Essay Questions –

Chapter 1

1. Discuss the importance of financial intermediation in the financial system.

Financial intermediaries are the “lubricants” that keep the economy going. Due to the increased
complexity of financial transactions, it becomes imperative for the financial intermediaries to keep re-
inventing themselves and cater to the diverse portfolios and needs of the investors. The financial
intermediaries have a significant responsibility towards the borrowers as well as the lenders.
The very term intermediary would suggest that these institutions are pivotal to the working of the
economy and they along with the monetary authorities have to ensure that credit reaches to the needy
without jeopardizing the interests of the investors. This is one of the main challenges before them.
Financial intermediaries have a central role to play in a market economy where efficient allocation
of resources is the responsibility of the market mechanism. In these days of increased complexity of the
financial system, banks and other financial intermediaries have to come up with new and innovative
products and services to cater to the diverse needs of the borrowers and lenders. It is the right mix of
financial products along with the need for reducing systemic risk that determines the efficacy of a
financial intermediary.

2. What are the roles of secondary capital market in the financial system?

Price discovery. The interplay of the supply of and the demand for shares brings about the
establishment of prices for them. Some shares are actively traded while others are not. The issue of
market efficiency is discussed later.

• An active secondary equity market facilitates primary market issues, i.e. improves the capacity of
issuers to place newly created equities. The knowledge by investors that they will be able to dispose of
securities if they so desire, i.e. an exit mechanism, brings this about.

• An active secondary market gives rise to the raising of capital at a price that is often cheaper than
in the absence of this market. In other words well-run companies are rewarded with the ability to raise
capital cheaply in comparison with companies that are not well run. This can be called a "discipline"
factor.

• An active secondary market provides the benchmark for the determination of the pricing of new
issues.

• An active secondary equity market registers changing market conditions rapidly, indicating the
receptiveness of the market for new primary issues.

• An active secondary equity market enables investors to rapidly adjust their portfolios in terms of
size, risk, return, liquidity and maturity.

3. Explain why the money market is so important in the economy.

Three factors explain the importance of money markets: their contribution to market efficiency and
market discipline; their impact on financial stability and on financing conditions in the economy at
large; and their role as an initial link in the chain of monetary policy transmission.
Deep and liquid money markets, not unlike other markets in the economy, play an important part
in information aggregation and price discovery. Indeed, money market rates, such as Euribor and Libor,
provide benchmark rates for the pricing of fixed-income securities and loan contracts throughout the
economy.

Moreover, interbank money markets play a significant role in providing incentives for banks to
conduct business in a safe and sound manner, thus ensuring market discipline.

Developments in money markets can have profound implications for financial stability and the
functioning of the entire economy, for they affect the financing conditions faced by non-financial
corporations and households. For example, it have a significant impact on the size of the balance sheet
of financial institutions and the amount of credit they can extend high asset valuation, low haircuts and
abundant liquidity in money markets can lead to higher leverage and credit expansion, whereas when
bad shocks hit the economy asset prices drop, haircuts increase and liquidity can dry up.

4. Explain the differences between brokers and dealers in the financial market.

When a firm is acting as a broker, it is acting as the customer’s agent and is merely executing
the customer’s order for a fee known as a commission. The role of the broker is simply to find someone
willing to buy the investor’s securities if the customer is selling or to find someone willing to sell them
the securities if they are buyers. The firm acts as a dealer when it participates in the transaction by
taking the opposite side of the trade. For example, the firm may fill a customer’s buy order by selling
the securities to the customer from the firm’s own account or the dealer may fill the customer’s sell
order by buying the securities for their own account. A brokerage firm is always acting as a dealer or in
a principal capacity when it is making markets over the counter.

Broker Dealer
 Executes customer’s
 Participates in the trade as a principal
orders
 Charges a markup or markdown Makes
 Charges a
a market in the security
commission
 Must disclose the fact that they are a
 Must disclose the
market maker, but not the amount of the
amount of the
mark-up or markdown
commission

5. Explain the key roles of the financial system. Why is it so important to the broader economy to
have an efficient and effective financial system?
The role of financial system is to permit the flow and efficient allocation of funds throughout the
economy. It gathers money from the suppliers of funds and transfers it to the demanders of finds in the
most efficient manner possible.
The primary functions of financial markets are:
- facilitating the flow of funds
- providing the mechanism for the settlement of transactions
- generating and disseminating information that assists decision making
- providing means for the transfer and management of risk
- providing ways of dealing with the incentive problems the arise in financial contracting
It is important to the broader economy to have an efficient and effective financial system as it can
result in regards to the ability of businesspeople to invest in their firm, and the flow of individual
preferences for current spending and saving.

