Chapter 2. The role of financial markets

João Cadete de Matos
(Banco de Portugal)
Daniele Fano
(Fondazione AIB)
Filipa Lima
(Banco de Portugal)
Amanda Seneviratne
(Australian Bureau of Statistics)

This chapter describes the financial markets as a key to understanding financial systems: capital markets for shares and bonds, money markets, foreign exchange markets, derivatives markets, and other markets related to deposits, loans and pooled investment. For each of these markets, the focus is on their purpose and major players, and on financial intermediation activities. The chapter also describes the construction of tables that illustrate the interconnectedness between institutional sectors, and provides a brief description of the risk elements within the financial system and the ability of the financial accounts and balance sheets to capture such information.

  

1. Introduction

Financial accounts and balance sheets are often presented by showing an overview of all transactions and positions, disaggregated by institutional sectors (non-financial corporations, financial corporations, households, government, etc.). Another way of presenting financial developments is by showing overviews of the various financial markets.

The financial system of a nation can be thought of as having three overlapping components:

  • The financial institutions (such as banks), which are described in the 2008 System of National Accounts (2008 SNA) as belonging to the financial corporations sector (see Chapter 3).

  • The financial markets, such as the stock exchange; their participants, the issuers of shares on the exchange; and the investors in these shares, such as households. The 2008 SNA captures these financial markets by describing the financial instruments that make up the market, and grouping participants in the markets by institutional sectors.

  • The payment system (e.g. electronic means by which payments are effected) and its participants (e.g. banks and other enterprises).

The interaction of the three components of the financial system, through mechanisms of financial intermediation and financial markets, enables funds from saving in some parts of the economy to become available for investment or consumption in other parts of the economy. In addition to describing this interaction, the chapter also focuses on the mechanism of financial intermediation, and the structure and activities of the financial markets within the overall financial system.

2. Financial markets in the 2008 SNA

The 2008 SNA describes financial intermediation as an activity undertaken by financial institutions (financial intermediaries) of matching the needs of borrowers with the desires of lenders. There are many ways in which money can be borrowed and lent. The act of financial intermediation is one of devising financial instruments that encourage those with saving to commit to lend to financial institutions on the conditions inherent in the instruments, so that these financial institutions, in a second round, can then lend the same funds to others as another set of instruments with different conditions. This activity encompasses financial risk management and liquidity transformation.

A financial market may be defined narrowly as a market in which trading of financial instruments such as equities (e.g. shares), debt securities (e.g. bonds) and currencies occur at competitive transaction costs and at prices that reflect supply and demand, with no intervention of financial intermediaries (or the need for a “middle man”). An example is trading on stock exchanges in many countries. Alternatively, financial markets may be thought of more broadly to include the interaction of financial intermediaries with financial markets. Below are examples of financial markets which include financial intermediation:

  • organisations that facilitate trade in securities, e.g. a stock exchange in a physical location like the New York Stock Exchange, or an electronic system like the NASDAQ;

  • banks offering services to households such as loans or accounts;

  • trade in foreign currency, which often concerns direct transactions between two parties (over-the-counter), but is nonetheless described as the foreign exchange market;

  • corporate mergers and acquisitions, activities which include the sale of equities and the underwriting activity of investment bankers to organise the deal;

  • delisting of equities from a stock exchange and transferring to a private equity (unlisted equity) market, and vice versa;

  • the privatisation of government owned enterprises; and

  • investments by households into mutual funds (pooled investment).

Figure 2.1 below shows how financial markets and financial intermediaries move funds from lenders to borrowers across sectors and the Rest of the World. The movement of funds can be between: lenders and financial intermediaries; lenders and markets; markets and the financial intermediaries and vice versa; markets and borrowers; and financial intermediaries and borrowers. In this chapter, financial markets will be discussed with this broad definition in mind.

Figure 2.1. Illustration of relationships in financial markets
picture

Types of financial markets

The global financial system is comprised of the following financial markets: the capital market, consisting of the share market and the bond market; the money market; the foreign exchange (Forex) market; and the market for derivatives. Figure 2.2 provides a short overview.

Figure 2.2. Types of financial markets
picture

Financial markets can be either primary or secondary. Primary markets are used to describe new lending and borrowing arrangements that are raising funds for new investment. For example, a primary market activity is the issue of a new set of treasury bonds by government or the flotation of new shares, rights issues, and dividend reinvestment schemes on the equity market. These transactions occur between issuers and investors. Secondary markets are used to describe the subsequent buying and selling of securities that have already been issued. Transactions in the secondary market occur between investors, and the market allows investors to reduce or increase their holdings of financial assets. The primary market cannot operate effectively unless there is an efficiently operating secondary market. Investors are less likely to invest their funds if they cannot retrieve or reallocate their funds at any given time. This illustrates the importance of liquidity in a secondary market. Liquidity refers to the ease with which a security can be sold without the loss of value.

Capital markets

Capital markets are markets for financial assets which have a maturity period above one year or indefinite maturity. A distinction is typically made between the share market and the bond market.

a) Share market

The share (or equity) market operates the issuance and trading of a share in the ownership of corporate enterprises. The share market includes trading of shares listed on a stock exchange as well as unlisted shares traded privately (private equity) or over-the-counter (OTC) through a dealer network. The stock exchange provides an important way for enterprises to raise money publicly by selling shares of ownership of the company in a public market. The stock exchange also acts as the clearing house for each transaction by collecting and delivering shares and guaranteeing the payment to the seller of the security, therefore eliminating the risk of an individual buyer or seller defaulting. Exchanges may be physical locations where transactions are carried out on the trading floor (New York Stock Exchange) or a virtual market composed of networks of computers (NASDAQ) where trades are made electronically.

In general, shares of small companies are traded over-the-counter because the relative size of the company makes it difficult to meet exchange listing requirements. The unlisted shares are traded by broker-dealers who negotiate directly with one another over computer networks and by phone. Broker-dealers are generally part of large financial institutions such as investment banks. By contrast, private equity consists of investors that invest directly into private companies or conduct buyouts of public companies that result in a delisting of the publicly listed shares. These types of activities involve the purchase and sale of equities, underwritten by investment bankers.

Participants in the share market range from individual retail investors (households), institutional investors (pension funds, insurance companies, mutual funds, hedge funds and banks) and companies trading in their own shares. The term institutional investor refers to the fact that over time markets (including the share market) have become dominated by buyers and sellers from institutions, a move away from wealthy businessmen with long family histories in particular corporations who have historically dominated investing. For example, the majority of private equity investment consists of investment from institutional investors who can commit large sums of money for long period of times, as private equity investment often demands long holding periods.

