Chapter 4 – Financial markets and financial institutions

4.1. Real vs financial assets

4.1.1. Real assets

Real assets represent all the elements required for the production of goods and services which a society’s members are able to generate. They are the essential building blocks of an economy’s wealth, representing the core resources that determine its productive capacity. In the context of a company, real assets are the cornerstone of its ability to produce output. These are the physical or tangible and non-physical or intangible resources that the company utilizes in its operations. The examples of real assets include property, plant and equipment, land, buildings and machines.

Intangible assets: These do not have a physical presence but still needed as part of the production process. They include knowledge, intellectual property i.e. patents, copyrights, trademarks and trade secrets.

From topic 1, we know that investment decisions are vital for any business as they directly impact the company’s potential to create value. Making wise investment decisions means identifying which real assets will yield the most favourable cash flows, taking into consideration the costs of obtaining, operating, and improving these assets. These decisions are not confined to initial purchases; they also encompass the continuous process of maintaining existing assets to ensure their ongoing productivity and deciding when and how to upgrade them to respond to technological advancements, market demands, or regulatory requirements. The aim is to optimize the efficiency and profitability of the assets throughout their lifecycle, ensuring that they contribute positively to the company’s financial health and competitive position.

4.1.2. Financial assets

Financial assets i.e. financial securities are assets that are created by the law which outlines the rights and obligations of the holder and the issuer. These assets do not contribute directly to the productive capacity of the economy. They represent the claims over the cashflows produced by real assets. Unlike real assets, financial assets are created by the financing decisions. The examples of financial assets include stocks and bonds which represent the claims of the capital providers’ claims on the cash flows.

4.2. The financial system

The financial system is a complex network that includes financial markets, institutions and products, all of which play a critical role in the economy. The financial system’s primary purpose is to efficiently direct funds from savers, who have excess funds, to borrowers, who have a deficit of funds, thereby facilitating investment in productive ventures, which is critical for economic growth and prosperity. In order for the financial system to have a smooth functioning that allows for free flow of capital and ensures its integrity and stability, there needs to be independent bodies that oversee the financial system. These are regulators who enforce legal requirements, protect consumers, monitor risks and maintain confidence in the financial system.

4.2.1 Financial markets

• Financial markets are physical or virtual venues where financial instruments are traded. Financial markets can be classified according to different criteria:
• Maturity: money vs capital market
• New and outstanding security: primary vs secondary market
• Asset types: equity, bond, fx and derivatives
• Organisation of transactions: exchange traded vs over the counter.

4.2.1.1 Money markets versus capital market

Money markets provide a platform for the issuance and trading of short-term securities i.e. instruments with maturities of less than 12 months. The money markets are largely composed of institutional investors, such as banks, mutual funds, and corporations, rather than individual investors. These participants either have surplus funds and are looking to earn interest or have a short-term shortage of funds and need to borrow. Unlike stock exchanges, money markets do not have a specific physical trading location. Transactions can be completed over the counter (OTC), through electronic systems, or via telephone. The instruments traded in the money markets include Treasury notes, certificates of deposit, commercial bills, promissory notes, inter-bank loans, and repurchase agreements (repos). Each of these serves a specific function in terms of liquidity management for financial institutions:

• Treasury notes: Short-term debt obligations issued by the government.
• Certificates of deposit (CDs): Term deposits with banks that offer higher interest rates than regular savings accounts.
• Commercial bills: Issued by companies to finance their immediate cash flow needs.
• Promissory notes: Unsecured notes that are used for financing a wide range of transactions.
• Inter-bank loans: Short-term loans made from one bank to another to manage liquidity.
• Repurchase agreements (Repos): Short-term borrowing for dealers in government securities; the dealer sells the government securities to investors with an agreement to buy them back at a higher price at a later date.

