Chapter 1

An Overview of Financial Markets and Institutions

Contents
 Basic components of the financial system: Markets and institutions
 The role of financial resources in the economy
 Characteristics of financial assets
 Financial asset innovation
 The role and type of financial markets
 The role and type of financial institutions
1.1. Basic components of the financial system: Markets and institutions.
1. Financial markets aremarkets in which funds are transferred from people who have
an excess of available funds to people who have a shortage.Financial markets, such as
bond and stock markets, are crucial to promoting greater economic efficiency by
channeling funds from people who do not have a productive use for them to those who
do.
 Financial markets are markets for financial instruments e.g. stocks, bonds etc, also
called financial claims or securities.
 Financial instruments are monetary contracts between parties. They can be
created, traded, modified and settled.
 Stock (also capital stock) is all of the shares into which ownership
ofa corporation is divided. A common stock (typically just called a stock)
represents a share of ownership in a corporation. It is a security that is a claim
on the earnings and assets of the corporation. Issuing stock and selling it to the
public is a way for corporations to raise funds to finance their activities. The
stock market, in which claims on the earnings of corporations (shares of stock)
are traded, is the most widely followed financial market in almost every country
that has one; that’s why it is often called simply “the market.”
 The stock market is also an important factor in business investment
decisions,because the price of shares affects the amount of funds that can be
raised by selling newly issued stock to finance investment spending. A higher
price for a firm’s shares means that it can raise a larger amount of funds, which
can be used to buy production facilities and equipment.
 In finance, a bond is an instrument of indebtedness of the bond issuer to the
holders. A bond is a debt security that promises to make payments periodically
for a specified period of time. Debt markets, also often referred to generically as
the bond market, are especially important to economic activity because they
enable corporations and governments to borrow in order to finance their
 activities; the bond market is also where interest rates are determined. The
most common types of bonds include municipal bonds and corporate bonds.
 The bond is a debt security, under which the issuer owes the holders a debt and
(depending on the terms of the bond) is obliged to pay
them interest (the coupon) or to repay the principal at a later date, termed
the maturity date.
 A security is a tradable financial asset. The term commonly refers to any form
of financial instrument.A security (also called a financial instrument) is a claim
on the issuer’s future income or assets (any financial claim or piece of property
that is subject to ownership).
 A financial asset is a non-physical asset whose value is derived from
acontractual claim, such as bank deposits, bonds, and participations in
companies' share capital. Financial assets are usually
more liquid thanother tangible assets, such as commodities or real estate.
 An interest rate is the cost of borrowing or the price paid for the rental of
funds (usually expressed as a percentage of the rental of $100 per year). There
are many interest rates in the economy - mortgage interest rates, car loan rates,
and interest rates on many different types of bonds.
 For funds to be transferred from one country to another, they have to be
converted from the currency in the country of origin (say, birr) into the
currency of the country they are going to (say, dollar). The foreign exchange
market is where this conversion takes place, so it is instrumental in moving
funds between countries. It is also important because it is where the foreign
exchange rate, the price of one country’s currency in terms of another’s, is
determined.
 Interest rates are important on a number of levels. On a personal level, high interest rates
could deter you from buying a house or a car because the cost of financing it would be
high. Conversely, high interest rates could encourage you to save because you can earn
more interest income by putting aside some of your earnings as savings. On a more
general level, interest rates have an impact on the overall health of the economy because
they affect not only consumers’ willingness to spend or save but also businesses’
investment decisions. High interest rates, for example, might cause a corporation to
postpone building a new plant that would provide more jobs.
 Indeed, well-functioning financial markets are a key factor in producing high
economic growth, and poorly performing financial markets are one reason that many
countries in the world remain desperately poor. Activities in financial markets also have
direct effects on personal wealth, the behavior of businesses and consumers, and the
cyclical performance of the economy.
2. The second major focus is financial institutions. Financial institutions are
what make financial markets work. Without them, financial markets would not be able
to move funds from people who save to people who have productive investment
opportunities. They thus play a crucial role in improving the efficiency of the
economy.
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 Financial institutions (also called financial intermediaries) facilitate flows of funds
from savers to borrowers. E.g. banks, finance companies, etc.
 A financial intermediary is an institution or individual that serves as a
middleman among diverse parties in order to facilitate financial transactions.
Common types include commercial banks, investment banks, stockbrokers,
pooled investment funds, and stock exchanges.
 Financial intermediaries areinstitutions such as commercial banks, savings and
loan associations, mutual savings banks, credit unions, insurance companies, mutual
funds, pension funds, and finance companies that borrow funds from people who
have saved and in turn make loans to others.
 Structure of the Financial System: The financial system is complex, comprising many
different types of private-sector financial institutions, including banks, insurance
companies, mutual funds, finance companies, and investment banks - all of which are
heavily regulated by the government.
 Financial Crises: At times, the financial system seizes up and produces financial
crises, major disruptions in financial markets that are characterized by sharp declines
in asset prices and the failures of many financial and nonfinancial firms. Financial
crises have been a feature of capitalist economies for hundreds of years and are typically
followed by the worst business cycle downturns.
 Central Banks and the Conduct of Monetary Policy: The most important financial
institution in the financial system is the central bank, the government agency
responsible for the conduct of monetary policy;this in Ethiopia is the National Bank
of Ethiopia.
 Monetary policy involves the management of interest rates and the quantity
ofmoney, also referred to as the money supply (defined as anything that is generally
accepted in payment for goods and services or in the repayment of debt). Because
monetary policy affects interest rates, inflation, and business cycles, all of which have a
major impact on financial markets and institutions.
 Banks and Other Financial Institutions: Banks are financial institutions that accept
deposits and make loans. Included under the term banksare firms such as commercial
banks, savings and loan associations, mutual savings banks, and credit unions.
Banks are the financial intermediaries that the average person interacts with most
frequently. A person who needs a loan to buy a house or a car usually obtains it from a
local bank.
 Because banks are the largest financial intermediaries in our economy, they deserve
careful study. However, banks are not the only important financial institutions. Indeed, in
recent years, other financial institutions such as insurance companies, finance
companies, pension funds, mutual funds, and investment banks have been growing at the
expense of banks.
 Financial Innovation: In the good old days, when you took cash out of the bank or
wanted to check your account balance, you got to say hello to a friendly human.
Nowadays, you are more likely to interact with an automatic teller machine (ATM)

