Week 1 – Financial System and Interest rates
• Financial System
The financial system consists of financial markets and financial institutions. These markets and institutions provide the structure to the financial system. Financial market is a general term that includes a number of different types of markets (e.g. money market, capital market) for the creation and exchange of financial assets, such as loans, bonds and shares.
Financial institutions are companies such as commercial banks, credit unions, insurance companies, superannuation funds and finance companies that provide financial services to the economy. The distinguishing feature of financial institutions is that they invest their funds in financial assets, such as business loans, shares and bonds, rather than real assets, such as property, plant and equipment.
The critical role of the financial system in the economy is to gather money from people and businesses with surplus funds and channel the gathered money to those who need it.
Businesses need money for day-to-day expenses or to invest in new productive assets to expand their operations. Consumers too, need money, which they use to purchase things such as houses, cars and boats — or to pay university fees. A well-developed financial system is critical for the operation of a complex economy such as that of Australia. An economy cannot function efficiently without a competitive and sound financial system that gathers money and channels it into the best investment opportunities.
Example: You receive $10 000 from your parents to help pay your expenses for the year, but you need only $5000 for the first semester. You wisely decide to invest the remaining
$5000 for a short time to earn some interest income. After shopping at several banks near your campus, you decide that the best deal is a $5000 term deposit that matures in 3 months and pays 5% interest. The bank pools your money with funds from other term deposits and uses this money to make business and consumer loans. In this case, assume that the bank makes a loan to the pizza restaurant near campus: $30 000 for 5 years at a 9%
interest rate. The bank decides to make the loan because of the pizza restaurant’s sound credit rating and because it expects the pizza restaurant to generate enough cash flows to repay the loan. The pizza restaurant owner wants the money to invest in additional assets to earn greater returns (net cash inflows) and thereby increase the value of the business.
During the same week, the bank makes loans to other businesses and also rejects a number of loan requests because the borrowers have poor credit ratings or the proposed projects have low rates of return.
1) Competition among banks for deposits will drive term deposit interest rates up and loan interest rates down.
2) The bank gathers money from you and other consumers in small dollar amounts, aggregates it, and then makes loans in much larger dollar amounts.
3) An important function of the financial system is to direct money to the best investment opportunities in the economy. If the financial system works properly, only business projects with high rates of return and good credit standing are financed. The financial system contributed to increased productivity and efficiency in the economy.
4) Finally, note that the bank has earned a profit from the deal. The bank has borrowed money at 5% by selling term deposits to consumers and has lent money to the pizza
restaurant and other businesses at 9%. Thus, the bank’s gross profit is 4 per cent (9 – 5), which is the difference between the bank’s lending and borrowing (deposit) rates. Banks earn their money from the spread of the interest rates amongst loans.
• How funds flow through the system
The system moves money from lender-savers (whose income exceeds their spending) to borrower-spenders (whose spending exceeds their income). The largest lender-savers in the economy are households, but some businesses and many state and local governments at times have excess funds to lend to those who need money. The largest borrower-spenders in the economy are generally businesses, followed by the Commonwealth Government.
Funds can flow directly through financial markets, wherein lender-savers invest directly in financial securities or can flow indirectly through financial institutions wherein the financial institutions mediate between lender-savers and borrower-spenders.
• Direct Financing
In direct transactions, the lender-savers and the borrower-spenders deal ‘directly’ with one another; borrower-spenders sell securities, such as shares and bonds, to lender-savers in exchange for money. These securities represent claims on the borrowers’ future income or assets. A number of different interchangeable terms are used to refer to securities,
including financial instruments and financial claims. The financial markets where direct transactions take place deal with large sums, with a typical minimum transaction size of $1 million. For most companies, these markets provide funds at the lowest possible cost. The major buyers and sellers of securities in the direct financial markets are commercial banks;
other financial institutions, such as insurance companies and finance companies; large business companies; the Commonwealth Government; hedge funds; and some wealthy individuals. It is important to note that financial institutions are major buyers of securities in the direct financial markets. Although individuals participate in direct financial markets, they also can gain access to many of the financial products produced in these markets through retail channels at investment banks or financial institutions such as commercial banks. For example, individuals can buy or sell shares and bonds in small dollar amounts at Macquarie Bank Limited, or from the Commonwealth Bank’s retail brokerage business, CommSec.
Direct financing – without using the market- Suppose that the Westfield Group needs $200 million to build a new centre and decides to fund it by selling long-term bonds with a 15- year maturity. Say that Westfield contacts a superannuation fund, which express an interest in buying Westfield’s bonds. The superannuation fund will buy Westfield’s bonds only after determining 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
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Direct financing – using the Market - To raise finance, companies can issue their own securities (e.g. bonds and shares) in the financial market, particularly in the capital market.
For example, to raise $200 million the Westfield Group could issue bonds or shares in the capital market (i.e. through the ASX).
