Question

Financial institutions, financial markets and financial system 

a) Identify which one of the following securities has the highest nominal annual yield at issuance and which one is the safest investment? Use the key determinants of Nominal Interest Rate to briefly explain why. (4 marks)

20-year treasury bonds 10-year corporate bonds with AAA rating 30 -year corporate bonds with AAA rating 10-year corporate bonds with BB rating 30-year corporate bonds with BB rating 3-month treasury notes

b) Monetary policy is one of the key responsibilities of the Reserve Bank of Australia

i) What is Monetary policy? (1 mark)

ii) If inflation next quarter is predicated to fall to 1% p.a. due to the impact of Covid-19, how would the RBA adjust the official cash rate in response to this situation? Briefly explain the reason for this adjustment (Include in your answer the inflation target of monetary policy, the expected effect of any suggested change in cash rate on consumption, investment and the likely change to net export). (4 marks)

c) As the major authorized deposit-taking institutions (ADIs), Australian banks’ safety and profit level have major impacts in Australian economy.

i) List and define 3 major risks faced by banks (3 marks)

ii) List 3 factors that affect the Interest Rate Margin (IRM) of banks. (3 marks)

iii) Briefly explain how the Covid-19 pandemic would affect the major risks of banks and its potential impact on the IRM of banks (2 marks)

iv) Banks are regulated in terms of capital adequacy. Briefly discuss how this requirement would help banks maintain safety during the Covid-19 pandemic. (3 marks)