This chapter will contain a number of tables using figures from Australia as a way to illustrate the concepts discussed in this chapter. Table 2.1 shows some details of the Australian total equity market, classified by issuing and holding sectors, from the Australian National Accounts: Finance and Wealth publication. The table includes the share market as described above and also the ownership of public sector corporations (unlisted equities) by the government sectors, and the foreign direct investment in subsidiaries (unlisted equities).

Table 2.1. Australian equity market
Millions of AUD, amounts outstanding on 31 December

ISSUED BY

HELD BY

2014

2015

2016

2014

2015

2016

Total equity and investment fund shares

4 323 752

4 575 436

4 820 364

4 323 752

4 575 436

4 820 364

 Listed

1 580 331

1 627 506

1 757 818

 Unlisted

2 743 421

2 947 930

3 062 546

Non-Financial corporations

1 856 872

1 958 358

2 174 751

312 296

307 684

305 887

Financial corporations

1 458 406

1 564 270

1 535 332

1 919 343

2 054 943

2 125 939

 Banks and other depository corporations

583 943

606 529

613 140

148 099

156 823

155 942

 Pension funds

0

0

0

1 009 608

1 104 074

1 267 415

 Insurance corporations

114 345

113 448

118 239

298 916

312 140

242 186

 Investment funds

695 750

768 766

723 007

322 984

338 793

314 557

 Other financial corporations

64 368

768 766

723 007

322 984

338 793

314 557

General government

0

0

0

424 727

449 362

481 527

Households

0

0

0

720 440

772 083

798 174

Rest of the World

1 008 474

1 052 808

1 110 281

946 946

991 364

1 108 837

Source: Australian Bureau of Statistics (2017), 5232.0-Australian National Accounts: Finance and Wealth (database), www.abs.gov.au/ausstats/[email protected]/mf/5232.0/.

 http://dx.doi.org/10.1787/888933589713

Table 2.1 shows that the Australian equity market increased by 6% and 5% in 2015 and 2016, respectively. Australian non-financial corporations had just over 45% of the total equity issuance at the end of 2016, and the Australian pension fund sector was the largest investor in the market with 26% of the total equity held, followed by overseas investors and Australian households.

b) Bond market

Bonds are issued on the bond market with original term to maturity of one or more years. The investors are usually paid a set periodic interest, called a coupon, for the life of the bond and receive their initial investment back at maturity. Some bonds have variable interest rates, some have indexed principal repayments, and some bonds are zero-couponed or deep discount bonds that are issued at a discount to face value.

Governments and large trading enterprises issue bonds to finance long-term funding for government deficit financing and for business investment requirements, and financial institutions such as banks issue bonds to fund their loan assets. Private enterprises raise medium to long-term funding by issuing corporate bonds, debentures and notes. For these entities, the bond market generally provides an alternative source of funds than borrowing directly from banks and other financial institutions. An important part of the bond market is the government bond market; due to its size and liquidity, government bonds are often used to compare other bonds and their credit risk. Another reason why the government bonds are important is related to their role in borrowing and lending to other governments. Governments often purchase debt from other countries; for example, Japan is major holder of US government debt. The bond market in many countries is bigger in terms of the value of securities issued than the listed share market (the most popular financial market quoted in the media) This is the case for Australia, as illustrated when comparing the numbers in Table 2.2 with those in Table 2.1.

Table 2.2. Total bond market, Australia
Millions of AUD, amounts outstanding on 31 December

ISSUED BY

HELD BY

2014

2015

2016

2014

2015

2016

Total bonds

1 895 969

2 124 833

2 301 953

1 895 969

2 124 833

2 301 953

 Issued in Australia

1 255 367

1 468 310

1 559 488

  of which non-resident bonds

133 440

150 091

157 966

 Issued offshore

640 602

656 523

742 465

  of which resident bonds

529 240

547 214

618 103

  of which non-resident bonds, held by residents

111 362

109 309

124 362

Non-financial corporations

242 583

243 784

285 855

24 074

10 128

12 117

Financial corporations

1 091 173

1 227 460

1 288 647

880 256

1 049 984

1 135 165

 Banks and other depository corporations

503 511

535 675

581 044

577 977

708 606

768 548

 Pension funds

0

0

0

147 961

170 441

182 032

 Insurance corporations

8 098

6 888

6 656

73 941

77 125

77 619

 Central borrowing authorities1

242 243

269 507

267 127

12 278

14 190

17 176

 Other financial corporations

337 321

415 390

433 820

68 099

79 622

89 778

General government

317 411

394 189

445 123

30 191

23 227

23 384

Households

0

0

0

3 769

3 845

4 175

Rest of the World

244 802

259 400

282 328

957 679

1 037 649

1 127 112

  of which non-resident bonds issued in Australia

66 721

75 045

78 983

1. Central borrowing authorities are financial institutions of regional governments in Australia.

Source: Australian Bureau of Statistics (2017), 5232.0-Australian National Accounts: Finance and Wealth (database), www.abs.gov.au/ausstats/[email protected]/mf/5232.0/.

 http://dx.doi.org/10.1787/888933589732

The majority of the trading in the bond market occurs over-the-counter between broker-dealers and large institutional investors through organised electronic trading networks. Only a small number of bonds, mainly corporate bonds, are listed on exchanges. Table 2.2 shows the details of the Australian bond market from the Australian National Accounts: Finance and Wealth publication. The table presents two views of the Australian bond market, which consists of both resident and non-resident bond issuers and holders. The first view shows where the bonds were issued, that is in Australia or in offshore markets. In the second view, the issuance of resident and non-resident bonds in Australia and the offshore markets are presented by sector of issuance and the holding sectors.

Table 2.2 shows that at the end of 2016, just over 28% of Australian domestic bonds were issued offshore and 10% of bond issued in Australia were non-resident bonds. The largest issuers of bonds were the banks and other depository corporations, followed by the general government sector (mainly made up of the central government) and non-residents. The largest investors in the Australian bond market with just over 47% of the total bond issuance were non-resident investors; the pension fund sector held only 9% of the bond market, compared to 26% of the total equity market (see Table 2.1).

Money markets

The money market is where financial instruments with high liquidity and very short maturities are traded. This market brings together individuals and institutions with temporary surpluses of funds and temporary shortage of funds. Money market securities are short-term, that is, they have an original term to maturity of less than one year, often 30, 90 or 180 days. They are issued by borrowers at a discount to face value and carry no payments other than repayments of face value at maturity.

Money market securities consist of negotiable certificates of deposits, bankers’ acceptance (bills of exchange), treasury bills (notes) and commercial paper (promissory notes). The securities are typically issued by government, financial institutions and large corporations. The majority of trading in the money market is undertaken over-the-counter through organised electronic trading networks, between brokers-dealers and large institutional investors.

