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FINANCIAL INSTITUTIONS, INSTRUMENTS AND MARKETS
Page ii
ASSURANCE OF LEARNING
Many educational institutions today are focused on the notion of assurance of learning, an important element of some
accreditation standards. This eighth edition of Financial Institutions, Instruments and Markets is specifically created

to support assurance of learning initiatives designed to draw on and expand key knowledge and skill sets required by
graduates such as: communication, initiative and enterprise, self-management, life-long learning, problem
solving, technology, teamwork, planning and organising.1
Chapter learning objectives and pedagogical features throughout the text are developed to directly relate to the
learning outcomes for your course which may assist instructors in making the collection and presentation of assurance of
learning data easier.
AACSB STATEMENT
McGraw-Hill Education is a proud corporate member of AACSB International. Understanding the importance and value of
AACSB accreditation, Financial Institutions, Instruments and Markets 8e has sought to recognise the curriculum
guidelines detailed in the AACSB standards for business accreditation. A variety of pedagogical features in chapters are
designed to draw on the general knowledge and skill guidelines found in the AACSB standards: communication abilities,
use of information technology, ethical understanding, reflective thinking, critical analysis and diversity
and multicultural understanding.2
The AACSB leaves content coverage and assessment within the purview of individual schools, the mission of the school and
the faculty. While Financial Institutions, Instruments and Markets 8e and the teaching package make no claim of specific
AACSB qualification or evaluation, we have geared pedagogical features and online assessment tools towards some of the
general knowledge and skills areas.

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Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd
Additional owners of copyright are acknowledged in on-page credits.
Every effort has been made to trace and acknowledge copyrighted material. The authors and publishers tender their
apologies should any infringement have occurred.
Reproduction and communication for educational purposes
The Australian Copyright Act 1968 (the Act) allows a maximum of one chapter or 10% of the pages of this work, whichever
is the greater, to be reproduced and/or communicated by any educational institution for its educational purposes
provided that the institution (or the body that administers it) has sent a Statutory Educational notice to Copyright
Agency Limited (CAL) and been granted a licence. For details of statutory educational and other copyright licences
contact: Copyright Agency Limited, Level 15, 233 Castlereagh Street, Sydney NSW 2000. Telephone: (02) 9394 7600.
Website: www.copyright.com.au


Reproduction and communication for other purposes
Apart from any fair dealing for the purposes of study, research, criticism or review, as permitted under the Act, no
part of this publication may be reproduced, distributed or transmitted in any form or by any means, or stored in a
database or retrieval system, without the written permission of McGraw-Hill Education (Australia) Pty Ltd, including,
but not limited to, any network or other electronic storage.
Enquiries should be made to the publisher via www.mheducation.com.au or marked for the attention of the permissions
editor at the address below.
National Library of Australia Cataloguing-in-Publication Data
Author:
Title:
Edition:
ISBN:
Notes:
Subjects:

Other
Authors/Contributors:

Viney, Christopher, author.
Financial institutions, instruments and
markets / Christopher Viney, Peter Phillips.
8th edition
9781743079959 (paperback)
Includes index.
Financial institutions—Australia. Financial
institutions—Australia—Problems, exercises,
etc. Financial instruments—Australia.
Financial instruments—Australia—Problems,
exercises, etc. Money market—Australia. Money
market—Australia—Problems, exercises, etc.
Phillips, Peter John, author.

Published in Australia by
McGraw-Hill Education (Australia) Pty Ltd
Level 2, 82 Waterloo Road, North Ryde NSW 2113
Publisher: Jillian Gibbs
Senior product developer: Lisa Coady
Production editor: Natalie Crouch
Permissions editor: Haidi Bernhardt
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Indexer: Graham Clayton
Cover design: Christa Moffit
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This book has achieved remarkable acceptance by academics and their students in a significant number of tertiary
institutions throughout Australia, New Zealand and Asia, and by professionals within the financial services industry. In
this eighth edition, Dr Peter Phillips and myself continue to present a finance text for you that is authoritative and
scholarly, which at the same time highlights the dynamic, exciting and global nature of financial institutions,
instruments and markets.
The recent global financial crisis gradually became apparent from mid-2007 and had a significant adverse effect on the
financial markets from 2008. As the crisis then rapidly evolved it led to an extended period of continuing financial
market uncertainty and extreme volatility. Major global financial institutions had to be bailed out by government or
failed, sovereign debt in a number of countries reached unprecedented levels, economic activity slowed significantly and
unemployment rose to very high levels, particularly in the USA and a number of European countries. The nature and
contagion effects of this evolving global financial crisis are discussed in detail in various chapters of the book.
Within this context, it is important that the eighth edition should encourage new generations of students and industry
practitioners to understand, anticipate and challenge the complex and rapidly evolving structure of the financial
system.
As argued by Nobel Laureate and leading economist Professor Joseph Stiglitz, effective financial market regulation
within the context of the integrated global financial markets is required to mitigate future financial crises.
Interestingly, the government initiated a review of the Australian financial system in 1997 (the Wallis Report). In
part, structural and regulatory change that was implemented as a result of that report ensured the Australian financial
system came through the global financial crisis relatively unscathed. The government has currently commissioned a new
review of the system (the Murray Report). The final report is due at the end of 2014 and hopefully the government and
regulators will act upon its recommendations of the report to ensure the financial system is made even more efficient
and robust.
One thing is certain, change will occur. As students of the financial system you must keep yourself informed about the
structure and operation of financial institutions, instruments and markets. Importantly, you must think about and
anticipate future directions and change. When, as a young boy of sixteen I began working in the industry, it was the
time of pounds, shillings and pence. I was required to record all transactions using a nib pen dipped in ink. Daily,
weekly, monthly and annual statements were added in my head. It was an exciting day when we received a mechanical adding
machine—its dimensions were 300×400×200 mm and it could only add, subtract, multiply and divide. I had to pull a large
handle to input each entry into the machine. There has been unbelievable change to the insulated environment of those
days. In particular, there has been significant deregulation of the financial markets, the development of electronic
information and product delivery systems, new and sophisticated financial products, the integration of domestic
financial systems into a global financial system and, from time to time, major financial and economic crises.
To remain relevant in business and finance you must continue to educate yourself and those for whom you may be
responsible in the future. You must read the daily press and periodic financial journals to keep yourself up to date. I
suggest you add notations of current and proposed future changes to the financial system to your personal copy of this
book. This is not a text that you will sell at the end of a particular unit of study, but rather is an important
reference that you should continue to use for further studies and on into your professional career.
I have enjoyed my career working in and teaching about the financial system. I encourage you to accept every opportunity
that comes your way and I wish you the best of success.
CH R I S T O P H E R VI N E Y

