Financial Institutions (HSC SSCE Business Studies): Revision Notes
Financial Institutions
Introduction
Financial institutions are organisations that collect funds from savers and channel these funds into financial assets. They provide essential financial services and facilitate transactions including investments, loans and deposits. While banks are the most common source of finance for businesses, funding is also available from investment banks, finance companies, superannuation funds, life insurance companies, unit trusts and the Australian Securities Exchange.
The Role of Financial Intermediaries
Financial institutions act as intermediaries between those who have surplus funds (savers) and those who need funds (borrowers). This intermediary role is critical to the functioning of the economy, as it allows businesses to access the capital they need for operations and growth.
Banks
Banks are the major operators in financial markets and represent the most important source of finance for Australian businesses. They offer a comprehensive range of financial products and services to meet the diverse needs of individuals, businesses and governments.
Services offered by banks
Banks provide traditional services such as:
- Credit cards and cheque facilities
- Overdrafts and loan products (personal, business and mortgages)
- Investment and savings accounts
- Insurance products
- Internet banking and ATM access
- Financial advice and planning
Beyond traditional banking, modern banks also offer:
- Business banking services
- Trading in financial markets
- Stockbroking services
- Funds management
How banks make profit
Understanding Bank Profitability
Banks operate as profit-driven businesses. They accept deposits from savers (individuals, businesses and governments) and pay a relatively low interest rate on these deposits. The bank then lends this money to borrowers at a higher interest rate. The difference between the interest rate paid to depositors and the interest rate charged to borrowers represents one of the key ways banks generate profit.
Worked Example: Interest Rate Spread
If a bank pays 2% interest on savings accounts but charges 6% interest on business loans, the 4% difference (known as the interest rate spread) contributes to the bank's profit margin.
This means for every $100,000 in deposits, the bank:
- Pays $2,000 to depositors
- Earns $6,000 from borrowers
- Generates $4,000 in profit from the spread
The Big Four
Australia currently has 53 banks operating, but the market is dominated by four major institutions:
- ANZ Banking Group
- Commonwealth Bank of Australia (CBA)
- National Australia Bank (NAB)
- Westpac Banking Corporation
These four banks hold the majority of market share in Australian banking.
Investment banks
Investment banks specialise in providing financial services primarily to the business sector rather than individual consumers. They offer customised borrowing and lending solutions tailored to specific business needs. A prominent example in Australia is Macquarie Bank.
Key services provided by investment banks
Investment banks offer sophisticated financial services including:
- Trading in money markets, securities and financial futures
- Arranging long-term finance for company expansion projects
- Providing working capital solutions
- Arranging project finance for large-scale developments
- Advising clients on foreign exchange risk management
- Providing advisory services for mergers and takeovers
- Portfolio investment management
- Underwriting corporate and semi-government securities issues
- Operating unit trusts (cash management, property and equity trusts)
- Arranging overseas finance
Conditions on loans
Equity Stakes as Loan Conditions
Investment banks may impose specific conditions when lending to businesses. For instance, they might require an equity stake in the borrowing business, giving the investment bank partial ownership in exchange for providing capital. This arrangement allows investment banks to share in the potential upside of the business while providing necessary funding.
Finance companies
Finance companies are non-bank financial intermediaries that specialise in providing smaller-scale commercial finance. They fill an important gap in the market by serving businesses that may not meet traditional bank lending criteria or require more flexible arrangements.
Services provided
Finance companies focus on:
- Short-term and medium-term business loans
- Consumer hire-purchase arrangements
- Personal loans with security
- Lease finance (they are the major providers in this area)
- Factoring services (purchasing accounts receivable)
- Cash flow financing solutions
How finance companies raise funds
Finance companies raise capital through issuing debentures. A debenture is a type of debt instrument that:
- Has a fixed term (maturity date)
- Pays a fixed rate of interest
- Provides security to lenders through priority claim over the company's assets if liquidation occurs
Debenture Security
If a business that borrowed from a finance company fails, the finance company has the right to sell the business's assets to recover the original loan amount. This priority claim over assets makes debentures a relatively secure form of investment for those who purchase them.
Trade-offs for borrowers
The Cost of Convenience
While finance companies can provide rapid access to funds, this convenience typically comes at a cost — interest rates are usually higher than those charged by traditional banks. Businesses must weigh the benefit of quick, flexible financing against the increased cost of borrowing.
