Chapter One

An Overview of the Financial System

Introduction
Dear learner! In this chapter, you will deal about the concept financial system and concepts
that are related with it. In addition to this, you will learn about the role of financial system in the
economy. In order to study the effects of financial markets and financial intermediaries on the
economy, we need to acquire an understanding of their general structure and operation. In this
chapter we will learn about the major financial instruments that are traded in financial markets.
Finally, the lending and borrowing in the financial system will be discussed in detail. Have a nice
reading!

Chapter Objectives! After studying this chapter, you should be able to meet these learning
objectives:

 Explain the meaning of financial system;

 Describe the role of financial system in the economy;
 Describe the meaning of financial assets;
 Identify and explain the properties and roles of financial assets;
 Describe the meaning of financial markets;
 Identify and explain the role, classification and participants of financial markets;
 Understand the lending and borrowing in the financial system.
The role of financial system in the economy
Dear learner, can you give your definition of financial system?

The financial system is a collection of markets, institutions, laws & regulations, and techniques
through which bonds, stocks, and other securities traded, interest rates determined, and financial
services produced & delivered. It is a system that aims at establishing and providing a regular,
smooth, effective and efficient linkage between depositors and investors. The financial system of
nations might be either bank based, for instance, in the case of Ethiopia or market based as in
modern economies. In general, the financial system makes funds available for lending &
borrowing (credit). It is the means to reach the level of economic development nowadays
enjoyed by advanced economies.
The economic development of any country depends upon the existence of a well-organized
financial system. It is the financial system which supplies the necessary financial inputs for the
production of goods and services which in turn promote the well-being and standard of living of
the people of a country. The financial system of an economy consists of three components: (1)
financial markets; (2) financial intermediaries; and (3) financial regulators. Thus, the ‘financial
system’ is a broader term which brings under its fold the financial markets and the financial
institutions which support the system. The major assets traded in the financial system are money
and monetary assets. The responsibility of the financial system is to mobilize the savings in the
form of money and monetary assets and invest them to productive ventures. An efficient
functioning of the financial system facilitates the free flow of funds to more productive activities
and thus promotes investment. Thus, the financial system provides the intermediation between
savers and investors and promotes faster economic development.

The financial system determines:

 The cost of credit (interest rate), and

 The volume of credit that will be available to pay for goods/services.

The events in the financial system have powerful impact upon the health of the nation's
economy. In this regard, when credit becomes more costly and less available, total spending for
goods & services falls and businesses cut back production and reduces their investment, because
of which unemployment rises & the economy's growth slows down. On the contrary, when the
cost of credit declines and loanable funds become more readily available, total spending in the
economy increases, more jobs are created and the country’s economic growth accelerates.

The financial system is an integral part of the economic system and cannot be viewed in isolation
from it. The ultimate effect of financial operations is to increase the investment activity in the
economy/society and bring welfare by increasing the level of goods and services provided to the
needy.
Functions performed by the financial system

There are seven basic functions of the financial system in the modern society. These are:

 Savings Function;
 Wealth Function;

 Liquidity Function;

 Credit Function;

 Payments Function;

 Risk Function; and

 Policy Function;

 Savings Function

Financial markets & institutions provide a conduit for the public’s savings. In this regard, bonds,
stocks, deposits, and other financial claims sold in the money and capital markets provide a
profitable, relatively low-risk outlet for the public’s savings. The savings function of any
financial system, thus, supplies the vital raw material to investments (i.e. funds) so that the
economy can properly grow & flourish as well as the living standard in the society would be
improved.

 Wealth Function
For those businesses and individuals choosing to save funds, the financial instruments sold in the
money and capital markets provide an excellent way to store wealth (i.e. to preserve value or
hold purchasing power) until funds are needed for spending in future periods. While we might
choose to store our wealth in “things” [for instance, by purchasing home appliances, furniture,
clothes, possessing automobiles or personal car(s), and the like], such assets often are subject to
depreciation and as well carry greater risks of loss. However, the financial instruments (meaning
financial assets) do not wear & tear overtime, usually generate income, and, normally, their risk
of loss is much less than would be for other forms of storing wealth.