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C H R I S T O P H E R V I N E Y brings to this book a wealth of industry experience and academic knowledge associated with the
international financial markets. His appreciation of the nature of both the theoretic and the applied functions and
operations of the global financial system is reflected in the clear and interesting presentation of issues in such a way
that the reader is motivated to learn.
Prior to moving into academia Chris spent twenty-seven years in the commercial banking industry including retail
banking, corporate lending, risk management, personnel, property, policy and administration. His academic career
included appointments at Monash University and Deakin University, Melbourne, Australia. He has taught in the areas of
financial markets, financial institutions management, corporate finance, treasury management and personal financial
planning. Chris has also taught in Singapore, Malaysia, Thailand, Indonesia and New Zealand. He has received university
awards for contributions to the internationalisation of teaching and learning programs. As the director of the finance
international study programs at Monash and Deakin Universities, Chris has taken select groups of students overseas as
part of their tertiary studies. He has also published research papers on the capital markets, operational risk
management, bureau de change, money laundering and education and training.
Following the passing of Michael McGrath with the first edition of the text, Chris has guided the evolution of future
editions of the book and it has now become a principal learning and reference source for undergraduate students,
postgraduate students and industry practitioners alike. As the text book continues to evolve, a co-author, Peter
Phillips, has joined Chris in writing the seventh and eighth editions.

P E T E R P H I L L I P S has been teaching economics and finance at the University of Southern Queensland (USQ) in Toowoomba,
Australia since 1998. Presently, he is an Associate Professor in Finance at USQ. He has taught in the areas of financial
markets and institutions, portfolio management and corporate finance as well as several economics courses, including
macroeconomics and econometrics. Peter completed a PhD at USQ in financial economics in 2003. Since then he has
published a number of papers on the topic of Self Managed Superannuation Funds (SMSFs) in which he and his co-authors
explore various aspects of the portfolios chosen by SMSF investors. He has recently completed work on a book that
explores SMSFs in more detail.

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Acknowledgments
The challenge of maintaining the currency and relevancy of a book with the scope of financial institutions, instruments
and markets is enormous. This daunting task is tackled at many levels. At one level we are most appreciative of those
users of the book, including academics, practitioners and students, who provide ongoing feedback in the form of comment,
suggestion and discussion. We value your contributions immensely.
The quality of the production of the book is also dependent on the expertise and hard work of the people at McGraw-Hill
Education Australia. As authors, we have been very fortunate to have the dedicated editorial support of Jillian Gibbs
and Jane Roy. We would also like to acknowledge and thank the team at McGraw-Hill including: Lisa Coady, Natalie Crouch,
Marisa Rey Bulen, Haidi Bernhardt and Maryann D'Sa.
CH R I S T O P H E R VI N E Y

