Financial Institutions and Markets-Chapter One: An Overview of Financial System

CHAPTER ONE

AN OVERVIEW OF FINANCIAL SYSTEM

1.1 Introduction
This chapter is designed to introduce you to the basic concepts of the Financial Systems. The
first part of this chapter deals with the role of the financial system in the economy. Properties and
roles of the different types of financial assets that are created and traded in the financial system
are also discussed in the second part of this chapter. The third part of this chapter provides
information regarding the role, classification and participants of financial markets in the financial
system. Finally, the last part discusses the lending and borrowing in the financial system.

The financial system of an economy provides the means to collect money from the people who
have it and distribute it to those who can use it best. Hence, the efficient allocation of economic
resources is achieved by a financial system that allocates money to those people and for those
purposes that will yield the greatest return. Financial system is a system that aims at establishing
and providing a regular, smooth, effective and efficient linkage between depositors and
investors. Therefore, financial system is the collection of markets, individuals, laws, polices,
conventions, techniques and institutions through which bonds, stocks, and other securities are
traded, interest rates are determined and financial services are provided and delivered. The word
“system” in the term “financial system” implies a set (group) of complex and closely connected
or intermixed institutions, agents, practices, markets, transactions, claims, and liabilities within
an economy.

1.2 Basic Components of Financial System

A financial system refers to a system which enables the transfer of money between investors and
borrowers. Financial system has five basic components. They are:
 Financial Institutions
 Financial Markets
 Financial Instruments (Assets or Securities)
 Financial Services
 Money

1|Page
Financial Institutions and Markets-Chapter One: An Overview of Financial System

Figure 1: Five Basic Components of Financial System

1. Financial Institutions
Financial institutions facilitate smooth working of the financial system by making investors and
borrowers meet. They mobilize the savings of investors indirectly via financial markets, by
making use of different financial instruments as well as in the process using the services of
numerous financial services providers. They offer services to organizations looking for advises
on different problems including restructuring to diversification strategies. They offer complete
array of services to the organizations who want to raise funds from the markets and take care of
financial assets for example deposits, securities, loans, etc.

2. Financial Markets
A financial market is the place where financial assets are created or transferred. It can be broadly
categorized into money markets and capital markets. Money market handles short-term financial
assets (less than a year) whereas capital markets take care of those financial assets that have
maturity period of more than a year. The key functions are:
1. Assist in creation and allocation of credit and liquidity.
2. Serve as intermediaries for mobilization of savings.
3. Help achieve balanced economic growth.
4. Offer financial convenience.
One more classification is possible: primary markets and secondary markets. A primary market
handles new issue of securities in contrast secondary markets take care of securities that are
presently available in the stock market. Financial markets catch the attention of investors and
make it possible for companies to finance their operations and attain growth. Money markets
make it possible for businesses to gain access to funds on a short term basis, while capital
markets allow businesses to gain long-term funding to aid expansion. Without financial markets,
borrowers would have problems finding lenders. Intermediaries like banks assist in this

2|Page
Financial Institutions and Markets-Chapter One: An Overview of Financial System

procedure. Banks take deposits from investors and lend money from this pool of deposited
money to people who need loan. Banks commonly provide money in the form of loans.

3. Financial Instruments
This is an important component of financial system. The products which are traded in a financial
market are financial assets, securities or other type of financial instruments. There is a wide
range of securities in the markets since the needs of investors and credit seekers are different.
They indicate a claim on the settlement of principal down the road or payment of a regular
amount by means of interest or dividend. Equity shares, debentures, bonds, etc., are some
examples.

4. Financial Services
Financial services consist of services provided by Asset Management and Liability Management
Companies. They help to get the necessary funds and also make sure that they are efficiently
deployed. They assist to determine the financing combination and extend their professional
services up to the stage of servicing of lenders. They help with borrowing, selling and purchasing
securities, lending and investing, making and allowing payments and settlements and taking care
of risk exposures in financial markets. These range from the leasing companies, mutual fund
houses, merchant bankers, portfolio managers, bill discounting and acceptance houses. The
financial services sector offers a number of professional services like credit rating, venture
capital financing, mutual funds, merchant banking, depository services, book building,
etc. Financial institutions and financial markets help in the working of the financial system by
means of financial instruments. To be able to carry out the jobs given, they need several services
of financial nature. Therefore, financial services are considered as the 4th major component of
the financial system.

5. Money
Money is understood to be anything that is accepted for payment of products and services or for
the repayment of debt. It is a medium of exchange and acts as a store of value.