 Liquidity Function

For wealth that is stored in financial instruments, the financial markets provide a means of
converting those instruments in to ready cash with little risk of loss. The financial system
provides liquidity for savers that already purchased financial instruments but need funds and,
thus, willing to selloff these instruments at any given moment to investors in the market.
  Credit Function

The financial markets furnish credit to finance consumption and investment spending [i.e. loan
of funds in return for a promise of future payment(s)]. Consumers frequently need credit to
purchase a home, other consumable commodities & services, and retire outstanding debt
obligations. Businesses draw upon their lines of credit to stock their shelves, construct buildings,
meet payrolls, and grant dividends to their stockholders. State, local, and federal governments
frequently borrow to construct buildings and other public facilities and cover daily cash expenses
until tax revenues flows in. Nowadays, the volume of credit extended by money and capital
markets in the developed economies is huge and growing rapidly due to the respective growth of
their economy, inflation, and the tax deductibility of interest payments as all appear to have
resulted in credit expansion.

 Payments Function

The financial system also provides a mechanism for making payments for goods and services.
Certain financial assets, mainly checking accounts and NOW (Negotiable Order of Withdrawal)
accounts serve as a medium of exchange in the making of payments. (Note that NOWs have
become a common means of payments in advanced economies.) Plastic credit cards issued by
many banks, credit unions, and retail stores give the customer instant access to short-term credit.
They are widely accepted as a convenient means of payment.

 Risk Function

The financial markets offer to businesses, consumers, and government units a protection against
life, health, property, and income risks. This is accomplished, among other things, by sale of life
& property (or casualty) insurance policies. In addition to making possible the selling of
insurance policies, the money & capital markets have been used increasingly by businesses and
consumers to “self-insure” against risk. This simply means building up one’s holdings of
securities, deposits, and so on as a precaution against future loss. The liquidity of most financial
instruments makes it easy to raise spendable cash quickly in an emergency.

 Policy Function

Recent experiences in the advanced economies reveal that the financial markets have been the
principal channels through which governments carried out the policy of attempting to stabilize
 the economy and avoid excessive inflation. By manipulating the level of interest rates and the
availability of credit, governments can affect the borrowing and spending plans of the public.
This, in turn, influences the growth of the economy, opportunities for jobs, increases in
production, and the rise in prices of goods & services.

Flows in the Economy

The basic function of any economy is to allocate scarce resources (i.e. material, financial, and
human resources) in order to produce the goods and services needed by society. Allocation of
scarce resources to produce the goods and services needed by the society is a complex task.
Allocation of resources is a complex task because of the scarcity of resources and unlimited
human want.

In short, any economic system must combine inputs – land & other natural resources, labor &
managerial skill, and capital – in order to produce outputs in the form of goods & services and
provide to the society. This implies that the economy generates a flow of production (goods &
services) in return for a flow of payments.

Diagram 1.1: Flows in the Economic System

Flow of Production
Land & Other Natural Resources, Goods and Services Sold
Labor & Managerial Skill, and to the Public
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Capital.

Flow of Payments
The flow of payments and production within the economic system can also be considered a circular
flow between producing units and consuming units. By definition, the producing units are those
economic units that involve in capital formation (mainly are businesses and governments); and the
consuming units are those economic units that possess factors of production and sell these inputs to
the producing units in order to generate income.

Diagram 1.2: Circular Flow of Production and Payments

Flow of Expenditure

Flow of Production of Goods & Services

Producing Consuming Units

Units

Flow of Productive Services

Flow of Income
In modern economies, households provide labor, managerial skills, and natural resources to
business firms and governments in return for income in the form of wages, rents, dividends, and
so on. Most of the income received by households is spent to purchase goods & services. The
result of this spending is a flow of funds back to producing units as an income, which in turn
stimulates the producing units to produce more goods & services in future periods. The circular
flow of production and income, thus, is an inter-dependent – and never ending – process.