There are currently 144 registered finance companies operating in Australia.
Life insurance companies
Life insurance companies are non-bank financial intermediaries that provide financial protection in the event of death or other specified circumstances. Policyholders pay regular premiums, and in return, the insurer guarantees to pay a lump sum to designated beneficiaries when the insured person dies or when other conditions specified in the policy are met.
Investment role
Life insurance companies play a significant role in providing capital to businesses. The premiums collected from policyholders create large pools of funds called reserves. These reserves must be invested to generate returns that will cover future claims. Life insurance companies invest these funds in:
- Corporate shares (equity)
- Business loans (debt)
- Property and other financial assets
This makes life insurance companies important providers of both equity and debt finance to the corporate sector.
Contemporary issues
COVID-19 Impact on Life Insurance Claims
The COVID-19 pandemic has significantly impacted life insurance claims patterns. While claims related to health insurance and car accidents decreased during lockdowns, there has been a substantial surge in claims for income protection and total permanent disability linked to mental health conditions such as depression.
In 2019, Australian life insurers paid out $750 million in mental health-related claims to nearly 7000 Australians, representing a 53% increase in mental health disability payouts over five years.
Superannuation funds
Superannuation is a government-mandated retirement savings scheme that requires all employers to make financial contributions to a fund on behalf of their employees. These contributions accumulate over an employee's working life to provide income support during retirement.
Compulsory superannuation requirements
Understanding Compulsory Superannuation
The federal government introduced compulsory superannuation in 1992. This system is mandatory, not optional, for employers.
Under current legislation:
- Employers must make contributions for all employees aged 18 to 69 who earn more than $450 (before tax) in a calendar month
- Employers must also contribute for employees under 18 who work more than 30 hours per week and earn above the $450 threshold
- The current contribution rate is 9.5% of an employee's salary
- These contributions are paid on top of the employee's wages (not deducted from wages)
Planned increases to the superannuation guarantee
Legislation provides for staged increases in the superannuation guarantee rate:
| Period | Superannuation guarantee rate |
|---|---|
| July 2014 – June 2021 | 9.5% |
| July 2021 – June 2022 | 10% |
| July 2022 – June 2023 | 10.5% |
| July 2023 – June 2024 | 11% |
| July 2024 – June 2025 | 11.5% |
| July 2025 onwards | 12% |
Investment approach
Superannuation funds invest the contributions they receive in diversified portfolios to generate returns for members. Common investments include:
- Company shares (Australian and international)
- Property (commercial and residential)
- Managed funds
- Fixed interest securities
The goal is to grow members' retirement savings through investment returns over time.
Regulation
Prudential Regulation of Superannuation
The Australian Prudential Regulation Authority (APRA) serves as the prudential regulator of the Australian financial services industry, including superannuation funds. APRA oversees the sector to ensure funds are managed prudently and members' interests are protected.
Importance as a capital source
The growth of compulsory superannuation has created enormous pools of investment capital. Over 25 years, superannuation funds have become major investors in Australian businesses, providing substantial equity and debt finance to the corporate sector. This makes superannuation funds increasingly important sources of capital for business finance.
Unit trusts
Unit trusts (also called mutual funds) pool money from many small investors and invest these combined funds in specific types of financial assets. This structure allows individual investors with limited capital to access professional investment management and diversified portfolios.
Investment options
Unit trusts can invest in various asset classes including:
- Cash and money market instruments
- Australian shares
- International shares
- Fixed interest securities (such as government bonds)
- Property (commercial and residential)
- Commodities (some unit trusts invest in gold, silver, oil and gas)
Structure and management
Unit trusts are typically connected to professional management firms that:
- Make investment decisions on behalf of unitholders
- Manage a diversified portfolio to spread risk
- Charge management fees for their services
How unit trusts work
Worked Example: Unit Trust Operation
The process operates as follows:
Step 1: Investment Multiple investors contribute funds to the unit trust. For example, 1000 investors each contribute $5,000, creating a pool of $5 million.
Step 2: Pooling The trust pools all investor money together, creating a single large investment fund.
Step 3: Management A professional fund manager invests the pooled funds in a portfolio of investment assets (such as shares, property, and bonds).