Capital markets facilitate the raising of long-term funds. Here is a breakdown of these markets:

• Equity market: This market is where ownership stakes in companies are issued and traded. Investors who purchase equities are essential providing capital to the firms as owners.
• Corporate debt market: his market is for the issuance and trading of corporate bonds, which are debt securities issued by companies to fund their operations, expansions, or investments. Investors who buy corporate bonds are essentially lending money to the issuing company in return for periodic interest payments and the return of the bond’s face value at maturity.
• Government debt market: Governments issue debt securities, such as bonds and treasury bills, to finance budget deficits and fund various projects. These securities are considered to be backed by the full faith and credit of the issuing government, making them one of the safest investment options. They can be traded in both domestic and international capital markets.
• Foreign exchange market: This is a global decentralized market for the trading of currencies. It supports international trade and investment by enabling currency conversion. For example, if a company in one country wants to purchase goods from another country, it can use the foreign exchange market to convert its currency into the currency of the seller’s country.
• Derivative market: Derivatives are financial instruments that derive their value from an underlying asset or benchmark. This market provides instruments like
• futures, forwards, options, and swaps, which are used for hedging against risks or speculating on future movements of the underlying assets. The derivatives market can be used to manage a range of risks, including interest rates, currencies, equities, and credit risks.

4.2.1.2. Primary markets versus secondary market

Primary markets are the financial venues where new securities are created and sold for the first time to investors. Corporations, governments, and other entities who need funding will issue new financial assets to raise capital directly from investors. Investment banks play a crucial role in facilitating this process. They help issuers to determine the price of the new securities and through rigorous marketing strategies, sell the securities to investors. Investors in the primary market can be institutional investors like pension funds and mutual funds, or retail investors. By purchasing the newly issued financial assets, investors provide the issuers with the funds they need. In return, investors receive the financial assets which may represent debt (bonds), equity (stocks), or other financial interests in the company. An example of a primary market is Initial Public Offerings (IPOs) where a company offers its shares to the public for the first time. IPOs can involve equity, but companies also issue debt and other financial assets through similar primary market mechanisms.

Secondary markets are marketplaces where investors buy and sell existing financial assets, those that have already been issued in primary markets. The financial instruments traded in secondary markets are stocks, bonds and other financial instruments. Unlike primary market, trading in the secondary market does not result in the creation of new assets. It is purely the exchange of ownership of existing securities. The trade is between two investors, and the money involved in the transaction goes from the buyer to the seller, not to the issuing company. The role of secondary market is to provide liquidity for financial assets. This liquidity is crucial because it gives investors the confidence that they can readily convert their assets into cash if needed. By providing liquidity, secondary markets reduce the risk of investing in primary markets. Investors are more likely to purchase new financial assets if they know that they can later sell them in a secondary market. This, in turn, helps primary markets function more effectively as it broadens the investor base and potentially lowers the cost of capital for issuers.

4.2.1.3. Exchange traded markets versus over the counter market

Exchange-traded markets are structured and regulated environments where securities are bought and sold. These markets such as the Australian Stock Exchange (ASX) or the New York stock exchange (NYSE) are characterized by their high level of organization, transparency, and stringent information disclosure requirements. These markets operate under strict regulatory oversight, which ensures fair trading practices and the protection of investors. Regulatory bodies establish rules that govern the operations of these markets and the conduct of all market participants. Issuers of securities in exchange-traded markets are required to provide comprehensive information about their financial health, performance, and any other material information that might affect the value of their securities. This requirement is designed to maintain a high level of transparency and allows investors to make informed decisions. Trading on exchanges is transparent, meaning that buy and sell orders, prices of securities and completed transactions, are visible to all market participants. This ensures that all participants have access to real-time information regarding market prices, contributing to a fair and competitive market environment.

Over-the-counter (OTC) markets are decentralized markets where trading of financial instruments is facilitated by a network of dealers rather than on a centralized exchange. OTC markets typically operate with less regulatory oversight compared to exchange-traded markets. This can lead to a wider range of products being traded, including those that may not meet the stringent listing requirements of formal exchanges. OTC markets offer more flexibility as the terms of trades are not standardized. This allows for the customization of trade agreements to suit the specific needs of the parties involved. Unlike the centralized nature of exchange trading, OTC markets do not have a physical location or central exchange. Trading occurs directly between parties. Financial institutions or dealers act as market makers by quoting prices at which they will buy (bid) and sell (ask) financial instruments. Dealers hold an inventory of financial instruments to facilitate this trading. Prices in OTC markets can often be negotiated. Since trades do not occur in a public venue, dealers can provide private quotes to clients and may adjust prices based on the size of the transaction or the relationship with the client.