An important segment of the money market is interbank lending, banks borrowing and lending to each other using short-term securities and repurchase agreements for specified terms. Most interbank lending is for maturities of one week or less, the majority being overnight. Banks borrow and lend money in the interbank lending market in order to manage liquidity and satisfy regulations such as reserve requirements set by central banks. The US federal funds rate and the London Interbank Offered Rate (LIBOR) are published interbank interest rates which are used widely to determine short-term interest rates across the world. Figure 2.3 shows the details of the holding sectors of the Australian money market securities issued by banks as at 31 December 2016.

Figure 2.3. Holding sectors of the Australian bank money market securities
Shares of the amounts outstanding on 31 December 2016
picture

Source: Australian Bureau of Statistics (2017), 5232.0-Australian National Accounts: Finance and Wealth (database), www.abs.gov.au/ausstats/[email protected]/mf/5232.0/.

 http://dx.doi.org/10.1787/888933587965

In the Australian money market, banks are the most significant issuer of these securities, issuing just over 75 % of the total securities in the market at the end of 31 December 2016. Non-residents hold the majority of the Australian bank money market securities, at 41%, followed by pension funds and insurance corporations at 19%.

Foreign exchange markets

The foreign exchange market is the means whereby currencies of different countries can be bought and sold. It sets the current market price of the value of one currency as demanded against another. It is the most liquid market in the world, with participation by nearly all sectors of the economy. The market is a global over-the-counter market where broker-dealers negotiate directly with each other. In terms of trading volume it is also the largest market in the world, with the United Kingdom geographically having the largest share of the volume, followed by the United States (Figure 2.4). The large volume of trade through the United Kingdom makes it the most important centre for foreign exchange, and consequently a particular currency’s quoted price is more than likely to be the London market price.

Figure 2.4. Geographical distribution of global foreign exchange market turnover
Shares of market turnover in 2016
picture

Source: Bank for International Settlements (2016), Triennial Central Bank Survey: Foreign exchange turnover in April 2016, www.bis.org/publ/rpfx16fx.pdf.

 http://dx.doi.org/10.1787/888933587984

The foreign exchange market assists international trade and investment by enabling currency conversions to pay for goods and services. It also facilitates investment in foreign securities, is integral in derivative contracts that try to minimise risk in currency fluctuations, and supports direct and indirect speculative activity on the movement of currencies. The majority of the transactions in the foreign exchange market occur between large banks and broker-dealers from major financial institutions, followed by smaller banks, large corporations and hedge funds. Pension funds, insurance corporations and mutual funds have increased their participation in these markets in the last 20 years. Central banks also play an important role in the market by controlling the money supply, inflation and/or interest rates, often having official and unofficial target rates for their currencies.

Derivative markets

As explained in Chapter 1, derivatives are financial instruments that are linked to another financial instrument (bonds, shares), an indicator (interest rates, market indices) or a commodity, that isolate specific financial risks associated with those instruments, indicators or commodities, and transform them into financial instruments that can be traded in the financial markets in their own right. The value of the derivative is derived from the price of the underlying item (the “reference price”). Derivatives are not issued for the purpose of raising new capital or transferring ownership of assets; instead, they are used to manage financial risks, and perform arbitrage between markets to increase profits, sometimes for speculative reasons.

There are two broad types of derivatives: options and forward-type contracts. The major difference between the two is that a buyer of an option contract acquires an asset, and the option writer incurs a liability, whereas for forward-type contracts, either party is a potential debtor. There are large assortments of derivatives in the two broad categories. Forward type contracts include futures (which are traded on exchanges), swaps (such as interest rate, foreign currency and equity) and forward rate agreements. Options include call and put options, warrants and more exotic variations.

Derivative trading most commonly takes place over-the-counter (OTC) but can also occur on specialised or other exchanges, such as the Chicago Mercantile Exchange. The main participants in the derivative market include large trading and financial corporations (banks, mutual funds, and insurance corporations). Exchange traded derivatives are traded via specialised derivative exchanges (future exchanges) or other exchanges. At the exchanges, the parties enter into standardised contracts that are defined by the exchange, and the exchange acts as the intermediary to the related transactions. The exchange facilitates liquidity, mitigates all credit risk concerning the default of one party in the transaction, provides transparency and maintains the current market price. In contrast, OTC derivatives are privately negotiated between two parties, and include both common derivative products such as swaps as well as more exotic derivatives (exchange-traded derivatives only comprise common derivative products). The OTC market is the largest market for derivatives and is generally unregulated in relation to required disclosures. The main players in the OTC market are large financial institutions such as banks and hedge funds, and broker-dealers, mainly from large financial institutions that arrange transactions for their customers.

The compilation of high quality derivatives estimates presents one of the more difficult challenges for national statisticians. Derivatives comprise quite a heterogeneous set of financial instruments, many of which are complex and difficult to understand. The 2008 SNA requires survey respondents to compile and report information that is often not routinely generated for internal management reporting purposes. At the time of writing this publication, the Australian national accounts publishes a derivative market table with inputs from a simple domestic derivatives model and non-resident derivatives data collected in a quarterly survey of international investment. Australia, along with other countries, is planning to improve the compilation of the statistics on derivatives over the medium to longer term. In doing so, they plan to utilise, for example, information from repositories on OTC derivative trading data. These data repositories were set up globally as a response to the 2007-09 economic and financial crisis to provide some transparency around the significant OTC derivative market to financial market regulators. It has proven to be quite difficult to account for these heterogeneous financial products within the framework of the 2008 SNA, as new “innovative constructs” are being developed almost continuously.

Other financial markets

The broad definition of financial markets includes the interaction of financial intermediaries with the financial markets. It therefore also comprises the deposit market, the loan market, and the pooled investment market. Applying the broad definition makes it possible to present all transactions and positions included in the financial accounts and positions in the form of markets, with supply (the issuers) and demand (the holders) of the relevant financial instruments included.

a) Deposit market

The 2008 SNA does not provide a precise definition of a deposit. Therefore, the distinction between deposits and loans is somewhat blurred, and differs between countries’ national accounts. For example, the Australian national accounts added additional criteria to the definition of deposits, such that deposit liabilities can only be incurred by institutions which are included in the calculation of the central bank’s definition of “broad money”. In Australia these institutions are: the central bank; banks; credit unions; building societies; and registered financial corporations. In most countries, deposit-taking institutions are regulated by prudential authorities.

The deposit market provides households and businesses a place to keep funds to purchase goods and services, pay and receive wages and salaries, and earn interest income from interest-bearing accounts. Moreover, bank deposits in many developed countries, including Australia, are a major source of funding of the bank loan asset market. All sectors of an economy participate in the banking deposit market. Building societies and credit unions can, for example, be major deposit taking institutions for households and smaller businesses, while the central bank is the major deposit taking institution for banks, government sector and non-resident central banks. Table 2.3 shows the detail of the Australian bank deposit market, using the 2008 SNA categories of transferable and other deposits.

