Accounting Finance ACC 4004 Introduction to Financial System

Accounting & Finance (ACC 4004) Introduction to Financial System Week 1 1

Learning Objectives: • Financial System, its Functions and benefits. • Problems of direct financing. • Financial intermediation and its role. • Functions of Financial Intermediaries. • Benefits of financial intermediation. 2

What is Finance? • FINANCE: Study of how individuals, institutions, governments, and businesses acquire, spend, and manage money and other financial assets • FINANCIAL ENVIRONMENT: Encompasses the financial system, institutions, markets, and individuals that make the economy operate efficiently 3

Three Areas of Finance within the Financial System • Institutions and Markets • Investments • Financial Management [Note: These areas do not operate in isolation but rather interact or intersect with each other. ] 4

Finance Area Definitions • FINANCIAL INSTITUTIONS: Help the financial system operate efficiently and transfer funds from savers to investors • FINANCIAL MARKETS: Physical locations or electronic forums that facilitate the flow of funds 5

Finance Area Definitions (Continued) • INVESTMENTS: Involves sale or marketing of securities, analysis of securities, and management of investment risk • FINANCIAL MANAGEMENT: Involves financial planning, asset management, and fund raising decisions to enhance firm value 6

Six Principles of Finance • Money has a time value • Higher returns are expected for taking on more risk • Diversification of investments can reduce risk 7

Six Principles of Finance (Cont’d) • Financial markets are efficient in pricing securities • Manager and stockholder objectives may differ • Reputation matters 8

1. Time Value of Money • Money in hand today is worth more than the promise of receiving the same amount of money in the future • Time value of money exists because a sum of money today could be invested and “grow” over time 9

2. Risk-Return Tradeoff • Risk is the uncertainty about the outcome or payoff of an investment in the future • Rational investors would choose a riskier investment only if they feel the expected return is high enough to justify the greater risk 10

3. Diversification of Investments • All investment risk is not the same • Some risk can be removed or diversified by investing in several different assets or securities. 11

4. Efficient Financial Markets • A financial market is “information efficient” if at any point in time the prices of securities reflect all information available to the public • When new information becomes available, prices quickly change to reflect that information • Information efficient markets provide liquidity and fair prices 12

5. Management Vs. Owner Objectives • Management objectives may differ from owner objectives (called principal-agent problem) • Owners or equity investors want to maximize the returns on their investments • Managers may seek to emphasize the size of firm sales, assets, or other perks • Solution: tie manager compensation to performance measures beneficial to owners 13

6. Reputation Matters! • Ethical Behavior: How an individual or organization treats others legally, fairly, and honestly • High reputation value reflects high quality ethical behavior, so employing high ethical standards is the “right” thing to do 14

Financial System “A set of markets for financial instruments, and the individuals and institutions who trade in those markets, together with the regulators and supervisors of the system. ” 15

Functions of Financial System • channels funds from lenders to borrowers – Financial systems channels funds from surplus units (often household) to deficit units (mostly firms). • creates liquidity and money • provides a payments mechanism • provides financial services such as insurance and pensions • offers portfolio adjustment facilities 16

End Users of Financial System • The end-users of the financial system are – People – firms and; – other organizations • The end-users, faced with a desire to lend or borrow, have broadly three choices; – Deal directly with each other, this is costly, risky, inefficient and unlikely – Use one of the organised markets where lenders buy liabilities issued by borrowers. This is via tradable instruments. 17

End Users of Financial System – Use a financial intermediary such as a bank, building society or a pension fund. The intermediaries have an asset (a deposit from a lender) and they create liabilities (usually loans for lenders) Howells & Bain 2007: 2, Fig 1. 1 18

Benefits of Financial System • makes borrowing and lending cheap • creates liquidity and money • makes it easier for firms to invest and thus increases the rate of economic growth • makes transactions easier and thus encourages trade and exchange • increases the range of investments and loans available to individuals and companies 19

Benefits of Financial System • provides a payment mechanism • provides financial services such as insurance and pensions • offers portfolio adjustment facilities • provides regulation • provides advice 20

Saving & Lending • Excess of Current Income over consumption is Saving. • Saving can be used to buy real assets (like machinery, equipment etc. ) which would be Investing. • But in personal sector people will have no investment in general. • The difference of saving and investing would be financial surplus. • The financial surplus is available for lending. 21

Activity/Discussion Group 1 (Lenders) • Consider yourself Lenders/with excess funds. What are your main consideration/concerns while lending your money? Group 2 (Borrowers) • Consider yourself Borrowers/with shortage of funds. What are your main consideration/concerns while borrowing money? 22

Requirements of Lenders • Risk Minimisation • Default risk • Capital Risk • Income risk • Maximisation of Return • Cost Minimisation • Liquidity • Lenders prefer most liquid assets due to uncertainty about the future events. 23

Requirements of Borrowers • Minimum costs • The return to lenders would be the cost to borrowers. • The borrowers would like to have funds at the lowest possible cost. • Longer maturity • Borrowers would like funds for a longer period of time in order to reduce the risk of uncertainty or funds becoming short and expensive in future. • Funds at a particular specified date • Lower transaction costs 24