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 when withdrawing cash, and to use your home computer to check your account
balance.E-finance: A new means of delivering financial services electronically.
All Economic units can be classified into:
In an economy, production, consumption and exchange are carried out by
threebasic economic units: the household, the firm, and the government.
 Households supply labor, demand products, and save for the future.
Households make consumption decisions and own factors of production. They provide
firms with factor services in production, and buy finished goods from firms
forconsumption.

 Factors of production are the resources people use to produce goods and services;
they are the building blocks of the economy. Economists divide the factors of
production into four categories: land, labor, capital, and entrepreneurship.
 Businesses demand labor, supply products, and invest in productive assets.
Firms make production decisions. These include what goods to produce, how these
goods are to be produced and what prices to charge. They employ the various factors of
production and they sell the finished goods to the households for consumption and to the
government.

 Governmentscollect taxes and provide “public goods” (e.g. education, defense).

The government collects taxes from households, buys goods from firms, and distributes
those goods to households individually or collectively. It also redistributes purchasing
power between households.
Thus the Budget positions of any economic unit can be: Surplus or deficit or balanced in a
given budget period
 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.
Financial claims arise as SSUs lend to DSUs.
 Funds can be transferred through IOUs (I OWE YOU) from SSU to DSU. IOUs are
called as financial claims.
 An IOU (I owe you) is usually an informal document acknowledging debt.

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 Financial claim is liability to DSU and asset to SSU.
 One’s liability is another’s asset: What is payable by one is receivable by another.
 Assets arising this way are “financial assets.” The financial system “balances”-total
financial assets equal total liabilities.
 SSU can hold the financial claims until maturity or sold to someone. The ease, with
which a financial asset may be sold to another SSU, is its marketability. Ability to resell
financial claims makes them more liquid by giving SSUs choices:
 Match maturity of claim to planned investment period;
 Buy claim with longer maturity, but sell at end of period; or
 Buy claim with shorter maturity, then reinvest.
Exhibit 1.1 – Transfer of Funds

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Methods of Financing:
1. Direct Financing: The simplest way for funds to flow.

 DSU and SSU find each other and bargain (negotiate).

 SSU transfers funds directly to DSU.
 DSU issues claim directly to SSU.
 Preferences of both must match as to-
- Amount
- Maturity
- Risk
- Liquidity

Direct Financing: efficient for large transactions if preferences match.