Table 2.3. Australian bank deposit market
Millions of AUD, amounts outstanding on 31 December

2014

2015

2016

Transferable

Other

Transferable

Other

Transferable

Other

Total bank deposits

553 216

1 226 270

631 721

1 300 654

704 315

1 407 476

Non-financial corporations

156 156

206 712

178 942

192 869

200 337

208 473

Financial corporations

94 983

261 004

98 153

276 158

104 042

304 587

Depository corporations

18 635

15 803

17 548

23 952

16 286

23 849

Pension funds

47 179

199 833

50 585

203 475

56 670

223 338

Insurance corporations

16 248

9 814

15 112

9 419

14 397

8 786

Investment funds

8 590

17 932

9 916

20 199

11 132

20 733

Other financial corporations

4 331

17 622

4 992

19 113

5 557

27 881

General government

28 957

36 634

29 072

43 063

32 529

45 502

Households

239 264

556 890

294 774

579 863

324 729

627 751

Rest of the World

33 856

165 030

30 780

208 701

42 678

220 736

Total deposit market

645 920

1 388 118

736 279

1 453 252

809 581

1 585 631

Source: Australian Bureau of Statistics (2017), 5232.0-Australian National Accounts: Finance and Wealth (database), www.abs.gov.au/ausstats/[email protected]/mf/5232.0/.

 http://dx.doi.org/10.1787/888933589751

In Australia, the banks are the most significant deposit taking institution, holding respectively 87 per cent and 89 per cent of the total transferable and other deposit markets as at 31 December 2016. Within the bank deposit market, households are the largest contributor, holding 46 per cent and 45 per cent of the banks’ transferable and other deposit market. In Australia, during the three year period up to 31 December 2016, households’ transferable deposit grew 36 per cent, while households’ other deposits grew 13 per cent. The larger growth rate in transferable deposits is related to the significant growth during this period of deposit accounts that households use to offset the interest charges of their home loan accounts.

b) Loan market

The loan market referenced here consists mostly of secured loans, where the borrower pledges an asset such as residential property, or plant and equipment of a business as collateral, and unsecured loans, where the loans are not secured against the borrower’s assets. In essence, the loan market in this context implies that actual issue of debt securities does not occur and the relevant instruments are usually not traded. In this sense, it is quite different from the bond market and the money market. Unsecured loans typically include credit card debt, personal loans and bank overdrafts. A further breakdown of the loan market is often made into personal loans (if the borrower is a household) and business loans. For both personal and business loans, secured loans will generally attract a lower rate of interest to unsecured loans. Loan markets, for example, serve households to purchase residential property or vehicles, and small and large businesses to raise funds for capital investments in non-financial assets.

The major providers of loans in the market are banks, followed by other deposit taking institutions and securitisation companies. The latter organisations are financial intermediaries that pool various types of assets such as residential mortgages, commercial property loans and/or credit card debt, and package them as collateral to issue debt securities, referred to as asset backed securities. The loan market also contains significant loan transactions between parent companies and their subsidiaries. Table 2.4 offers a breakdown of the Australian loans market.

Table 2.4. Australian loan market
Millions of AUD, amounts outstanding on 31 December

Borrowed by:

2007

2012

2016

Banks

Securitiser

Banks

Securitiser

Banks

Securitiser

Loan market

1 314 742

218 095

1 917 529

115 153

2 667 384

115 326

Non-financial corporations

335 511

19 687

387 962

14 371

543 176

16 740

Financial corporations

46 072

2 328

30 219

543

37 038

1 014

General government

1 098

0

5 540

0

6 656

0

Households

838 884

196 080

1 317 227

100 239

1 738 951

97 572

Rest of the World

93 177

0

176 581

0

341 563

0

Source: Australian Bureau of Statistics (2017), 5232.0-Australian National Accounts: Finance and Wealth (database), www.abs.gov.au/ausstats/[email protected]/mf/5232.0/.

 http://dx.doi.org/10.1787/888933589770

The 2007-09 economic and financial crisis significantly impacted the securitisation sector, and Australia was not an exception. At the end of 2007, the market for securitised loans was AUD 218 095 million. By 31 December 2012, it had declined by 47 per cent of the value on 31 December 2007. Since then the securitised loan market has struggled to recover, and by 31 December 2016, total securitised loans were AUD 115 326 million. During the same period, the total bank loan market doubled in value from 31 December 2007 to 31 December 2016.

c) Pooled investment market

The pooled investment market consists of investment funds through which investors indirectly invest in shares, bonds, money market instruments, and real estate assets. The main advantage of investing in such funds is that these funds give investors access to professionally managed, diversified portfolios, even at small amounts of capital. Mutual funds and exchange-traded investment funds are examples of investment funds that are open to the public, while hedge funds and private equity funds are typically limited to private placements (non-public offerings) to chosen investors.

The 2008 SNA categorises investment fund units between i) money market fund (MMF) shares/units; and ii) non-money market fund (NMMF) shares/units. The difference between these funds is that MMFs typically invest in money market instruments with a residual maturity of less than one year, while NMMF investment funds invest in longer-term financial assets and in non-financial assets such as real estate. The major investors in investment funds are pension funds, insurance corporations, households and other investments funds. Table 2.5 shows investment details about Australian investment funds.

Table 2.5. Total equity, Australian investment fund market
Millions of AUD, amounts outstanding on 31 December

HELD BY

1988

2002

2016

MMF

NMMF

MMF

NMMF

MMF

NMMF

Total equity

6 889

23 075

35 542

242 338

37 677

685 330

Non-financial corporations

0

437

0

170

198

2 179

Financial corporations

 Depository corporations

0

42

0

628

0

644

 Pension funds

264

4 460

2 182

66 591

12 870

203 950

 Insurance corporations

1 863

8 354

1 898

68 454

7 505

174 567

 Investment funds

1 021

3 097

4 389

67 974

1 703

111 912

 Other financial corporations

0

407

0

2 318

0

48 582

General government

0

0

0

12 621

0

19 459

Households

3 741

3 294

27 073

9 598

15 401

30 254

Rest of the World

0

2 984

0

13 984

0

93 783

Source: Australian Bureau of Statistics (2017), 5232.0-Australian National Accounts: Finance and Wealth (database), www.abs.gov.au/ausstats/[email protected]/mf/5232.0/.

 http://dx.doi.org/10.1787/888933589789

The investment fund sector has grown significantly in Australia in the last 25 years, and this is especially the case for NMMFs, where the equity outstanding grew 950% from December 1988 to December 2002, and then a further 182% from December 2002 to December 2016. NMMFs may be broken further down in specific sub-categories, such as bond funds, equity funds, balanced funds and others targeted to specific securities and investment styles. Pension funds and insurance corporations are the major investors in the NMMFs, together holding 55% of the equity in these funds as at 31 December 2016.