4.2.1.4.  Financial markets by products

Equity market: The market where equities, commonly known as shares, are traded is typically referred to as the stock market or equity market. These include ordinary shares, preference shares and hybrid securities. Equities are most commonly traded on organized exchanges, such as the Australian Securities Exchange (ASX), which provide a platform for buyers and sellers to transact in a regulated and standardized environment.

Bond market: The bond market, also known as the debt market or credit market, is where investors trade bonds, which are long-term debt instruments. These includes corporate bonds and long-term government debt securities. While a significant volume of bond trading occurs over-the-counter (OTC), where trades are negotiated privately between two parties, bonds can also be listed and traded on formal exchanges like the Australian Securities Exchange (ASX). OTC transactions are typically larger and involve institutional investors, whereas exchange trading can offer more accessibility for retail investors.

Foreign exchange market: The currency market, also known as the foreign exchange market or FX market, is a global decentralized marketplace for the trading of currencies. The primary function of the FX market is to enable the conversion of one currency into another. This is necessary for international trade, where businesses and individuals need to pay for goods and services in a foreign currency. The market consists of a network of banks, financial institutions, brokers, and dealers who are licensed to trade in foreign exchange. These participants operate in major financial centres around the world and conduct transactions directly with each other or through electronic trading platforms. The FX market operates 24 hours a day, five days a week, and is the most traded market in the world, with trillions of dollars exchanged daily.

The derivatives market: is where financial instruments known as derivatives are traded. These are securities whose value is derived from the value of other underlying financial assets, such as stocks, bonds, commodities, currencies, interest rates, or market indexes. The types of derivative instruments include:

Options: Contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price within a certain time period.

Futures: Standardized contracts traded on an exchange that obligate the buyer to purchase, or the seller to sell, an underlying asset at a predetermined price on a specified future date.

Forwards: Customized contracts between two parties to buy or sell an asset at a specified price on a future date. These are often used for hedging purposes.

Swaps: Contracts to exchange cash flows or other financial instruments for the purpose of exchanging risk (e.g., interest rate risk, currency risk).

4.2.2. Australia’s financial institutions

Financial institutions can be divided into three broad categories: financial intermediaries, investing institutions and financial agency institutions.

4.2.2.1 Financial Intermediaries

Intermediated Finance is a key feature of the financial system, providing a more efficient allocation of resources, risk management, and liquidity transformation. It allows for the pooling of funds from many small investors to meet the large capital requirements of borrowers, while also providing security and return for the investors. During this process, the supplier of funds i.e. the investor provide funds to a financial intermediary, such as depositing money in a bank through instruments like a term deposit. The user of the fund (the borrower) is the individual or entity that requires funds for purposes such as buying a house, starting or expanding a business, or other financial needs. They receive funds from the financial intermediary in the form of loans or other credit arrangements, such as a housing loan. In the middle of the transaction is the financial intermediary i.e. the bank who takes on the role of managing funds between the suppliers and users. With the funds collected from investors, the intermediary extends loans or credit to those in need of funds. In this system, the claims of the supplier of funds (investor) and the user of funds (borrower) are solely with the financial intermediary. The investor does not have a direct claim against the borrower, which means that if the borrower defaults on the loan, the bank is responsible for compensating the investor, not the borrower.

