You are on page 1of 58

Chapter 1: Introduction to Financial System

1.1. An Overview of the Financial system


1.2. The Functions of Financial Systems
1.3. Financial Institutions
1.4. Financial Services and Instruments
1.5. Real assets and Financial assets
1.6. Financial Markets
1.7. Internalization of Financial Markets
1.8. Financial Regulation
Chapter 1:Introduction to Financial System
Financial Systems
1.1. An Overview
 Finance is the art and science of managing money.
Virtually all individuals and organizations earn or raise
money and spend or invest money.
 Finance is important to individuals, business and
government to achieve their economic objectives.
 Finance plays a pivotal role to every general person to earn
and invest money; for business to raise and invest funds;
and to the government to plan expenses and incomes, to
execute goals of government and to achieve development
of a country.
 Finance deals with procurement of funds and their
effective utilization. That is, it is the study of how to raise
money and invest it productively.
 Finance consists of three interrelated areas:
(1) money and capital markets, which deals with securities
markets and financial institutions;
(2) investments, which focuses on the decisions made by both
individual and institutional investors as they choose
securities for their investment portfolios; and
(3) financial management, or “business finance,” which
involves decisions within firms.
 The career opportunities within each field are many and
varied, but financial managers must have a knowledge of
all three areas if they are to do their jobs well.
 In relation to money and capital markets, Finance is
concerned with the process, institutions, markets, and
instruments involved in the transfer of money among
individuals, businesses and governments (Gitman ,2006).
 The financial sector is all about the wholesale, retail,
formal and informal institutions in an economy offering
financial services to customers, businesses and other
financial institutions. In its broadest definition, it includes
everything from banks, stock exchanges, and insurers, to
credit unions, microfinance institutions and money
lenders (DFID, 2004.
 A financial system may be defined as a set of institutions,
instruments and markets which fosters savings and
channels them to their most efficient use.
 The system consists of individuals (savers),
intermediaries, markets and users of savings
(government, public and private sector entities).
 Economic activity and growth are greatly facilitated by
the existence of a financial system developed in terms of
the efficiency of the market in mobilizing savings and
allocating them among competing users (Machiraju,
2008).
 The financial system or the financial sector of any
country consists of (a) specialized and non
specialized financial institutions,
(b) organized and unorganized financial markets, and
(c) financial instruments and services which facilitate
transfer of funds,
(d) procedures and practices adopted in the markets
and
(e) financial relationships are also parts of the
system.
 The financial system is concerned about money,
credit and finance. The terms intimately related yet
somewhat different from each other.
 Money refers to the current medium of exchange or
means of payment.
 Credit or loan is a sum of money to be returned
normally with interest; it refers to the debt of economic
unit.
 Finance is monetary resources comprising debt and
ownership funds of the state, company or person
(Bhole, 2004).
 The financial system comprises of a variety of
intermediaries, markets and instruments.
 It provides the principal means by which savings are
transformed in to investments.
 It help in the formation of capital.
 Given its role in the allocation of resources, the
efficient functioning of the financial system is critical
to a modern economy (Chandra, 2008).
 Therefore, a financial system is defined as a function as
an intermediary and facilitates the flow of funds from
the areas of surplus to the areas of deficit.
 In other words, a financial system is a system that aims at
establishing and providing a regular, smooth, effective
and efficient linkage between depositors and investors.
 Economic growth and development of any country
depends upon the strength of its financial system.
 Thus, a financial system can be said to play a significant
role in the economic growth of a country by mobilizing
the surplus funds and utilizing them effectively for
productive purposes.
Financial
System

Financial Financial Financial Financial


Institutions Markets Instruments Services

Regulatory Intermediary Non- Others Organized Unorganized


intermediary

Banking Non-banking Primary Secondary

Capital Money
Markets Markets

Equity/Stock Debt Market Derivative


Market Market
 Key financial intermediaries in an economy could
include the following: commercial banks,
development financial institutions, insurance
companies, mutual funds, non banking financial
companies and non banking financial services
companies (Chandra 2008).
1.2. Functions of Financial System