Demand for credit

To provide an overall view on borrowing and lending in an economy, data are often summarised in statistics on the demand for credit. Credit may be defined broadly as all funds provided to those seeking to borrow. Since financial corporations mainly act as intermediaries, meaning they borrow in order to lend, analytical measures of credit usually exclude the lending between these corporations. Furthermore, lending and borrowing between enterprises that have special relationships, such as between companies in the same group or between government agencies, is often excluded from credit measures because these transactions are frequently of a non-market nature. Similarly, some types of financial instruments, such as accounts payable, are not considered to be part of an organised financial market. Table 2.6 and Figure 2.5 present a summary of the demand for credit and credit outstanding in Australia by the non-financial sectors.

Table 2.6. Australian demand for credit and credit outstanding by non-financial sectors
Billions of AUD

Credit market outstanding at end

Demand for credit during

Other changes during

Credit market outstanding at end

Q3 2016

Q4 2016

Q4 2016

Q4 2016

Non-financial corporations

3 063.2

49.5

17.3

3 129.9

Private

2 926.7

64.0

17.3

3 008.0

Public

136.5

-14.5

0.0

121.9

General government

670.0

14.8

-24.8

660.0

National

514.8

23.3

-24.7

513.4

State and local

155.2

-8.5

-0.1

146.6

Households

2 052.0

28.6

2.7

2 083.3

Total

5 785.2

92.9

-4.8

5 873.2

Source: Australian Bureau of Statistics (2017), 5232.0-Australian National Accounts: Finance and Wealth (database), www.abs.gov.au/ausstats/[email protected]/mf/5232.0/.

 http://dx.doi.org/10.1787/888933589808

Figure 2.5. Australian demand for credit by non-financial sectors
Billions of AUD
picture

Source: Australian Bureau of Statistics (2017), 5232.0-Australian National Accounts: Finance and Wealth (database), www.abs.gov.au/AUSSTATS/[email protected]/Lookup/5232.0Main+Features1Dec%202016?OpenDocument.

 http://dx.doi.org/10.1787/888933588003

Demand for credit in the fourth quarter of 2016 was AUD 92.9 billion. Households borrowed an additional amount of AUD 28.6 billion, while private non-financial corporations raised a net AUD 64.0 billion, and general government raised a net AUD 14.8 billion. Australian households raised credit primarily through the loans market. Other private non-financial corporations raised credit through a variety of channels or markets: loan borrowings, issuance of shares and other equity, and issuance of bonds. General government raised credit through issuances of government bonds.

As can be derived from Figure 2.5, a significant amount of short-term volatility exists in the demand for credit by non-financial sectors. However, the long-term trend in Australia in the last 20 years has been a steady growth in the demand for credit.

The credit market presented above may be narrowed in scope for alternative analytical requirements. For example, Australia’s central bank, the Reserve Bank of Australia, publishes monthly credit market aggregates of private and public enterprises, and households, which includes only the financial instruments of loans, short-term securities, and bank acceptances. The lenders included are banks, non-bank financial institutions, and securitisation companies. These credit aggregates for households and businesses are utilised by the central bank in formulating Australia’s monetary policy.

Box 2.1. Australian financial markets – data sources

Indicator 2 above illustrated financial markets using data from the Australian National Accounts, Finance and Wealth quarterly publication. On a quarterly basis, the publication produces:

  • for each sector and subsector, financial accounts and balance sheets by financial instrument;

  • twelve financial instrument market tables, each with a breakdown into nineteen sectors and subsectors issuing/accepting/borrowing by counterparty (sub)sector; the tables are presented within a from-whom-to-whom framework (see Indicator 3); and

  • quarterly household balance sheets.

The data within the publication is mainly based on administrative data collected by the Australian Prudential Regulatory Authority (APRA) and Australian Bureau of Statistics (ABS) statistical surveys. Of particular importance are the ABS Survey of Financial Information (SFI) and the Survey of International Investment (SII), both of which are conducted quarterly. Other data sources are used to supplement the ABS and APRA sources, such as market capitalisation for different sector and subsector share issuance from the Australian Securities Exchange data; information on central government from ledgers obtained from Government Finance Statistics (GFS); debt issuance data from Austraclear (an Australian debt registration service); and bond price indices from private financial market analysts.

All in all, detailed information on the balance sheets for depository corporations, pension funds and insurance corporations is provided by the APRA administrative data. Data for the non-regulated financial corporations in Australia, such as investment funds and securitisation companies, are gathered from the ABS SFI surveys. For the government sector and subsectors, data is collected through Government Finance Statistics (GFS) plus ABS SFI collection, while the ABS SII collection provides the data for the transactions and positions between residents and non-residents. Data for the household sector is mainly derived from counterparty information collected via APRA administrative data and ABS surveys.

Source: Australian Bureau of Statistics.

3. Financial intermediation

Role of financial intermediation and intermediaries in financial markets

As discussed in Indicator 2 of this chapter, financial markets may be defined narrowly to mean a market in which trading of financial instruments occur with no intervention of financial intermediaries. They can also be defined more broadly to include the interaction of financial intermediaries with financial markets. While this is a simple way to present the various financial markets, it should be noted that even the financial institutions that are participants in the narrow definition of financial markets perform the activity of financial intermediation, which is defined in paragraph 17.228 of the 2008 SNA as follows: “devising financial instruments that encourage those with saving to commit to lend to the financial institutions on the conditions inherent in the instruments, so that the financial institutions can then lend the same funds to others as another set of instruments with different conditions”. As such, the issuance of debt securities and equity by banks, which is part of the narrowly defined financial markets, cannot be distinguished from the banks’ role as financial intermediaries.

In all the financial markets presented in Indicator 2, the role of financial intermediation is evident. In the case of banks, deposits, bonds, equities and money market instruments are devised and then channelled to fund borrowers such as households in the form of loans. In the case of pension funds, the reserves from accumulating the contributions from households, the so-called insurance technical reserves, are channelled to fund borrowers such as non-financial corporations in the form of bonds and equities. Similarly, investment fund equity shares/units are channelled to fund borrowers such as non-financial corporations and banks in the form of bonds and equities.

However, for other participants in the narrowly defined markets (e.g. capital markets) that are not financial corporations, such as non-financial corporations, government and households, financial instruments such as debt are devised (or packaged), but the role is not considered financial intermediation, as the funds are generally not used to channel funds from lenders to borrowers. Instead they are used to invest in, for example, machinery and equipment, or to finance a shortfall of income. In this sense, non-financial corporations, government and households can be considered as the ultimate borrowers (or lenders).