 DSUs and SSUs “seize the day” - DSUs fund desired projects immediately.SSUs earn timely
returns on savings.
 Direct markets are “wholesale” markets. Transactions typically $1 million or
more.Institutional arrangements common.

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Indirect finance
 Borrowers borrow indirectly from lenders via financial intermediaries (established to
source both loanable funds and loan opportunities) by issuing financial instruments which
are claims on the borrower’s future income or assets.

1.2. Financial resources

 Financial assets, also referred to as financial instruments or securities, are intangible

assets. They are often used to finance the ownership of tangible assets as equipment’s and
real estate. Some examples of financial assets are: stocks, bonds, bank deposits, loans.
The role of financial resources
 Transfer fundsfrom surplus unitstodeficit units:
 (Transfer capital from savers (investors) to capital users (usually corporations).
Example: A person allocates pension savings to a new issue of stock, and company
management uses proceeds of new issue to expand.
 Redistribute the unavoidable riskassociated with the cash flow generated by tangible
assets among the deficit units and surplus units.
 Risk transfer, sharing, and management.
 Reduction of risk bearing by repackaging risks.
Example: Firm uses financial futures to hedge (reduce) foreign currency risk.
Characteristics of financial assets
 Moneyness-used as a medium of exchange.
Money: a medium of exchange (a paper claim backed by the government), is held to allow
the completion of transactions.
 Divisibility & denomination-denominated in smaller sizes.
 Extent to which fractional amounts of an asset can be sold/bought.
1. Physical assets are often indivisible (cars) but not always (gas).
2. Financial assets often are divisible (equity of a corporation).
 In this course we will treat all financial assets as divisible.
 Reversibility-ability to be converted back to cash at a lower cost(low round trip cost).

 Term to maturity-length of time between when the instrument is issued and its
liquidation.

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  Some instruments are liquidated upon demand by the creditor.
 Instruments may be issued with the term of a few days to- so many years.
Eg. Treasury bill Vs Bonds
 Instruments may be liquidated prematurely.
 Cash flow and return predictability- return on a financial asset depends on the cash
flow expected to be received.
 Complexity- some financial assets may be combinations of two or simpler assets.
 Tax status-financialassets have different tax status.
 Liquidity-can be resold without substantial loss of value.
 Liquidity differs based on the issuer's identity the degree of market
capitalization.
 Convertibility-ability to be converted into other financial assets.
 Currency- are denominated in a certain currency.

1.3. Financial Market

 A Financial Market is a market in whichfinancial assets (securities) such as stocks and

bondscan be purchased or sold.
 Fundsare transferred in financial markets when one party purchases financial assets
previously held by another party.

The role and type of financial markets

 The role of financial markets

 Eliminate arbitrage
 The simultaneous purchase and sale of an asset in order to profit from a
difference in the price).
 Raising capital
 Commercial transactions- financial marketsprovide the grease that makes many
commercial transactions possible.
 Investing-provide an opportunity to earn a return on fundsthat are not immediately
needed.
 Risk management- futures, options and other derivatives contracts can provide
protection against many types of risk.

 Classification of financial markets

 Money markets and Capital markets
 Primary and secondary market

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  Fixed claim and residual claim markets
Debt Markets
 Short-term (maturity < 1 year) – theMoney Market
 Long-term (maturity > 10 year) – the Capital Market
 Medium-term (maturity >1 and < 10 years)

1. Money markets and Capital markets

 Those financial markets that facilitate the flow of short-term funds (with maturities of
one year or less) are known as money markets while those that facilitate the flow of
long-term funds(with maturities of more than ten years) are known as capital markets.
 Money market securities are debt securities that have a maturity of one year or less.
 They have a relatively high degree of liquidity, due to their short maturities, and
because they typically have an active secondary market.
2. Primary and secondary market
 The issuance of new corporate stock or new Treasury securities is a primary market
transactionwhile the sale of existing corporate stock or Treasury security holdings by
one investor to another is a secondary market transaction.
 Primary market transactions provide funds to the initial issuer of securities;
secondary market transactions do not.
Secondary markets – Organization of exchanges

1. Organize exchanges where buyers and sellers of securities (or their brokers or agents)
meet in one central location to conduct trades.
2. Over the counter market: - Dealers at different locations who have an inventory of
securities stand ready to buy and sell securities over the counter.

