The Financial System

 Describe what a financial system is

The financial system constitutes a set of subsystems of financial institutions,
financial markets, financial instruments and services which helps in the
formation of capital. It provides a mechanism by which savings are transformed
to investment. They perform at least two main types of financial service that
reduce the costs of moving funs between borrowers and lenders, leading to a
more efficient allocation of resources and faster economic growth.
Financial Intermediaries are the facilitators of the financial transactions that
take place with the financial system.
Such intermediaries include the following:
 Commercial and merchant banks
 Specialized banks, e.g., investment banks, development banks;
 Primary mortgage institutions; and
 Insurance companies, etc.
The following Diagram depicts the transfer of funds between those seeking it
and those who have spare of it and want to allow others use it.
The transfer of capital can take place in the two different ways, direct and
indirect
Direct Financing


FundSeeker
Funds
Surplus
 Budget Unit
 Securities
 & Bonds

Indirect Financing

FundSeeker Bonds Funds Securities Surplus

 Budget Unit
 Funds Funds
 Financial
 Intermediation

&
Fund Seeker
  Bonds Securities
Surplus Budget

Unit


Funds Funds

Diagram 1.1: The Financial System Actors

 Identify and describe the difference between the two types of fund
Transfer
The Direct Transfer:-Direct transfers of money and securities, as shown in the
top section, occur when a fund seeking entity/business sells its stocks or bonds
directly to savers, without going through any type of financial intermediary.
The entity/business delivers its securities to savers, who in turn give the firm
the money it needs.

Indirect Transfer:-As shown above too, transfers may also go through an

investment banking house, which underwrites the issue. An underwriter serves
as a middleman and facilitates the issuance of securities. The company sells its
stocks or bonds to the investment bank, which in turn sells these same securities
to savers.
Transfers can also be made through a financial intermediary such as a bank or
mutual fund.
 Determine what the role and functions of a financial system are
Functions of the Financial System
From the foregoing discussions, it becomes possible to narrate that the financial
system performs some vital functions to the economy, which tend to enhance the
performance of the economy toward its growth and development. Such functions
include the following:

I. Saving function: An important function of a financial system is to

mobilize savings and channelize them into productive activities. It is
through financial system the savings are transformed into investments.
 II. Liquidity function: The most important function of a financial
system is to provide money and monetary assets for the production of
goods and services. Monetary assets are those assets which can be
converted into cash or money easily without loss of value. All
activities in a financial system are related to liquidity-either provision
of liquidity or trading in liquidity.
III. Payment function: The financial system offers a very convenient
mode of payment for goods and services. The cheque system and
credit card system are the easiest methods of payment in the economy.
The cost and time of transactions are considerably reduced.
IV. Risk function: The financial markets provide protection against life,
health and income risks. These guarantees are accomplished through
the sale of life, health insurance and property insurance policies.
V. Information function: A financial system makes available price-
related information. This is a valuable help to those who need to take
economic and financial decisions. Financial markets disseminate
information for enabling participants to develop an informed opinion
about investment, disinvestment, reinvestment or holding a particular
asset.
VI. Transfer function: A financial system provides a mechanism for the
transfer of the resources across geographic boundaries.
VII. Reformatory functions: A financial system undertaking the
functions of developing, introducing innovative financial
assets/instruments services and practices and restructuring the existing
assts, services etc, to cater the emerging needs of borrowers and
investors (financial engineering and re engineering).
VIII. Other functions: It assists in the selection of projects to be financed
and also reviews performance of such projects periodically. It also
promotes the process of capital formation by bringing together the
supply of savings and the demand for investible funds.

What is the difference between a physical asset and a financial asset?

Financial Assets
Financial Assets are different from real or physical assets. Physical asset markets
(also called “tangible” or “real” asset markets) are those for products such as
wheat, coffee, real estate, computers, and machinery. Financial asset markets, on
the other hand, deal with stocks, bonds, notes, mortgages, and other claims on real
assets, as well as with derivative securities whose values are derived from changes
in the prices of other assets.

The financial assets can be grouped into two main categories such as debt
instruments and equity instruments.
1. Debt Instruments
These are the financial instruments that are normally used by corporate entities and
government to raise funds on the basis of debt obligations. This implies that such
financial instruments are repayable by the organizations issuing them for raising
funds from the financial markets from their operations. Therefore, they become
assets not to those who issues them rather to those who buy them.
The various debt instruments being used for financial transactions in money market
include the following:

i) Treasury Bills;
ii) Commercial Papers; and
iii) Certificate of Deposits.

The holders, therefore, are entitled to the funds at maturity dates in addition to the
regular income accruing to them on them on the basis of interest payments by the
corporate entities and government. Some of such instruments can be redeemed
before their maturity dates as agreed to by the parties involved in the transactions.
Such financial assets or instruments are also negotiable, being capable of being
traded for cash before their maturity date.
The various debt instruments being used for financial transactions in capital market
include the following:

i) Development Loan;
ii) Debenture;
iii) Bonds;
iv) Mortgage Loan;
v) Leases; and
vi) Hire Purchase Contracts.
 2. Equity Instruments
There are some financial instruments that are being used in the financial markets to
raise equity funds by corporate entities. Such financial instruments are essentially
Ordinary or Common Shares being used to raise funds to enhance the capital base
of corporate organizations. Preferred shares are also means of obtaining funds.
Once again the holders of these instruments consider them as assets.

Spot versus futures markets: Spot markets are markets in which assets are bought
or sold for “on-the-spot” delivery (literally, within a few days). Futures markets
are markets in which participants agree today to buy or sell an asset at some future
date.

Money versus capital markets: Money markets are the markets for short-term,
highly liquid debt securities. In Ethiopia, Treasury Bills market, Foreign exchange
market and Certificate of Deposits could be cited as examples. In the international
market, The New York, London, and Tokyo money markets are among the world’s
largest. Capital markets are the markets for intermediate- or long-term debt and
corporate stocks. The Bank Term loans, the Government Bond sale could be sited
as those in the capital market in Ethiopia. In the International scene, The New
York Stock Exchange, where the stocks of the largest U.S. corp

Primary versus secondary markets: Primary markets are the markets in which
corporations raise new capital. If Nib or United Bank were to sell a new issue of
common stock to raise capital, this would be a primary market transaction. The
corporation selling the newly created stock receives the proceeds from the sale in a
primary market transaction. Secondary markets are markets in which existing,
already outstanding, securities are traded among investors.

Private placement versus public issue markets. Private markets, where

transactions are negotiated directly between two parties, are differentiated from
public markets, where standardized contracts are traded on organized exchanges.
Bank loans and private debt placements with insurance companies are examples of
private market transactions. Because these transactions are private, they may be
structured in any manner that appeals to the two parties. By contrast, securities that
are issued in public markets (for example, common stock and corporate bonds) are
ultimately held by a large number of individuals. Public securities must have fairly
standardized contractual features, both to appeal to a broad range of investors and
also because public investors do not generally have the time and expertise to study
unique non-standardized contracts.

Budget positions creating financial needs of economic units: Surplus or deficit.

• Surplus spending units ( SSUs) have income for the period that exceeds
spending, resulting in savings.

– Other words for “SSU” are saver, lender, or investor. Most SSUs are
households.

• Deficit spending units (DSUs) have spending for the period that exceeds
income.

– Another word for “DSU” is “borrower”. Most DSUs are businesses or

governments.