AND

PE T E R PH I L L I P S

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C H A P T E R 1 A modern financial system: An overview
highlights various aspects of the global financial crisis with a special focus on the importance of regulation
for ensuring financial markets stability
introduces the financial institutions, financial instruments and financial markets that comprise domestic and
global financial systems and explains why a stable financial system is important for economic growth
provides a concise context that assists the reader to understand the relationships of the material in the
following chapters
extended learning—globalisation of the financial markets and the drivers of change in the financial system
extended learning—the impact of the Asian financial crisis on the financial system
C H A P T E R 2 Commercial banks
contains a detailed discussion on the commercial bank, including its role, products, off-balance-sheet
business, regulation and supervision
provides a concise explanation of the capital adequacy and liquidity standards that apply to banks under the
Basel II and Basel III Accords
outlines aspects of the regulatory response to the global financial crisis
extended learning—standardised approach to credit risk
extended learning—business continuity risk management
extended learning—corporate governance and ethics
C H A P T E R 3 Non-bank financial institutions
an examination of investment banks, managed funds, superannuation funds, cash management trusts, public unit
trusts, life and general insurance offices, hedge funds, finance companies, building societies, credit unions
and export finance corporations
extended learning—project finance and structured finance
C H A P T E R 4 The share market and the corporation
considers the management structure of a publicly listed corporation
discusses the important roles of a stock exchange in facilitating the listing of a corporation's shares on the
exchange (primary market role) and the ongoing trading of existing shares (secondary market role) on the share
market
examines the managed products and derivative products offered by a stock exchange, including exchange traded
funds, contracts for difference, real estate investment trusts, infrastructure funds, options, warrants and
futures contracts
examines the interest rate market role, the trading and settlements roles, the information role and the
regulatory roles of a stock exchange
C H A P T E R 5 Corporations issuing equity in the share market
introduces the capital budgeting investment decision process; funding issues related to debt and equity;
initial public offerings, stock exchange listing rules and alternative forms of equity issues
extended learning—Australian Securities Exchange (ASX) listing requirements
C H A P T E R 6 Investors in the share market
considers the role of the investor in the share market; risks associated with buying and selling shares
discusses taxation; financial performance indicators and the pricing of shares
introduces share market indices and the interpretation of share market information
C H A P T E R 7 Forecasting share price movements
examines fundamental analysis and technical analysis approaches to share price forecasting
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considers the nature and impact of electronic trading on the markets
introduces the random walk hypothesis and the efficient markets hypothesis (EMH) within the context of
forecasting share price movements
introduces behavioural finance as an alternative theoretical framework to the EMH for understanding share
price movements
C H A P T E R 8 Mathematics of finance: an introduction to basic concepts and calculations
introduces the principles of mathematical calculations that underpin financial market instruments, including
simple interest, compound interest, present value, future value, yield, annuities and effective rates of
interest
C H A P T E R 9 Short-term debt
examines the main sources and types of short-term intermediated and direct finance available to a business
corporation, including trade credit, bank overdrafts, commercial bills, promissory notes, negotiable
certificates of deposit, inventory finance, accounts receivable financing and factoring
calculation of prices and yields on discount securities
C H A P T E R 10 Medium- to long-term debt
identifies the main types of longer-term debt available to a corporation, including term loans, fully drawn
advances, mortgage finance, debentures, unsecured notes, subordinated debt and leasing
calculation of prices and yields on fixed interest securities
extended learning—securitisation
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C H A P T E R 11 International debt markets
explores the structure of the international debt markets, in particular the euromarkets (eurocurrency,
euronote and eurobond markets) and the US money and capital markets.
examines the main generic products offered in the international debt markets
considers the important role of credit rating agencies in the international debt markets
extended learning—novation, subparticipation and transferable loan certificates
extended learning—convertible bonds and warrants
extended learning—US medium-term notes
extended learning—Standard & Poor's credit rating definitions
C H A P T E R 12 Government debt, monetary policy and the payments system
examines why governments issue short-term and longer-term debt securities, the types of securities and the
pricing of those securities. It also considers the purpose and implementation of monetary policy; the
operation of the payments system, exchange settlement accounts, real-time gross settlement and repurchase
agreements
extended learning—fixed-coupon Treasury bonds: price calculation using the Australian Office of Financial
Management (AOFM) formula
C H A P T E R 13 An introduction to interest rate determination and forecasting
examines the macroeconomic context and the loanable funds approach to interest rate determination and the
impact of changes in related variables
considers the term structure and risk structure of interest rates within the context of the expectations
theory, the segmented markets theory and the liquidity premium theory
extended learning—the yield curve and expectations theory calculations
C H A P T E R 14 Interest rate risk measurement
identifies methods used to measure interest rate risk and introduces an exposure management system
examines interest rate risk measurement models, including re-pricing gap analysis, duration and convexity
considers internal and external interest rate risk management techniques
C H A P T E R 15 Foreign exchange: the structure and operation of the FX market
examines the structure, participants, operation and conventions in the global FX markets
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discusses and calculates spot and forward FX quotations
considers the impact of the Economic and Monetary Union of the European Union (EMU)
C H A P T E R 16 Foreign exchange: factors that influence the exchange rate
introduces different exchange rate regimes used by various nation-states
in the context of a floating exchange rate, considers factors that affect the determination of an equilibrium
exchange rate, including relative inflation rates, national income growth rates, interest rates, expectations
and central bank intervention
considers the application of regression analysis in the measurement of exchange rate sensitivity
extended learning—purchasing power parity
C H A P T E R 17 Foreign exchange: risk identification and management
recognises FX risk and presents an organisational FX risk policy structure
discusses the measurement of transaction FX exposures
examines internal and external market-based hedging techniques using derivative products
C H A P T E R 18 An introduction to risk management and derivatives
introduces the fundamentals of understanding risk and risk management
provides a concise introduction to generic derivative products and markets, in particular futures, forwards,
option and swap contracts
C H A P T E R 19 Futures contracts and forward rate agreements
examines the purpose, structure and operation of a futures market, including structuring and calculating risk
management strategies
considers forward rate agreement contracts and the use of an FRA to manage interest rate risk exposures
C H A P T E R 20 Options
examines the purpose, structure and operation of options markets
introduces option contract strategies that may be applied in a wide range of risk exposure scenarios
C H A P T E R 21 Interest rate swaps, cross-currency swaps and credit default swaps
examines the purpose of interest rate swaps (including facilitating speculation) and considers the
construction of a swap to manage an interest rate risk exposure
in the context of international markets, considers the construction of a currency swap to manage both an
interest rate exposure and an FX risk exposure
introduces the credit default swap and discusses the structure of, and parties to, a CDS.

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PART INTRODUCTIONS Introducing each of the six parts is a short overview of the material covered in the following
chapters. These openers are a helpful introduction to how the key concepts, institutions or instruments work together
and how they fit within the larger picture.

CHAPTER OPENERS Each chapter begins with a short overview of the information contained in the chapter, providing not
only an introduction to the chapter, but also a useful study reference.

LEARNING OBJECTIVES These numbered points clearly outline what each reader should know and be able to do by the end of
the chapter. They will also assist in exam revision. Each learning objective notes the numbered section in which the
learning objective appears in the chapter. They are directly linked to the end-of-chapter summary, which systematically
works through each learning objective.

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KEY TERMS, MARGIN DEFINITIONS AND THE KEY TERMS LIST Each key term or concept is highlighted in the text at its
first appearance, and the definition provided in the corresponding margin. A boxed list of these key terms appears at
the end of each chapter and each entry is followed by the page on which it first appeared (thus linking to the margin
definition) as well as providing the context for the definition. A full list with definitions appears in the glossary.

FINANCIAL NEWS CASE STUDY Found at the end of every chapter, each financial news case study contains excerpts from
financial articles that provide real-world examples of concepts discussed within the chapter. They are followed by
related discussion questions providing the opportunity for self-assessment and putting into practice what you've
learned!

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REFLECTION POINTS Located after every major section within each chapter, the reflection points highlight the most
significant material covered as well as providing regular summaries and a useful tool for revision, which will help
students identify areas requiring further study.

CHAPTER SUMMARIES The chapter summaries comprehensively review the topics covered in each chapter and are linked
directly to the learning objectives, listing each learning objective and a summary of the relevant material.

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EXTENDED LEARNING The extended learning sections provide an additional resource for self-assessment and a variety of
activities designed to address the more complex aspects of the chapter. These sections are accompanied by extended
learning questions which test students' understanding of the material.

END OF CHAPTER QUESTIONS Each chapter contains a number of different question types useful to test student recall and
understanding of the material covered in the chapter. The True or false questions test your recall and the answers are
helpfully contained at the end of the book, an excellent tool for exam revision. These true or false questions can also
be used as short answer questions to test students' ability to provide more information.
The Essay questions provide the opportunity to put the concepts that have been learnt into practice, highlighting
students' ability to analyse and evaluate the material.
The Extended learning questions relate to the in-depth extended learning sections and require students to demonstrate a
deeper understanding of the concepts and theories presented in the chapter.
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EXPLORING FINANCE ON THE WEB This updated resource provides a comprehensive list of useful finance websites including
central banks, financial institutions, government sites, exchanges and markets. It also provides online learning tools
such as financial newspapers and magazines, currency converters, background reading and suggested databases.

