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Todays goals Understand the fundamental principles of financial intermediation Explain financial claims and distinguish between marketable and non-marketable financial claims Identify various financial markets, and banking and non- banking financial intermediaries Distinguish between deposit-taking and non-deposit- taking financial intermediaries Understand banking versus shadow banking markets Explain the functions and characteristics of money and monetary bases Explain the importance of market liquidity to the operation of the global economy 2

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Financial Assets An asset is any property of value held or owned by an individual or company A Financial Asset can be thought of as financial property eg: Cash (money) in your wallet Deposit with a bank Corporate bond Common share of a company 3 Casu, Girardone & Molyneux: Chapter 1.2

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Financial System The typical components of any financial system: 1. Financial Assets 2. Borrowers and Savers of financial assets 3. Financial Intermediaries 4. Central Bank regulators (set and manage the rules of the financial system) Financial systems exist within individual countries which have their own currency Currency blocks (eg Euro) can have common components (eg European Central Bank) 4

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Financial Intermediation Two fundamental parties to any financial system: 1. Borrowers (deficit units) 2. Savers (surplus units) Financial Intermediation is conducted by third parties who take deposits from Savers and make loans with those deposits to Borrowers Financial intermediation increases economic efficiency by offering valuable transformative services to both Borrowers and Savers 5 Casu, Girardone & Molyneux: Chapter 1.2

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Intermediation Savers Financial Intermediaries Borrowers Savers Financial (Capital) Markets Borrowers versus Direct Finance 6 Casu, Girardone & Molyneux: Chapter 1.2

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Financial Claims Financial Claims are contractual obligations created when a Borrower accepts money from a Saver (or Lender) Obligation to pay that money back at some time in the future Obligation to pay interest or a return on that money Can be Secured or Unsecured by other assets Holder of financial claim has a Financial Asset Grantor of financial claim has a Financial Liability 7 Casu, Girardone & Molyneux: Chapter 1.2

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Marketability Financial Claims are said to be marketable if a holder can efficiently sell (transfer) the claim to a third party eg: Commercial Paper (CP) Bonds Shares Asset Backed Securities (ABS) Financial Claims are said to be non-marketable if a holder can not efficiently sell (transfer) the claim to a third party eg: Structured Project Finance Loan Insurance Policy Bank deposit 8

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Major world financial systems CountryCurrencyCentral BankMajor Banks (sample) ChinaRMBPBOCBOC, ABC, ICBC, CCB USAUSDFederal ReserveCiti, JP Morgan, BAML EUEURECBDeutsche, SG, BNP UKGBPBOEBarclays, RBS, Lloyds AustraliaAUDRBAANZ, CBA, Westpac, NAB CanadaCADBOCRBC, CIBC, TD, BNS, BMO Hong KongHKDHKMAHSBC, Stan Chart 9

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Types of financial intermediaries Intermediaries are either: Regulated licensed banks or building societies etc Non bank financial institutions (NBFIs) Regulated banks are typically: Retail Commercial Banks Wholesale Commercial Banks Universal Banks Deposit-Taking Institutions eg banks Non-Deposit-Taking Institutions eg insurance companies 10 Casu, Girardone & Molyneux: Chapters 2.3, 3.2, 3.3,3.5

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Types of financial intermediaries Non Bank Financial Institutions are typically: Investment Banks Insurance Companies Pension / Mutual Funds Private Equity Funds Hedge Funds Venture Capital Funds Securitised Lenders 11 Casu, Girardone & Molyneux: Chapters 2.4, 3.6

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Building Societies Member based mutual (cooperative) organisations Operate at retail level Mortgage and savings product focused Mostly unlisted Smaller balance sheets, regional Nationwide Building Society (UK) Yorkshire Building Society (UK) IMB (Australia) 12 Casu, Girardone & Molyneux: Chapter 3.3

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Retail Banks Limited liability corporate organisations Primary focus at retail level Mortgage and savings products Mostly listed Medium sized balance sheets Large number of smaller customers 13 Casu, Girardone & Molyneux: Chapter 3.3

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Wholesale Commercial Banks Limited liability corporate organisations Primary focus at wholesale or corporate level Corporate loans All listed Large sized balance sheets Smaller number of larger customers 14 Casu, Girardone & Molyneux: Chapter 3.3

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Universal Banks Limited liability corporate organisations Focus at retail and wholesale / corporate level Retail banking, corporate and Capital Markets products All listed Large sized balance sheets Large number of large and small customers 15 Casu, Girardone & Molyneux: Chapter 3.2

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Investment Banks Partnerships or limited liability corporate organisations Focus at wholesale / corporate level Capital Markets products Listed and unlisted Volatile balance sheets Smaller number of large customers 16 Casu, Girardone & Molyneux: Chapter 3.6

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Insurance Companies Mutuals or limited liability corporate organisations Focus at retail and wholesale / corporate level Premium based risk management products Listed typically Large off-balance sheet exposures 17 Casu, Girardone & Molyneux: Chapter 2.4