Answer 1

A Financial System plays a vital role in the economic growth of a
country. It intermediates between the flow of funds belonging to those who
save a part of their income and those who invest in productive assets. It
mobilises and usefully allocates scare resources of a country. The financial
system of most developing countries is characterised by coexistence and co-
operation between the formal and informal financial sectors. The formal
financial sector is characterised by the presence of an organised, institutional
and regulated system which caters to the financial needs of the modern
spheres of economy, the informal financial sector is an unorganised, non-
institutional and non-regulated system dealing with the traditional and rural
spheres of the economy. The existence of an efficient financial system
facilities economic activity and growth. The growth of financial structure is a
precondition to economic growth. Markets, institutions and instruments are
the prime movers of economic growth. The financial system of a country
diverts its savings towards more productive uses and so it helps to increase
the output of the economy. Besides mobilising savings, the financial system
helps accelerate the volume and rate of savings by providing a diversified
range of financial instruments and services through intermediaries. This
results in an increased competition in the financial system which channelises
resources towards the highest-return investment for a given degree of risk.
This lowers financial intermediation costs and stimulates economic growth. A
sophisticated financial system makes innovation least costly and more
profitable, thereby enabling faster economic growth. In addition to affecting
the rate as well as the nature of economic growth a financial system is useful
in evaluating assets, increasing liquidity, and producing and spreading
information. The financial system plays an important role in disciplining and
guiding management companies, leading to sound corporate governance.
III. COMPONENTS OF FINANCIAL SYSTEM:
The organisation/structure of the Financial System consists of
(i)
Financial Markets and (ii) Financial
Assets/instruments.
Financial markets:
Another significant component of the organisation of the Financial
System comprises of Financial Markets which perform a crucial function in
the savings - investment process as facilitating organisations. They are not
sources of finance but they are a link between the savers and investors, both
individual as well as institutional. Based on the nature of funds which are
their stock-in-trade, the financial markets are classified into (i) Money Market
and (ii) Capital/ Securities Market. Financial Markets are the centres or
arrangements that provide facilities for buying and selling of individuals, and
government trade in financial products on these markets either directly or
through brokers and dealers on organised exchanges or off-exchanges. The
participants on the demand and supply sides of these markets are financial
institutions, agents, brokers, dealers, borrowers, lenders, savers and others,
who are interlinked by the laws, contracts, covenants and communication
networks. Financial markets are the centres or arrangements that provide
facilities for buying and selling of financial claims and services. The
corporations, financial institutions, individuals and government trade in
financial products on these markets either directly or through brokers and
dealers on organised exchange or off-exchanges. Financial markets are
sometimes classified as primary (direct) and secondary (indirect) markets.
The primary markets deal in the new financial claims or new securities and
therefore they are also known as the New Issue Markets. On the other hand,
secondary Markets deal in securities already issued or existing or outstanding.
The primary markets mobilise savings and they supply fresh or additional
capital to business units. Although secondary Markets do not contribute
directly to the supply of additional capital, they do so indirectly by rendering
securities issued on the primary markets liquid. Stock Markets have both the
primary and secondary market segments. The Financial Markets are also classified as Money Markets and Capital Markets. Under this classification
both of these markers perform the same function of transferring resources to
the producers. The conventional distinction is based on the differences in the
period of maturity of financial assets issued in these markets as the money
markets deal in short term claims whereas the capital markets deal in long
term claims. As in accordance with the various purposes the Financial
Markets may be also classified as (i) organised and unorganised (ii) formal
and informal (iii) official and parallel and (iv) domestic and foreign. The
financial transactions which take place outside the well established exchanges
or without systematic and orderly structure or arrangements constitute
unorganised markets.
Financial assets/instrumental (Securities):
The third component of the organisation of the financial system is
financial assets/instruments (securities). They represent claims on a stream of
income and/or assets of another economic unit and are held as a store of value
and for the return that is expected. Financial Securities are financial assets
representing claims to the payment of money in future; it may be the
repayment of the principal and/or payment in the form of interest or dividend.
A financial instrument is a claim against a person or an institution for
payment, at a future date, of a sum of money and/or a periodic payment in
the form of interest or dividend. The term 'and/or' implies that either of the
payments will be sufficient but both of them may be promised. Financial
instruments represent paper wealth shares, debentures, like bonds and notes.
many financial instruments are marketable as they are denominated in small
amounts and traded in organised markets. This distinct feature of financial
instruments enables people to hold a portfolio of different financial assets
which, in turn, helps in reducing risk. Different types of Financial instruments
can be designed to suit the risk and return preferences of different classes of investors. Financial securities are financial instruments that are negotiable and
tradeable. Financial instruments differ in terms of marketability, liquidity,
reversibility, type of option, return, risks and transaction costs. Financial
instruments help financial markets and financial intermediaries to perform the
important role of channelising funds from lenders to borrowers. Availability
of different variety of financial instruments helps financial intermediaries to
improve their own risk management. The securities may be direct securities
(primary) or indirect securities (secondary). Direct securities are those issued
by the users of the funds directly to the suppliers of funds. The various
securities issued by the corporate sector are direct securities whereas the
financial claims created by financial intermediaries are indirect securities.
Financial securities may be also broadly classified into corporate securities
and government securities. Government securities are securities issued by the
government for raising a public loan or as notified in the official gazzette.
Financing instruments fall into one of two categories : debt and equity. Debt
instruments generally-represent fixed obligations to repay a specific amount
at a specified date in the future, together with interest. Equity instruments
generally represent ownership interests entitled to dividend payments, when
declared, but with no specific right to a return on capital. In addition to the
various types of conventional securities there are derivative securities as well.
These are securities whose values are deceived from the value of underlying
assets. These securities are traded in a market known as the derivative market.
Financial instruments differ from each other in respect of their investment
characteristics which, of course are inter dependent and inter related. Among
the investment characteristics of financial assets or financial products, the
following are important (i) liquidity, (ii) market ability, (iii) reversibility, (iv)
transferability, (v) transactions costs, (iv) risk of default or the degree of
capital and in come uncertainty and a wide array of other risks, (vii) maturity
period, (viii) tax status, (ix) options such as call back or buy back option, (x)
volatility of prices and (xi) the rate of return- normal effective and real.

Corporate bonds: After the government sector, corporate bonds have historically been the largest segment of the bond market. Corporations borrow money in the bond market to expand operations or fund new business ventures. The corporate sector is evolving rapidly, particularly in Europe and many developing countries.

Corporate bonds fall into two broad categories: investment grade and speculative-grade (also known as high yield or “junk”) bonds. Speculative-grade bonds are issued by companies perceived to have lower credit quality and higher default risk than more highly rated, investment grade companies. Within these two broad categories, corporate bonds have a wide range of ratings, reflecting the fact that the financial health of issuers can vary significantly.

Speculative-grade bonds tend to be issued by newer companies, companies in particularly competitive or volatile sectors, or companies with troubling fundamentals. While a speculative-grade credit rating indicates a higher default probability, higher coupons on these bonds aim to compensate investors for the higher risk. Ratings can be downgraded if the credit quality of the issuer deteriorates or upgraded if fundamentals improve.