1.3 The Role of the Financial System in The Economy

Therefore, whether simple or complex, all financial systems perform at least one basic function.
They move scarce funds from those who save and lend (surplus-budget units) to those who wish
to borrow and invest (deficit-budget units). The following are some roles played by financial
system to enhance the economic growth of a country.

1. Facilitate the flow of funds from the savers to the investors: The first goal is to facilitate
the flow of funds from the savers (those entities having a surplus of funds) to the investors
(those entities with a deficit of funds). In the process, money is exchanged for financial assets.
However, the transfer of funds from savers to borrowers can be accomplished in at least three
different ways. These are: - direct finance, semi-direct finance, and indirect finance. Most

3|Page
Financial Institutions and Markets-Chapter One: An Overview of Financial System

financial systems have evolved gradually from direct finance toward indirect finance. Let see
them one by one as follows:
A) Direct Finance: Borrowers borrow funds directly from lenders in financial markets by
selling them securities (also called financial instruments). Borrowers and lenders meet each
other and exchange funds in return for financial assets. It is the simplest method of carrying
financial transactions. You engage in direct finance when you borrow money from a friend
and give him or her IOU (a promise to pay) or when you purchase stocks or bonds directly
from the company issuing them. We usually call the claims arising from direct finance
primary securities because they flow directly from the lender to the ultimate users of funds.
That means the investors sell their shares of stock or others directly to the general public in
an Initial Public offerings (IPO).

Direct Finance

Borrower or Funds Saver or Lenders

Spenders (Surplus budget units)
(Deficit budget units)
Primary securities (stocks, bonds,
notes, etc)

Primary Secondary
Securities securities
Financial
intermediaries

Loan able funds Loan able funds

Indirect Finance
Figure 1: the flow of funds in the financial system (direct and indirect finance)

The principal lenders or savers are households, but business enterprises and the government
(particularly state and local government), as well as foreigners and their governments, sometimes
also find themselves with excess funds and so lend them out. The most important borrower-
spenders are business and the government (particularly the federal government) but households
and foreigners also borrow to finance their purchases of cars, furniture, and houses.

 The following can be visible draw backs of this system:

i) Both borrower and lender must desire to exchange the same amount of funds at the
same time.

4|Page
Financial Institutions and Markets-Chapter One: An Overview of Financial System

ii) The lender must be willing to accept the borrower’s IOUs (a promise to pay), which
may be quite risky, illiquid or slow to mature.
iii) There must be a coincidence of wants between surplus and deficit – budget units in
terms of the amount and form of a loan. Without that fundamentals coincidence, direct
finance breaks down.
iv) Both lender and borrower must frequently incur substantial information costs simply to
find each other.
v) The borrower may have to contact many lenders before finding the one surplus – budget
unit with just the right amount of funds and willingness to take on the borrower’s IOU.

B) Semi direct Finance: Early in the history of most financial systems, a new form of financial
transaction appears which we call semi direct finance.
Borrower-Spenders (Deficit
PrimaryBudget Units) Saver-Lenders
Primary
Securities Security brokers and dealers (Surplus Budget Units)
Securities
Proceeds of security sales (less fees and commission)
Flow of
funds

Figure 2: the flow of funds in the financial system (semi-direct finance)

Here, some individuals and business firms become securities brokers and dealers whose essential
function is to bring surplus and deficit budget units together – thereby reducing information
costs. Broker is an individual or institution that provides information concerning possible
purchases and sales of securities. Either a buyer or a seller of securities may contact a broker,
whose job is simply to bring buyers and sellers together. Dealer is also an individual or
institution that serves as a middle man between buyers and sellers, but the dealer actually
acquires the seller’s securities in the hope of marketing them at a more favorable price. Dealers
take a position of risk because by purchasing securities outright for their own portfolios, they are
subject to risk of loss if those securities decline in value.

C) Indirect Finance: The limitations of both direct and semi direct finance stimulated the
development of indirect finance carried out with the help of financial intermediaries. The
process of indirect finance using financial intermediaries (institutions), called financial
intermediation, is the primary route for channeling funds from lenders to borrowers, (see
figure 1 above). Financial intermediaries issue securities of their own or buy securities issued
by corporations and then sell those securities to investors. Examples of such securities
include: checking and saving accounts, health, life and accident insurance policies, retirement
plan and shares in mutual fund.
1) They generally carry low risk of default.

5|Page
Financial Institutions and Markets-Chapter One: An Overview of Financial System

2) The majority can be acquired in small denominations.

3) They are liquid (for most) and can be easily converted into cash with little risk of
significant loss for the purchaser.