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CAREERS IN FINANCE Introduces students to the enormous career opportunities that exist in both local and international
economics. A list of web addresses of select employers of finance graduates is a source of organisation-specific career
information. A useful guide to preparing on-line application is also presented.

GLOSSARY This useful list of definitions contains all of the key terms and concepts as they appear in the margin notes.
FINANCIAL ABBREVIATIONS This comprehensive list covers all the major financial abbreviations used both in the text
and in the financial world, providing a quick, easy-to-use reference point. It is helpfully located on the inside front
cover to make looking up terms easy!
WORLD CURRENCIES Located on the inside back cover for ease of reference, this handy, updated table lists the
currencies of all the world's major countries, as well as their common abbreviations.

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McGraw-Hill Connect is a digital teaching and learning environment that improves performance over a variety
of critical outcomes; it is easy to use and proven to be effective.
Proven effective
With Connect, you can complete your coursework anytime, anywhere. Connect can give you access to your assignments, eBook
(within Connect Plus), videos, animations and more. Millions of students have used Connect and the results are in:
research shows that studying with McGraw-Hill Connect will increase the likelihood that you'll pass your course and get
a better grade.

Connect support
Connect includes animated tutorials, videos and additional embedded hints within specific questions to help you succeed.
The Connect Success Academy for Students is where you'll find tutorials on getting started, your study resources and
completing assignments in Connect. Everything you need to know about Connect is here!

Visual progress
Connect provides you with reports to help you identify what you should study and when your next assignment is due, and
tracks your performance. Connect's Overall Performance report allows you to see all of your assignment attempts, your
score on each attempt, the date you started and submitted the assignment, and the date the assignment was scored.

To find out more about Connect and Connect Plus visit www.mheducation.com.au/digital/connect

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The following websites have been selected as useful and interesting sources of information relevant to financial
institutions, instruments and markets. As you continue your search of the internet you will find many more sites; this
is just the beginning! See your library's subject page on finance/economics/business where there will be listings of
search terms for the library catalogue and for databases, lists of subject-specific dictionaries and resources available
to use/borrow, often with their call numbers and the general call numbers to look for your subject. These pages may also
list significant journals in your field as well as databases and newspapers.
BACKGROUND

READING

Both Yahoo! and Google provide good entry points for the latest news, facts and figures as well as providing a gateway
to other resources. Yahoo! has a specific Australian and New Zealand site, www.yahoo.com.au/finance. Google Finance has
an international site, www.google.com/finance.
FINANCE

GLOSSARIES

This text includes a glossary of the main financial market words referred to in the book. As you extend your
understanding of the financial system further, www.investorwords.com provides online access to over 6000 words and 20 000
links. It is the biggest financial glossary on the web.
DATABASES
This is a list of some of the suggested databases your library may have access to that contain finance articles and
information. If your institution does not have access to all the databases you may be able to get access through another
institution, so check with your library about borrowing rights at other universities.
Proquest: Academic research library Covers finance, has full text articles.
Connect4: Annual report collections Business provides full text annual reports from various Australian companies
including some company financial statements.
APA Full Text (Australian Public Affairs full text) Lists a large range of Australian periodicals with some access to
full text.
Proquest: Banking Information Sources International database, full text article access. Covers banking and industry and
the financial services industry.
Expanded Academic ASAP Full text articles available, international.
Factiva Full text available, covers most Fairfax publications including Business Review Weekly, The Australian Financial
Review and The Age.
Science Direct Full text, international. Includes access to journals such as Journal of Financial Markets, Journal of
International Money and Finance and Journal of Banking and Finance.
You can find these databases by selecting your subject (finance, business, economics) and searching the library subject
pages for relevant journal listings. Alternatively, look them up in alphabetical order through the online library
catalogue to check for access. You may need a password when accessing them off campus.
WORLD

CURRENCIES

http://en.wikipedia.org/wiki/List_of_circulating_currencies This site has a comprehensive list of the majority member
states of the United Nations with their ISO-4217 currency codes and abbreviations listed.
www.xe.com/currencyconverter provides a convenient foreign exchange currency converter.
Page xxiii
FINANCE MEDIA
Although not all of these may be available from your library (either in hard copy or through online access with a
password) it is worth investigating the possibilities of interlibrary loans. Ask your subject librarian for information
about accessing the catalogues of other libraries.
Wall Street Journal
http://online.wsj.com/public/asia
The Wall Street Journal has great information available online without subscription.
MSN Money
www.money.msn.com
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A useful site that has good coverage of financial events in the ‘news’ section including video clips.
The Financial Times
www.ft.com/home/uk
Online access to full text articles from either the UK, US or Asian editions of the paper.
Fortune Magazine
http://www.fortune.com
Fortune Magazine home, access to full text articles.
AUSTRALIAN

AND INTERNATIONAL INSTITUTIONS AND AUTHORITIES

The Reserve Bank of Australia website www.rba.gov.au/links provides direct link access to the websites of:
central banks
EMEAP members
other international organisations
Australian government departments and authorities
Australian legislation
Australian financial sector organisations
AUSTRALIAN

MAJOR BANKS

ANZ Banking Group – www.anz.com.au
Commonwealth Bank of Australia – www.commbank.com.au
National Australia Bank – www.nab.com.au
Westpac Banking Corporation – www.westpac.com.au
SELECT

INTERNATIONAL FINANCIAL INSTITUTIONS

Allianz – www.allianz.com
Citibank – www.citibank.com
Credit Suisse – www.credit-suisse.com
Goldman Sachs – www.goldmansachs.com
ING Bank – www.ing.com
JPMorgan Chase & Co – www.jpmorgan.com
UBS Investment Bank – www.ibb.ubs.com
CREDIT

RATING AGENCIES

Fitch Ratings – www.fitchibca.com
Moody's Investors Service – www.moodys.com
Standard & Poor's – www.standardandpoors.com
INFORMATION

PROVIDERS

Bloomberg – www.bloomberg.com
Dow Jones – www.dowjones.com
Thomson-Reuters – www.reuters.com
EXCHANGES