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Pension / Mutual Funds Trust based corporate organisations Focus at retail and wholesale / corporate level Investment management products Listed and unlisted Limited to no leverage 18 Casu, Girardone & Molyneux: Chapter 2.4

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Hedge / Private Equity Funds Trust based corporate organisations Focus at wholesale / corporate level Investment management products Target absolute returns High potential leverage 19

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Venture Capital Funds Trust based corporate organisations Focus at wholesale / corporate level Investing in startup or early stage companies Target absolute returns Zero leverage 20 Casu, Girardone & Molyneux: Chapter 3.5

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Securitised Lenders Trust based corporate organisations Focus at retail and wholesale / corporate level Originating and funding portfolios of financial assets Highly structured Special Purpose Companies High leverage 21

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Shadow banking The term Shadow Banking has been used in the past 5- 10 years to describe a banking-like system of financial intermediation conducted by NBFIs As a result it is largely unregulated and is considered to have contributed significantly to the 2007-9 GFC Post 2007-9 GFC shadow banking closed down but in recent years it is re-emerging in the form of P2P lending, crowdfunding and private equity 22

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Financial markets Places or platforms where financial assets are bought and sold Electronic or over-the-counter (OTC) Open outcry exchanges are almost things of the past (eg futures pits) Most significant financial markets conduct trade in: Securities (shares and bonds eg NYSE, Nasdaq) Futures and derivatives (eg Chicago Mercantile Exchange / Chicago Board of Trade) Foreign exchange (largest cash market of them all) Commodities (much of the physical trade is OTC) 23

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Financial market regulation Everywhere there is a financial market there is usually a regulator establishing and monitoring the rules governing that market China CSRC oversees securities markets US SEC oversees US security markets UK FSA Australia ASIC Regulators aim to ensure markets are fair and orderly 24 Casu, Girardone & Molyneux: Chapter 7

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Information Asymmetry Financial market participants often have varying levels of information > Information Asymmetry 1. Some players have differing information 2. Some players have Inside Information 3. All players have imperfect information Inside Information is usually gained from private sources and is usually illegal to trade from (insider trading) A key regulatory task is to prevent insider trading 25 Casu, Girardone & Molyneux: Chapter 1.4

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Global financial markets In 2015 most financial markets attract participants from all over the world ie they are global in nature eg: Gold derivatives traded in USD by most global players AUD corporate bonds can be held by most global investors but more interest generally shown by Australian investors Shares traded on NYSE by investors on all continents Some markets have restrictions such that many global players can not access them -> localised pricing and trading Many markets are highly correlated with each other 26

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Financial market liquidity Market liquidity impacts a participants ability to: 1. Transact in a market at their time of choosing 2. Transact volume of choosing 3. Minimise transaction costs Increasing market liquidity grows volumes while lowering per unit transactions costs => Increased economic efficiency 27

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The history of money Before money, market participants used the Barter System: Participants exchange goods and services directly for other goods and services Very inefficient because of high transactions costs, lack of price transparency, minimal standardisation and costly/difficult to store wealth Commodity Money, a fixed weight of grain, was used by the Mesopotamians some 3,000 BC Commodity money was replaced by gold and silver, and eventually by banknotes (first used in China during the Song Dynasty circa 1,000 AD) Today we may be standing at the dawn of Cryptocurrency 28 Casu, Girardone & Molyneux: Chapter 5.3

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The uses of money Medium of exchange widely accepted as payment for goods and services Medium of valuation widely accepted as method of relative valuation of goods and services Store of value confidence that participants can hold money into the future to pay for goods and services in a predictable way Standard of Deferred Payment - goods and services consumed now can be paid for in the future with money 29 Casu, Girardone & Molyneux: Chapter 5.3

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The properties of money To be a viable medium of exchange a monetary asset needs various qualities: 1. Acceptable to participants 2. Standardized quality 3. Durable 4. Valuable relative to its weight ie efficient to use 5. Divisible to accommodate various prices of goods and services 30 Casu, Girardone & Molyneux: Chapter 5.3

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Money of today Governments around the globe today issue banknotes and coins which derive value by government order or Fiat Governments decree by law that all public and private financial liabilities can be repaid by this Fiat money designating it as legal tender The right to issue (or print) money comes with responsibility. Printing excessive banknotes or expanding the Money Supply can cause inflation and lead to collapse in trust in that money 31 Casu, Girardone & Molyneux: Chapter 5.3

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Yes, Zimbabwe? Zimbabwean dollar was the official currency from 1980 to 2009, when it was abandoned Following a period of hyperinflation the currency was redenominated on three occasions from 2006 When abandoned the $Z had been redenominated by 10^25! 32

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Money Supply Monetary aggregates are measures of the quantity of money in circulation typically broader than simply banknotes and coins: M1 is defined as banknotes, coins and on-call deposits M2 is defined as M1 + most term deposits M1 and M2 is carefully watched by many markets to monitor government trustworthiness! 33 Casu, Girardone & Molyneux: Chapter 5.3