2. Allowing economic agents to share risks:

There are many risks that have very costs but low likelihood of occurring such as natural
disasters, early death, failure of a business and others. Risk averse (opposing something strongly)
peoples prefer to share these risks rather than bear them alone. The risk management function in
the financial system is exercised in different ways which is the most common on the insurance
industries.

3. To generate liquidity:
There are two notions of liquidity concepts. These are:
a. The market liquidity of an asset (real or financial assets): It is the ease with which it
may be traded.
b. The funding liquidity: is the ability of an entity to come-up with cash on a short notice. For
example, firms holding cash on its balance sheet or a person/individual with cash in its wallet
has a high degree of funding liquidity.

1.4 Financial Assets

Asset is any possession that has value in an exchange. Assets are commonly known as anything
with a value that represent economic resources or ownership that can be converted into
something of value such as cash. Asset classified in to three as tangible, intangible and financial
assets.
A. Tangible Assets (Physical Assets or Real Assets): Physical assets have a physical
characteristics or location such as buildings, equipment, inventories etc. Physical assets
are tangible assets and can be seen and touched, with a very identifiable physical
presence. The value of tangible asset depends on particular physical properties, example:
buildings. That means their physical condition is relevant for the determination of market
value. Physical assets provide continuous stream of services. Physical assets wear out or
subject to depreciation. They usually experience a reduction in value due to wear and tear
of the asset through continuous use known as depreciation, or may lose their value in
becoming obsolete, or too old for use. Certain tangible assets are also perishable, such as
a container of apples, or flowers that need to be sold soon in order to ensure that they do
not perish and lose their value.
B. Intangible assets: Intangible asset represents legal claims to some future benefit. Their
value bears no relation to the form, physical or otherwise in which the claims are
recorded. Example, good will, patents, copyrights, royalties, etc.

6|Page
Financial Institutions and Markets-Chapter One: An Overview of Financial System

C. Financial Assets: Financial assets represent a financial claim with a right to some cash.
They represent a claim against the income or wealth of a business firm, household, or
unit of government represented usually by a certificate of receipt or other legal document
and usually created by the lending of money (credit transactions). Simply, it is a claim on
the issuer’s future income or assets. Therefore, financial assets are intangible, meaning
that they cannot be seen or felt and may not have a physical presence except for the
existence of a document that represents the ownership interest held in the asset. It is
important to note that the papers and certificates that represent these financial assets do
not have any intrinsic value (the paper held is only a document certifying ownership and
is of no value). The paper derives its value from the value of the asset that is represented.

1.4.1 The Role of Financial Asset in the Financial System

Financial assets play a vital role in the economic performance of financial institutions and they
have two principal economic functions:
A) Mobilizing/transferring funds from those who have surplus of funds to deficit units who need
to invest in financial assets.
B) Redistributing unavoidable risk associated with the cash flow generated by tangible assets.
Example: To understand the two economic functions of financial assets in the financial system
see the following illustration:
A) Mr. X has got a license to open a manufacturing business organization. Mr. X has estimated
the required finance. He needs Br. 1 million to operate his business. Actually he has Br.
200,000 from his life saving.
B) Mr. Y has Br. 800,000. From this total amount he plans to spend Br. 100,000 for his personal
consumption. The remaining 700,000 Br is planned for investment.
C) Mr. Z has got a bonus fund worth of Br. 300,000 and he plans to spend Br. 100,000 and to
invest the remaining Br. 200,000.
Fortunately, Mr. X, Y, and Z meet in Addis Ababa. Sometime during their conversation, they
discuss their financial plans. By the end of the evening, they agree to deal on it. Mr. X agrees to
invest Br.100,000 of his savings in the business and sell a 50% share to Mr. Y for Br. 700,000
Mr. Z agrees to lend Mr. X Br 200,000 for four years interest rate of 20% per year. Mr. X will be
responsible for operating the business without the assistance of Mr. Y and Z.

Two financial claims came out of this agreement. The first is the equity instrument issued by
Mr. X and purchased by Mr. Y for Br. 700,000. The other is a debt instrument issued by Mr. X
and purchased from Mr. Z for Br. 200,000. Thus, two financial assets allowed funds to be
transferred from Mr. Y & Z who has a surplus of funds to Mr. X, who needed to invest in
tangible assets.