Financial intermediaries refer to institutions who serve as middlemen between parties in financial transactions. These are typically known as ADIs (Authorised deposit taking institutions). As the name implied, these institutions are authorised by a financial regulatory body to accept deposits from the public. Banks, credit unions, and building societies are examples of ADIs. They pool the deposits they receive and use these funds to provide loans or credit to borrowers. The financial intermediary creates a separate contract with each party—the lender (or depositor) and the borrower. Their revenue is earned primarily through the interest spread. This is the difference between the interest rates they charge borrowers for loans and the interest rates they provide to depositors for their savings. For instance, a bank may offer a 1% interest rate on savings accounts but charge 4% interest on home loans, earning a spread of 3%.

4.2.2.2. Investing institutions

Investing institutions are entities that manage and sell investment products to the public and use the pooled funds to invest in a variety of asset classes. Depending on the regulations, these institutions can invest in both real and financial assets. These institutions include:

Superannuation funds: These funds collect contributions from employers on behalf of employees as well as from fund members directly. They invest these contributions across different asset classes with the goal of providing income benefits for members upon retirement. Common investments include equities, debt securities, real estate, and cash.

Managed funds: These funds pool money from many investors to invest in a diversified portfolio of financial assets. Professional fund managers select and manage these assets on behalf of the investors. Managed funds provide investors with access to a wider range of investments than they might be able to afford or manage on their own.

Private equity firms: These firms invest in private companies that are not listed on a stock market. Investments made by private equity firms are usually long-term and can be high-risk, partly because of the illiquidity of the shares—they are more difficult to sell compared to public equities. Private equity can be classified into two types:

• Venture capital firms (VC): Venture capital firms focus on investing in start-up and early-stage companies with high growth potential. These investments are inherently risky due to the unproven nature of the businesses but can yield high returns if the companies succeed.
• Private equities: In addition to venture capital, private equity also includes buyouts, growth capital, and mezzanine capital. PE investments are characterized by active ownership, where the PE firm seeks to add value to the company through strategic, operational, or managerial improvements.

Hedge funds: are often considered to be higher risk compared to traditional investment funds that are often considered not suitable for retail investors. Unlike traditional managed funds, which may focus on a diversified portfolio of stocks or bonds, hedge funds often engage in a wide array of investment and trading activities. These can include leveraged investments, short-selling, derivatives trading, and other sophisticated investment strategies. Hedge funds generally operate with less regulatory oversight than other investment vehicles such as mutual funds. This allows them more freedom in their investment decisions, but it also means less protection for investors. They are often only accessible to accredited or qualified investors who have a higher degree of financial literacy and can bear the risk of loss.

General insurance companies: are financial entities that collect premiums from households and businesses and provide a range of insurance policies to protect individuals and businesses against various risks. These include property, motor vehicle and employer’s liability insurance. In order to ensure that they have sufficient liquidity to cover claims and operational expenses, general insurance companies invest their assets primarily in short-term financial securities such as deposits, short-term loans, government securities or liquid equities. he investment strategies of general insurance companies are often conservative, emphasizing liquidity and safety due to the nature of their liabilities. They need to ensure that funds are available when claims are made, which can be unpredictable. Consequently, they tend to avoid locking in their assets in long-term or illiquid investments. Their investment decisions are also subject to regulatory guidelines that aim to maintain solvency and protect the interests of the insured parties.

Life insurance companies: unlike general insurance, life insurance companies offer a range of financial products and services, primarily focusing on risk mitigation and financial planning for individuals. The type of products they offer include life insurance which offers financial compensation to beneficiaries upon the policyholder’s death. They also provide accident and disability insurance: which covers for losses due to accidental injuries or disability, which can include lump-sum payments or ongoing income support. To support their long-term liabilities (such as life insurance payouts), life insurance companies tend to invest in a mix of equities and debt securities. Besides traditional insurance, life insurance companies offer investment products that combine investment with insurance coverage, such as annuities. They may also manage superannuation (retirement savings) products, allowing policyholders to invest and grow their funds for retirement.

4.3 Financial regulators

The objectives of regulators are:

Systematic Stability: This refers to the overall health and functioning of the financial system. Systemic stability is achieved when the system is resilient to economic shocks and able to operate without significant crises, such as widespread bank failures or bank runs. A bank run occurs when a large number of depositors withdraw their funds simultaneously, often due to fears that the bank will become insolvent. Ensuring systemic stability is crucial to prevent such crises, which can lead to severe economic and social disruptions.

