1. 8-1 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Chapter 8 The Capital Market

2. 8-2 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 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 and financial intermediaries. Outline the role of securitisation. Identify and explain the role of investing institutions.

3. 8-3 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 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 the flow of funds from the savings surplus units to the savings deficit units. The flow of funds may be direct or indirect.

4. 8-4 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 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. 8-5 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 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. The debt and equity markets together form the capital market.

6. 8-6 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Primary Market Primary market refers to transactions between companies seeking finance and investors directly. Primary market transactions create new financial securities. For example: company raises new funds to finance its investment. It is the market for new issues of securities, where the sale proceeds go to the issuer of the securities.

7. 8-7 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 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. This enables borrowers to raise long-term funds even though individual suppliers of funds may be prepared to provide funds only for much shorter terms.

8. 8-8 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Organisational Structure Between Financial Markets Financial assets created through indirect financing cannot be traded in secondary market whereas assets created through direct financing are marketable securities. Marketable securities can be traded through an exchange or over the counter. Exchange-traded market: Where a broker is organised and carries out clients’ instruction to buy or sell securities in an exchange-traded market. Over-the-counter market: No organised exchange; market consists of financial dealers who trade with clients and with each other.

9. 8-9 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 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). 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).

10. 8-10 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 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. 8-11 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 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. Basel II framework has applied in Australia from 1 January 2008.

12. 8-12 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 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. 8-13 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 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, etc.

14. 8-14 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 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.  Allowing investments to be realised through the sale of securities.

15. 8-15 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 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. 8-16 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Financial Agency Institutions (cont.) Brokers and the stock exchange (cont.): –Companies have alternatives to the ASX: CAP start 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. 8-17 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 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. 8-18 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 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. 8-19 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 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. 8-20 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 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. 8-21 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Financial Intermediaries (cont.) Money market corporation –Assets of these institution declined considerably in the mid-1990s to 2007. This decline reflects the ongoing deregulation of the Australian financial system. Finance companies –Initially concerned with lending to individuals by providing installment credit for retail sales. –Majority of their funds raised by public debenture issues

22. 8-22 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University –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). Securitisation: –The process of making assets marketable by aggregating income-producing assets in a pool and assuming new securities backed the pool. –Securitisation allows a financial institution to fund its lending indirectly through the capital market. Financial Intermediaries (cont.)

23. 8-23 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Financial Intermediaries (cont.) –Securitisation market in Australia has been dominated by securitisation for residential mortgage but range of assets that can be securitised has broadened. (Figure 8.4). –Four major Australian banks securitise only a small portion of their mortgage loans compared to small institution. –Australian securities have been active in issuing asset-backed securities in both the domestic and offshore markets. –Asset-based securities offer slightly higher yields than non asset-backed bonds of similar quality. As a result, potential investors are attracted to asset-backed securities. –Securitisation grew rapidly in Australia due to deregulation, which has allowed financial market to become more efficient in providing finance to borrowers (Battellio, 2004).

24. 8-24 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 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.

25. 8-25 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Investing Institutions (cont.) Insurance and superannuation companies: –Raise large amounts as premiums and contributions that 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. –While the number of small funds has grown strongly, the number of funds in corporate funds has declined dramatically due to licensing requirements that were phased in during a transitional period that ended on 30 June 2006.

26. 8-26 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Investing Institutions (cont.) Insurance and superannuation companies (cont.) –Superannuation funds are potentially the largest institutional source of equity capital for Australian companies. –Key features of superannuation industry in recent times are the growth in funds under management and the number of funds. –High growth in the number of funds in small DIY super funds (four members or less), where the members manage their own funds.

27. 8-27 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Investing Institutions (cont.) Insurance and superannuation companies (cont.) –Management of superannuation is a significant activity for life insurance companies. –It might seem that overtime superannuation funds have been directing a growing proportion of contributions in domestic equities. –However, value of any assets held at any time will reflect past returns as well as new investment pattern. Hence, returns on shares are usually higher than returns on other assets. (The returns on Australian shares were unusually high from 2002 to 2007).

28. 8-28 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 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 asset types include shares, commercial debt instruments, and diverse property such as office buildings. –Real estate investment trusts (REITs): allow investors to acquire an interest in a professionally managed portfolio of real estate. Some REITs only invest in real estate such as hotels and shopping centres. –Infrastructure funds: invest in assets involved in the supply of essential goods and services such as railways and oil/gas pipelines. Most infrastructure funds involve a company/trust group that issues stapled securities.

29. 8-29 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Summary Primary market: New financial instrument transaction. Secondary market: transactions in existing financial securities 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).

30. 8-30 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University 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 was adopted for risk and capital adequacy assessment of Australian financial institutions from 1 January 2008.