Financial assets: role and properties

Dear learner, can you define financial assets?

An asset is any resource that we expect to provide future benefit and, hence, has economic
value. We can categorize assets in to two types: tangible assets and intangible assets.
Tangible asset is an asset that has physical existence. An intangible asset represents a legal claim
to some future economic benefit or benefits. Financial assets, such as stocks and bonds, are also
intangible assets because the future benefit come in the form of a claim to future cash flows.

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 Financial assets are special forms of assets that represent claims against the assets or resources of
other economic units, which are held as a store of value and for the return that is expected. In
other words, they are claims against the income or wealth of a household, a business firm, and/or
a unit of government. While the value of a tangible (or physical) asset depends on its physical
properties, a financial asset represents a claim to future cash flows in the form of interest,
dividends, and so on.

With regard to their features, financial assets are represented by a certificate, receipt, or other
legal document that are created by the lending of money, that is, transfer of funds from surplus
spending economic unit to another – deficit spending – economic unit. Stocks, Bonds, Insurance
Policies, Deposits, and the like are among the examples of financial assets. In general, financial
assets do have diverse characteristics that make them different from other, conventional forms of
assets. The following are the major characteristics of financial assets:

 They do not provide a continuing stream of services to their owners as do “real

assets”.
 They are promises to future returns to their owners.
 They serve as a store of value/store of purchasing power.
 They cannot be depreciated or do not wear & tear over time. Moreover, their physical
condition is not relevant in determining their market value.

 They are represented by a piece of paper that serves as a contract.

 They do have little and/or no value as a commodity.
 They do have low (or minimal) transport & storage costs relative to their value.
 They are fungible, that is, easily changed inform. Financial assets are easily transacted
& converted in to some other form; in other words, they are easily interchanged with –
or substituted for – other assets.
Kinds/Classification of Financial Assets

Although the diverse kinds of securities created and/or issued whenever money is borrowed and
lent in the financial system that constitute what we call financial assets. Depending on the nature
of the claim financial instruments can be categorized in to two. These are equity and debt
securities.

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1. Equities (Stocks):

Stocks or shares are one kind of financial assets that represent claims against a firm’s profit &
proceeds from sale of assets. They are “ownership” securities.

2. Debt Securities:

Debt securities are also referred to as IOUs (I owe you). Some of the debt securities are bonds,
notes, mortgages, debentures, and all other payables. Debt securities legally entitle the holders a
priority claim. The claims are fixed in amount & time (or maturity).

Debt securities may be:

 Negotiable – that can be transferred from holder to holder; or

 Non-Negotiable – that cannot legally be transferred to another party.

In addition to the above three kinds of financial assets, there are hybrid forms of financial
assets – for instance, preferred stocks and convertible bonds – that exhibit the characteristics of
both debt and equity. Moreover, considering the characteristics of the issuers of the various
financial instruments, we may classify financial assets in terms of direct (or primary), indirect
(or secondary), and derivatives (“conditional”) claims. The meaning and characteristics of
each of these claims is discussed below.

Direct (Primary) Claim(s):

Direct (or primary) claims are those securities that are directly issued by business firms and
governments in order to raise funds from the public and referred to as direct claims (or primary
claims). Examples of primary claims include Shares, T-Bills, Bonds (or Debentures), etc.

Indirect (Secondary) Claim(s):

Indirect financial assets are claims against financial intermediaries (i.e. those instruments issued
by financial intermediaries, such as banks, insurances, etc). Note that financial intermediaries
mainly raise funds from the public by issuing their own – secondary – claims and then transfer
these funds to satisfy the financial needs of business firms and governments through lending
those funds – i.e. purchasing primary claims. Examples of secondary claims include Checking &
Saving Accounts; Health, Life, and Accident Insurance Policies; Retirement Plans; and Shares in
Mutual Funds.