For the financial markets presented in Indicator 2 which were more broadly defined, such as loan, deposit and pooled investment markets, the important distinction here is that in general all of these markets include the interaction of financial intermediaries and therefore the activity of financial intermediation as defined in the SNA occurs within these financial markets.

Expansion of the “core” financial intermediation in financial markets

While not all intermediation takes place within the financial sector, the vast majority does so in most economies. Intermediation can occur explicitly through subsidiaries in the financial sector and sub-sectors, or implicitly through “captive” financial companies, all of which may be included on the books of the parents. For example, a wholly-owned subsidiary that is consolidated in the books of its parent, may exist to provide a specific stream of financial services to the parent – ancillary services in support of the parent’s operations.

This gives rise to two financial statistics issues. First, these captive companies may not be directly observable and therefore cannot be separately distinguished and sectored within the financial corporations’ sector. Second, captive companies can also be found within non-financial corporations outside of the financial corporations’ sector, while the associated services can be exclusively financial in nature. This second case is of interest, since it underlines that some financial activity can take place outside purely financial corporations.

Non-financial corporations may thus be engaged in financial intermediation as secondary or tertiary activities. This type of intermediation usually revolves around lending and (financial) leasing (and obtaining the required sources of funds), in support of their primary activities (e.g. vehicle manufacturing). In other words, these units provide financing to customers that are buying or acquiring the parent company’s product. Another example may relate to holding companies of large, often multinational operating, enterprises whose sole activity is to raise funds from the financial markets in order to finance the activities of related companies. These captive companies often will not have decision-making autonomy. A separate set of books for these captive companies may not be available, as they are consolidated within the books of the operating enterprise in the non-financial corporations’ sector. As a consequence, they are not considered as separate institutional units (unless they are resident in another country than the rest of the enterprise group). Therefore, there may be no direct measure of these intermediation services and the related financial instruments in the financial statistics for an economy. This intermediation activity thus falls outside the financial corporations’ sector and may not be visible to analysts using the statistics that can be derived from financial accounts and balance sheets.

Notwithstanding the above, for analytical purposes, it may be useful to treat these captive companies as a separate establishment of their parent enterprises. This would enhance the understanding of financial intermediation in different economies, and broaden the notion of “shadow banking” in the process. That said, this objective may be difficult to accomplish, as separate sets of books may not be kept for captive finance/leasing companies. However, these type of activities are often related to specific financial instruments, such as, in the case of leasing and finance companies, loans and leases on the asset side and a source of funds (typically, short-term paper and bonds) on the liability side. Therefore, for completeness and analytical purposes, it is possible to present this information (for those specific instruments) on intermediation activity as a supplement to the standard delineations of the financial corporations’ sector and the financial markets, in a pseudo-sector entitled “intermediation activities of non-financial corporations”. This would enhance the usefulness of the financial accounts and balance sheets in terms of the accounting for the sources and uses of funds in the relevant markets.

4. Interconnectedness between sectors

National accounts provide an integrated framework for developing financial flows and stocks. Its underlying principles ensure that the linkages of the economic and financial activities within an economy are fully captured and consistent. The exhaustiveness of national accounts means that all financial assets have a counterpart in liabilities. If someone has provided a loan to someone else, the lender will have a financial asset on its balance sheet, while the borrower has an equivalent amount of debt on its balance sheets. As a consequence, one can construct so-called “from-whom-to-whom tables” (FWTW tables, or matrices), which show the interconnectedness between (institutional) sectors. They present, for a given financial instrument (or groups of instruments), the assets of the owning sectors (or creditor sectors) broken down by counterparty sectors (the debtor sectors which have incurred the liabilities) with the respective values of the transactions during a certain period of time and/or the stocks at the end of the period. The diagonal of the FWTW table shows the intra-sector transactions and stocks, i.e. claims/liabilities between entities belonging to the same sector. These amounts are cancelled out in so-called “consolidated” overviews of financial assets and liabilities of a sector. For more details, please refer to Chapter 1.

Tables 2.7and 2.8, and Figure 2.6 contain fictional data meant to illustrate FWTW tables. In the example of Table 2.7, it is possible to observe that, in the period under analysis, non-financial corporations (NFC), as debtors, issued a net amount of debt securities of 120, with an intra-sector transaction of 50. The household sector (HH) was the other major counterpart/creditor, with a change of 50 in claims towards NFC. On the asset side, the NFC, as creditors, acquired a total net amount of 50, by increasing their holdings of securities issued by the Rest of the World (RoW) by 30, and increasing their intra-sector claims by 50 (exactly the same as in the debtor side of the analysis), while reducing their claims on the other resident sectors (financial corporations (FC) by -10, and general government (GG) by -20).

Table 2.7. FWTW table for transactions in debt securities

Debtor

NFC

FC

GG

HH

RoW

Total

Creditor

NFC

 50

-10

-20

0

30

 50

FC

 10

-10

10

0

-50

-40

GG

  0

45

-25

0

-10

10

HH

 50

-10

50

0

-20

 70

RoW

 10

-10

90

0

-

 90

Total

120

5

105

0

-50

180

 http://dx.doi.org/10.1787/888933589827

Table 2.8. FWTW table for stocks of debt securities

Debtor

NFC

FC

GG

HH

RoW

Total

Creditor

NFC

  500

   200

   300

0

1 000

2 000

FC

1 000

 7 500

 6 000

0

2 000

16 500

GG

  100

 2 000

 4 000

0

  100

6 200

HH

2 000

 3 500

   100

0

  500

6 100

RoW

2 500

 3 000

 6 000

0

-

11 500

Total

6 100

16 200

16 400

0

3 600

42 300

 http://dx.doi.org/10.1787/888933589846

Figure 2.6. Debt securities: exposure to the other institutional sectors
picture

 http://dx.doi.org/10.1787/888933588022

Table 2.8, showing the relevant FWTW table for stocks, allows the users to have a measure of the exposure of each institutional sector vis-à-vis the other domestic sectors and the rest of the word for a certain moment in time. It can be seen that the NFC sector had a net liability position for debt securities of 4 1001, and that the main net financing sectors of the NFC sector are HH (2 000) and RoW (1 500).2 This is also shown in the first graph of Figure 2.6. In the case of the RoW, a net asset position can be derived for debt securities vis-à-vis all domestic sectors, except HH. Regarding the HH sector, their holdings of debt securities are mainly vis-à-vis the corporate sectors of the domestic economy (FC and NFC).

