25556 Chap.1 Functions of the Financial System
Functions of the Financial System
Topic 1 opens the subject by asking what a financial system is for. The answer is a list of five functions: settling payments, moving funds from savers to borrowers, transferring risk, promoting the efficient use of funds and keeping the whole arrangement stable.
Every institution and market studied later can be placed against this list, so it is worth learning the five names and one concrete example of each.
The chapter traces the flow of funds along its direct and indirect routes, separates default risk from market risk, shows with numbers what a hedge gains and gives up, and explains the forces that make a system efficient, including information asymmetry, moral hazard and the pooling of funds.
It closes with the safeguards that protect stability, from the central bank's role as lender of last resort to the supervision APRA applies.
What this chapter covers
- 01
The five functions of a financial system
- 02
Settlement and the three tasks of money
- 03
Surplus units, deficit units and the flow of funds
- 04
Default risk, market risk and hedging
- 05
Information asymmetry, moral hazard and pooling
- 06
Stability and the lender of last resort
Worked example · free
Trace a retiree's savings along the direct and indirect routes
- 1Units: the retiree supplies funds, so the retiree is the surplus unit in both halves; the home-buying family and the airport company are the deficit units.
- 1Term deposit half: funds pass through a bank, which pools deposits and relends them as loans, so this is the indirect route, intermediation.
- 1Bond half: the airport company issues securities straight to the investor through the financial markets, so this is the direct route.
- 1Contracts and risk: the retiree holds a deposit claim on the bank, so the bank carries the family's default risk; with the bonds the retiree holds the company's promise directly and carries its default risk personally.
Key terms
- Settlement
- The completion of a transaction when the buyer hands over money, either cash or a payment instruction, for the item bought.
- Default risk
- The chance that a borrower or issuer fails to make a payment it has promised, such as a scheduled loan repayment.
- Derivative
- A contract whose value depends on a market variable and which lets one party pass a risk to another.
- Pooling of funds
- Combining many small amounts from savers into the large, long-term sums that borrowers need.
- Lender of last resort
- The central bank's role of lending to banks that are solvent but temporarily short of liquid funds.
Functions of the Financial System FAQ
What are the five functions of the financial system?
They are settlement of payments, the movement of funds from surplus units to deficit units, risk transfer, promoting efficiency and stability. Learn each with an example: a card payment for settlement, a home loan for the flow of funds, a fuel or currency hedge for risk transfer, disclosure rules for efficiency and emergency central bank lending for stability.
What is the difference between direct and indirect financing?
In direct financing the borrower sells securities, such as bonds or shares, to investors through the markets, so the investor holds a claim on the borrower. In indirect financing a bank or other institution takes deposits and makes loans, so each party contracts only with the institution, which carries the borrower's default risk.
How is market risk different from default risk?
Default risk concerns whether a borrower will pay what it promised. Market risk is a loss caused by a surprise move in a rate or price, for instance an interest rate, a currency or a share price, even when every party pays on time. A share portfolio hit by a crash faces market risk; a missed loan repayment is default.
Why does hedging not always leave a firm better off?
A hedge fixes the future price, so the firm is protected if prices move against it but gives up the gain if prices move in its favour. Whether hedging was worthwhile can only be judged against the certainty it bought, not against the price that eventually occurred.
What is moral hazard in finance?
Moral hazard arises when a person has an incentive to act for their own benefit at the expense of someone they owe a duty of care, such as an adviser recommending the product that pays the highest commission. Fiduciary duties and professional codes of ethics are the remedies the subject discusses.
Exam move
Write the five functions down the left of a page and, beside each, one Australian example and the institution or market that performs it. Then practise classifying short scenarios, because the quiz practice questions test the boundary between similar ideas, such as market risk against default risk.
Rework the hedging example with your own prices above and below the locked price until you can state both the saving and the forgone gain without hesitation. Finally, explain information asymmetry and moral hazard aloud with a borrower and an adviser as the cases, and check that each explanation names who is disadvantaged.
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