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 Derivatives (Conditional) Claim(s):

Derivatives are those financial instruments whose values are derived from the values of some
other asset or market indexes.

The term “conditional”, perhaps, may not be scientific and is used in this module just to describe
derivative instruments, whose value depend conditionally on the value of some other asset or
market indexes. Examples of derivatives include options, forwards, and futures contracts the
values of which are derived from the value of some other assets and/or indices.

The prevalence of a variety of securities to suit the investment requirements of heterogeneous

investors offer different investment choice to them and are an important element in the maturity
and sophistication of the financial system.

Financial markets: role, classifications and participants

The financial system fulfills its various roles through various forms of markets wherein financial
claims & services are traded. Financial market is a market where financial instruments (financial
assets) can be bought or sold. Although the existence of financial market is not a necessary
condition for the creation and exchange of a financial instrument, in most economies financial
instruments are created and subsequently traded in some type of financial market. The purpose of
financial markets in an economy is to allocate savings efficiently during a period of time – a day,
a weak, a month, or a quarter – to those economic units that use funds for investments in real
assets or else spend for consumption purposes. Through these markets, there moves a vast flow
of funds, continually being drawn upon by demanders of funds and continually being replenished
by suppliers of funds.
The role of financial markets

Financial markets provide three major economic functions. These are:

A. Determination of the price of the traded asset. The interaction of buyers and sellers in the
financial market determine the price of the traded asset. Or, equivalently, they determine the
required return on a financial instrument. Because the inducement for firms to acquire funds
depends on the required return that investors demand, this feature of financial market signals
how the funds in the financial market should be allocated among financial instruments.

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 B. A mechanism for an investor to sell financial instrument (liquidity). Financial markets
provide a mechanism for an investor to sell a financial instrument. Because of this feature, it
is said that a financial market offers, liquidity, an attractive feature when the circumstances
either force or motivate an investor to sell.
C. Reduction in the cost of transaction (search cost and information cost). There are 2 costs
associated with transacting: searching cost and information cost. Search cost represents
explicit cost, such as the money spent to advertise one’s intention to sell or purchase a
financial instrument, and implicit costs, such as the value of time spent in locating
counterparty. The presence of some form of organized financial market reduces search cost.

Information costs are costs associated with assessing the investment merits of a financial
instrument.
Classification of Financial Markets

The flow of funds through financial markets may be divided in to different market segments
depending upon the characteristics of financial claims being traded and the needs of different
groups. In general, these segments can be categorized under any one of the following four forms
of financial markets:

A. Money Market versus Capital Market;

B. Open Market versus Negotiated Market;
C. Primary Market versus Secondary Market; and/or
D. Spot Market versus Forward, Futures, and Options Markets.
Money Market versus Capital Market
1. Money Market

The money market is designed for the making of short-term loans. It is the institution through
which individuals and institutions with temporary surpluses of funds meet borrowers who have
temporary funds shortages. It enables economic units (principally business firms and
governments) to manage liquidity.

By convention, money market securities are maturing within one year or less. One of the money
market’s principal functions is to finance the working capital needs of corporations and to
provide governments with short-term funds until tax funds are collected. The money market also
supplies funds for speculative buying of securities and commodities.
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 Suppliers of Funds

In the money market, commercial banks are the most important institutional suppliers of funds
(lenders) to both business firms and governments. Non-financial business corporations with
temporary cash surpluses also provide substantial short term funds to banks, securities dealers,
and other corporations.

Demanders of Funds

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The government treasury is often the largest demander of money market funds in most nations.
In addition, the largest and best-known corporations and securities dealers are active borrowers
in the money market through their offerings of short-term notes.

