Modern Financial System

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Chapter 1 A modern financial system: an overview
The introduction of money and the development of local markets to trade goods were the genesis of the financial system of today. Money is a medium of exchange that facilitates transactions for goods and services. With wealth being accumulated in the form of money, specialised markets developed to enable the efficient transfer of funds from savers (surplus entities) to users of funds (deficit entities). A modern financial system comprises financial institutions, instruments and markets that provide a wide range of financial products and services. Importantly, a financial system encourages accumulated savings which are then available for investment within an economy. Financial assets, or financial instruments, incorporate attributes of risk, return (yield), liquidity and time-pattern of cash flows. Savers are able to satisfy their own personal preferences by choosing various combinations of these attributes. By encouraging savings, and allocating savings to the most efficient users, the financial system has an important role to play in the economic development and growth of a country. A range of different financial institutions has evolved to meet the needs of financial market participants and to support economic growth. Chapters 2 and 3 examine the major types of financial institutions. At this stage the institutions are categorised by the nature of their principal activities. Depository institutions, such as commercial banks, building societies and credit unions, specialise in gathering savings in the form of deposits and use those funds in the provision of loans to customers. Investment banks and merchant banks tend to specialise in the provision of off-balancesheet advisory services to clients (e.g. merger and acquisition advice). Contractual savings institutions, such as insurance offices and superannuation funds, enter into obligations in which they receive funds on the undertaking they will pay a policy holder or member of a fund a specified sum when a nominated event occurs. Finance companies sell debt instruments directly to surplus entities and then use those funds to provide loans to borrowers. Unit trusts sell units in a trust. The accumulated funds are pooled and invested in asset classes specified within the trust deed. Commercial banks dominate in terms of their share of the assets of financial institutions. Financial markets and instruments allow borrowers to meet the requirements of the matching principle; that is, short-term assets should be funded by short-term liabilities and long-term assets should be funded by long-term liabilities and equity. The financial instruments are central to any financial relationship between two parties and can be distinguished on the basis of the relationship between the deficit entities and the surplus entities. Where the saver acquires an ownership claim on the deficit entity, the financial instrument is referred to as equity. Where the relationship is one that is commonly known as a loan, the financial instrument is referred to as a debt instrument. A financial instrument that incorporates the characteristics of both debt and equity is known as a hybrid. Another category of instruments has been developed called the derivative (futures, forwards, swaps and options). The main use of a derivative is in the management of commodity and financial risks. The markets in which debt and equity are created and sold by the issuers of the instruments are known as primary markets. Investors who buy primary market instruments generally have a preference for liquidity. Markets that facilitate the sale of previously issued instruments, such as a stock exchange, are called secondary markets. By providing a structure for the trading of instruments, secondary markets serve the most important function of adding liquidity to financial Instructor’s Resource Manual t/a Financial Institutions, Instruments and Markets 5e, by Viney 1

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