1. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 8–1 Chapter 8 The Capital Market

2. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 8–2 Learning Objectives Understand the functions of a capital market. Distinguish between the roles of financial agency institutions, financial intermediaries and investing institutions. Identify and explain the role of financial agency institutions, financial intermediaries and investing institutions.

3. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 8–3 The Flow of Funds An economic entity will be either a ‘savings deficit unit’ or a ‘savings surplus unit’ (over a given period of time). The financing process involves a flow of funds from the savings surplus units to the savings deficit units. The flow of funds may be direct or indirect.

4. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 8–4 Financial Intermediaries Financial intermediaries are institutions that act as a principal in accepting funds from depositors and lending them to borrowers. They enable the preferences of savers and lenders to be matched. This is achieved via: – Asset transformation – Maturity transformation – Credit risk diversification – Creation of liquidity

5. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 8–5 Definition of ‘Capital Market’ The market in which long-term financial securities are traded. The suppliers and users of funds can negotiate the conditions on which funds will be transferred. This transfer can be done in either the debt or equity market. It is the debt and equity markets together which form the capital market.

6. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 8–6 Primary Market ‘Primary market’ refers to transactions between companies seeking finance and investors directly. Primary market transactions create new financial securities. It is the market for new issues of securities, where the sale proceeds go to the issuer of the securities.

7. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 8–7 Secondary Market Secondary market transactions involve transactions in existing financial instruments. The instruments that are traded are those that have already been created in the primary market. The secondary market enhances the marketability and liquidity of primary issue instruments.

8. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 8–8 Deregulation of the Financial Markets Lifting of controls over interest rates paid by banks (December 1980). Removal of quantitative controls over bank lending (June 1982). Floating of the AUD (December 1983).

9. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 8–9 Removal of restrictions on the terms of bank deposits (August 1984). Allowing access to banking licences for foreign banks (February 1985). Removal of bank interest rate ceilings (April 1986). Deregulation of the Financial Markets (cont.)

10. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 8–10 Deregulation of the Financial Markets (cont.) Financial markets are, however, subject to regulatory controls, primarily prudential, to protect all participants. These controls are administered by the Australian Prudential Regulation Authority (APRA) since July 1998. The traditional approach to regulating financial institutions is capital adequacy — limit the ratio of equity to assets above some minimum.

11. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 8–11 Deregulation of the Financial Markets (cont.) The Basel Accord established international rules on capital adequacy, accounting for differing risk profiles of banks’ loan books. Problems with the original Basel Accord. Basel II is more comprehensive in accounting for risk of diverse bank assets, thereby providing a more accurate method to track capital adequacy. APRA signals intention to adopt Basel II from the end of 2007.

12. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 8–12 Business Funding The major financial institutions in the Australian capital market involved in providing funds to companies can be divided into three categories: – Financial agency institutions – Financial intermediaries – Investing institutions

13. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 8–13 Financial Agency Institutions Facilitate direct funding, but do not themselves provide the funds. Operate in both the primary and secondary markets. Bring together the savings surplus units and savings deficit units. Examples: stockbrokers, stock exchange, merchant banks.

14. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 8–14 Financial Agency Institutions (cont.) Brokers and the stock exchange – Traditional function of a stock exchange ( and brokers) is to provide facilities for the trading of shares, bonds and other securities such as convertible notes, options and preference shares. – This involves the performance of three functions:  Mobilising of savings.  Allocation of resources.  Allows investments to be realised through the sale of securities.

15. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 8–15 Financial Agency Institutions (cont.) Brokers and the stock exchange (cont.) – The Australian Stock Exchange Ltd (ASX) was preceded by the Australian Associated Stock Exchanges (AASE), which represented the six capital city stock exchanges. In April 1987, the ASX commenced as a truly national stock exchange. – Since October 1990, all shares have been traded on the Stock Exchange Automated Trading System (SEATS). – In 1996, the ASX demutualised, forming a company; it listed on the Australian Stock Exchange in 1998.

16. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 8–16 Financial Agency Institutions (cont.) Brokers and the stock exchange (cont.) – Companies have alternatives to the ASX: CAPstart Private Equity Market, regional stock exchanges such as Bendigo and Newcastle Stock Exchanges. – Stockbroking firms are an important means by which companies can issue new securities, providing:  Advice on terms of the issue.  Placement of shares.  Underwriting services or organising underwriting.  Short-term money market issues.

17. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 8–17 Merchant banks – Classified under the Financial Corporations Act 1974 as money market corporations (not licensed by the Reserve Bank of Australia, so cannot use ‘bank’ in their business names). – Involved in financial markets, both as financial agents and as financial intermediaries. – From 1 July 1998, merchant banks are regulated by ASIC. Financial Agency Institutions (cont.)

18. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 8–18 Merchant banks (cont.) Four main functions: – The money market operation. – The investment management function. – The corporate financial advisory (or investment banking) function. – Making a market in foreign exchange and derivative securities. Financial Agency Institutions (cont.)

19. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 8–19 Financial Intermediaries Provide funds as a principal. Borrow funds on their own behalf and then lend the funds to other parties. Obtain income from an interest spread rather than fees or commissions.

20. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 8–20 Financial Intermediaries (cont.) Banks – Primarily borrow from depositors and lend to a wide range of borrowers. – Also involved in ‘off balance sheet’ areas such as providing guarantees, letters of credit, bill-endorsements, and market-related activities such as forward rate agreements, foreign currency hedges, and dealing in other derivatives. – As of 1 July 1998, regulatory role taken from RBA with banks now regulated by APRA.

21. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 8–21 Finance companies – Initially concerned with lending to individuals by providing instalment credit for retail sales. – Majority of their funds raised by public debenture issues. – Many finance companies were owned by banks, but with deregulation of the banking sector, the importance of finance companies has decreased. – Most have become specialised institutions (focusing on areas such as motor vehicle finance). Financial Intermediaries (cont.)

22. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 8–22 Investing Institutions Accept funds from the public and invest them in a variety of assets. Examples of investing institutions: – Superannuation funds – Life insurance companies – Unit trusts This class of institutions is also regulated by APRA.

23. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 8–23 Investing Institutions (cont.) Insurance and superannuation companies – Raise large amounts as premiums and contributions which are largely long-term commitments. – Accordingly, they tend to acquire long-term assets such as shares, bonds and other forms of debt issued by governments and companies. – Superannuation industry has grown in importance since the 1990s due to government-mandated superannuation guarantee.

24. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 8–24 Investing Institutions (cont.) Insurance and superannuation companies – Key features of superannuation industry in recent times are the growth in funds under management and the number of funds. – The high growth in the number of funds is in small DIY super funds (four members or less), where the members manage their own funds.

25. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 8–25 Investing Institutions (cont.) Unit trusts and investment companies – Entities that pool investors’ funds, investing in a range assets, attempting to reduce risk through diversification. – Examples of the types of assets include shares, commercial debt instruments (commercial bills) and diverse property such as shopping centres and office buildings.

26. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 8–26 Summary Capital market can be divided into three categories: Financial agency institutions – Brokers and stock exchanges, bring together suppliers and demanders of funds. Financial intermediaries – Borrow funds and lend to third parties (banks).

27. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 8–27 Summary (cont.) Investing institutions – Pool investor funds, investing in shares and other long-term instruments. APRA is the primary regulator of financial institutions in Australia. – Basel II to be adopted for risk and capital adequacy assessment of Australian financial institutions from the end of 2007.