AND MARKETS

Australian Securities Exchange – www.asx.com.au
New Zealand Stock Exchange – www.nzx.com
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CME Group (Chicago Board of Trade and Chicago Mercantile Exchange) – www.cmegroup.com
Hong Kong Exchange – www.hkex.com.hk
Euronext (formerly London International Financial Futures Exchange) – www.euronext.com
London Metal Exchange – www.lme.com
London Stock Exchange – www.londonstockexchange.com
Lloyds of London – www.lloyds.com
NASDAQ – www.nasdaq.com
New York Stock Exchange – www.nyse.com
Shanghai Stock Exchange – www.sse.com.cn
Singapore Exchange – www.sgx.com
Sydney Futures Exchange (a part of the Australian Securities Exchange) – www.asx.com.au
Tokyo Stock Exchange – www.tse.or.jp/english
CLEARING ,

SETTLEMENTS AND CUSTODIAN SERVICES

Austraclear – www.asx.com.au
Clearstream – www.clearstream.com
Euroclear – www.euroclear.com
Reserve Bank Information and Transfer System – www.rba.gov.au/rits
SWIFT – www.swift.com

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One of my very good friends established his own engineering business after graduating many years ago. The business has
grown and is very successful. A few years ago he obtained a copy of this text book and after reading commented that he
wished he had been able to study the book as part of his engineering degree before he began in business, as it would
have saved him from many of the financial pitfalls he experienced over the years. Within the context of careers in
finance, this true story highlights that a career in finance can be established in any country, economic sector,
industry sector, business or government.
The range of career opportunities is enormous. For example, commercial banking provides an enormous range of options
including retail finance, corporate lending, international banking, treasury and information technology, to name but a
few. Investment banking also offers specialist finance opportunities including mergers and acquisitions, project
finance, securitisation, underwriting and venture capital. Funds management or personal financial planning are also
other career opportunities. Small, medium and large businesses all require people skilled in finance to manage their
assets, liabilities and cash flows. Government departments and authorities also require finance graduates to assist with
the financing of capital or recurrent expenditures. Stock-broking is yet another career opportunity.
Finance is a global market and therefore there are possibilities for working in a range of developing and advanced
financial markets. In particular, you may wish to work in London or New York. While visiting many of the global
financial markets, I have encountered many people from different countries who have made the transition from their local
market to the international financial markets.
During your studies you may find certain areas of finance that particularly excite and interest you. Research the types
of organisations that provide career opportunities in your areas of interest; understand the structure and culture of
the organisations and carefully consider the organisation's guidelines for graduate employment. Most large employers
include a link to this information on their website. Some examples include:
ANZ Banking Group – www.anz.com.au/about-us/careers
Commonwealth Bank – www.commbank.com.au/about-us/careers.html
National Bank of Australia – www.nab.com.au/about-us/careers
Westpac Banking Corporation – www.westpac.com.au/about-westpac/careers
Goldman Sachs – www.goldmansachs.com/careers
Macquarie Bank – www.macquarie.com.au/careers
Reserve Bank of Australia – www.rba.gov.au/careers
Australian Prudential Regulation Authority – www.apra.gov.au/aboutAPRA/workingatAPRA
Department of Treasury – www.treasury.gov.au/About-Treasury/recruitmentandcareers
Telstra Corporation – www.telstra.com.au/careers
BHP Billiton Limited – www.bhpbilliton.com/careers
KPMG – www.kpmg.com/au/en/careers
Ernst & Young – www.ey.com/au/en/careers
Tips for online applications
Before you start
Allow yourself plenty of time as each application can take between two and four hours at a minimum! Read the
application instructions carefully, to determine whether you:
have the appropriate/minimum software and hardware to undertake this process
have the option of downloading a copy of the application form to assist you in preparing all relevant
information and in filling out the form
have to fill out the form in one sitting, or whether you have the option of saving, exiting out and returning
to the form when you are ready
Page xxv
know what information you will be required to include in the application form (course/unit details, results
etc.) so you can have this handy when you are completing the forms
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know whether additional information (cover letters, etc.) can be attached if desired.
Obtain a copy of your academic transcript.
Collect all the information you require, for example course/unit details. Also have electronic access to your
résumé to cut and paste into the application form.
If you need to use computer labs or library computers, book ahead of time.
Working on the application
Print out the application form to use as a draft. Complete responses offline and cut and paste into the
application.
Remember to fill out all the fields.
Save regularly as you progress through the application form if possible.
Proofread your applications—not all online application forms have spell checks.
Leave plenty of time to submit the applications electronically. Typically, employer websites experience a huge rush
towards the application deadlines. You may experience delays or be unable to submit due to technical problems if
sites are overloaded.
Make sure your email address and mobile phone numbers are correct! All too often students record these inaccurately
—it is vital that you are contactable, particularly if employers wish to schedule you for testing/interviews. If
they can't reach you, they won't bother trying again, given the numbers of applications they will be processing.
If you don't receive acknowledgment, or you are unsure whether your application has been received, contact the
relevant recruitment coordinator to confirm receipt of your application.
If you are having any problems with the technology or have questions regarding the form, contact the graduate
recruiter in that organisation as soon as possible.
Print out a copy of the application for your records (and make a note of any contact you have with the
organisation)—it will help if and when you are invited to an interview.
In addition to proofreading, reread your application before you hit the ‘send’ button. Does it present you in the
best possible way? You will not get another chance to revise it!
Distinguish yourself from other applicants
Employers advise that the best way to make your application stand out are the simple things:
Fill out all the fields.
Proper business language should be used as you would for a paper-based application. Just because it is an online
form doesn't mean that you should use more informal or text language, or insert symbols, for example smiley faces.
Check your spelling, or get others to check it for you—spell checks don't pick up everything.
Answers to in-depth questions should be carefully thought out and tailored to each employer, not a generic cut-andpaste answer. Use proper paragraphs, not just a list of dot points.
These tips may seem obvious, but you'd be amazed at the number of applications which are not successful because they
haven't followed this advice!

