FINS1612 NOTES

Topic 1: Introduction (Chapter 1: A Modern Financial System: An

Overview)
1.1
Understand the effects and consequences of a financial crisis on a financial
system and a real economy.
The GFC had a significant strain on financial systems and the real economies of many countries
and highlighted the interconnectedness of the worlds financial markets. The interconnected
global financial system traces its origins to the introduction of money and the development of
local markets to trade goods. Money is a medium of exchange that facilitates transactions for
goods and services. With wealth being accumulated in the form of money, specialised markets
developed to enable the efficient transfer of funds from savers (surplus entities) to users of funds
(deficit entities). Financial instruments incorporate attributes of risk, return (yield), liquidity and
time-patter of cash flows. Savers are able to satisfy their own personal preferences by choosing
various combinations of these attributes. By encouraging savings, and allocating savings to the
most efficient users, the financial system has an important role to play in the economic
development and growth of a country. The real economy and the financial system are connected.
1.2
Explain the functions of a modern financial system and categorise the main
types of financial institutions, including depository financial institutions,
investment banks, contractual savings institutions, finance companies and unit
trusts.
A financial system: comprises of financial institutions, instruments and markets facilitating
transactions for goods and services and financial transactions.
Money: solves the divisibility problem i.e. where medium of exchange does not represent equal
value for the parties to the transaction. Also allows for specialisation in production.
Markets: bring opposite parties together + establish rates of change (prices) in facilitating
exchange of goods + services.
Surplus units: savers of funds available for lending.
Deficit units: borrowers of funds for capital investment and consumption.
An efficient financial system encourages savings, directs savings to the most efficient users, is a
combination of assets and liabilities comprising the desired attributes of return, risk, liquidity and
timing of cash flows.
Most people have used the services of a financial institution at some stage, even if the service
was simply a basic bank account. Financial institutions may specialise in:
- taking deposits, providing advice to corporate and government clients or offering financial
contracts such as insurance
- Financial institutions are essential to the operation of the modern financial system
Financial institutions permit the flow of funds between borrowers and lenders by facilitating
financial transactions. Institutions may be categorised by differences in the sources and uses of
funds.
- Depository financial institutions: Mainly attract the savings of depositors through on
demand deposit and term deposit accounts; e.g. commercial banks, building societies and
credit cooperatives. Mainly provide loans to borrowers in household and business sectors.
- Investment banks and merchant banks: Mainly provide off-balance-sheet (OBS)
advisory services to support corporate and government clients; e.g. advice on mergers and
acquisitions, portfolio restructuring, finance and risk management. May also provide some
loans to clients but are more likely to advise on raising funds directly in capital markets.
- Contractual savings institutions: The liabilities of these institutions are contracts that
require, in return for periodic payments to the institution, the institution to make payments

to the contract holders if a specified event occurs; e.g. life and general insurance
companies and superannuation funds. The large pool of funds is then used to purchase
both primary and secondary market securities. Payouts are made for insurance claims and
to retirees.
Unit trusts: not as important. Formed under a trust deed and controlled and managed by
a trustee. Funds raised by selling units to the public; investors purchase units in the trust.
Funds are pooled and invested by fund managers in a range of asset classes specified in
the trust deed. Types of unit trusts include equity, property, fixed interest and mortgage
trusts.