6. Why is denomination divisibility an important intermediation service from the perspective of

the typical household?
 Typical households do not have sufficient cash to invest in the direct credit markets, where
minimum transactions are often $1 million. Financial intermediaries facilitate indirect investment by
households by offering financial claims with smaller denominations. Otherwise, households would
have to accumulate large sums of money before they could invest. During the time required to
accumulate, say, $1 million, the household would earn no interest income - a substantial opportunity
cost! And a disincentive to save and invest.

7. Compare and contrast debt and equity as a source of funds for financial claims.
Financial claims are sourced from either debt or equity funds. Debt funds are supplied in the form
of a loan and are either short-term (referred to as money) or long-term (referred to as capital). Suppliers
of loans face credit risk - the risk that the borrower will default on scheduled repayments as specified
in the loan agreement. The lender is compensated for this with interest income. Equity funding involves
the acquisition of an ownership share of a business, which is usually seen as a longer-term investment
and hence referred to as capital investment. Equity investors face investment risk, the possibility that
the investors expected return will not be realised, and are compensated with dividend payments and
capital growth (where the value of the ownership share increases over time) for bearing this.

8. Why are direct financing transactions more costly and/or inconvenient than intermediated
transactions?
The parties to direct finance have to find each other and negotiate a more or less exact match of
preferences as to amount, maturity, and risk. Intermediaries provide all parties choices about financial
activity, and drive costs down through competition, diversification, and economies of scale.

As long as financial intermediaries have the edge in informational efficiency (lower cost of
information discovery), funds will flow through financial intermediaries. In the 1980's, as information
and communications technology advanced, investment bankers claimed an increased share of the
savings/investment throughout. Businesses issued commercial paper instead of borrowing from banks.
Loans were divided into origination, service and funding cash flows and securitization began. Funds
will flow to investment via the lowest cost route. Large commercial banks have turned to informational
processing and risk intermediation via standby letters of credit, commitments, and OTC derivatives,
such as swaps.

9. What impact did the GFC have on the global financial system? What will the long-term
implications be for the members of the sector?

The GFC brought the global financial system to the brink of collapse with significant impacts on:
- Asset values (share markets declined dramatically, bond values collapsed as interest rates were
moved, international finance declined as international trade declined, mortgage finance stopped
as asset value and available capital declined for example).
- Financial institutions around the world collapsed and many were either merged or required
significant government bailouts to keep them afloat. This also meant a great deal of job losses
in the financial sector.
- Confidence in the financial system declined and capital flows between institutions, into capital
markets and across borders changed significantly.
- The required government intervention and extension of sovereign debt (to significant levels in
some areas - particularly Europe), had a long term effect that will also drive government
reregulation of the financial sector.
- A significant repricing of risk in all asset classes.
The long term effects were at the time of writing still being established, however several things are
clear:
- Reregulation globally is likely to lead to more strigent control of ris, mix and type of operations
and level of oversight of financial institutions.
 - The medium to long term impact of government debt and ownership/intervention in the
financial sector may subdue markets and economic activity (and therefore financial activity)
for some time.
- The repricing of risk in all asset classes will change market behaviour for some time and subdue
both retail and wholesale market activity.
- The negativity surrounding the financial institutions has exacerbated consumer distaste and
mistrust in financial institutions which will continue to be a public relations battle for some
time.

10. Discuss the spread of banking assets across Australian financial institutions. Examine the data
in table 1.2 and discuss the impact that the GFC has had on the different types of financial
institutions.
Banking assets in Australia are spread across a variety of different types of institutions including
banks, credit unions, building societies and other financial institutions. While there are more credit
unions than any other type of institution, the bank dominates the percentage of assets held and within
this the four big banks holds the clear majority and dominate the entire sector. Indeed, these four
institutions dominate much of our region with significant control over New Zealand and the Pacific
Island countries.
Table 1.2 shows that over the crisis period (2007-2009), the banks came out on top with an increase
in growth in assets over the period of 19%. Conversely, securitises’ assets decline by 14%, public unit
trust 8% and superannuation funds 6%, reflecting the impact of stock market declines on the
superannuation and unit trusts. In the case of securitises, there performance relates to the lack of appetite
for mortgage backed securities as well as a decline in the value of the underlying assets held in existing
portfolios (the decrease in property values and increasing numbers of loan defaults). Despite this, the
Australian financial system has been comparatively very robust and has no direct cash bailouts such as
those that occurred in most other developed countries.