Secondary markets
 Security brokers and dealers are crucial to well functioningsecondary markets.
 Brokers are agents of investors who match buyers with sellers of securities.
 Dealers link buyers and sellers by buying and selling securities atstated prices.
3. Fixed claim and residual claim markets
 Debt instruments and preferred stock are classified as part of the fixed income market.
 Equity instrumentsare residual income securities.

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Asymmetric information
Asymmetric information is a term that refers to when one party in a transaction is in
possession of more information than the other.
 Another reason Financial Institutions exist is to reduce the impact of asymmetric
information.
 One party lacks crucial information about another party, impacting decision-making.
 We usually discuss this problem along two fronts: adverse selection and moral hazard.
Function of Financial
Asymmetric Information: - Adverse Selection and Moral Hazard
 Adverse Selection
1. Before transaction occurs.
2. Potential borrowers most likely to produce adverse outcome are ones most
likely to seek a loan.
3. Similar problems occur with insurance where unhealthy people want their known
medical problems covered.
 Moral Hazard
1. After transaction occurs.
2. Hazard that borrower has incentives to engage in undesirable (immoral)
activities making it more likely that won’t pay loan back.
3. Again, with insurance, people may engage in risky activities only after being
insured.
4. Another view is a conflict of interest.
 Financial intermediaries reduce adverse selection and moral hazard problems, enabling
them to make profits. How they do this is covered in many of the chapters to come.
 Because of their expertise in screening and monitoring, they minimize their losses,
earning a higher return on lending and paying higher yields to savers.

1.4. The role and type of financial Institutions

 The role of financial Institutions

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  Maturity intermediation- they create loans of long term maturity out of deposits
that mature in the short term.
 Risk reduction through diversification-they diversify risk by investing in different
sectors of the economy.
 Reducing the cost of contracting and information processing-they are better
equipped in completing contracts and processing information.
 Providing a payment mechanism-enable individuals and businesses to effect
payments using checks, credit cards, debit cards, and through electronic transfer.

 Types of financial Institutions

1. Deposit taking institutions

 Commercial Banks
 Saving and Loan Associations
2. Non-deposit taking institutions
 Insurance companies
 Mutual funds
 Pension funds
 Investment Banks

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 Types of Financial Intermediaries

Mutual funds
 Mutual funds sell shares to surplus units and use the funds received to purchase a
portfolio of securities.A portfolio is a collection of financial investments like stocks,
bonds, commodities, cash, and cash equivalents.
 They are the dominant non-depository financial institution when measured in total assets.
 Some mutual funds concentrate their investment in capital market securities, such as
stocks or bonds.

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 A mutual fund is a firm that manages a pool of money that has been placed with the
fund by investors (who buy shares in the fund).
 The Money is invested in specified types of assets.
 Fund shares’ value changes over time with changes in value of the fund's assets.

1.5. Financial asset Innovation

 Financial innovation can be defined as the act of creating and then popularizing
new financialinstruments as well as new financialtechnologies, institutions and
markets. It includes institutional, product and process innovation.
 Types of financial Innovations
 Market broadening instruments
 Risk management instruments
 Arbitrage instruments
1. Market broadening instruments -increase market liquidity and availability of
fundsby attracting new investors and offering new opportunities for borrowers.
E.g. - Mortgage backed securities
2. Risk management instruments-reallocate financial risk to the less risk averse,
which have offsetting position and thus have the ability to shoulder them.
3. Arbitraging instruments and processes-enable traders to take advantages of
difference in the costs and returns between markets.

 Drivers of financial innovation

 Endeavortocircumvent regulationsand find loopholes in tax rules.
 A need to efficiently redistribute risksamong market participants.
 Increased volatility of interest rate, inflation and equity prices and exchange rates.
 Advances in computer and communication technologies.

1.6. Regulation of Financial Markets

 Main Reasons for Regulation
1. Increase Information to Investors
 Decreases adverse selection and moral hazard problems.

