Introduction to Banking and Finance Guy Hargreaves We

Introduction to Banking and Finance Guy Hargreaves We. Chat: Guyhargreaves ACE-102

Course goals in summary �Understand the role of financial systems and financial intermediation �Understand the importance of financial regulation and the role of Central Banks �Understand the major financial instruments and markets �Appreciate the fundamentals of risk and return in financial systems 2

Course Coverage �Motivation for the existence of financial markets and financial intermediaries �Main types of financial instruments, financial markets and financial intermediaries �Financial market pricing and efficiency �Unique characteristics of banks and recent developments in the banking sector �Financial crises and contagion risk for the real economy �Regulation in the financial sector: motivation and recent developments �Theory of central banking: monetary policy, supervision and lender of last resort 3

About. me � 27 year of experience Investment and Corporate Banking in Asia Pacific region �Kiwi living in Hong Kong with wife and three children �My goal: deliver academic based introduction to banking and finance from the perspective of a highly experienced practitioner => please feel free to ask questions at any time 4

Structure and assessment �Text: Introduction to Banking; Casu, Girardone & Molyneux � 3 x 50 min lectures Mon-Fri 8. 30 -11. 30 am � 1 x 50 min tutorial Mon-Thur 2. 30 -3. 30 pm �Exam: 2 hours on Friday, 5 th May � multiple choice questions + short essay � 100% of final mark 5

Overview of financial intermediation and the global financial system

Today’s goals �Understand the fundamental principles of financial intermediation �Explain “financial claims” and distinguish between marketable and non-marketable financial claims �Identify various financial markets, and banking and nonbanking financial intermediaries �Distinguish between deposit-taking and non-deposittaking financial intermediaries �Understand banking versus shadow banking markets �Explain the functions and characteristics of money and monetary bases �Explain the importance of market liquidity to the operation of the global economy 7

Financial Assets �An asset is any “property” of value held or owned by an individual or company �A Financial Asset can be thought of as financial property eg: � Cash (money) in your wallet � Deposit with a bank � Corporate bond � Common share of a company 8

Financial System �The typical components of any financial system: 1. 2. 3. 4. Financial Assets Borrowers and Savers of financial assets Financial Intermediaries Central Bank regulators (set and manage the rules of the financial system) �Financial systems exist within individual countries which have their own currency �Currency blocks (eg Euro) can have common components (eg European Central Bank) 9

Financial Intermediation �Two fundamental parties to any financial system: 1. Borrowers (deficit units) 2. Savers (surplus units) � Financial Intermediation is conducted by third parties who take deposits from Savers and make loans with those deposits to Borrowers � Financial intermediation increases economic efficiency by offering valuable transformative services to both Borrowers and Savers 10

Intermediation… Savers Financial Intermediaries Borrowers …versus Direct Finance Savers Financial (Capital) Markets Borrowers 11

Financial Claims �Financial Claims are contractual obligations created when a Borrower accepts money from a Saver (or Lender) � Obligation to pay that money back at some time in the future � Obligation to pay interest or a return on that money � Can be Secured or Unsecured by other assets �Holder of financial claim has a Financial Asset �Grantor of financial claim has a Financial Liability 12

Marketability �Financial Claims are said to be marketable if a holder can efficiently sell (transfer) the claim to a third party eg: Commercial Paper (CP) � Bonds � Shares � Asset Backed Securities (ABS) � �Financial Claims are said to be non-marketable if a holder can not efficiently sell (transfer) the claim to a third party eg: Structured Project Finance Loan � Insurance Policy � Bank deposit � 13

Major world financial systems Country Currency Central Bank Major Banks (sample) China RMB PBOC BOC, ABC, ICBC, CCB USA USD Federal Reserve Citi, JP Morgan, BAML EU EUR ECB Deutsche, SG, BNP UK GBP BOE Barclays, RBS, Lloyds Australia AUD RBA ANZ, CBA, Westpac, NAB Canada CAD BOC RBC, CIBC, TD, BNS, BMO Hong Kong HKD HKMA HSBC, Stan Chart 14

Types of financial intermediaries �Intermediaries are either: � Regulated licensed banks or building societies etc � Non bank financial institutions (NBFIs) �Regulated banks are typically: � Retail Commercial Banks � Wholesale Commercial Banks � Universal Banks �“Deposit-Taking Institutions” – eg banks �“Non-Deposit-Taking Institutions – eg insurance companies 15

Types of financial intermediaries �Non Bank Financial Institutions are typically: � Investment Banks � Insurance Companies � Pension / Mutual Funds � Private Equity Funds � Hedge Funds � Venture Capital Funds � Securitised Lenders 16

Building Societies �Member based mutual (cooperative) organisations �Operate at “retail level” �Mortgage and savings product focused �Mostly unlisted �Smaller balance sheets, regional � Nationwide Building Society (UK) � Yorkshire Building Society (UK) � IMB (Australia) 17

Retail Commercial Banks �Limited liability corporate organisations �Primary focus at “retail level” �Mortgage and savings products �Mostly listed �Medium sized balance sheets �Large number of smaller customers 18

Wholesale Commercial Banks �Limited liability corporate organisations �Primary focus at “wholesale or corporate level” �Corporate loans �All listed �Large sized balance sheets �Smaller number of larger customers 19

