (2)
Summarize the roles of transaction costs, risk sharing, and information costs as they relate to financial intermediaries
This helps to answer the question, why do we have intermediaries
List and describe the different types of financial intermediaries
Identify the reasons for and different types of financial market regulations
Function of Financial Markets
Timing of income and desired spending don’t necessarily match
In any given period, if your income exceeds your desired spending, you are in surplus
conversely, if your spending in a given period exceeds your income, you are in deficit
Financial markets perform the essential function of channeling funds from economic agents who have saved surplus funds to those that have a shortage (or deficit) of funds
Direct finance: borrowers borrow funds directly from lenders in financial markets, for example by selling them securities
Intermediated finance: an intermediary such as a bank stands between the borrower and the lender
Function of Financial Markets
Promotes economic efficiency by producing an efficient allocation of capital, which increases production
generally, in an efficient financial system, funds will flow to uses that generate the highest reurns
Directly improves the well-being of consumers by allowing them to schedule purchases better over time
timing of spending doesn’t have to match income
Figure 1: Flows of Funds Through the Financial System
Structure of Financial Markets: some key distinctions
Debt and Equity Markets
Debt instruments (have a fixed maturity, and pay interest)
Equities (have no fixed maturity, and pay dividends)
Primary and Secondary Markets
Sale of securities to investors at the time of issuance. Investment banks may underwrite (facilitate the sale of) securities in primary markets.
Secondary markets: trading between investors after issuance of the securities. Brokers and dealers may facilitate this.
Structure of Financial Markets: further disctinctions
Exchanges and Over-the-Counter (OTC) Markets:
Exchanges: Market with formal centralized location. Main example is a stock exchange. The ‘location’ may now be an electronic platform
OTC markets: Dealers decentralized and linked electronically. Includes foreign exchange and most other markets other than equities and futures.
Money and Capital Markets:
“Money markets” (more correctly, [short-term] securities markets) deal in short-term debt instruments (less than a year).
Main purpose: management of cash flows
“Capital markets” deal in longer-term debt and equity instruments
Main purpose: funding of long-term spending plans (eg, develop a mine, or a new business)
Size of markets: some facts and figures for Australia
In looking at the size of these markets, it is important to distinguish between stocks (amounts outstanding) and flows (new borrowing activity)
In stock terms, the majority of corporate funding is equity rather than debt
Household borrowing comes mainly from banks
Some figures:
Nom GDP (2021) = $2.2 tr (approx)
Bank lending to businesses (Stock outstanding, Dec 2020) = $1.1 tr
Bank lending to households (Stock outstanding, Dec 2019) = $2.2 tr
ASX market capitalisation (Jan 2022) = $2.5 tr
Bond markets in Australia
Function of Financial Intermediaries: Indirect Finance
Financial intermediation (indirect finance) has both costs and benefits in comparison to direct finance
Lower transaction costs (time and money spent in carrying out financial transactions)
Economies of scale (search cost in finding someone with a matching financial requirement)
Liquidity services (lender can get their money back at short notice, or use the use loaned funds as a transactions balance)
Reduce the exposure of investors to risk
Risk assessment: banks are in the risk assessment business and can do this efficiently
Diversification – risks spread across different types of borrower
Function of Financial Intermediaries: Indirect Finance
Asymmetric information means that the two parties to a transaction do not have equal access to the relevant information
In a loan transaction, the borrower has an information advantage in relation to:
capacity to repay
intention to repay
likely behaviour if loan is received
In general, this problem can be managed but not eliminated
Banks or financial intermediaries are likely to be more efficient at managing this problem than individuals
Two types of problem arising from asymmetric information
Adverse Selection (before the transaction): try to avoid selecting the risky borrower by gathering information about them
eg income, credit history, assets
Moral Hazard (after the transaction): ensure borrower will not engage in activities that will prevent him/her to repay the loan.
Sign a contract with restrictive covenants on use of the loan funds
Collateral requirements (eg, a secured home loan)
Credible enforcement capacity
Function of Financial Intermediaries: Indirect Finance
Conclusion:
Financial intermediaries allow “small” savers and borrowers to benefit from the presence of financial markets without having to find direct counter-parties to deal with
Main types of financial institutions in Australia, Jun 2020
Source: https://www.rba.gov.au/fin-stability/fin-inst/main-types-of-financial-institutions.html#adis
Type Main regulator Number Assets ($billion) Per cent of total
Banks APRA 98 5410.4 56
CUBS APRA 40 54.7 1
Non-ADI FIs ASIC 135 571.7 6
Insurers and fund managers APRA 2000 (approx.) 3671.1 38
Regulation of the Financial System
To increase the information available to investors:
Reduce adverse selection and moral hazard problems
example: a bond issuer has to comply with prospectus requirements
Reduce insider trading and related violations (SEC in United States; mainly ASIC in Australia)
when you buy or sell a share, you want to be confident that you have the same access to information as your counterparty
example: selling shares in a newly-opened mine
Consumer protection: consumers can seek redress for unfair practices (eg promoting irresponsible lending or investing, hidden charges)
Market conduct (integrity)
Regulation of the Financial System
To ensure the soundness of financial intermediaries:
Restrictions on entry (bank authorisation process)
you can’t trade as a bank unless authorized by APRA
Disclosure of information
Restrictions on Assets and Activities (control holding of risky assets)
Deposit insurance (avoid bank runs)
Limits on Competition (mostly in the past):
Branching (United States)—limits on interstate banking
Restrictions on (bank) interest rates (both U.S. and Australia—now abolished in both countries)
Regulation of the Australian Financial System
The Council of Financial Regulators (CFR) is the coordinating body for Australia’s main financial regulatory agencies
Comprises the Reserve Bank of Australia (RBA) (which chairs the Council), the Australian Prudential Regulation Authority (APRA); the Australian Securities and Investments Commission (ASIC); and the Australian Treasury
Meetings are chaired by the RBA Governor
The CFR members discuss regulatory issues and, as necessary, coordinate responses to potential risks to financial stability
Regulation of the Financial System (Australia), cont.
Australian Prudential Regulation Authority: The prudential regulator of banks, insurance companies and superannuation funds, credit unions, building societies and friendly societies in Australia
Australian Securities and Investments Commission: Australia’s corporate, markets and financial services regulator
2016201120062001199619912021 0 100 200 300 400 500 600 700 800 $b 0 100 200 300 400 500 600 700 800 $b BondsonIssueinAustralia Non-government** State governments Australian government* * ExcludesbondspurchasedbytheAustralianGovernment. ** ExcludesADIs’self-securitisations,includesgovernment-guaranteed bonds. Sources:ABS;AOFM;Bloomberg;KangaNews;PrivatePlacement Monitor;RBA;StateTreasuryCorporations
2016201120062001199619912021 0 150 300 450 600 $b 0 150 300 450 600 $b TotalNon-governmentBondsonIssue Allcurrencydenominations Financials Non-financial corporations Non-residents* Asset-backed securities * Australiandollar-denominatedbondsonly. Sources:ABS;Bloomberg;KangaNews;PrivatePlacementMonitor;RBA
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