 A good financial system has the following six


functions
1. Clearing and settling payments
2. Pooling resources and subdividing shares
3. Transferring resources across time and
space
4. Managing risk
5. Providing information
6. Dealing with incentive problems
Functions of Financial System
1. Clearing and settling payments
 “A financial system provides ways of clearing and settling
payments to facilitate the exchange of goods and services.”
 Financial institutions, now a days, provides different
payment system.
 For example, depository institutions (like banks)
provide ATMs, credit/debit cards.
Functions of Financial System
2. Pooling resources and subdividing shares
 “A financial system provides a mechanism for pooling of
funds to undertake large-scale indivisible enterprise or for
subdividing of shares in enterprises to facilitate
diversification”.
 Securitization is an efficient vehicle for pooling
non-traded securities and subdividing by selling
claims on the pool on the market
 For Example: asset backed securities.
Functions of Financial System
3. Transferring resources across time and space
 “A financial system provides ways to transfer economic resources
through time, across geographic regions and, among industries.”
 The financial intermediaries transfer resources across time
and space, thus allowing investors and consumers to
borrow against future income and meet current needs.
 As a result, there is an eefficient separation of investment
& financing horizons (maturity).
 In other words, short-term deposits used to finance long-
term lending and rollover loans for financing infinite
projects
Functions of Financial System
4. Managing risk
 “A financial system provides ways to manage uncertainty and
control risk.”
 For instance, by facilitating diversifications, financial
intermediaries allow savers to maximize returns to
their assets and to reduce risks.
Functions of Financial System
5. Providing information
 “A financial system provides price information that helps co-
ordinate decentralised decision-making in various sectors of the
economy.”
 That is, by providing a mechanism for appraisal of the
value of the firm, financial systems allow investors to
make informed decisions about the allocation of their
funds.
Functions of Financial System
6. Dealing with incentive problems
 “A financial system provides ways to deal with the incentive
problems when one party to a financial transaction has
information and the other party does not, or when one party is
an agent for another.”
1.3. Financial Institutions
 Financial institution are organizations that provides
financial services for its clients.
 They can also be defined as business organizations
that act as mobilizers and depositors of savings and
as purveyors of credit or finance.
 Financial institutions serve as intermediaries by channeling
the savings of individuals, businesses and governments in to
loans and investments.
 Many financial institutions directly or indirectly pay savers
interest on deposited funds; others provide services for a fee.
 Some financial institutions accepts customers’ savings
deposits and lend this money to other customers or to other
firms; others invest customers’ savings in earning assets such
as real estate or stocks and bonds; and some do both.
Financial institutions are required by the government to
operate within established regulatory guidelines (Gitman,
2006).
 Roles of financial institutions can be shown in the following
items:
1. Mobilize savings in a financial form by offering instruments with attractive
yields and appropriate maturities that people want to acquire.
2. It can increase the efficiency of investment by screening project proposals
and by monitoring the behaviour of borrowers and issuers of equity.
3. Provision of finance for medium or long term projects
4. Promotion of investment of public and private capital for development
the projects in line with the national development objectives
5. Provision of technical assistance to help prepare, finance and carryout
development projects and programmes
6. It can provide ways of pooling and pricing risks that enable large and high
risk activities to be undertaken. Hence it affects risk sharing between
households and firms
7. It also reduces the transaction costs of market economy by providing a
convenient and cheap medium of exchange-making it easier for both
buyers and sellers to engage in business.
8. Financial services allow the poor to convert flows of savings overtime
into lump sums that can be used not only for investment to generate
income but also to reduce vulnerability to shocks, cover lifecycle needs
and acquire useful consumer durables.
9. Promotion of Gross national saving
10. Promotion of capital investment and others.

 In general they provide both financial and non financial services like
appraisal, implementation, monitoring of projects and training
entrepreneurs and the like.
 Financial institutions generally fall under financial
regulation from a government authority.
 Types of Financial Institutions
 Common types of financial institutions include
 banks,

 InsuranceCo,
 Leasing Co,

 Investment Co, and

 Mutual Funds.
1.4. Financial Services and Instruments

 Financial services comprise of various functions


and services that are provided by financial
institutions in a financial system. Example, Leasing,
factoring, underwriting, depository, housing
finance etc.
FINANCIAL INSTRUMENTS
 Financial claims such as financial assets and
securities dealt in a financial market are referred
to as financial instruments.
 Example, Government bonds, corporate bonds,
common stock etc.
1.5. Real assets and Financial assets

 Assets are things that people own.