Deposit Protection: refers to safeguarding the interests of bank depositors, those with small account balances who may not have the financial expertise to fully understand complex banking products and the health of the financial institutions themselves. Asymmetric information is a situation where one party, in this case, the financial institutions have more or better information than depositors. To protect depositors, various mechanisms such as deposit insurance schemes are put in place, which guarantee to cover deposits up to a certain amount, thereby reducing the risk for individual depositors.

Social objectives: Many financial institutions are profit driven therefore without appropriate mechanisms in place, they will not serve the interest of the public as a whole. The institutions need to be given incentives so that they will engage in behaviours that benefit every members of society. This includes keeping bank fees low to ensure affordability for all segments of society, providing financial support to specific sectors of the economy that may have social value, such as small businesses or industries that create significant employment opportunities. These objectives often align with broader goals such as income redistribution, economic inclusion, and the promotion of equitable growth.

There are three main regulatory bodies in Australia:

• The RBA (Reserve Bank of Australia): The RBA serves as Australia’s central bank and its main functions are crucial to the nation’s financial system and overall economic performance. The RBA oversees the payment systems to ensure they are safe and efficient, and providing banking services to the government and other financial institutions. The most important function of the RBA is formulating and implementing monetary policy. The main tool the RBA uses for this purpose is setting the cash rate, which is the interest rate on overnight loans in the money market. In the first Tuesday of every month except January, the RBA board meets to decide the outcome of its review of the cash rate and releases a statement that announces any changes to the rate. Changes to the cash rate can influence a range of other interest rates, including those for mortgages and savings, and can thereby affect the behaviour of borrowers and savers, the level of economic activity, and ultimately the rate of inflation. Finally, the RBA monitors and assess the health of the financial system and work with other regulatory bodies to manage and mitigate systemic risks. The RBA aims to prevent problems that may arise from the financial system, such as bank runs or the collapse of financial institutions, that could have detrimental effects on the economy.
• ASIC (Australian Securities and Investments Commission): is an independent Australian government body that acts as Australia’s corporate regulator. Its role is to enforce and regulate company and financial services laws to protect Australian consumers, investors, and creditors. ASIC oversees companies to ensure they adhere to corporate governance standards. Corporate governance involves a set of rules and processes by which a company is directed and controlled, focusing on the internal and external corporate structures with the intention of monitoring the actions of management and directors and thereby mitigating the risks of corporate fraud. For the financial services sector: ASIC supervises and regulates the insurance, banking and superannuation industry to ensure they operate efficiently, honestly and fairly with the aim to promote transparency and market integrity.
• APRA (Australian Prudential Regulation Authority): While ASIC is focused on consumer protection and market integrity, APRA is involved in the prudential oversight of financial institutions. APRA’s core function is to oversee banks, credit unions, building societies, general insurance companies, life insurance, and most members of the superannuation industry. It sets standards and supervises institutions to ensure that, under all reasonable circumstances, these financial promises made to consumers are met. APRA ensures that the institutions it supervises manage risks effectively, requiring them to hold sufficient capital and have appropriate risk management frameworks in place to deal with potential adverse scenarios. APRA is responsible for planning for financial crises and has a role in responding to them if they occur. This includes the power to take control of an institution if its viability is threatened and managing its restructure or orderly exit from the industry if necessary.

References:

Graham, J., Smart, S. B., Adam, C., Gunasingham, B. Introduction to Corporate Finance (2nd Asia – Pacific Edition) 2017.

Brealey, R., Myers S. C., Allen F., Edmans, A. Principles of Corporate Finance (14th Edition) 2022.

Peirson, G., Brown, R., Easton, S., Howard, P., Pinder, S. Business Finance (12th Edition) 2015.

Reserve Bank of Australia (rba.gov.au)

ASIC Home | ASIC

Welcome to APRA | APRA