The FWTW tables may also be shown as flow of funds charts, which display the net flows, for the period under analysis, between the institutional sectors including the Rest of the World. In this type of chart, circles are used to represent the sectors. The area of the circle is proportional to the net flows (or positions) of each sector, for a given financial instrument (or groups of instruments), filled in grey when positive and in blue when negative. Arrows are used to show the flows from the creditors to the debtor (on a net basis), with the width of the arrow proportional to the magnitude of transactions (or positions) between the relevant sectors. The scheme may be adapted to other instruments or to the total of transactions in all financial instruments. Figure 2.7 shows the net flows of debt securities presented in Table 2.7, as a flow of funds scheme.

Figure 2.7. Flow of funds chart
picture

 http://dx.doi.org/10.1787/888933588041

Box 2.2. Changing economic patterns through the flow of funds – example for Portugal

The flow of funds representation provides a picture of inter-sectoral patterns of an economy. In this box, four different phases of the evolution of the Portuguese economy are shown using the financial accounts compiled by Portugal’s central bank, Banco de Portugal.

a) 2000-07

The period of 2000-07 roughly comprises the period between Portugal joining the Euro Area up to the initial tensions in global financial markets on the wake of the 2007-09 economic and financial crisis. During this period, the financial sector was carrying out its typical intermediary role, raising funds mainly from the Rest of the World, and channelling these funds to non-financial corporations. There was a significant asymmetry between domestic and foreign financing sources, as domestic saving and lending were clearly insufficient to finance the needs of the domestic sectors. Hence, the vast majority of the funding was coming from abroad. Another important trademark of this period was the relatively contained funding needs of the general government.

2007
picture

b) 2008-10

The second period covers the international financial turmoil up to 2010, when the Greek sovereign debt crisis broke out. As compared with the previous period, the overall financing needs of the country were larger than before, with those of the general government reaching around 10% of GDP. At the same time, the government ceased to be able to access international funding. To cover the financing gap, the financial sector stepped in and most of the funding provided by financial corporations was channelled to government instead of to corporations. In other words, there was a crowding out effect of domestic credit being diverted to the public sector away from the private sector.

2010
picture

c) 2011 and 2012

The third period started in 2011 with the beginning of the Economic and Financial Assistance Programme to Portugal. The main consequence of the Assistance Programme was the replacement of the funding of the government sector from the domestic financial sector to foreign international institutions (European Union, International Monetary Fund and European Central Bank). Also due to the Programme, the general government became a net lender to the financial sector by granting financial support to banks.

2011
picture

d) 2013 and 2014

The Assistance Programme to Portugal ended in 2014. The flow of funds of the Portuguese economy in this period was very different from the beginning of the 2010s. Portugal became a net lender in 2012, the government deficit decreased, and non-financial corporations became net lenders, as a consequence of a sharp decline in non-financial investments. Moreover, households increased their saving rate as a result of a contraction in private consumption.

2014
picture

Source: Banco de Portugal (2015), Financial Accounts, www.bportugal.pt/EstatisticasWeb/(S(vejoqt45bzga0v55jov0 hj3x))/SeriesCronologicas.aspx.

These FWTW tables and flow of funds charts thus enable a comprehensive tracking of the relationships between the different sectors of an economy. As such, they are an important analytical tool for macroeconomic and financial stability analysis, in a world characterized by an increasing financial interconnectedness between economies and ever increasing financial positions of the different sectors.

Net flows

NFC

FC

GG

HH

RoW

Total

NFC

-

-20

-20

-50

20

-70

FC

20

-

-35

10

-40

-45

GG

20

35

-

-50

-100

-95

HH

50

-10

50

-

-20

70

RoW

-20

40

100

20

-

140

The national accounts framework of the FWTW tables thus provides an important tool to capture and illustrate the interconnectedness between the different sectors. It also enables a comprehensive tracking of the relationships between the different sectors of an economy and the identification of the exposure of each institutional sector vis-à-vis the other sectors.

5. Risk elements within the financial system

Financing and investment involves risks and may create vulnerabilities, which are discussed in this section. First the main risks related to financial intermediation as such are addressed. Subsequently, a broader overview of the various types of risks related to the engagement in the financial markets is presented in slightly more detail.

Financial intermediaries – risk and maturity transformation

Financial intermediaries have a primary role of channelling funds from savers to borrowers, but they also undertake the crucial role of transforming risk and maturity. In general, financial intermediaries hold assets with higher risk of default than their own liabilities. To minimise this risk, financial intermediaries undertake risk transformation by the processes of diversification, screening and monitoring of assets, and the formation of reserves. There are two ways to undertake diversification: by spreading risk and by pooling risk. Financial intermediaries spread risk by bearing the risk of their investors (household bank deposits), and investing these household funds across various financial instruments and sectors, for example by issuing loans to households and purchasing government bonds. Secondly, financial intermediaries pool risk, for example by ensuring that their loan assets are large enough to contain the risk of any loans that may default and the loss due to the default is spread among all investors. The process of diversification allows financial intermediaries to allocate assets and bear risk more efficiently.

The role of financial intermediaries in maturity transformation is related to the fact that investors and borrowers have differing maturity needs – savers typically want to lend funds at short maturity and borrowers want to borrow for long maturities. The financial intermediary finances the needs of borrowers with long-term maturity preferences by pooling the investor funds (i.e. deposits) that have short-term maturity. This role of the financial intermediary ensures that investors and borrowers have more choice concerning the maturity of their investments and borrowings.

Types of financial risks and strategies for the mitigation of risks

There are multiple types of financial risk faced by financial market participants and financial intermediaries associated with their functions they undertake in the financial system. Listed below are some of these risks and strategies that are undertaken for mitigation.

Credit default risk is the risk associated with borrowers failing to make the required debt payments. The loss to the lender could include the principle and the interest. The risk is likely to impact loans, bonds and derivatives. Examples are a household unable to make payments due on a mortgage loan to a bank, or a corporate bond issuer not making coupon or principle payments to the holder. In the case of a bank loan, the bank may mitigate credit default risk by requiring borrowers to provide collateral, taking out insurance, such as mortgage insurance, or undertaking credit assessments on customers to rank the potential risk. With unsecured loans, the banks will charge a higher price for higher risk customers, and with revolving products such as credit cards, risk is controlled through setting credit limits. For default risk related to bonds and derivatives, financial intermediaries or other counterparties may hedge using derivative products such as swaps or credit derivatives, such as credit default swaps.

