CHAPTER ONE

An Overview of the Financial System

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Introduction

The financial system is the set of markets and intermediaries used by households, firms, and
governments to implement their financial decisions. It includes the markets for stocks, bonds,
and other securities, as well as financial intermediaries such as banks and insurance companies.
Funds flow through the financial system from entities that have a surplus of funds to those that
have a deficit. Often these fund flows take place through a financial intermediary. A financial
system makes possible a more efficient transfer of funds by mitigating the information
asymmetry problem between those with funds to invest and those needing funds. In addition to
the lenders and the borrowers, the financial system has three components: (1) financial markets,
where transactions take place; (2) financial intermediaries, who facilitate the transactions; and
(3) regulators of financial activities, who try to make sure that everyone is playing fair.

Financial system is a system that aims at establishing and providing smooth, regular, efficient
and effective linkage between savers and borrowers. It is a set of complex and closely connected
instructions, practices, agents and claims related to the financial aspects of the economy.
The Role of the Financial System in the Economy

Financial system is very important for the economic and all round development of any country,
its major roles/functions can be explained as following:
1. Promotion of Liquidity

The major function of the financial system is the provision of money and monetary assets for the
production of goods and services. There should not be any shortage of money for productive
ventures. In financial language, the money and monetary assets are referred to as liquidity. In
other words, the liquidity refers to cash or money and other assets which can be converted into
cash readily without loss. Hence, all activities in a financial system are related to liquidity –
either provision of liquidity or trading in liquidity.

2. Mobilizations of Savings

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Another important activity of the financial system is to mobilize savings and channelize them
into productive activities .i.e., they channel funds from those who have savings to those who
have more productive use of them.

The financial system should offer appropriate incentives to attract savings and make them
available for more productive ventures. Thus, the financial system facilitates the transformation
of savings into investment and consumption. The financial intermediaries have to play a
dominant role in this activity .i.e., they facilitate the flow of funds from saving-surplus agents
with no profitable use of their funds to deficit-spending agents with profitable projects.

3. Provides financial services

We assume that most people are risk-averse. That is, they are prepared to make a payment (or
sacrifice some income) in order to avoid uncertainty, especially if the uncertainty may mean the
possibility of a serious loss. Among the non-deposit taking institutions, this service is carried out
by insurance companies. They allow people to choose the certainty of a slightly reduced current
income (reduced by the premiums they pay) in exchange for avoiding a catastrophic loss of
income (or wealth) if some accident should occur.

Pension funds, unit trusts and investment trusts all offer savers the opportunity to accumulate a
diversified portfolio of financial assets, though each does it in a slightly different way. Pension
funds, in particular, help people to accumulate wealth over a long period and then to exchange
this for income to cover the (uncertain) period between retirement and death.

4. Offer portfolio adjustment facilities

Lastly, it should always be remembered that while savers may be building up a portfolio of
wealth by acquiring financial assets, they want to be able to rearrange that portfolio from time to
time as they observe changes in the risk/return characteristics of the assets which they hold. If we
use the phrase ‘net acquisition’ to describe the additional assets that a household is able to add to
its portfolio each year, we must remember that total purchases of assets may be much larger
because some assets already in the portfolio may have been sold as part of the portfolio

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adjustment process. A Financial system must provide people with the means to make cheap and
frequent adjustments to their portfolio of assets (and liabilities).

Financial Assets

In any financial transaction, there should be a creation or transfer of financial asset. Hence, the
basic product of any financial system is the financial asset. Financial assets are intangible assets
where typically the future benefits come in the form of a claim to future cash. Another term used
for a financial asset is a financial instrument. Certain types of financial instruments are referred
to as securities and generally include stocks and bonds. For every financial instrument there is a
minimum of two parties. The party that has agreed to make future cash payments is called the
issuer; and the party that owns the financial instrument and therefore the right to receive the
payments made by the issuer is referred to as the investor.