Instruments that are traded in the money market are:

 Treasury bills: are short term government IOUs means I owe you and hence, are safe and
popular investment medium for financial institutions and corporations of all sizes. They
are issued at discount.
 Certificates of deposit (CDs): are issued by largest, best known commercial banks and
other depository institutions. The issuers use the funds raised from CDs and other sources
to extend loans to corporations and other borrowers.
 Bankers’ acceptance and Commercial paper: both are short term IOUs issued by large,
well-established borrowers of funds.
 Federal funds: Federal funds are essentially reserve balances of banks held by federal
reserve. (it is the National bank that plays the central banking role such as accepting
reserve deposits of commercial banks in the context of Ethiopia)
 Euro currency:
2. Capital Market

The capital market is designed to finance long-term investments by businesses, governments, and
households. Funds raised in the capital market makes possible the construction of factories,
highways, schools, residential buildings, and the like. Such financial instruments have original
maturities of more than one year and range in size from small loans to very large, multimillion
credits.

Suppliers of Funds

The suppliers of funds in the capital market are more varied than in the money market. The bulk
of long-term funds in the capital market, however, are provided by financial institutions such as
banks, insurance companies, and pension funds.

Demanders of Funds

Among the demanders of funds in the capital market, families & individuals, who need such
funds in order to finance purchase and/or construction of a new home. Moreover, State & local
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 governments also rely on such funds to build schools, highways, and other infrastructures as well
as provide essential services to the public.

Instruments that are traded in the capital market are:

 Mortgage loans: often constitute the larger segment of ling-term funds meant to support
the building of homes, apartments and business structures such as factories and shopping
centers.
 Tax exempt( free tax) (municipal) bonds: these are issued by state and local governments.
 Consumer loans: are provided to households to make purchases ranging from automobiles
to home appliances.
 Eurobonds and Euro notes: are international capital market instruments.
 Corporate stock market: is the best-known segment of the capital market for individual
stocks represented by the major exchanges.
 Corporate Notes and Bonds: are issued to raise long-term funds and they are traded in the
over-the-counter (OTC) market.
Open Market versus Negotiated Market
2. Open Market

Some corporate bonds & stocks are sold in the open market to the highest bidder and bought and
sold many number of times before the corporate bonds are paid off. The open market, in this
regard, is competitive. The world’s major stock exchanges are examples of open markets.

3. Negotiated Market

In the negotiated market for corporate bonds, securities generally are sold to one or a few buyers
under private contract and held to maturity. For instance, a loan from a bank represents a
negotiated market. Securities are sold under a privately negotiated “treaty” with one or a few
buyers.

Primary Versus Secondary Market

1. Primary Market

Primary market is a market for the trading of new securities that never issued before. Its principal
function is the raising of financial capital to support new investment in buildings, equipment, and
inventories.
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 The following are examples of transactions undertaken in the primary market: Issuance (or sell)
of new shares to investors, Borrowing money through a new mortgage agreement, or Negotiating
a loan at a bank.

2. Secondary Market

The secondary market deals in securities that are previously issued. Its chief function is to
provide liquidity to security investors, i.e. provide an avenue for converting existing stocks,
bonds, and other securities in to ready cash.

The following are examples of transactions undertaken in the secondary market: Sale or re-sale
of shares (stocks) or bonds currently held to other investors, Purchase of securities currently
bought & sold (traded) in the market, and so on.

The volume of trading in the secondary market is by far larger than the trading in the primary
market. However, the secondary market does not support new investments. The funds exchanged
(generated) in the secondary market often do not go to – or do not reach – the original issuers of
these securities (i.e. firms)). Rather as trading of securities in the secondary market made among
investors, the funds are also transferred from one investor to another in the market.

Nevertheless, the primary & secondary markets are closely intertwined, i.e. a rise in interest rates
or security prices in the secondary market usually leads to a similar rise in prices or rates on
primary market securities and vice versa. This happens because investors frequently switch from
one market to another in response to differences in price and yield

In addition, investors tend to be more willing to purchase new securities when they know they
can sell them in the secondary market. In some occasions, however, new securities may directly
be issued and sold to investors in the secondary market.