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Front Matter
PART 1.FINANCIAL INSTITUTIONS
Chapter 1.A modern financial system: an overview
Chapter 2.Commercial banks
Chapter 3.Non-bank financial institutions
PART 2.EQUITY MARKETS
Chapter 4.The share market and the corporation
Chapter 5.Corporations issuing equity in the share market
Chapter 6.Investors in the share market
Chapter 7.Forecasting share price movements
PART 3.THE CORPORATE DEBT MARKET
Chapter 8.Mathematics of finance: an introduction to basic concepts and
calculations
Chapter 9.Short-term debt
Chapter 10.Medium- to long-term debt
Chapter 11.International debt markets
PART 4.GOVERNMENT DEBT, MONETARY POLICY, THE PAYMENTS SYSTEM AND
INTEREST RATES
Chapter 12.Government debt, monetary policy and the payments system
Chapter 13.An introduction to interest rate determination and forecasting
Chapter 14.Interest rate risk measurement
PART 5.THE FOREIGN EXCHANGE MARKET
Chapter 15.Foreign exchange: the structure and operation of the FX market
Chapter 16.Foreign exchange: factors that influence the exchange rate
Chapter 17.Foreign exchange: risk identification and management
PART 6.DERIVATIVE MARKETS AND RISK MANAGEMENT
Chapter 18.An introduction to risk management and derivatives
Chapter 19.Futures contracts and forward rate agreements
Chapter 20.Options
Chapter 21.Interest rate swaps, cross-currency swaps and credit default swaps
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Financial institutions
Chapter 1 A modern financial system: an overview
Chapter 2 Commercial banks
Chapter 3 Non-bank financial institutions
Page 2
Part 1
FINANCIAL INSTITUTIONS
Career opportunities in finance are enormous and they are available to you if you dedicate yourself to learning and
understanding how the financial institutions, instruments and markets work. You should be excited that one day you may,
for example, work in a commercial bank in Hong Kong or Sydney, or an investment bank in London or New York, or a
multilateral government organisation in Paris or Washington, or a multinational corporation anywhere in the world.
Further, it does not matter where you live or study; financial institutions, instruments and markets are essentially the
same in all developed countries. What you learn from this textbook will be relevant in the world of finance no matter
where your travels take you.
This textbook discusses the structure, functions and operations of a modern financial system; that is, you are going to
learn about financial institutions, financial instruments and financial markets. Each nation-state is responsible for
the structure and operation of its own financial system; however, they form an integrated global financial system.
Although institutions, instruments and markets are fundamentally alike, they may be differentiated by size, terminology,
the level of government regulation and prudential supervision. For example, in the UK the main type of financial
instrument issued on the stock exchange is called an ordinary share, whereas the same instrument issued in the USA is
known as common stock.
Internationalisation of the financial markets has, in part, occurred because of the development of sophisticated
technology-based information systems and product delivery systems. This has allowed new products and markets to evolve,
and an enormous increase in the volume and speed of the flow of funds through the international financial markets. As
will be seen, the combination of globalisation, deregulation, technology and competition has encouraged enormous
innovation and change within financial institutions, instruments and markets.
Much of what you will learn from this text is international in nature, but it will be necessary at times to focus on the
financial system of a particular nation-state. It is not possible to look at the variations that occur in the financial
systems of all nation-states. Therefore, when necessary, reference will be made to the Australian financial system as it
has a modern, efficient and stable financial system that operates effectively within the global financial system.
Page 3
Think of a financial system as being a number of financial institutions and markets through which funds move between
lenders and borrowers. The institutions and markets that facilitate this flow of funds develop the financial instruments
and techniques that encourage savings and investment. The financial system also provides the framework through which
central banks and prudential regulators influence the operations of participants in the financial system. Most
importantly, a central bank, through its monetary policy initiatives, affects the level of interest rates, economic
activity and business performance.
A financial system is essential in facilitating economic growth and future productive capacity in a country. The
provision of finance to business allows economic growth to occur, which should lead to increased productivity, increased
employment and a higher standard of living. A modern, sound and efficient financial system encourages the accumulation
of savings that are then available for investment in productive capital within an economy.
Chapter 1 presents an overview of a modern financial system and provides a context for the more detailed studies that
occur throughout the textbook. It introduces the main categories of financial institutions, discusses the functions of
financial markets and provides an overview of the types of instruments that are created within the markets. At the end
of Chapter 1, two extended learning sections are provided: ‘Globalisation of the financial markets’ and ‘The impact
of the Asian financial crisis on the financial system’.
Chapter 2 provides a detailed analysis of the roles and functions of the commercial banks. Commercial banks are the
largest financial institutions providing savings, lending and a wide range of other financial services for their
customers. The assets, liabilities and off-balance-sheet business of commercial banks are analysed in detail. At the end
of the chapter three extended learning sections are provided: ‘The standardised approach to credit risk’, ‘Business
continuity risk management’, and ‘Corporate governance and ethics’.
Chapter 3 extends the discussion of financial institutions further and looks at the operations and significance of other
types of financial institutions. In particular the chapter considers investment banks, managed funds, superannuation
funds, cash management trusts, public unit trusts, life insurance offices, general insurance offices, hedge funds,
finance companies, general financiers, building societies, credit unions and export finance corporations. At the end of
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the chapter an extended learning section is provided: ‘Project finance and structured finance’.