 Generally assets can be classified in to two broad
classes as Real and Financial assets
 The distinction between these terms is easiest to see
from an accounting viewpoint.
 A real asset does not have a corresponding
liability associated with it.
 Financial assets have a corresponding liability
but real assets do not.
Real Vs Financial …
 A financial asset carries a corresponding liability
somewhere. If an investor buys shares of stock, they
are an asset to the investor but show up on the right side
of the issuer corporation’s balance sheet.
 A financial asset, therefore, is on the left-hand side of the
owner’s balance sheet and the right-hand side of the
issuer’s balance sheet.
 Real assets of a business can be building, land,
machinery, real estate, inventory, and so on.
 Financial assets may take forms like deposits, loans,
securities, and so on.
Characteristics of Financial Assets
1. Money-ness
 Some financial assets are used as a medium of
exchange or in settlement of transactions.
 These assets are called money.
 Those financial assets which can be transformed in
to money at little cost, delay or risk can also be
considered as money.
 For example, money and cash deposited in a
checking account can be used as a medium of
exchange.
Characteristics of Financial Assets
2. Divisibility and denomination
 Divisibility relates to the minimum size at which a
financial asset can be liquidated and exchanged for
money. Or,
 Minimum amount to sell or purchase an asset or the
extent to which fractional amounts of an asset can be
sold and bought.
 For example, physical assets such as car, building etc are
often indivisible.
 A financial asset such as a deposit at a bank is infinitely
divisible but other financial assets have varying degrees
of divisibility depending on their denomination.
Characteristics of Financial Assets
3. Reversibility
 It refers to the cost of investing in a financial asset and then getting
out of it and back in to cash again. That is, cost of investing in
asset, then selling it for cash. Consequently, it refers to round-trip
cost.
 Example, a financial asset such as a deposit at a bank is obviously
highly reversible because usually there is no charge for depositing
to or withdrawing from it. Thus, deposits -- cost close to zero.
 For financial assets traded in organized markets or with “market
maker”, the most relevant component of round-trip cost is the so-
called bid-ask spread, to which might be added commissions and
the time and costs, if any, of delivering the assets.
Characteristics of Financial Assets
 The spread charged by a market maker varies
sharply from one financial assets to another,
reflecting primarily the amount of risk the market
maker is assuming by “making” a market.
 This market making risk can be related to two main
forces.
A. The variability of the price of financial assets.
B. The thickness of the market (the number of buyers
and sellers).
Characteristics of Financial Assets
4. Cash flows and return predictability
 Return predictability is a basic property of financial
assets, in that it is a major determinant of their
value.
 Assuming that investors are risk averse, the
riskiness of an asset can be equated with the
uncertainty or unpredictability of its return.
Characteristics of Financial Assets
5. Term of Maturity
 It is the length of time interval until the date when
the instrument is scheduled to make its final
payment, or the owner is entitled to demand
liquidation.
 Maturity may be uncertain for some financial
instruments or assets, example common stock and
non-redeemable preferred stock and certain for some
financial assets like Treasury bill, bonds, commercial
paper etc.
Characteristics of Financial Assets
6. Convertibility
 It refers to the ability of the financial assets to be

converted into another financial assets with in the


same class or different class.
 Example:

I. When a bond is converted in to anther bond.


II. A corporate convertible bond is a bond that the
bond holder can change in to equity.
Characteristics of Financial Assets
7. Liquidity
 How easily are the assets converted to cash?
 It refers to the speed with which the asset can be sold.
 How easy is the asset to buy/sell?
 How cheap is it the asset to buy/sell?
 Liquidity may depend not only on the financial assets but also
on the quantity one wishes to sell or buy. While a small
quantity may be quite liquid, a large lot may be run into
illiquidity problem.
 Note that liquidity is again closely related to whether a market
is thick or thin. Thinnest always has the effect of increasing
the round trip cost, even of a liquid financial asset.
Financial Vs Non-financial Business organizations