Spot versus Futures, Forward, and Option Markets

1. Spot Market

The spot market is a market where securities or financial services are traded for immediate
delivery (usually within one or two business days).

2. Futures or Forward Market

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The futures or forward market is designed to trade contracts calling for the future delivery of
financial instruments. It is a market for issuing and trading on contracts to purchase or sell
securities at some future date. The purpose of such a contract would be to reduce investor’s risk
by agreeing on a price today rather than waiting until the actual event occurs.

3. Options Market

An option is a special kind of futures contract that gives an investor the “right” not the obligation
to either buy from – or sell to – the writer of the option designated securities at a guaranteed
price at any time during the life of the contract. In option contracts, the option writer is obliged to
fulfill the contract upon the request of the option holder (the investor), however. Options market
offers investors in the money & capital markets an opportunity to reduce the risk of adverse
changes in security prices. Such markets make possible the trading of options on selected stocks
and bonds. When the option agreement expires, however, it can no longer be used and/or
becomes worthless.

Lending and borrowing in the financial system

Business firms, households, and governments play a wide variety of roles in modern
financial systems. It is quite common for an individual or institution to be a lender of funds in

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 one period and a borrower in the next, or to do both simultaneously. Indeed financial
intermediaries, such as banks and insurance companies, are in the business of operating on
both sides of the financial markets, borrowing funds from customers by issuing attractive
financial claims and simultaneously making loans available to other customers. Virtually all
of us at one point or another in our lifetimes will be involved in the financial system as a
borrower or lender of funds, and probably both.
A number of years ago, two economists, Gurley and Shaw (1956, 1960), pointed out that
each business firm, household, or unit of government active in the financial system must
conform to the following identity:
Change in Change in
Expenditure out of Current Income Holdings of Debt Holdings of
Current Income (E) – Receipts (I) = and Equity (hD) – Financial Asset
In symbols, (hFA)

E – R = ΔD – ΔFA; Or else, R – E = ΔFA – ΔD

If our current expenditure (E) exceeds our current receipts (R), we usually make up the
difference by: Reducing our holdings of financial assets (–ΔFA) – for example, by drawing
money out of a savings account, issuing debt or stock (+ΔD) or Using some combination of
both. On the other hand, if our receipts (R) in the current period are larger than current
expenditures (E), we can: Build up our holdings of financial assets (+ΔFA) – for example, by
placing money in a savings account or buying a few shares of stock, Payoff some outstanding
debt or retire stock previously issued by our business firm (–ΔD) or Do some combination of
both.
It follows that for any given period of time (for example, week, month, or year), the
individual economic unit must fall in to one of three groups:
2.
Deficit-Budget Unit
3. E > R; and so ΔD > ΔFA
4. (Net Borrower of Funds)
5.
6. Surplus-Budget Unit R > E; and, thus, ΔFA > ΔD
7.
8. (Net Lender of Funds)

A net lenderBalanced-Budget
of funds is really a net supplier of funds to the financial system. He or she
Unit R = E; and, therefore, ΔD = ΔFA
accomplishes this function by purchasing financial assets, paying of debt, or retiring equity
(Neither Net Lender nor Net Borrower)
(stock). In contrast, a net borrower of funds is a net demander of funds from the financial The

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business and government sectors of the economy tend to be net borrowers (demanders)
of funds, while the household sector, composed of all families and individuals, tends to
be a net lender (supplier) of funds.
Over any given period of time, of course, any one household, a business firm, or
unit of government may be a deficit –, surplus –, or balanced – budget unit. Most
of the large institutions that interact in the nation’s financial markets continually
fluctuate from one side of the market to the other. This is also true of most
households today. One of the most important contributions of the financial
system to our daily lives is in permitting businesses, households, and
governments to adjust their financial position from that of net borrower to net
lender and back again, smoothly and efficiently.

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