Real Assets Vs Financial Assets

Real Assets

A real asset is anything that generates a flow of goods or services over time. The material wealth
of a society is determined ultimately by the productive capacity of its economy. i.e. the goods
and services that can be provided to its members. This productive capacity is a function of the
real assets of the economy. Real assets need not be tangible.Both physical and human assets
together generate the entire spectrum of output produced and consumed by the society. Examples
are land, building, knowledge, machines, inventions, business plans, goodwill, reputation, etc
Financial Assets

A financial asset is a legal contract that gives its owner a claim to payments, usually generated
by a real asset. Financial instruments are no more than sheets of paper. Their value is derived
from the value of the underlying real assets. Examples include stocks, bonds, bank deposit, bank
loans, options, futures, etc.

Unlike real assets, financial assets do not represent a society’s wealth; do not contribute directly
to the productive capacity of the economy instead they are claims to the income generated by
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real assets or claims on the income from the government. They are a means by which individuals
hold their claims on real assets.

Distinction between real assets and financial assets

 Real assets are income-generating assets, whereas financial assets are the allocation of
income or wealth among investors.
 Real assets appear only on the asset side of the balance sheet, whereas financial assets
appear on both sides of balance sheets.
 i.e. Your financial claim on a firm is an asset, but the firm's issuance of
that claim is the firm's liability.
 Thus, When we aggregate overall balance sheets, financial assets will
cancel out, leaving only the sum of real assets as the net wealth of the
aggregate
 Financial assets are created and destroyed in the ordinary course of doing business. For
example, when a loan is paid off, both the creditor's claim (a financial asset) and the
debtor's obligation (a financial liability) cease to exist.
 Whereas real assets are destroyed only by accident or by wearing out over time.

Properties of Financial Assets

The following are the properties of Financial Assets, which distinguish them from Physical and
Intangible Assets:
1.      Currency:
Financial Assets are exchange documents with an attached value. Their values are dominated in
currency units determined by the government of an economy.
2.      Divisibility
Financial Instruments are divisible into smaller units. The total value is represented in terms of
divisions that can be handled in a trade. The divisibility characteristic of Financial Assets enables
all players, small or big, to participate in the market.
3.      Convertibility
Financial Assets are convertible into any other type of asset. This characteristic of convertibility
gives flexibility to financial instruments. Financial Instruments need not necessary be converted

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into another form of Financial Asset; they can also be converted into Physical/Tangible and
Intangible Assets.
4.      Reversibility
This implies that a financial instrument can be exchanged for any other asset and logically, the so
formed asset may be transferred back into the original financial instrument.
5.      Liquidity /Marketability/
Liquidity implies that the present need for other forms of asset prevails over holding the financial
instrument. The financial asset can be exchanged for currency with another market participant
who does not have immediate cash need, but expects future benefits.
6.      Cash Flow
The holding of the financial instrument results in a stream of cash flows that are the benefits
accruing to the holder of the financial instrument. However, a financial instrument by itself does
not create a cash flow.
7. Information Availability
In many cases, information concerning financial assets is more readily available than for real
assets
Role of financial assets in financial system

Financial assets serve two principal economic functions. First, financial assets transfer funds
from those parties who have surplus funds to invest to those who need funds to invest in tangible
assets. As their second function, they transfer funds in such a way as to redistribute the
unavoidable risk associated with the cash flow generated by tangible assets among those seeking
and those providing funds. However, the claims held by the final wealth holders generally differ
from the liabilities issued by the final demanders of funds because of the activity of entities
operating in financial markets, called financial intermediaries, who seek to transform the final
liabilities into different financial assets proffered by the public.

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Financial Markets

A financial market is a market where financial instruments are exchanged. The more popular
term used for the exchanging of financial instruments is that they are “traded.” They are markets
where people buy and sell financial instruments like stocks, bonds and future contracts.