11. Explain the concept of financial intermediation. How do financial intermediaries generate
profits?
Financial intermediation is the process by which financial institutions mediate unmatched
preferences of ultimate borrowers (DSUs) and ultimate lenders (SSUs). Financial intermediaries buy
financial claims with one set of characteristics from DSUs, then issue their own liabilities with
different characteristics to SSUs. Thus, financial intermediaries "transform" claims to make them
more attractive to both DSUs and SSUs. This increases the amount and regularity of participation in
the financial system, thus making financial markets more efficient.

12. Explain the differences between the money markets and the capital markets. Which market
would Holden use to finance a new vehicle assembly plant? Why?
Money markets are markets for liquidity, whether borrowed to finance current operations or lent
to avoid holding idle cash in the short term. Money markets tend to be wholesale OTC markets made
by dealers. Capital markets are where real assets or "capital goods" are permanently financed, and
involve a variety of wholesale and retail arrangements, both on organized exchanges and in OTC
markets.
GM would finance its new plant by issuing bonds or stock in the capital market. Investors would
purchase those securities to build wealth over the long term, not to store liquidity. GMAC, the finance
company subsidiary of GM, would finance its loan receivables both in the money market (commercial
paper) and in the capital market (notes and bonds). GM would use the money market to "store" cash
in money market securities, which are generally, safe, liquid, and short-term.

13. Discuss three forms of financial market efficiency. Why is it important that financial markets
be efficient?
- Weak-form Market Efficiency
This form postulates that prices of securities are instantly and fully reflects all information of
the past prices. Data about past price stock are not used the future price change of the stock. Under
 the weak-form Market Efficiency, everything is random because information flow is random. This
form is simply used a buy- and sell- strategy.

- Semi-Strong Market Efficiency

Postulates that publicly available information reflects the price of securities in the market. This
means that those investors who have additional information about the secutities are the only
one with an advantage. At any moment in time when we have anomalies, the stocks market
makes necessary adjustments as speedy as possible.
- Strong-form Market Efficiency
Postulates that price of asset fully reflects public and inside information available. In this
market, no one has advantage on the market in terms of predicting price of securities because
no data is available to make additional value to investor.

- Importance of Financial Markets being Efficient

When financial markets are efficient, no one will outperform the market by using the same
information that is already available. This is because at any given time, market prices of
securities reflect all known information. It is also held that in an efficient market, a change is
fast. Image of

14. What are the major risks faced by financial institutions and why is it important that each is
carefully managed?

Credit Risk (or default risk) is the possibility that a borrower may not pay as agreed. Management
of credit risk is important as excessive credit risk will lead to higher regulatory costs (credit based
capital adequacy requirements to be discussed later in the text) and may lead to the failure of the firm
through cash flow and non-performing loans problems.
Interest Rate Risk is the likelihood that interest rate fluctuations will change a security’s price and
reinvestment income. As a significant part of financial institutions investments and sources of funds are
interest-bearing and profits are generated on the margin between these, managing both the investment
and funding portfolio’s for interest rate risk is important for profits, cash flows and the stability of the
institution.
Liquidity Risk is the possibility that a financial institution may be unable to pay required cash
outflows. If a financial institution is unable to meet its short-term obligations because of inadequate
liquidity, the firm will fail even though over the long run the firm may be profitable.
Foreign Exchange Risk is the possibility of loss on fluctuations in exchange rates. These
fluctuations can cause gains or losses in the currency positions of financial institutions, and they cause
the Australian dollar values of non-Australian financial investments to change.
Political Risk is the possibility that government action will harm an institution’s interests. This
includes changes in regulation, appropriation of assets, changes to foreign investment and currency
transfer and trading rules, all of which can influence the earnings and value of a financial institution.
Reputational Risk is the potential for negative publicity to cause loss through decline in customer
base, increased litigation and revenue reductions.
Environmental Risk is the actual and/or potential threat of adverse impact on asset values due to
changes in the environment and6or organisational impacts on the environment.