Answers to application and analysis exercises

Solutions Manual

to accompany

Financial Markets, Institutions & Money 3rd Edition

Prepared by Mark Brimble, Anup Basu, Paul Docherty, Liam Lenten, & Dianne Thomson

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Chapter 1: Overview

© John Wiley & Sons Australia, Ltd 2013 1.2

Chapter 1 – Overview

Answers to application and analysis exercises

1.1 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?

Financial markets are the markets for buying and selling financial instruments. Financial markets

have five primary functions:

• 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
• provide ways of dealing with the incentive problems that arise in financial contracting

Having an efficient and effective financial system is critical as it facilitates commercial, retail and government transactions in a timely, low cost and reliable way. The opposite would be a system where funds take a long time to reach their destination (i.e. direct debits may take weeks), with high cost (significantly greater transactions costs) and with great risk (to either their value or likelihood of arrival). An efficient and effective financial system will also produce actual and timely information to enable effective financial decision making, which is also important in the complex financial world of today.

When one considers what we take for granted in the financial system (EFTPOS, Electronic Transfer, Direct Debit, etc) in terms of its reliability) and consider the time and cost involved in doing this manually, one can see the importance of the financial system.

1.2 Does it make sense that the typical household is an SSU, while the typical business firm is a DSU? Explain your answer.Households are ultimately SSUs, but have deficit periods when a home or other “big ticket” item is purchased. Businesses usually invest more in real assets than they receive in current operating cash flow.

1.3 Why is denomination divisibility an important intermediation service from the perspective of the typical household?Typical households do not have enough cash to invest in 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 investing. During the time this would take, the household would earn no interest income—a substantial opportunity cost, and a disincentive to save and invest.

1.4 Explain the economic role of brokers, dealers and investment bankers. How does each make a profit?Brokers, dealers, and investment bankers make markets at both primary and secondary stages.Funds are raised and claims issued as they bring SSUs and DSUs together in primary markets. In secondary markets they trade claims in volume, providing liquidity and price discovery.

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Solution Manual to accompany Financial Markets, Institutions & Money 3e by Kidwell et al

John Wiley & Sons Australia, Ltd 2013 1.3

1.5 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 realized, and are compensated with dividend payments and capital growth (where the value of the ownership share increases over time) for bearing this

1.6 What are some problems with direct financing that make indirect financing more attractive?Direct financing requires a more or less exact match between the characteristics of the financial claims DSUs wish to sell and those the SSUs want to buy. Direct financing can thus involve a costly search and negotiation process, often complicated by information asymmetries concerning ultimate credit risk of the DSU. Intermediaries transform direct claims sold by DSUs and make them more attractive to SSUs, helping DSUs find financing and SSUs find appropriate investments.

1.7 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.

1.8 What is moral hazard? Do you think this is a big issue for financial institutions?Moral hazard is where a party that is insulated from risk behaves differently to the way they would behave if they were not insulated. This is key concern for financial institutions, particularly insurance operations, as it increases the chance of loss and consequently creates the need (and associated cost) to monitor clients. Essentially, the ‘don’t worry, it’s insured’ attitude increases the cost of insurance operations.

1.9 Why are economies of scale important to the viability and profitability of financial intermediaries?Economies of scale give financial intermediaries a cost advantage. If their average cost decreases as the size of the transaction increases, financial intermediaries can profitably engage in denomination intermediation while remaining adequately diversified.

1.10 Explain how you believe economic activity would be affected if there were no financial markets and institutions.Financing relationships would arise only when preferences of SSUs and DSUs match. DSUs would not always obtain timely financing for attractive projects and SSUs would under-utilize their savings.The “production possibilities frontier” of the society would be smaller.

1.11 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 bought 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 3 / 4

Chapter 1: Overview

© John Wiley & Sons Australia, Ltd 2013 1.4

• 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 risk, 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 sometime 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.

1.12 What are the three sources of comparative advantage that financial institutions have over others in producing financial products?(1) Economies of scale —large volumes of similar transactions; (2) transaction cost control—finding and negotiating direct investments less expensively; and (3) risk management expertise—bridging the “information gap” about DSUs’ creditworthiness.

1.13 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 banks dominate the percentage of assets held and within this the four big banks hold 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, securitisers’ assets decline by 14%, public unit trusts 8% and superannuation funds 6%, reflecting the impact of stock market declines on the superannuation and unit trusts. In the case of securitisers, 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 had no direct cash bailouts such as those that occurred in most other developed countries. The reasons for this are discussed in the In Focus below.Overall, the financial intermediaries’ assets grew at an annual average rate of 8.0 per cent. This rate of growth was faster than the economy as a whole, which grew at approximately 4% per cent annually, and reflects the growth in indirect securities issued, the increase in the proportion of funds being channeled through the intermediation market and the tremendous wealth created by the Australian economy in recent years. What will be interesting to see is how the sector emerges from the financial crisis and the impacts that a more highly regulated environment and stricter credit standards will have.

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