Financial markets provide the following three major economic functions:

 Price discovery
 Liquidity
 Reduced transaction costs
Price discovery means that the interactions of buyers and sellers in a financial market determine
the price of the traded asset. Equivalently, they determine the required return that participants in
a financial market demand in order to buy a financial instrument. Because the motivation for
those seeking funds depends on the required return that investors demand, it is the functions of
financial markets that signals how the funds available from those who want to lend or invest
funds will be allocated among those needing funds and raise those funds by issuing financial
instruments.

Second, financial markets provide a forum for investors to sell a financial instrument and is said
to offer investors “liquidity”. This is an appealing to sell a financial instrument. Without
liquidity, an investor would be compelled to hold onto a financial instrument until either
condition arise that allow for the disposal of the financial instrument or the issuer is contractually
obligated to pay it off. For a debt instrument, that is when it matures, whereas for an equity
instrument that is until the company is either voluntarily or involuntarily liquidated. All financial
markets provide some form of liquidity. However, the degree of liquidity is one of the factors
that characterize different financial markets.

The third economic function of a financial market is that it reduces the cost of transacting when
parties want to trade a financial instrument. In general, one can classify the costs associated with
transacting into two types: search costs and information costs. Search costs in turn fall into
categories: explicit costs and implicit costs. Explicit costs include expenses that may be needed
to advertise one’s intention to sell or purchase a financial instrument; implicit costs include the

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value of time spent in locating counterparty to the transaction. The presence of some form of
organized financial market reduces search costs. Information costs are costs associated with
assessing a financial instrument’s investment attributes. In a price efficient market, prices reflect
the aggregate information collected by all market participants.
The role of markets in the economy
Markets are institutions set up by society to allocate resources such as labor, raw-material,
managerial skill capital and etc which are scarce relative to the demand for them.
Market has the following roles in the economy-
 Markets are channels through which buyers and sellers meet to exchange goods and
services.
 Market determines what goods and services will be produced
 Market distributes income
 Market reward superior productivity, innovation, sensitivity to customer needs with
increase profit, higher wages and salaries and other economic benefits.
TYPES OF FINANCIAL MARKETS
There are many ways to classify financial markets.

1. Based on type financial claims:-the financial claims traded in a financial market may be
either for a fixed dollar amount or for a residual amount. The financial assets traded
under a fixed dollar amount are referred to as debt instruments. The financial market
where debt instruments (bonds, treasury bills, commercial papers others) are traded is
known as debt markets. Financial assets traded under the residual amount are referred as
equity instruments. The financial market where equity instruments (stocks) are traded is
referred to as equity market.
2. Based on maturity of financial claims:- financial market for short –term financial assets,
which mature with in less than one year such as treasury bills, commercial papers,
certificate of deposits etc called money market.
Financial markets for long –term financial assets with the maturity of more than one year
is referred to as capital markets-. Based on this classification part of debt instruments
can be part of money market and capital market depending on their maturity. But all
equity instruments are generally as capital markets because of their perpetuity.

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 3. Based on whether the financial claims are newly issued or seasonal: The financial market
for newly issued financial assets is called primary market. Markets used for exchanging
financial claims previously issued called secondary market or the market for seasonal
instruments.
4. Based on the type of financial assets used in transactions: cash market and derivative
instrument market.
5. Based on organizational structure :
a) Auction market- all financial assets are traded in the centralized trading facility
through bidding. Example NBE treasury bills pronounce through TV for bidding.
b) Over- the- counter market- markets that do no operate in a specific fixed
location- rather transactions occur via telephone, wire transfers, computer trading.
This type of market allows a number of dealers (seller and buyer of financial
instruments) without any restriction.
c) Intermediated market –is a market where an entity called financial intermediary
issues financial claims against itself. With the funds it receives, it purchases
financial assets.

Financial Intermediaries/ Institutions

Despite the important role of financial markets, their role in allowing the efficient allocation for
those who have funds to invest and those who need funds may not always work as described
earlier. As a result, financial systems have found the need for a special type of financial entity
called a financial intermediary when there are conditions that make it difficult for lenders or
investors of funds to deal directly with borrowers of funds in financial markets. Financial
intermediaries include depository institutions and non-depository institutions such as insurance
companies, regulated investment companies, investment banks, etc.