Activity/Discussion What problems/issues could you face in daily life (consider savings, loans, banking needs etc. ) if there were no financial intermediaries (i. e. banks, building societies etc. ) around? 25

Direct Financing Direct financing is the provision of funds to the ultimate users of the funds (borrowers) by the ultimate investors (savers/lenders). Funds Lent (Financial Asset) Savers/ Depositors Borrowers Financial Claims (Financial Liability) 26

Savings into investment in an economy without Financial Intermediaries Arnold 2012: 17 27

Problems of Direct Financing • Difficulty in matching needs of lenders and borrowers • Incompatibility of financial needs • Lenders require higher return and liquidity while lower risk and transaction costs • Borrowers need lower interest (cost of funds), risk, transactions costs and longer term (lower liquidity) The speed and convenience with which an asset/financial instrument can be converted into money for a certain value is called liquidity. Howells & Bain 2007: 9 28

Problems of Direct Financing • Size of transaction- savers/depositors are willing and capable to lend smaller funds than required by the borrowers. • Maturity- mismatch between the maturity of funds demanded by lenders and borrowers i. e. lenders usually want to lend on short term/on-demand basis while borrowers like to have longer maturities. • Risk- lenders prefer to minimise risk and want their money to be safe, on the other hand individual borrowers carry risk of default. 29

Problems of Direct Financing • Transaction Costs – Search Costs- the costs involved in searching out potential contracting parties. – Information Costs- costs involved in obtaining information and negotiating the contracts. – Evaluation and Verification Costs- costs involving the evaluation and screening of borrowers’ proposal and verification of their credit worthiness. – Monitoring Costs- post transaction (i. e. loan) monitoring costs in order to ensure that borrowers observe loan covenants. – Enforcement Costs- further costs involved in enforcement of loan terms in case of borrowers’ default on their commitments. 30

End Users may: • Use a financial intermediary such as a bank or a pension fund. The intermediary have assets and they create liabilities. • Use one of the organised financial markets where lenders buy liabilities issued by borrowers. This is via tradable instruments.

Indirect (Intermediated) Financing Funds Lent Financial Intermediary (bank) Savers/ Depositors Financial Claim (Deposit) Borrowers Financial Claim (Loan) Financial Claims Buckle & Thompson 2004: 36 32

Financial Intermediaries (FIs) • Financial Intermediation – Intermediation means acting as a go-between the parties i. e. lenders and borrowers Howells & Bain 2007: 6 • Financial Intermediary (FI) • An organisation which borrows funds from lenders and lends them to borrowers on terms which are better for both parties if they dealt directly with each other. Howells & Bain 2007: 7 33

Financial Intermediaries (FIs) • FIs, like other type of firms, are profit maximizers. • FIs create financial assets for lenders and liabilities for borrowers. • FIs create a link between the lenders and borrowers and bring them together. • Financial intermediation, however, is different from broking • Intermediation means more than just introducing the parties to each other unlike broking. • Financial intermediaries create liquidity. 34

Savings into investment in an economy with Financial Intermediaries & Markets Arnold 2012: 19 35

The nature of financial intermediation • Better allocation of funds/resources • Intermediaries promote economic efficiency by transferring funds form surplus units to deficit units. • The process of intermediation generates financial claims (financial assets and liabilities) • The process of intermediation removes the two important barriers • Matching the complex needs of lenders and borrowers • Incompatibility of the needs • Lenders look for safety and liquidity which borrowers find difficult to promise.

Financial Intermediaries (FIs) in UK Casu et al. , 2006: 24 37

Deposit Taking Institutions (DTIs) • These provide a direct link between savers and borrowers. They are the banks and building societies with whom customers have accounts for depositing and withdrawing funds. Piesse et al 1995: 41 • Financial Institutions that obtain their funds mainly from accepting savings and/or demand deposits from the general public and provide regular banking services such as chequing and savings accounts. Casu et al 2006: 477

Non-Deposit Taking Institutions (NDTIs) A general term used to refer to financial institutions whose main activity is not to take deposits, such as insurance companies, pension funds, investment companies, finance houses and so on. Casu et al 2006: 489

Distinction between DTIs & NDTIs • DTIs are also called Monetary Financial Institutions (MFIs) and their deposits form the bulk of country's money supply. • Due to deposit taking from public, DTIs are subject to higher supervision and regulation compared to the NDTIs. • Different types of financial products and motives of people holding deposits and products of DTIs and NDTIs.