 From the discussions regarding the distinction between


real and financial assets it easy to understand the
difference between financial and non financial business
organizations.
 The former deals with financial assets while the later
deals with real assets.
 When we talk about the distinction between these
institutions it shouldn’t be taken to mean that there is
something unproductive about finance.
 At the same time, the role of financial sector should not
be overstressed.
1.6 Financial Markets

 Financial markets are the centers or arrangements that


provide facilities for buying and selling of financial
claims and services.
 They facilitate buying and selling of financial claims,
assets, services, and securities.
 In financial markets, funds or savings are transferred
from surplus units to deficit units.
 The corporations, financial institutions, individuals, and
governments trade in financial products on these markets
either directly or through brokers and dealers on
organized exchanges or off exchanges.
 The participants on the demand and supply sides of
these markets are financial institutions, agents, brokers,
dealers, borrowers, lenders, savers, and others who are
inter-linked by the laws, contracts, covenants, and
communication networks.
 Financial markets perform essential economic function
of channeling funds from households, firms and
governments that have saved surplus funds by spending
less than their income to those who have a shortage of
funds because they wish to spend more than their
income.
Overview of …
 Those who have saved and are lending the funds are called
the lender savers.
 Principal of such group are households.
 However, Business Firms, State & Local Gov’ts and foreign
Gov’ts & Individuals may find themselves with excess fund
and lend it out.
 Those who must borrow to finance their spending are known
as borrower spenders.
 The principal of borrower spenders are Business firms and
State &Local Gov’ts.
 However, individuals and foreign individuals and gov’ts also
borrow to finance their fund needs.
Direct Financing
 When borrowers directly borrow funds from the lenders
in the financial markets by issuing them variety of
securities, which are claims against the future earnings
and assets of borrowers is known as Direct Financing.
 E.g. 1. When a corporation raise money from any
economic unit by issuing common stock.
2.Bond issue to the general public by government
of Ethiopia to finance different developmental and
transformational investment plans.
Direct …
 Usually financial markets allow funds to flow from
economic units who lack productive investment
opportunities to those economic units who have them.
 Therefore, financial markets are critical for producing
efficient allocation of capital, which contributes to higher
production and efficiency for the overall economy.
 Financial markets improve the well being of consumers
by allowing them to time their purchases better.
Indirect Financing
 When borrowers indirectly borrow funds from the
lenders in the financial markets through the use of
financial intermediaries is known as an Indirect
Financing.
 The process of indirect finance using financial
intermediaries is called Financial
Intermediation.
Flows of Funds Through the Financial System
Indirect Finance

Financial
Intermediaries

Financial
Markets
Lender –Savers: Borrower-
spenders:
1. Households
1. Business firms
2. Business firms
2. Government
3. Government
3. Households
4. Foreigners Direct Finance
4. Foreigners
Classifications of Financial Markets
1. Debt and Equity Markets
Any economic unit can obtain funds in a financial Market in
two ways.
a. Issuing Debt Securities/Instruments such as a Bond or a
Mortgage-a contractual agreement by the borrower to pay
the holder of the instrument a fixed dollar amounts at a
regular time intervals until a specified date (the maturity
date), when a final payment is made.
 The classification of debt instruments based on maturity:
A. Short Term: with maturity period less than 1 year
B. Medium Term: debt instruments with maturity period between 1-10 years
C. Long Term: having maturity period of 10 years and above
Debt and Equity…
b. Issuing Equities such as common stock, which are
claims to share the net income (income after expenses
and taxes) and the assets of a business.
 Equities usually entail periodic payments in the form
of dividends to their holders and are considered long-
term securities because they have no maturity date.
 A place where debt funds can be obtained is called
Debt Market and a place where equity funds are
procured is called Equity Market.
 In many countries the size of debt markets is larger
that that of equity markets.
2. Primary Vs Secondary Financial Markets