The role of financial intermediaries is to create more favorable transaction terms than could be
realized by lenders/investors and borrowers dealing directly with each other in the financial
market.

This is accomplished by financial intermediaries in a two-step process:

(1) Obtaining funds from lenders or investors (by selling financial claims) and

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 (2) Lending or investing the funds that they borrow to those who need funds (use the
money to buy financial claims (IOUs) of economic units, there by funding them).

The funds that a financial intermediary acquires become, depending on the financial claim, either
the liability of the financial intermediary or equity participants of the financial intermediary. The
funds that a financial intermediary lends or invests become the asset of the financial
intermediary.

Here are two examples using financial intermediaries that we will elaborate further upon below.
In our first example, consider a commercial bank, a type of depository institution. Everyone
knows that a bank accepts deposits from individuals, corporations, and governments. These
depositors are the lenders to the commercial bank. The funds received by the commercial bank
become the liability of the commercial bank. In turn, as explained later, a bank will lend these
funds by either making loans or buying securities. The loans and securities become the assets of
the commercial bank. In our second example, consider a mutual fund (one type of regulated
investment company that we will discuss in the second chapter). A mutual fund accepts funds
from investors who in exchange receive mutual fund shares. In turn, the mutual funds invest
those funds in a portfolio of financial instruments. The mutual fund shares represent an equity
interest in the portfolio of financial instruments and the financial instruments are the assets of the
mutual fund.

Basically, the process we just described has allowed a financial intermediary to transform
financial assets that are less desirable for a large part of the investing public into other financial
assets—their own liabilities—which are more widely preferred by the public. This asset
transformation provides at least one of three economic functions: Maturity, intermediation and
Risk reduction via diversification.

Lending and borrowing in the financial system

To understand financial markets, let us look at what they are used for, i.e. what is their purpose?

Without financial markets, borrowers would have difficulty finding lenders themselves.
Intermediaries such as banks help in this process. Banks take deposits from those who have

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money to save. They can then lend money from this pool of deposited money to those who seek
to borrow. Banks popularly lend money in the form of loans and mortgages.

More complex transactions than a simple bank deposit require markets where lenders and their
agents can meet borrowers and their agents, and where existing borrowing or lending
commitments can be sold on to other parties. A good example of a financial market is a stock
exchange. A company can raise money by selling shares to investors and its existing shares can
be bought or sold.

Lenders

Many individuals are not aware that they are lenders, but almost everybody does lend money in
many ways. A person lends money when he or she:

 puts money in a savings account at a bank;

 contributes to a pension plan;
 pays premiums to an insurance company;
 Invests in government bonds; or
 invests in company shares.

Companies tend to be borrowers of capital. When companies have surplus cash that is not needed
for a short period of time, they may seek to make money from their cash surplus by lending it via
short term markets called money markets.

There are a few companies that have very strong cash flows. These companies tend to be lenders
rather than borrowers. Such companies may decide to return cash to lenders (e.g. via a share
buyback.) Alternatively, they may seek to make more money on their cash by lending it (e.g.
investing in bonds and stocks.)

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Borrowers

Individuals borrow money via bankers' loans for short term needs or longer term mortgages to
help finance a house purchase.

Companies borrow money to aid short term or long term cash flows. They also borrow to fund
modernization or future business expansion.

Governments often find their spending requirements exceed their tax revenues. To make up this
difference, they need to borrow. Governments also borrow on behalf of nationalized industries,
municipalities, local authorities and other public sector bodies.

Governments borrow by issuing bonds. Government debt seems to be permanent. Indeed the
debt seemingly expands rather than being paid off. One strategy used by governments to reduce
the value of the debt is to influence inflation. Municipalities and local authorities may borrow in
their own name as well as receiving funding from national governments.

Public Corporations typically include nationalized industries. These may include the postal
services, railway companies and utility companies. Many borrowers have difficulty raising
money locally. They need to borrow internationally with the aid of Foreign exchange markets.

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