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  SEC forces corporations to disclose information.
2. Ensuring the Soundness of Financial Intermediaries
 Prevents financial panics.
 Chartering, reporting requirements, restrictions on assets and activities,
deposit insurance, and anti-competitive measures.
3. Improving Monetary Control
 Reserve requirements
 Deposit insurance to prevent bank panics

1. Regulation Reason: - Increase Investor Information

 Asymmetric information in financial markets means that investors may be subject
to adverse selection and moral hazard problems that may hinder the efficient
operation of financial markets and may also keep investors away from financial
markets.
 Regulation takes care of this aspect.
 Such government regulation can reduce adverse selection and moral hazard
problems in financial markets and increase their efficiency by increasing the
amount of information available to investors.
2. Regulation Reason: - Ensure Soundness of Financial Intermediaries
 To protect the public and the economy from financial panics, the government has
implemented six types of regulations:
─ Restrictions on Entry
─ Disclosure
─ Restrictions on Assets and Activities
─ Deposit Insurance
─ Limits on Competition
─ Restrictions on Interest Rates
 Asymmetric information makes it difficult to evaluate whether the financial intermediaries
are sound or not.
 Can result in panics, bank runs, and failure of intermediaries.

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 3. Regulation Reason: - Improve Monetary Control
 Because banks play a very important role in determining the supply of money (which in
turn affects many aspects of the economy), much regulation of these financial
intermediaries is intended to improve control over the money supply.
 One such regulation is reserve requirements, which make it obligatory for all depository
institutions to keep a certain fraction of their deposits in accounts with the Federal
Reserve System (the Fed), the central bank in the United States.
 Reserve requirements help the Fed exercise more precise control over the money supply.

Chapter 2
Financial Market Structure

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Chapter Contents
 Money markets
 Bond markets
 Mortgage markets
 Stock markets
 Foreign exchange markets
 Derivate securities market

1.2Money markets
 Refer to the network of corporations, financial institutions, investors and governments
which deal with the flow of short-term capital.
 Money markets do not exist in a particular place or operate according to a single set of
rules. Rather, they are webs of borrowers and lenders, all linked by telephones and
computers.
 They bring borrowers and investors together without the comparatively costly
intermediation of banks.
 They help borrowers meet short-run liquidity needs and deal with irregular cash
flows without resorting to more costly means of raising money.
 There is an identifiable money market for each currency, because interest rates vary
from one currency to another.
 They have expanded significantly as a result of the general outflow of money from the
banking industry, a process referred to as disintermediation.
What do money markets do?
 Help issuers of instruments with cash management or with financing their portfolios of
financial assets.
 Attach a price to liquidity, the availability of money for immediate investment.
 Active/liquid money markets allow borrowers and investors to engaging in a series of
short-term transactions rather than in longer-term transactions, keeping down long-
term interest rate.

Types of instruments
1. Commercial paper

 A short-term debt obligation of a private-sector firm or a government-sponsored

corporation.
 Has maturity of between 90 days and 9 months.
 Is usually unsecured.
 Developed with the aim of allowing financially sound companies to meet their short-
term financing needs at lower rates than could be obtained by borrowing directly
from banks.
Types of Commercial paper

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  There are two types of Commercial Papers:
1. Direct Paper: Direct Paper is issued by large finance companies and bank-holding
companies that deal directly with investors rather than using a security dealer.
2. Dealer (or Industrial) Paper: is issued mainly by non-financial companies – including
public utilities, manufacturers, retailers, wholesalers, etc.

2. Bankers’ acceptance

 A promissory note issued by a non-financial firm to a bank in return for a loan.

 The bank resells the note in the money market at a discount and guarantees
payment.
 Is issued at a discount and has a maturity of less than six months.
 Is usually tied to the sale or storage of specific goods, such as an export order for
which the proceeds will be received in two or three months.
 Are not issued at all by financial-industry firms, investors rely on the strength of
the guarantor bank, rather than of the issuing company, for their security.

3. Treasury bills
 Securities with a maturity of one year or less, issued by national governments.

 Treasury bills issued by a government in its own currency are generally considered
the safest of all possible investments in that currency.

 Are used as principal source of financing where a government is

unable to convince investors to buy its longer-term obligations.
 As countries develop reputations for better economic and fiscal
management, they are often able to borrow for longer terms.
 Governments may issue Treasury Bills denominated in foreign
currency.
 But a sudden decline in the value of the currency increases the debt
burden and may even cause debt crisesas in Mexico in 1995, Russia in
1998 and Brazil in 1999.

Types of treasury bills (TBs)

 The major types of Treasury Bills issued in the money markets:

(1) Regular-Series Bills - issued routinely every week or month in competitive
auctions.