a. Primary Markets: deal with the new financial claims or new securities
and, therefore, they are also known as the new issue markets.
 These markets mobilize savings and they supply fresh or additional
capital to business units.
b. Secondary Markets: deal with securities that are already issued or
outstanding.
 Though they do not contribute directly to supply of additional capital,
they do so indirectly by rendering securities issued in the primary
markets liquid.
 Stock markets have both primary and secondary market segments.
3. Money and Capital Markets
 Another way of distinguishing between financial markets is
based on ‘maturity of securities traded in the market’.
a. The Money Market: only short-term debt securities are
traded.
 These markets tend to be more liquid as they are traded
more widely.
 Short-term debt securities have smaller fluctuations in
prices than long-term ones that conservative investors
prefer them for their safety.
 As a result, many corporations and banks actively avail the
service of these market to earn profit on idle/surplus funds
by investing on short-term instruments temporarily.
Money and Capital…

b. The Capital Market: long-term debt and


equity instruments are traded.
 Capital market securities, such as stocks and long-
term bonds, are often held by financial intermediaries
such as insurance companies and pension funds,
which have a little uncertainty about the amount of
funds they will have available in the future.
1.7 Internationalization of Financial Markets

 The growing interaction of the financial markets has


become an important trend.
 Before three decades, the U.S. financial markets were
having a larger size than any other countries in the
world and used to play a dominant role in the
industry.
 However, in recent days the dominance of U.S.
markets has been disappearing because of the
extraordinary growth of financial markets in the rest
parts of the world.
Internationalization …
 These extraordinary growth in the financial markets are
due to large increase in the pool of savings by citizens,
like in the case of Japan, and the deregulation of
financial sector which has enabled them to expand their
activities and services.
 Nowadays, indigenous businesses and banks can tap the
international financial markets to raise funds need for
their investment activities.
 Similarly, in many countries individuals and businesses
can invest their surplus funds in markets out side country
of their origin.
International Bond Market, Eurobonds, and Euro Currencies

 Traditional instruments in the international bond


market are known as Foreign Bonds.
 Foreign bonds are issued in foreign countries and are
denominated in that country’s currency.
 Suppose MIDROC Ethiopia raises €10,000,000 from
issuance of bonds in Germany bond market to
finance exploration, extraction and production of
Gold mines in Ethiopia.
 The bond is then said to be a foreign bond.
International Bond Market …
 A more recent innovation in the international bond
market is the Eurobond, a bond denominated in
a currency other than that of the currency in which it
is sold.
 For example a bond denominated in birr sold in
Nairobi- Kenya.
 According to figures in 2005 most of the new issues
in the international bond markets were Eurobonds,
and the markets for these securities has grown
substantially .
International Bond Market …
 A variant of the Eurobond is a Eurocurrencies, which
are foreign currencies that are deposited in banks outside of
the home country.
 The most important of Euro currencies is Eurodollars,
which are U.S. Dollars deposited in foreign banks outside of
the U.S.A. or in foreign branches of U.S. banks.
 These short-term deposits earn interest and so are similar to
short-term Eurobonds.
 You should, however, note that a bond denominated in Euro
is said to be a Eurobond if it is sold outside the countries that
have adopted the Euro
1.9. Financial Regulation
 Financial system of any country are among the
heavily regulated sectors of the economy.
 The following are three main reasons for regulating

the financial system.


1. To increase information available to investors
2. To ensure the soundness of the financial system &
3. To improve control of monetary policy
1. Increasing information available to investors
 Asymmetric information creates adverse selection and
moral hazards to innocent investors in the market.
 To avoid these problems, governments often establish
regulatory institutions that require organizations to
issuing securities to disclose certain information about
their sales, assets, and earnings to public and restrict
insider trading in corporations.
 In additions individuals and institutions engaging in such
acts are severely penalized.
2. Ensuring the soundness of the financial system
 To enhance investors’ trust in the financial markets by
ensuring the soundness of the financial system the
following regulatory acts can be taken:
a. Restrictions on entry into the financial
institutions industry
b. Adequate Disclosures by Fis

c. Restrictions on assets and activities


d. Introduction of deposit insurance

e. Limits on competition
f. Restrictions on interest rates
3. Improving control of monetary policy
 Government uses a regulatory tool of reserve

requirements to improve control of the money


supply in the economy.
 RR makes it obligatory for depository institutions to

keep a certain portion of their deposit in their central


bank account.
 RRs help central governments to exercise more
precise control over the money supply.
The End

You might also like