Discretionary vs. contractual savings or flow of funds • A main difference between the DTIs and NDTIs is the nature of financial contracts. • Discretionary Savings: Day to day decisions to acquire financial assets of varying kinds and in varying quantities. • Contractual Savings: The regular acquisition of a financial asset of a kind, of an amount and on a date specified in a contract. Howells & Bain 2007: 18

Creation of assets and liabilities • How intermediaries create assets and liabilities • What is financial asset from lender's point of view? • Loan or Deposit (in bank) is an Asset of Lender/saver (or customer of a bank) • What is financial liability from borrower's point of view? • Loan/Deposit is a Liability of borrower or (a bank) • What are financial assets and liabilities of a financial intermediary? • Deposits (of customers) are liabilities of bank (FI) while Loans are assets of the bank

Example Suppose a loan of £ 100, 000 has been granted by Lender (L) to the Borrower (B), draw their balance sheets under the following situations; A. Direct transaction between L & B B. An intermediated loan between L & B through an Intermediary (I). Draw the balance sheet of the Intermediary.

Example: Creation of Assets and Liabilities • Direct Financing Lender Liability Total Borrower Asset Liability 100, 000 Asset • Via Intermediary Lenders Liability Total Intermediary Borrower Asset Liability 100, 000 (deposit) 100, 000 (loan) 100, 000 (A) 100, 000 (B) 100, 000 (C) 100, 000 (D) Asset • Total Assets (=A+C)=200000 Total Liabilities (=B+D) =200000

Functions of FIs (banks etc. ) • How FIs solve problems of direct financing? • FIs create liquidity which is an essential requirement of lenders • Liquidity: Banks create liquidity for both lenders and borrowers • Liquidity has three dimensions • Time (Maturity Transformation) • Risk (Risk Transformation) • Cost (Transaction costs) • Banks, however, have to make the funds available to the borrowers for certain period of time.

Functions of FIs (Banks etc. ) • Maturity Transformation: Banks create liquidity mostly by maturity transformation • Banks transform funds for short period into medium and long term loans. • Banks are “borrowing short and lending long” • This “borrowing short and lending long” exposes FIs (Banks) to the liquidity risk. • Principally, not all the depositors of a bank will come to bank to demand their money back at the same time (except in case of a “bank run”)

Functions of FIs (Banks etc. ) • Risk Transformation: able to minimise the individual loan risks by; • Screening out bad risks (through trained staff and sophisticated techniques) • Diversifying risks (lending to different types of borrowers) • Pooling risks (large number of loans) • Holding capital and reserves as buffer against unexpected losses Buckle & Thompson 2004: 38 -39

Functions of FIs (Banks etc. ) • Transaction Costs: Cost reduction through economies of scale & scope. • Reduction in per unit cost of transaction due to large size and volume of transactions • Standard loan contracts • Better monitoring of borrowers through trained staff • Cross selling opportunities and economies of scope (selling variety of products and services using common resources (buildings, staff etc. ) (economies of scope).

Transaction costs-Example Suppose A agrees to lend £ 10, 000 to B for a year at a rate of 20% pa. • A’s cost for drawing contract & search costs- £ 500 • B’s costs (say advertising for finding a lender)- £ 100 Now they a find an intermediary who is willing to do intermediation on following term; • Search costs- £ 30, transaction costs- £ 70 • A mark-up of 30% on these costs for overheads and profits Howells & Bain 2005: 18

Transaction costs-Example • A. Total cost of transaction before intermediation • £ 500 + 100 = £ 600 • • B. Total cost of transaction with intermediary £ 30 + 70 = £ 100 + 30% mark up= £ 130 Saving in Cost of transaction = £ 600 - £ 130= £ 470 Howells & Bain 2005: 18

Functions of FIs (Banks etc. ) • Size Transformation: Banks perform the function of size transformation • Banks transform small amounts of deposits from a large number of depositors into larger size loans • Banks have access to large number of savers/depositors than any individual borrower • Economies of scale associated with their size

Benefits of Financial Intermediation • Benefits to ultimate lenders (surplus units) • Greater liquidity • Lower risk • Marketable securities • Like Certificate of Deposits (CDs) which are marketable and can be sold in market in case of cash needs • Transaction Costs • Simplified lending decisions and procedures Casu et al 2006: 17 -18

Benefits of Financial Intermediation • Benefits to ultimate borrower (Deficit units) • Maturity • Loans usually available for longer time periods • Size • Larger amounts of loan available form FIs • Lower transaction costs • Lower (generally) interest rates • Timing of loans- available when required Casu et al 2006: 18

Benefits of Financial Intermediation • Benefits to Society • Efficient utilisation of funds • Higher levels of borrowing and lending • Availability of funds for high risk ventures Casu et al 2006: 18

Bibliography Buckle, M. and Thompson, J. , (2004) The UK financial System: Theory and Practice. 4 th ed. Manchester: Manchester University press Casu, B. , Girardone, C. and Molyneux, P. , (2006) Introduction to Banking. England: FT Prentice Hall Howells, P. and Bain, K. , (2007) Financial Markets and Institutions. 5 th ed. England: Pearson Howells, P. and Bain, K. , (2005) The Economics of money, banking and Finance: A European text. 3 rd ed. England: Pearson Mishkin, F. S. and Eakins, S. G. , (2009) Financial Markets and Institutions. 6 th ed. Boston: Pearson Piesse, J. , Peasnell, K. and Ward, C. , (1995) British Financial markets and Institutions. 2 nd ed. Hertfordshire: Prentice Hall