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Page 4
Chapter 1
A modern financial system:
an overview
Chapter Outline
1.1 Financial crises and the real economy
1.2 The financial system and financial institutions
1.3 Financial instruments
1.4 Financial markets
1.5 Flow of funds, market relationships and stability
Learning objectives
1. LO 1.1 Understand the effects and consequences of a financial crisis on a financial system and a real economy.
2. LO 1.2 Explain the functions of a modern financial system and categorise the main types of financial institutions,
including depository financial institutions, investment banks, contractual savings institutions, finance companies
and unit trusts.
3. LO 1.3 Define the main classes of financial instruments that are issued into the financial system, that is, equity,
debt, hybrids and derivatives.
4. LO 1.4 Discuss the nature of the flow of funds between savers and borrowers, including primary markets, secondary
markets, direct finance and intermediated finance.
5. LO 1.5 Distinguish between various financial market structures, including wholesale markets and retail markets, and
money markets and capital markets.
6. LO 1.6 Analyse the flow of funds through the financial system and the economy and briefly discuss the importance of
‘stability’ in relation to the flow of funds.
Extended learning
1. LO 1.7 Appreciate the importance of globalisation of the international financial markets.
2. LO 1.8 Appreciate the effects, consequences and relevance of the Asian financial crisis.
Page 5
Introduction
The real economy where goods and services are exchanged is connected to the financial markets where financial securities
are exchanged. Each affects the other. The development of financial markets has made the exchange of value for goods and
services much easier. The introduction of money into the exchange process increases the speed and efficiency with which
transactions take place. The use of monetary value also makes it easier to save surplus funds. In order to attract these
surplus funds for use in capital projects or consumption spending, businesses and governments issue financial securities
such as shares and bonds that entitle investors to a share of business profits or periodic interest payments. These
securities change hands on the financial markets at prices that reflect the prevailing business conditions, risk and
uncertainty and expectations of future returns.
Ups and downs are to be expected in the normal course of the business cycle. However, financial markets are sometimes
characterised by high levels of volatility. These periodic bursts of volatility send market participants running for
cover as the capital values of investments suddenly appear to have been overestimated. The ensuing liquidation and
crisis is the market's remedial action to correct the miscalculations of the preceding economic boom. In the modern
financial system, this liquidation can take place at terrifying speed. Although the particular circumstances of each
crisis are unique, we can be sure that at the depths of a crisis there will be calls for a review of the ways in which
the financial system is regulated. We start our study of the financial system with a discussion of the ways in which
financial markets and the real economy interact during periods of financial crisis.

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1.1Financial crises and the real economy