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  The regular series bills comprise:
- Three-Month Bills that are auctioned “weekly”.
- Six-Month Bills that are auctioned “weekly” and provides the largest
amount of revenue for the treasury.
- One-Year Bills that are sold once “each month”.
(2) Irregular-Series Bills - issued only when the treasury has a special
cash need.
 Treasury bills do not carry a promised interest rate, but instead are
sold at a discount from par.
4. Interbank loans

 Loans extended from one bank to another with which it has no

affiliation.
 Are used by the borrowing institution to re-lend to its own customers.
 Includes overnight loans needed to maintain the required reserves.
 Banks extend short-term loans to one another at agreed upon interest rate.
 It is called LIBOR (London Inter Bank Offer Rate) in UK, Fed fund rate in the
US.
 A lending bank can charge more than LIBOR if the borrowing bank is not
creditworthy.

5. Time deposits or CDs

 Another name for certificates of deposit (CDs).
 Are interest-bearing bank deposits that cannot be withdrawn without penalty
before a specified date.
 Time deposits may last for as long as five years.
6. Repurchase agreement (Repos)

 Is a combination of two transactions:

1. A securities dealer, such as a bank, sells securities it owns to an investor,

agreeing to repurchase the securities at a specified higher price at a future
date.
2. Days or months later, the repo is unwound as the dealer buys back the
securities from the investor.

 Amount the investor lends is less than the market value of the securities, a
difference called the haircut.

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  In a reverse repo the roles are switched, with an investor selling securities to a
dealer and subsequently repurchasing them.
7. Futures

 Used for hedging and cash management.

 By buying or selling a futures contract on a short-term interest rate or a short-
term debt security, an investor can profit if the relevant rate is above or below
the chosen level on the contract’s expiration date.

2.2 Bond Markets

 The word “bond” means contract, agreement, or guarantee.
 An investor who purchases a bond is lending money to the issuer.
 A bond represents the issuer’s contractual promise to pay interest and repay
principal according to specified terms.
 Bonds offer a way for governments to borrow from many individuals rather
than just a handful of bankers.
 Are the most widely used of all financial instruments.
 As of 2009, the size of the worldwide bond market (total debt outstanding) is an
estimated at $82.2 trillion.

Why issue a bond?

- Diversify sources of funding.
- The issuer can raise far more money without exhausting its traditional credit lines
with direct lenders.
- Minimize cost of capital- cost is lower and the funds can be repaid over a longer
period.
- Matching revenue and expenses-bonds offer a way of linking the repayment of
borrowings for long term projects to anticipated revenue.
- Promoting inter-generational equity-bonds offer a means of requiring future
taxpayers to pay for the benefits they enjoy, rather than putting the burden on current
taxpayers.
- Controlling risk-the obligation to repay a bond can be tied to a specific project or a
particular government agency, insulating the parent corporation or government from
responsibility.
- Avoiding short-term financial constraints- governments and firms may turn to the
bond markets to avoid financial constraints.
The issuers

(1) National governments

 Bonds backed by the full faith and credit of national governments are called
sovereigns.
 Example, 2014 Ethiopian government issued bond raising up to $1bn with a 10-year
from foreign investors.
 Are generally considered the most secure type of bond.
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 (2) Lower levels of government
 Bonds issued by a government at the sub-national level, such as a city, a province or
a state, are called semi-sovereigns.
(3) Corporations
 Are issued by a business enterprise-owned by private investors or by a government.
 In issuing a secured obligation, the firm must pledge specific assets to bondholders.

Issuing bonds
 Each issue is preceded by a lengthy legal document- the offer document or
prospectus.
 Offer document lays out in detail:
 the financial condition of the issuer;
 the purposes for which the debt is being sold;
 the schedule for the interest and principal payments;
 the security offered to bondholders in the event the debt is not serviced as
required.
 A bond can be issued either through dealers or directly to the investors or
o Underwriter: is a company, usually an investment bank, that helps companies
introduce their new securities to the market.
Types of bonds

(1) Straight bonds

 Debentures (debenture bond - unsecured bond)

 Are the basic fixed-income investment.
 Owner receives interest payments on specified dates, usually every six months or
every year following the date of issue.
 The issuer must redeem the bond from the owner at its face value on a specific date.

(2) Callable bonds

 The issuer may reserve the right to call the bonds at particular dates.
 The difference between the call price and the current market price is the call
premium.
 A bond that is callable is worth less than an identical bond that is non-callable.