1.3
Define the main classes of financial instruments that are issued into the
financial system, that is, equity, debt, hybrids and derivatives.
Attributes of financial assets:
- Return/yield: total financial compensation received from an investment expressed as a
percentage of the amount invested.
- Risk: probability that the actual return on an investment will vary from the expected
return.
- Liquidity: ability to sell an asset within a reasonable time at current market prices and for
reasonable transaction costs. The higher the liquidity, the easier an asset will sell (i.e.
better it is as an investment).
- Time-pattern of cash flows: when the expected cash flows from a financial asset are to
be received by the investor or lender.
Financial instruments are financial assets that can be traded. They can also be seen as packages
of capital that may be traded. Most types of financial instruments provide an efficient flow and
transfer of capital all throughout the world's investors. These assets can be cash, a contractual
right to deliver or receive cash or another type of financial instrument, or evidence of one's
ownership of an entity.
Financial instruments are issued by a party raising funds, acknowledging a financial
commitment and entitling the holder to specified future cash flows. Double coincidence of
wants satisfied is a transaction between two parties that meets their mutual needs.
Equity and debt: two main sources of financial instruments an institution can use. Financial
instruments may be equity, debt or hybrid. Financial Instruments:
- Equity: Ownership interest in an asset, thus, have voting rights for the issues of an asset.
Residual claim on earnings and assets. E.g. Dividend, Liquidation. Types:
Ordinary share
Hybrid (or quasi-equity) security (e.g. Preference shares, Convertible notes)
- Debt: Ranks ahead of equity. Debt holders dont get to vote on issues, but otherwise have
more power. Contractual claim to: periodic interest payments, repayment of principal. Can
be:
short-term (money market instrument) or medium- to long-term (capital market
instrument)
secured or unsecured
negotiable (ownership transferable; e.g. commercial bills and promissory notes) or
non-negotiable (e.g. term loan obtained from a bank)
- Derivatives: Used mainly to manage price risk exposure and to speculate. A synthetic
security providing specific future rights that derives its price from:
a physical market commodity e.g. gold and oil
financial security e.g. Interest-rate-sensitive debt instruments, currencies and
equities
Three
1.
2.
3.

basic derivative contracts:

Futures contract (Chapter 18 and 19):
Forward contract (Chapters 17, 18 and 19):
Option contract (Chapters 18 and 20):

CLARIFY DERIVATIVES.
NEED TO TALK ABOUT HYBRIDS HERE.
1.4
Discuss the nature of the flow of funds between savers and borrowers, including
primary markets, secondary markets, direct finance and intermediated finance.
Flow of funds: the movement of funds through the financial system between savers and
borrowers giving rise to financial instruments.
Within Financial Markets:
- Primary and secondary market transactions:
Primary Market Transactions: The issue of a new financial instrument to raise
funds to purchase goods, services or assets by business/ governments/ individuals.
Funds are obtained by the issuer.
Secondary Market Transactions: The buying and selling of existing financial
securities. No new funds raised and therefore no direct impact on original issuer of
security. Transfer of ownership from one saver to another saver. Provides liquidity,
which facilitates the restructuring of portfolios of security owners

Direct finance: Users of funds obtain finance through primary market via direct relationship with
providers (savers).
Advantages:
Disadvantages:
- Avoids costs of intermediation
- Matching of preferences
- Increases access to diverse range of
- Liquidity and marketability of a
markets
security
- Greater flexibility in range of securities
- Search and transaction costs
- Assessment of risk, especially default
users can issue for different financing
risk
needs

Define IPO. IS that direct finance?

Intermediated financial flow markets: A financing arrangement involving two separate
contractual agreements whereby the saver provides funds to an intermediary and the
intermediary provides funding to the ultimate user of the funds.
Advantages:
- Asset transformation
- Maturity transformation
- Credit risk diversification and transformation
- Liquidity transformation
- Economies of scale
Disadvantages of intermediated financial flow markets?
1.5
Distinguish between various financial market structures, including wholesale
markets and retail markets, and money markets and capital markets.
- Wholesale and retail markets: relatively unimportant concepts. Wont be tested on
them.
Wholesale markets: direct financial flow transactions between institutional
investors and borrowers. Involves larger transactions
Retail markets: Transactions conducted primarily with financial intermediaries by
the household and small- to medium sized business sectors. Involves smaller
transactions
- Money markets: Wholesale markets in which short-term securities are issued and traded.
- Capital markets: markets in which longer term securities are issued and traded with
original term-to-maturity in excess of one year
1.6
Analyse the flow of funds through the financial system and the economy and
briefly discuss the importance of stability in relation to the flow of funds.
Matching principle: Short-term assets should be funded with short term (/money market)
liabilities (e.g. seasonal inventory needs funded by overdraft); longer term assets should be
funded by equity or longer term (capital market) liabilities (e.g. equipment funded by debentures,
lack of adherence to this principle accentuated effects of frozen money markets with the subprime market collapse).
1.7
Appreciate the importance of globalisation of the international financial
markets.
Globalisation of the Financial Markets
A nation-states financial system is an integral part of the global financial system. An important
relationship exists between an efficient financial system and growth in the real economy within a
nation-state (as discussed earlier). Similarly, as production and international trade between
multinational corporations and governments expanded, so too did the need for a global financial
system to support that expansion.
Essentially, globalisation refers to the process whereby financial markets are interconnected,
interdependent and integrated. The rapid development and adoption of technology-based
information systems, communication systems and product delivery systems has facilitated
globalisation of the financial markets and the standardisation of the financial instruments used in
the global markets. At the same time, technology has enabled the development of a whole new
range of sophisticated financial instruments that facilitate the movement of funds between
surplus units and deficit units in different nation-states. New markets in risk management
products, in particular those using derivative products, have also evolved.
While the role of technology in the development of global financial markets is critical, it should be
noted that there are a number of other important factors and relationships that impact upon
globalisation. These include:

Unrestricted movement of capital around the world. Theoretically, the global market will
encourage savings and allocate those savings efficiently to the most productive purposes
without regard to national boundaries.
Deregulation of nation-state financial systems, including the removal of significant
regulatory constraints that restrict financial markets, products, participants and pricing.
Financial innovation, to develop new systems, products and services.
The need of corporations and governments to diversify their funding sources on a global
scale.
Increased competition between financial markets and institutions for the provision of
financial products and services.
Exchange rate, interest rate and price volatility within the international markets and the
associated increase in demand for risk management products.
Changing demographic and savings patterns. For example, the ageing of populations of
many economies has resulted in the accumulation and mobilisation of greater levels of
savings.
The development of emerging markets, in particular, parts of Asia, South America and
Eastern Europe.

Rapid technological innovation and a more sophisticated business environment, together with
longer-term changes in the financial needs of market participants, are reshaping the financial
system. A progressively greater array of participants, products and distribution channels has
developed (and will continue to develop) the financial system. Competition is emerging from new
providers of financial services and through the increasing globalisation of financial markets.
Nation-states are striving to achieve improved market efficiency and performance.
To help understand the drivers for change in a modern financial system, it is beneficial to refer to
the interim report of an inquiry into the Australian financial system. The (interim) Murray
Report, released in 2014, considered the growing interconnectedness of the Australian financial
system with the rest of the world and identified a number of areas from which changes have
stemmed in the years since the previous financial system inquiry (Walliss 1997 Report). These
are:
- Growth and consolidation
- Post-GFC regulatory responses
- Technology
- Population dynamics.
Growth and Consolidation
A primary driver of change over time is the growth in size of the financial system. In Australia, the
financial system has grown considerably over the past two decades. This has been especially
evident in the superannuation sector. Interestingly, there has also been considerable
consolidation and an increase in concentration in Australias banking sector over the same period
of time. The key issues to emerge from these changes include:
- Competition
- Distortions in funding flows
- Efficiency of eh superannuation system
Although the interim Murray Report finds that c-------------------------------------1.8

Appreciate the efforts, consequences and relevance of the Asian financial crisis.

Topic 2: The Banking System (Chapter 2: Commercial Banks)

2.1 Evaluate the functions and activities of commercial banks within the financial
system.

2.2 Identify the main sources of funds for commercial banks, including current
deposits, demand deposits, term deposits, negotiable certificates of deposit, bill
acceptance liabilities, debt liabilities, foreign currency liabilities and loan capital.

2.3 Identify the main uses of funds by commercial banks, including personal and
housing lending, commercial lending, lending to government, and other bank assets.

2.4 Outline the nature and importance of banks off-balance-sheet business, including
direct credit substitutes, trade- and performance-related items, commitments and
market-rate-related contracts.

2.5 Consider the regulation and prudential supervision of banks.

2.6 Understand the background and application of Basel II and Basel III.

2.7 Examine liquidity management and other supervisory controls applied by APRA in
the context of Basel III.