Investment banks and direct financing- An important player in delivering critical services to
companies that sell securities in the direct financial markets is an investment bank.
Investment banks specialise in helping companies sell new debt or equity, although they also provide other services, such as the broker and dealer services discussed later. When investment bankers help companies bring new debt or equity securities to market, they perform two important tasks: origination and underwriting.
Origination is the process of preparing a security issue for sale. During the origination phase, the investment banker may help the client company determine the feasibility of the project being funded and the amount of capital that needs to be raised. Once this is done, the investment banker helps secure a credit rating, if needed, determines the sale date, obtains legal clearances to sell the securities, and gets the securities printed or created. If securities are to be sold in the public markets, the issuer must also lodge a prospectus with the Australian Securities and Investments Commission (ASIC). Securities sold in private are not required by ASIC to lodge a prospectus.
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Underwriting is the process by which the investment banker guarantees that the company will raise the funds it expects from its new security issue. In the most common type of underwriting arrangement, called stand-by underwriting, the investment banker guarantees to the company that the total funds that a company plans to raise by issuing new securities will be raised. The guarantee of the total amount of funding is important to the issuing company. It is likely that the company needs a specific amount of money to pay for a particular project or to fund operations, and receiving anything less than this amount will pose a serious problem. As you would expect, financial managers almost always prefer to have their new security issues underwritten on a stand-by basis. Under a stand-by underwriting arrangement, the investment banker will purchase any securities that are not sold from the issue at the offer price. Later, they will resell the shares in the market at the prevailing market price. The underwriter bears the risk that the resale price might be lower than the price the underwriter paid to the issuing company — this is called price risk. The resale price can be lower if the investment banker overestimates the value of the shares when determining the initial offer price of the issue. If this happens, the investment bank suffers a financial loss. The investment banker’s compensation for underwriting is called the underwriting spread. It is the difference between the price the investment banker pays for the security and the initial sale price.
• Types of financial Markets
Primary and secondary markets- A primary market is any market where companies initially sell new security issues (debt or equity). When such issues are open to the public, they are called initial public offerings (IPOs). The primary market may be a wholesale market where the sales take place outside of the public view.
A secondary market is any market where owners of securities (i.e. who have already bought the securities) can sell them to other investors. Securities already issued (i.e. outstanding securities) are bought and sold in the secondary market. When securities are bought and sold in the secondary market, the original issuers (i.e. companies that issued these securities in the primary market) do not receive any money.
Investors are willing to pay higher prices for securities that have active secondary markets, compared to similar securities which do not have active secondary markets. Secondary markets are important to companies as well because investors are willing to pay higher prices for securities in primary markets if the securities have active secondary markets.
Thus, companies whose securities have active secondary markets enjoy lower funding costs (i.e. raise funds at a lower cost)
An important characteristic of a security to investors is its marketability. Marketability is the ease with which a security can be sold and converted into cash. A security’s marketability depends on whether buyers for the security are readily available, and also on the costs of trading and searching for information, so-called transaction costs. The lower the transaction costs, the greater a security’s marketability. Because secondary markets make it easier to trade securities, their existence increases a security’s marketability. A term closely related to marketability is liquidity. Liquidity is the ability to convert an asset into cash quickly without loss of value. In common use, the terms marketability and liquidity are often used interchangeably, but they are different. Liquidity implies that when the security is sold, its value will be preserved; marketability does not carry this implication.
Two types of market specialists facilitate transactions in secondary markets. Brokers are market specialists who bring buyers and sellers together for a sale to take place. They execute the transaction for their clients (buyers and sellers) and charge a fee from both buyers and sellers for their services. They bear no risk of ownership of the securities during the transactions; their only service is that of ‘matchmaker’. In Australia, Commonwealth Securities Limited (CommSec) is a well-known broker. Dealers, ‘make markets’ for securities and do bear risk. They make a market for a security by buying and selling from an inventory of securities they own. Dealers make their profit, just as retail merchants do, by selling securities at a price above what they paid for them. The risk that dealers bear is price risk, which is the risk that they will sell a security for less than they paid for it.
Exchanges and Over the counter markets- ‘organised’ markets (more commonly called exchanges) are Traditional exchanges, such as the ASX, that provide a platform and facilities for members to buy and sell securities or other assets (such as commodities) under a
specific set of rules and regulations. All members of the ASX are brokers. Only members can use the exchange to facilitate their clients’ transactions (buying and selling of securities).
Securities not listed on an exchange are bought and sold in the over-the-counter (OTC) market. The OTC market differs from organised exchanges in that the ‘market’ has no central trading location. Instead, investors can execute OTC transactions by visiting or telephoning an OTC dealer or by using a computer-based electronic trading system linked to the OTC dealer. Traditionally, shares traded over the counter have been those of small and relatively unknown companies, most of which would not qualify to be listed on a major exchange.