(3) Putable bonds

 Gives the investor the right to sell the bonds back to the issuer at par value on
designated dates.
 This benefits the investor if interest rates rise.

(4) Perpetual debentures

 Irredeemable debentures,

20
 Are bonds that will last forever unless the holder agrees to sell them back to the
issuer.

(5) Zero-coupon bonds

 Do not pay periodic interest.

 Issued at less than par value and are redeemed at par value.
 Are designed to eliminate reinvestment risk-the loss an investor suffers if future
income or principal payments from a bond must be invested at lower rates than those
available today.
Properties of bonds
1. Maturity
 Has a date on which the bond issuer will have repaid all of the principal and will
redeem the bond.
2. Coupon
 The stated annual interest rate as a percentage of the price at issuance.
 Once a bond has been issued, its coupon never changes.
3. Current yield
 Has the effective interest rate for a bond at its current market price. This is
calculated by a simple formula:
Annual dollar coupon interest / current price
 If the price has fallen since the bond was issued, the current yield will be
greater than the coupon.
4. Yield to maturity
 This is the annual rate the bondholder will receive if the bond is held to
maturity.
 Yield to maturity includes the value of any capital gain or loss the bondholder
will enjoy when the bond is redeemed.
 Is the most widely used figure for comparing returns on different bonds.
5. Duration
 A number expressing how quickly the investor will receive half of the total
payment due over the bond’s remaining life.

Ratings of risk

 Bond issuers often seek a rating from one or more private ratings agencies before
they issue bonds
 The selected agencies investigate the issuer’s ability to service the bonds,
including such matters as financial strength, the intended use of the funds, the
political and regulatory environment, and potential economic changes.

21
 After completing its investigation, an agency will issue a rating that represents
its estimate of the default risk, the likelihood that the issuer will fail to service
the bonds as required.
 Three well-known companies are Moody’s Investors Service, Standard &
Poor’s, and Fitch ibca.

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 2.3 Mortgage Markets
What is mortgage?
 A pledge of property to secure payment of a debt.
 Debt incurred in order to buy land or building.
 Involves two parties: mortgagor (home owner) and mortgagee (lender).
 Mortgages may be insured by government agencies.
 Federal Housing Authority (FHA in US)
 Veterans Administration (VA in US)
 real estate that can be pledged as a mortgage are divided into two as
residential and non-residential property.

Terms
 Amortized—principal and interest is gradually repaid over the life of loan.
 Fixed Rate—Rate of interest is fixed.

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  Variable-Rate—Rate of interest varies depending on financial environment.
 Cash flow for lender is uncertain.
 Interest payments may vary - variable rate mortgages.
 Home owner may prepay, Refinance a fixed mortgage if interest rates decline.
Originators
 Commercial banks, thrift (S&Ls), and mortgage banks.
 Generate income from origination fee, application fee and profit from selling a
mortgage at a higher price.

Origination process
1. Homeowner applies for a mortgage loan.
2. Mortgage originator performs credit evaluation of the applicant based on Loan-
to-Value ratio (LTV) and Payment to Income ratio (PTI).
3. Contract signed.

Mortgage Rate depends on

1. Market rates: - Long-term market rates are determined by the supply of and
demand for long-term funds, which are in turn influenced by a number of
global, national, and regional factors.
2. Term: - Longer-term mortgages have higher interest rates than shorter-term
mortgages.
3. Discount points: - Discount points (or simply points) are interest payments made
at the beginning of a loan. A loan with one discount point means that the
borrower pays 1% of the loan amount when the borrower signs the loan paper
and receives the proceeds of the loan.

Originators can
1. Keep mortgage (borrower signed loan paper) in their portifolios.
2. Sell to an investor.
3. Use it as a collateral for issuance of a security.

Mortgage-backed security (MBS)

 A mortgage-backed security is a type of asset-backed security that is secured by a

mortgage or collection of mortgages.
 The mortgages are sold to a group of individuals (a government agency or investment
bank) that securitizes, or packages, the loans together into a security that investors can
buy.
 Securitizes-turning something which is not tradable to tradable.

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  Securitization-Individual mortgages may be “pooled” and sold as a unit to reduce
uncertainty.
 Involves securities issued with mortgages used as a collateral.
 THREE types:
1. Pass through securities.
2. Collateralized mortgage obligation(CMO).
3. Mortgage backed bond.