7|Page
Financial Institutions and Markets-Chapter One: An Overview of Financial System

1.4.2 Properties of Financial Assets

Financial assets have certain properties which help to determine the intention of investors on
financial assets being traded in financial market. These specific properties distinguish them from
physical and intangible assets. Some of them are:
a) Moneyness: some of the financial assets are used as a medium of exchange to settle
transactions and they termed/serve as money. This characteristic is a clearly desirable one
for investors in the market.
b) Divisibility and denomination: divisibility relates to the minimum size in which a
financial asset can be liquidated and exchanged for money. It is the characteristic of an
asset to be bought and sold in small portions or fractions. Financial assets are easily
divisible compared to physical assets which are sold or bought in whole quantities. The
smaller the size, the more the financial asset is divisible. Financial assets have varying
degree of divisibility depending on their denomination.
c) Reversibility: is the cost of investing in financial securities and then getting out of it and
back in to cash again. This property also called round trip cost. Example, deposits at
bank. A firm can deposit currency in a bank and accept a deposit certificate that can be
used to earn a rate of return. When the need for currency arises, the bank deposit can be
withdrawn in the form of currency again and used as an exchange instrument to buy any
other type of asset through which productive activity can be carried on.
d) Term to maturity: is the length of the interval until the date when the instrument is
scheduled to make its final payment or the owner is entitled to demand liquidation.
e) Liquidity: it is the degree in which financial assets can easily be liquidated (sold) without
a loss in value. For this term, most scholars argued that there is no uniformly accepted
definition, but according to Professor James Tobin liquidity is defined in terms of “How
much sellers stand to lose if they wish to sell immediately as against engaging in a costly
and time-consuming search.” Any financial asset which takes more time to convert in to
cash is termed as illiquid asset. Example, pension funds. Whereas the less the time taken
to convert in to cash is a liquid one. Example, Deposits in banks.
f) Convertibility: is the ability of the financial assets to be convertible in to other financial
assets. Example, a corporate convertible bond is a bond that the bond holder can change
in to equity shares.
g) Currency: Most financial assets are denominated in one currency, such as US dollar or
Yen, and investors must choose them with that feature in mind.
h) Cash flow and return predictability: Are turn that an investor will realize by holding a
financial asset depends on the cash flow that is expected to be received. This includes
dividend payments on stocks and interest payments on debt instruments.
i) Complexity: some financial assets are complex in the sense that they are actually
combinations of two or more simpler assets. To find the true value of such an asset, one
must decompose it in to its component parts and price each component separately.

8|Page
 Financial Institutions and Markets-Chapter One: An Overview of Financial System

j) Tax status: Investors are more concerned with income after taxes than before taxes of
financial assets. All other properties of financial assets remain the same; taxable
securities would have to offer a higher before tax yields to investors than tax exempt
securities to be preferred. But, investors with in high tax brackets benefit most from tax-
exempt securities. The yield/income after tax can be determined using the following
formula: Yat = Ybt (1-T) where: Yat-yield after tax, Ybt-yield before tax and T -Tax rate
Generally, the yield after tax depends on the existing Tax rates.

1.5 Financial Markets

Financial Market is a market in which financial assets (securities) such as stocks and bonds can
be bought and sold. Or it is a market in which funds are transferred or mobilized from people
(surplus units) having an excess of available funds to those people (deficit units) with a shortage
of funds to invest. As a market for financial claims, the main actors are households, business
(including financial institutions), and government units that purchase/sell financial asset. In short
those participants are broadly categorized in to surplus and deficit units.

1.5.1 The Role of Financial Markets in the Financial System

We have defined a financial market as a market for creation and exchange of financial assets. If
you buy or sell financial assets, you will participate in financial markets in some way or the
other. Financial markets play a pivotal role in allocating resources in an economy by performing
following important functions:
a) Financial markets facilitate price discovery. The continual interaction among numerous buyers
and sellers who use financial markets helps in establishing the prices of financial assets. Well
organized financial markets seem to be remarkably efficient in price discovery. That is why
financial economists say “if you want to know what the value of a financial asset is, simply look
at its price in the financial market.”
b) Financial markets provide liquidity to financial assets. Investors can readily sell their financial
assets through the mechanism of financial markets. In the absence of financial markets which
provide such liquidity, the motivation of investors to hold financial assets will be considerably
diminished. Thanks to transferability and negotiability of securities through the financial
markets, it is possible for companies and other entities to raise long term funds from investors
with short term and medium term horizons. While one investor is substituted by another when a
security is transacted, the company is assured of long term availability of funds.
c) Financial markets considerably reduce transaction costs. The two major costs associated with
transacting are search costs and information costs. Search costs comprise of explicit costs such as
the expenses incurred on advertising when one wants to buy or sell an asset and implicit costs
such as the effort and time one has to put to locate a customer. Information costs refer to costs
incurred in evaluating the investment merits of financial assets. Financial markets pool and
communicate information about the buyers and sellers of a financial instrument. This is one of
the basics of supply and demand.