Step 4: Returns Investment earnings are distributed back to investors in the form of:
- Distributions (regular income payments from dividends or interest earned)
- Capital gains (profits when investments increase in value)
The pooling structure provides small investors with access to diversification and professional management that would otherwise be unavailable to them individually.
Australian Securities Exchange
The Australian Securities Exchange (ASX) is Australia's primary stock exchange. It was created through the merger of the Australian Stock Exchange and Sydney Futures Exchange in July 2006. The ASX operates as a marketplace where securities, particularly shares, are bought and sold.
Functions of the ASX
The ASX performs multiple critical functions:
- Market operator: Provides the platform for trading
- Clearing house: Ensures transactions are settled properly
- Payments system facilitator: Manages the financial flows
- Compliance oversight: Monitors adherence to operating rules
- Corporate governance promotion: Encourages high standards among listed companies
Products and services
The ASX offers trading in numerous financial instruments:
- Shares (equities)
- Futures contracts
- Exchange traded options
- Warrants
- Contracts for difference
- Exchange traded funds (ETFs)
- Real estate investment trusts (REITs)
- Listed investment companies
- Interest rate securities
Major stocks traded on the ASX include BHP Billiton, Commonwealth Bank, Rio Tinto, CSL and Westpac.
Primary market function
The primary market deals with the new issue of debt instruments and equity by businesses seeking capital. When a company issues new shares through the ASX primary market, it receives the proceeds from the sale of these securities. This represents new capital flowing into the business that can be used for expansion, operations or other corporate purposes.
Exam Tip: Primary Market
The primary market is where businesses raise NEW capital — this is a common exam question topic. Remember: primary = new securities issued = capital raised by the business.
Secondary market function
The secondary market involves the trading of existing securities between investors. When investors buy and sell pre-owned shares, the transaction occurs between the two investors — no new capital flows to the company whose shares are being traded.
Key characteristics of the secondary market:
- Involves individuals, businesses, governments and financial institutions trading existing securities
- Does not increase the total amount of financial assets in the economy
- Increases the liquidity of financial assets (ease of buying and selling)
- Indirectly influences the primary market by establishing prices and providing exit opportunities for investors
Exam Tip: Primary vs Secondary Markets
Understanding the distinction between primary and secondary markets is crucial for evaluation questions about how businesses raise capital.
- Primary market: NEW securities issued → Capital raised BY the business
- Secondary market: EXISTING securities traded → Capital flows BETWEEN investors (NOT to the business)
Accessing the share market
Investors can buy and sell shares through:
- Full service brokers: Provide investment advice and execute trades, but charge higher fees
- Online trading platforms: Allow investors to make their own decisions with lower fees
- Direct company offerings: Purchasing shares when a company conducts a public float
Exam guidance
Exam Question Strategies
When answering questions about financial institutions:
1. Identify questions Clearly state which institution is most appropriate for the scenario (e.g., banks for general business loans, investment banks for complex corporate finance)
2. Explain questions Describe how the financial institution operates and the services it provides (e.g., explain how banks act as intermediaries)
3. Analyse questions Examine the advantages and disadvantages of using a particular financial institution (e.g., finance companies provide quick access to funds but charge higher interest rates)
4. Evaluate questions Make a judgement about which financial institution would be most suitable, considering factors such as:
- Cost of finance (interest rates and fees)
- Speed of access to funds
- Flexibility of arrangements
- Amount of capital required
- Purpose of the finance
- Size and nature of the business
Key Takeaways
Remember These Key Points:
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Financial institutions act as intermediaries, collecting funds from savers and providing them to borrowers
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Banks are the most important source of business finance, earning profit through the interest rate spread between deposits and loans
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Investment banks provide customised corporate finance solutions and advisory services for complex transactions
-
Finance companies specialise in smaller commercial finance and leasing, raising funds through debentures
-
Life insurance companies invest premium reserves, providing both equity and debt to the corporate sector
-
Superannuation funds manage compulsory retirement savings (currently 9.5%, moving to 12% by 2025), investing in diversified portfolios
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Unit trusts pool money from small investors for professional management of diversified portfolios
-
The ASX operates both as a primary market (issuing new securities to raise capital) and a secondary market (trading existing securities to provide liquidity)
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The distinction between primary and secondary markets is critical: primary markets provide NEW capital to businesses, while secondary markets trade EXISTING securities between investors