Interest rate risk is the risk associated with interest bearing investment earnings fluctuating with changes in interest rates. A change in interest rates has an inverse impact on the value of investments. For example, an increase in interest will decrease the value of debt securities with a fixed coupon rate. The impact of the interest rate change is dependent on the time to maturity and the coupon rate of the securities. The impact on the value of short-term securities is much smaller than on long-term securities. For financial intermediaries, interest rate risk can be split into two components: traded and non-traded interest rate risk, the latter often referred to as interest rate risk on the balance sheet. Traded interest rate risk impacts the market value of banks’ traded securities such as government securities and interest rate swaps. The interest rate risk on the balance sheet arises from the bank’s core activities, and the main source of the interest rate risk is the maturity mismatch or re-pricing risk, reflecting the fact that banks’ assets and liabilities are of different maturities and are priced at different interest rates.

To minimise interest rate risk associated with bond assets, investors may hedge using derivative products, such as forwards, options and interest rate swaps. To manage maturity mismatches between the assets and liabilities on bank balance sheets, banks have adopted tools such as the asset liability management framework. The framework undertakes sophisticated modelling that allows the measurement of the mismatch of the assets and liabilities maturity patterns, and recommends strategies such as direct restructuring of balance sheets or adoption of financial instruments such as swaps, futures, options and other customised agreements to alter the balance sheet interest risk exposure. Furthermore, in most countries banks are regulated, and some national banking regulators have demanded banks to hold extra capital against both interest rate risks associated with the trading positions and the balance sheet.

Foreign exchange risk is the potential risk of loss from fluctuating foreign exchange rates when an investor has exposure to foreign currency or to foreign currency traded investments. For example, holders of foreign bonds face currency risk, when bonds make interest and principle payment in a foreign currency. Foreign exchange risk may impact exporting and importing businesses, investors in foreign financial assets, and foreign direct investment in a company. To minimise foreign exchange risk, a variety of foreign exchange derivatives are available such as forward contracts, future contracts, options and swaps.

Risks such as credit default risk and interest rate risk may be indirectly captured in national accounts. For example, an indirect measure of credit default risk may be ascertained by comparing, for example, loans at market value with the same loans at nominal values, where the market values would typically adjust the valuation of loans by deducting the value of specific provisions for bad and doubtful debt. The exposure of the interest rate risk on the banks’ balance sheets may be broadly ascertained by comparing the value of short- and long-term liabilities and assets. The 2008 SNA disaggregates both loans and, to a lesser extent, deposits into short- and long-term maturities, along with a split of debt securities into short- and long-term.

New international reporting requirements since the 2007-09 economic and financial crisis have requested countries to collect data on debt securities both on an original and a residual term to maturity. The latter measure should assist in highlighting interest rate risk both from a trading and a balance sheet perspective. Similarly, the new reporting standards dictate that assets and liabilities issued in foreign currency should be reported separately by financial institutions, assisting in exposing any vulnerability to foreign currency risks.

The balance sheets, presented in a FWTW framework at a given point in time and over time, can also be useful in providing an assessment of the overall health of resident and non-resident sectors, by providing:

  • the household sector’s exposure to real estate assets in times of asset price decreases;

  • pension funds’, investments funds’ and life insurance corporations’ exposure to debt securities during times of liquidity risks in the security market;

  • so-called “leverage measures”, such as debt-to-equity measures in the non-financial corporations sector; during periods of buoyant income and stable and low interest rates, a leveraged corporation, i.e. a corporation with substantial debt as compared to equity and reserves, stands to make a substantial return on equity compared with an un-leveraged corporation. However, during more uncertain times a leveraged corporation is at risk from fluctuations in earnings and/or rising interest rates, such that debt servicing costs may not be met;

  • probable measures of increasing or declining cost of funds for banks assets by showing proportion of deposits, equity and debt funding over time;

  • overall debt and type of debt by financial instrument for households, government and non- financial corporations, either direct comparison or to their disposable income;

  • households’ debt-to-assets ratio, or more specifically debt-to-residential assets ratio, whereby an increase in the ratio over time is indicative that (mortgage) debt grew faster than the value of (residential) assets owned by households;

  • debt-to-liquidity asset ratio, illustrating a sector’s ability to extinguish debt;

  • holding gains or losses over time by asset type; and

  • shifts in short- to long-term debt financing, potentially indicating a decline in cost pressures in the capital markets.

Key points

  • The financial system of a nation can be thought of as having three overlapping components: financial corporations; the financial markets; and the payment system. The interaction of the three components, through mechanisms of financial intermediation and financial markets, enables the channelling of funds from savers to borrowers.

  • Financial markets may be defined narrowly to mean a market in which trading of financial instruments such as securities and currencies occur at low transaction costs and at prices that reflect supply and demand, with no intervention of financial intermediaries (or the need for a “middle man”). Within the global financial system the following financial markets fall into the narrow definition: capital markets (which consist of share markets and bond markets); money markets; derivatives markets; and foreign exchange markets.

  • The broad definition of financial markets includes the interaction of financial intermediaries with the financial market. The following markets additionally fall into this broad definition: the deposit market, the loan market, and the pooled investment market.

  • The role of financial intermediation, or the devising of a financial instrument (debt securities, equities, derivatives, loans and deposits) by financial intermediaries (banks, investment funds, pension funds) to channel funds from lenders to borrowers, is evident in a majority of the financial markets described.

  • Data on the interconnectedness between sectors (FWTW tables and flow of funds schemes) enable a full knowledge of the financial linkages between the various actors in the economy, by capturing the flows between the different sectors of the economy and revealing the level of exposure of each institutional sector vis-à-vis the other sectors. As such, they are a relevant analytical tool in the fields of macroeconomic and financial stability analysis.

  • Financial intermediaries undertake the crucial role of transforming risk and maturity. There are multiple types of financial risk faced by financial market participants and financial intermediaries associated with functions they undertake in the financial system, including credit default risk, interest rate risk and foreign exchange risk. The financial accounts and balance sheets indirectly capture some of these risks.

References

ABS (2017), 5232.0-Australian National Accounts: Finance and Wealth (database), www.abs. gov.au/ausstats/[email protected]/mf/5232.0/.

Banco de Portugal (2015), Financial Accounts, Banco de Portugal, Lisbon, www.bportugal.pt/EstatisticasWeb/(S(vejoqt45bzga0v55jov0hj3x))/SeriesCronologicas.aspx.

BIS (2016), Triennial Central Bank Survey: Foreign Exchange Turnover in April 2016, Bank for International Settlements, Basel, www.bis.org/publ/rpfx16fx.pdf.

Notes

← 1. The net liability position of the NFC sector in the instrument debt securities is obtained from the difference between the debtor position of the NFC sector in this instrument (6 100), and the creditor position in the same instrument (2 000).

← 2. The RoW is a net creditor of the NFC sector (for the instrument debt securities). This value is obtained considering the creditor position minus the debtor position of the RoW sector vis-à-vis the NFC sector (2 500 minus 1 000).