9|Page
 Financial Institutions and Markets-Chapter One: An Overview of Financial System

d) Financial markets transfer risks: Markets allow individuals to share or pool risk across the entire
market. Agents prefer stability and sharing risk is one way to help increase stability.

Besides, in line to the above functions the market can help participants to facilitate:
 the raising of capital/fund (in the capital market)
 international trade (currency /foreign exchange market)
 transfer of risks (in the derivative market)

1.5.2 Classification of Financial Markets

Financial markets are classified under different bases to trade financial assets:
i. Classification on the bases of origin/issuance of an asset
a. Primary market: is a market in which newly issued securities (stocks, bonds, or other
financial instruments) are traded.
b. Secondary market (After market): is a market to transact financial instruments that were
previously issued. That means it is a market in which previously issued/second hand
securities are traded. Examples of secondary market are: NYSE and Nasdaq.
ii. Classification on the bases of maturity/term of claims
a) Money market: is a markets that trade debt securities with maturities of one year or less
(e.g., CDs and Government Treasury bills)
b) Capital market: is a markets that trade debt (bonds) and equity (stock) instruments with
maturities of more than one year.
iii. Classification on the bases of type/ownership of financial claims
a) Equity market: is the financial market for residual claims (equity instruments). Example
stock market.
b) Debt market: the financial market for fixed claims (debt instruments). It is a market in
which securities that require the issuer (the borrower) to pay the holder (the lender)
certain fixed dollar amounts at regularly scheduled intervals until specified time (the
maturity date) is reached, regardless of the success or failure of any investment projects
for which the borrowed funds are used are going to be traded.
iv. Classification on the bases of organizational structure of the market
a) Organized exchange market (auction): is an organized and regulated financial market
where securities are bought and sold at a price governed by demand and supply forces. It
is a market where buyers and sellers of securities (or their agents or brokers) meet in one
central location to conduct trades. Example, New York and American stock exchange.
b) Over the counter market (OTC): is a market made through brokers or dealers called
market makers using a negotiation over telephone or computer based networking system.
v. Classification on the basis timing of delivery
a) Spot/cash market: the market where the delivery occurs immediately the transaction
occurs.

10 | P a g e
Financial Institutions and Markets-Chapter One: An Overview of Financial System

b) Futures/forward market: is the market where the delivery occurs at a pre-determined time
in the future.
1.6 Lending and Borrowing in the Financial System
Business firms, households and governments play a wide variety of roles in modern financial
system. It is quite common for an individual/institution to be a lender of funds in one period and
a borrower in the other, or to do both simultaneously. Indeed financial intermediaries, such as
banks and insurance agencies operate on both sides of the financial market; borrowing funds
from customers by issuing attractive financial claims and simultaneously making loan available
to other customers. Economists John Gurley and Edward Shaw (1960) point out that each
business firm, household or a governmental unit active in the financial system must conform to
the following identity:
R−E=∆ FA−∆ D
(Current income receipts – Expenditures out of current income) = (Change in holdings of
financial assets - change in debt and equity outstanding)
If current expenditure (E) exceeds current income receipts (R), the difference will be made up
by:
1) Reducing our holdings of financial assets (-ΔFA), for example by drawing money out of a
saving account
2) Issuing debt or stock (+ΔD) or
3) Using some combination of both
On the other hand, if current income receipts (R) in the current period are larger than current
expenditure (E),
1) Build up our holdings of financial assets (+ΔFA) for example, by placing money in a saving
account or buying a few shares of stock
2) Pay off some outstanding debt or retire stock previously issued by the business firm(-ΔD) or
3) Do some combination of both of these steps
It follows that for any given period of time (Example, day, week, month or year), the individual
economic unit must fall in to one of the following three groups.
Deficit Budget Unit (DBU) = net borrower of funds: E>R; and so ΔD>ΔFA
Surplus Budget Unit (SBU) = net lender of funds: E<R; and so ΔD<ΔFA
Balanced Budget Unit (BBU) = neither net borrower nor net lender: E=R; and so ΔD=ΔFA
A net lender of funds (SBU) is really a net supplier of funds to the financial system. He/she
accomplish this function by purchasing financial assets, pay off debts or retiring equity (stock).
In contrast a net borrower of funds (DBU) is a net demander of funds from the financial system;
selling financial assets, issuing new debts or selling new stocks. The business and the
government sectors of the economy tend to be net borrowers (demanders) of funds (DBU); the
household sector, composed of all families and individuals, tend to be a net lender (supplier) of
funds (SBU).

11 | P a g e