Universal Banks �Limited liability corporate organisations �Focus at “retail and wholesale / corporate level” �Retail banking, corporate and Capital Markets products �All listed �Large sized balance sheets �Large number of large and small customers 20

Investment Banks �Partnerships or limited liability corporate organisations �Focus at “wholesale / corporate level” �Capital Markets products �Listed and unlisted �Volatile balance sheets �Smaller number of large customers 21

Insurance Companies �Mutuals or limited liability corporate organisations �Focus at “retail and wholesale / corporate level” �Premium based risk management products �Listed typically �Large off-balance sheet exposures 22

Pension / Mutual Funds �Trust based corporate organisations �Focus at “retail and wholesale / corporate level” �Investment management products �Listed and unlisted �Limited to no leverage 23

Hedge / Private Equity Funds �Trust based corporate organisations �Focus at “wholesale / corporate level” �Investment management products �Target absolute returns �High potential leverage 24

Venture Capital Funds �Trust based corporate organisations �Focus at “wholesale / corporate level” �Investing in startup or early stage companies �Target absolute returns �Zero leverage 25

Securitised Lenders �Trust based corporate organisations �Focus at “retail and wholesale / corporate level” �Originating and funding portfolios of financial assets �Highly structured Special Purpose Companies �High leverage 26

Shadow banking �The term Shadow Banking has been used in the past 5 -10 years to describe a banking-like system of financial intermediation conducted by NBFIs �As a result it is largely unregulated and is considered to have contributed significantly to the 2007 -9 GFC �Post 2007 -9 GFC shadow banking closed down but in recent years it is re-emerging in the form of P 2 P lending, crowdfunding and private equity 27

Financial markets �“Places or platforms” where financial assets are bought and sold � Electronic or “over-the-counter” (OTC) � Open outcry exchanges are almost things of the past (eg futures pits) �Most significant financial markets conduct trade in: � Securities (shares and bonds eg NYSE, Nasdaq) � Futures and derivatives (eg Chicago Mercantile Exchange / Chicago Board of Trade) � Foreign exchange (largest cash market of them all) � Commodities (much of the physical trade is OTC) 28

Financial market regulation �Everywhere there is a financial market there is usually a regulator establishing and monitoring the rules governing that market � China – CSRC oversees securities markets � US – SEC oversees US security markets � UK – FSA � Australia – ASIC �Regulators aim to ensure markets are fair and orderly 29

Information Asymmetry �Financial market participants often have varying levels of information –> Information Asymmetry 1. Some players have differing information 2. Some players have Inside Information 3. All players have imperfect information � Inside Information is usually gained from private sources and is usually illegal to trade from (insider trading) � A key regulatory task is to prevent insider trading 30

Global financial markets �In 2015 most financial markets attract participants from all over the world ie they are global in nature eg: � Gold derivatives traded in USD by most global players � AUD corporate bonds can be held by most global investors but more interest generally shown by Australian investors � Shares traded on NYSE by investors on all continents �Some markets have restrictions such that many global players can not access them -> localised pricing and trading �Many markets are highly correlated with each other 31

Financial market liquidity �Market liquidity impacts a participant’s ability to: 1. Transact in a market at their time of choosing 2. Transact volume of choosing 3. Minimise transaction costs �Increasing market liquidity grows volumes while lowering per unit transactions costs => Increased economic efficiency 32

The history of money �Before “money”, market participants used the Barter System: Participants exchange goods and services directly for other goods and services � Very inefficient because of high transactions costs, lack of price transparency, minimal standardisation and costly/difficult to store wealth � �“Commodity Money”, a fixed weight of grain, was used by the Mesopotamians some 3, 000 BC �Commodity money was replaced by gold and silver, and eventually by banknotes (first used in China during the Song Dynasty circa 1, 000 AD) �Today we may be standing at the dawn of Cryptocurrency 33

The uses of money �Medium of exchange – widely accepted as payment for goods and services �Medium of valuation – widely accepted as method of “relative” valuation of goods and services �Store of value – confidence that participants can hold money into the future to pay for goods and services in a predictable way �Standard of Deferred Payment - goods and services consumed now can be paid for in the future with money 34

The properties of money �To be a viable medium of exchange a monetary asset needs various qualities: 1. Acceptable to participants 2. Standardized quality 3. Durable 4. Valuable relative to its weight ie efficient to use 5. Divisible to accommodate various prices of goods and services 35

Money of today �Governments around the globe today issue banknotes and coins which derive value by government order or “Fiat” �Governments decree by law that all public and private financial liabilities can be repaid by this “Fiat” money – designating it as “legal tender” �The right to issue (or print) money comes with responsibility. Printing excessive banknotes or expanding the Money Supply can cause inflation and lead to collapse in trust in that money 36

Yes, Zimbabwe? �Zimbabwean dollar was the official currency from 1980 to 2009, when it was abandoned �Following a period of hyperinflation the currency was redenominated on three occasions from 2006 �When abandoned the $Z had been redenominated by 10^25! 37

Money Supply �Monetary aggregates are measures of the quantity of money in circulation – typically broader than simply banknotes and coins: � M 1 is defined as banknotes, coins and on-call deposits � M 2 is defined as M 1 + most term deposits �M 1 and M 2 is carefully watched by many markets to monitor government trustworthiness! 38