LEARNING OBJECTIVE 1.1
Understand the effects and consequences of a financial crisis on a financial system and a real economy
The most recent crisis was the global financial crisis (GFC). The GFC has been described as the most significant
economic crisis since the Great Depression in the 1930s. In 2007, realisation that house prices in America had begun to
fall and mortgage defaults were increasing, particularly in sub-prime mortgages which had been issued to low-income
individuals who were sometimes without a documented ability to meet the monthly repayments, initiated a liquidation of
trading positions in the mortgage markets which quickly evolved into a banking crisis. Uncertainty about the value of
assets posted as collateral and the solvency of counterparties significantly disrupted the financing arrangements upon
which financial institutions relied to fund their activities. Uncertainty about the solvency of financial institutions
flowed through the financial system. Unable to fund their activities through the usual channels, some financial
institutions were forced to seek equity capital injections from investors or obtain emergency funding from central
banks. Some were bailed out by their sovereign government. Others were forced to sell themselves to stronger financial
institutions. Many others were forced to file for bankruptcy.
GLOBAL FINANCIAL CRISIS (GFC) the global financial crisis (GFC) refers to the financial crisis of 2008 that has been
traced to the collapse of the housing market in the United States and the consequences of that collapse for the market
for mortgage-related securities
SUB-PRIME MORTGAGES loans to borrowers that under normal credit assessment standards would not have the capacity to
repay
The effects of the crisis flowed into the ‘real’ economy. Economic growth in the USA slowed considerably. According to
the Bureau of Economic Analysis (www.bea.gov), from the second half of 2008 through the first half of 2009, the USA
experienced four consecutive quarters of negative economic growth (falling gross domestic product or GDP). Contributing
to this were severe declines in private investment, including back-to-back declines of 36 per cent and 42 per cent in
2009. The Bureau of Labor Statistics (www.bls.gov) recorded a steep increase in the unemployment rate in the USA, which
doubled from 5 per cent in 2007 to just over 10 per cent in 2009. Amid the uncertainty and economic turmoil, financial
markets continued to reel. Share markets in most of the advanced economies experienced precipitous falls and at the
depths of the crisis had recorded losses of more than 50 per cent. The American stock market alone experienced losses in
2008 of $8 trillion. Currency markets were not immune from the volatility. The Australian dollar experienced
depreciations of more than 30 per cent against the major currencies.
During the crisis, a number of prestigious Wall Street firms lost their independence or failed completely. Bear Stearns
was purchased by JPMorgan Chase & Co. for just $10 per share in March 2008, after trading at $150 per share a year
earlier. In July, the mortgage broker IndyMac was placed in ‘conservatorship’ by the US government. In September, two
government-chartered mortgage lenders, Freddie Mac and Fannie Mae, were similarly placed in the care of the US
government. Lehman Brothers collapsed in mid-September. At the same time that Lehman Brothers tried in vain to arrange a
bailout or takeover, Merrill Lynch sold itself to Bank of America to avoid a Lehman-style collapse. Lehman Brothers'
collapse created enormous market volatility as market participants struggled to predict the effects of the investment
bank's failure on the intertwined network of trades that characterises the financial markets. Governments and central
banks desperately tried to stabilise the markets. Meanwhile, other financial institutions found themselves under
tremendous pressure. Washington Mutual was placed in receivership. Wachovia was purchased by Wells Fargo. AIG was
effectively taken over by the Federal Reserve.
Page 6
FEDERAL RESERVE the central bank of the USA
Banks and other financial institutions are always vulnerable to ‘runs’. These are situations where all at once many
customers demand their money back from a financial institution. Financial institutions do not operate with 100 per cent
reserves and cannot possibly meet all of these demands. Before the GFC, financial institutions became more vulnerable
because of maturity mismatching in their financing arrangements. Most financial institutions had become reliant on very
short-term or overnight financing to finance their operations. Repurchase agreements or ‘repos’ are very short-term
funding arrangements and financial institutions had come to rely heavily on overnight repo financing in the decade
before the crisis. During the crisis, when financial institutions became wary about the solvency of their counterparties
(and themselves), repo financing became either increasingly expensive or impossible to secure. Without the overnight
repo markets, financial institutions did not have the capital to sustain their operations for any length of time. This
was exacerbated by the redemption and withdrawal requests being received from investors and depositors. Bear Stearns,
for example, found that it was unable to secure repo financing once doubts surfaced about its solvency. Although Bear
Stearns had more than $18 billion in capital, this fell far short of what was required to finance its day-to-day
operations. Bear Stearns was taken over by JPMorgan Chase & Co. just a few days after its repo financing evaporated.
With Bear Stearns gone, the financial markets awaited the next ‘domino’ to fall.
When the crisis hit, information about the market value of the securities traded among financial institutions and the
magnitude of financial obligations of particular institutions was difficult or impossible to obtain. Collateralised debt
obligations (CDOs), which are portfolios of mortgages and other loans arranged into ‘tranches’ according to levels of
risk, are complex by nature because it is very difficult to determine the quality of the numerous individual loans in
each of the tranches. This complexity and the absence of liquid secondary markets for the securities led to large writedowns in the estimated values of these securities when financial institutions realised that there were no buyers willing
to engage in transactions at prices even close to the previously recorded selling prices. With prices falling, writedowns in the value of positions in these markets spiralled downwards. Uncertainty about which institutions held the
riskiest CDO tranches contributed to financial institutions' unwillingness to extend financing to their counterparties.
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To make matters even worse, buyers of CDOs had usually entered into credit default swaps (CDSs) with other financial
institutions. CDSs were designed to insure their buyers against default on bonds, tranches or by institutions. As CDOs
fell rapidly in value and financial institutions reeled, the large outstanding liabilities potentially facing the
‘sellers’ of CDSs and the uncertainty over how much insurance had been sold by which institutions contributed further
to the spiral in valuations, balance sheet write-downs and the viability of financial institutions.
Although most of the drama and many of the popular accounts of the crisis focused on Wall Street and its ‘blue-blood’
banking establishments, as time has passed the GFC has come to be thought of as having two main parts. The first, which
we have just described, was the initial liquidation of assets due to the trouble emanating from and engulfing the Wall
Street banks. The second was what has come to be known as the eurozone crisis or the sovereign debt crisis. This
second instalment of the GFC emanated from and engulfed the central banks of a number of European countries. That is, in
‘part two’ it was country or government debt, otherwise known as sovereign debt, that became ground zero as the crisis
evolved.
EUROZONE CRISIS or SOVEREIGN DEBT CRISIS the economic and international financial crisis that followed the GFC,
which saw multiple European governments seek bailouts from the European Central Bank (ECB) and other stronger European
countries
The eurozone crisis can be traced to late 2009 when the new Greek government announced that its deficit, understood by
the world financial community to already be an astronomical 113 per cent of the country's national income, was actually
twice as large, or more than 220 per cent of the country's gross domestic product. There was a very great possibility
that Greece would fail to meet its obligations to investors in Greek sovereign debt (Greek government bonds). This
immediately precipitated panic in the international bond markets.
Like any market, investors need to have confidence that they will receive the cash flows they are entitled to and the
issuer of the debt, whether it is a corporation or a government, will not default on its obligations. It looked like
Greece might do just that. The panic in the international bond markets led to a collapse in bond prices and a spike in
the cost of borrowing for governments suspected of being in a similar position to Greece, especially Ireland, Spain,
Portugal and Italy. Government services and welfare programs became the victims of harsh austerity measures. As the
government sector of these economies was curtailed, national incomes fell rapidly and other economic indicators
deteriorated.
The economic booms in these now troubled countries had been fuelled by money coming from banks in other European
countries, particularly in northern Europe. These banks held trillions of dollars in Greek, Irish, Spanish and Italian
debt, which were consequently trading at substantially lower prices. The trouble had spread north and west, like a
virus. This had disastrous and far-reaching economic consequences. National incomes fell precipitously in the worst
affected countries and unemployment soared. Most of the Eurozone, including relatively strong economies such as France
and Germany, soon found itself amid an economic malaise that has shown no real signs of abating. And so, the GFC
continues to ripple through the global economic and financial system.
Page 7
A number of explanations for the GFC have been proposed. These include greed, irrationality, fraud, the inherent
instability of capitalism, the disproportionate size of the financial sector compared to the manufacturing or ‘real’
sector of the economy, shadow banking, lax lending standards, deregulation and free-market policies, over-reliance on
badly designed mathematical models for measuring risk, inappropriate incentives structures within financial
institutions, ‘captured’ ratings agencies that were too lenient in rating mortgage debt, out-of-control financial
innovation and misguided government or central bank policy. There are many different points of view and strong and
convincing arguments can be made for each of the possible explanations for the GFC. Whatever role each of these factors
might have played, the fundamental explanation for the GFC is quite straightforward. Throughout the early 2000s, central
banks, particularly the US Federal Reserve, set interest rates at very low levels. This created a boom in consumption,
housing and other asset prices driven by easy credit available throughout the economic system. In the absence of
increasingly intense credit expansion, sooner or later the credit-driven boom had to come to an end. The larger and
longer the boom, the more catastrophic must be the ensuing recession or depression. Despite the unique circumstances of
each individual case, all economic crises can be traced to this same root cause.
Following the onset of the crisis, governments and central banks around the world undertook unprecedented interventions
in the financial and economic systems. In America, for example, the federal government arranged a $700 billion bailout
plan and, as we have seen, even took ownership of some financial institutions. In Australia, the federal government
implemented a guarantee on deposits with banks, building societies and credit unions to prevent ‘runs’ on these
institutions by their customers. As the banking crisis gave way to concerns about economic growth, governments turned
their attention to fiscal stimulus to encourage economic activity and prevent recession. In Australia, the government
implemented two stimulus packages totalling more than $50 billion in late 2008 and early 2009. Various factors
contributed to greater stability in Australia during the crisis and a mitigation of its effects on the real economy.
However, the effects of the GFC continue to be felt in most parts of the developed world and, although Australia managed
to navigate the crisis better than other countries, dealing with the legacy of the GFC will present a challenge for many
years to come.
Many lessons might be learned from the GFC. A stable financial sector is vital to the health of the overall economy.
Perceived mistakes by regulators, including allowing interest rates to remain at very low levels for long periods of
time, as well as perceptions that the crisis was caused by a financial sector that is out of control, have sparked calls
for strong regulatory reforms. Innovative financial products and securities, such as CDOs and CDSs, present a challenge
to regulators. New products do not always fall within the scope of existing regulations. The incentive arrangements and
governance within financial institutions is another factor that attracted the attention of critics before, during and
after the GFC. Regulations that limit compensation packages within the financial sector or realign incentive structures
such that they do not encourage large amounts of risk taking represent attractive options to those who are critical of
perceived excesses within the financial sector. Finally, the way that risk is managed within financial institutions has
emerged as a very prominent subject. Risk is intertwined and interrelated. The existence of one risk will change the
dynamics of other risk exposures. With the GFC, it appears that there was a lack of understanding of who was ultimately
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