Types of Mortgage-backed securities

1. Pass through securities:
 A security consisting of a pool of residential mortgage loans. All payments of
principal and interest are passed through to investors each month.
 A security created by pooling mortgages and selling shares/participation
certificates in the pool.
 Gives the investors a pro rata share of the principal and interest on the pool.
 The pool may consist several thousands or just a few.
 Help investors eliminate the unsystematic/random risk.
2. Collateralized Mortgage Obligation:
 A multi-class pass through with a number of bond holder classes.
 Each bond holder has a different guaranteed coupon paid semiannually.
3. Mortgage-backed bonds:
 Bonds in which mortgages are used as a collateral.
 Is more a collateralization than securitization.
Sub-Prime Mortgages
 Loans extended to borrowers who do not qualify for loans at the usual market
rate of interest because of a poor credit rating or because the loan is larger than
justified by their income.
 They constituted 2% of mortgage loans in 2000 and about 17% in 2004.
Real Estate Bubble
A real estate bubble or property bubble (or housing bubble for residential markets) is
a type of economic bubble that occurs periodically in local or global real estate markets,
typically following a land boom. ... Bubbles in housing markets are more critical than
stock market bubbles.
 The asset a price or price range that strongly exceeds the asset's intrinsic value.
Caused by two factors
1. Increase in sub-prime mortgages.
2. Real estate speculators.

2.4 Stock Markets

 Where equity claims are traded.

 Common(ordinary) stock and preferred stock.
 Includes both primary market and secondary market.
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  Primary market is where initial public offering/IPOs are issued and also where
seasoned offerings are made.
 Seasoned offering have rights offerings.

Value of rights offerings

Value of the right

=
Market value – Average price
Secondary markets
 Where stocks once issued are traded.
 Include floor-based exchange(NYSE) and electronic-based exchange (NASDAQ)

26
27
28
 The trading process
Merrill Lynch :is a wealth
management division of
Bank of America.
National Association of Stock Dealers Automated Quotation(NASDAQ)
 One of over the counter markets.
 Devoid of a physical location.
 Has more firms listed than in NYSE.
 A dealer market where dealers stand ready to buy and sell stocks.

The trading process

Order Order

Broker
Investor Cash
( Merrill Cash Dealer
Lynch)
Shares Shares

Stock Market Indexes

 is a composite value of a group of secondary market traded stocks.

29
Example: Dow Johns Industrial Average (DJIA), S & P 500, NASDAQ composit-
industrials, banks, & insurance companies, DAX.
2.5 Foreign Exchange Markets

 Markets where currencies of different countries are traded.

 Spot rateand forward rate.
 Determinants of Exchange Rate:
 relative inflation rates
 relative interest rates
 relative income levels
 government controls
 expectations

Forex mkt

30
Determinants of Exchange Rate
 As a general rule, a country with a consistently lower inflation rate exhibits a rising
currency value, as its purchasing power increases relative to other currencies.
 Higher interest rates / for investors, saving offer lenders in an economy a higher
return relative to other countries.
 Therefore, higher interest rates attract foreign capital and cause the exchange rate to
rise.
 The excess demand for foreign currency lowers the country's exchange rate until
domestic goods and services are cheap enough for foreigners, and foreign assets are too
expensive to generate sales for domestic interests. (Weaker local currency).
Government influence on exchange rates
1) Direct intervention
 By exchanging foreign currency with local currency.
 Can be sterilized or non-sterilized intervention.

Sterilized intervention
 the government buys or sells local currency (in the forex market) to
manipulate the exchange rate and at the same time undertakes an offseting
transaction in the money market to keep money supply unaffected.
Example
 When central banks intervene to weaken the currency, they sell their reserves
of the currency on the open market; how to weaken $?
 When they want to strengthen the currency, they buy the currency by
exchanging their domestic currency for the foreign currency.
Non-sterilized intervention
 The the government buys or sells local currency to manipulate its value.

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  No offseting transaction is undertaken in the money market to keep money
supply unaffected.
2) Indirect intervention
 Adjustment of interest rate-increase interest rate to discourage outflow of funds.
 Using foreign exchange controls-restriction on the exchange of the currency.

2.6 Derivative Securities Markets

 Derivative financial instruments

 Derive value from underlying assets
 Financial instruments the value of which is derived from the prices of
securities, commodities, money or other external variables.
 Are created to manage price volatility.
 Are widely used to speculate on future expectations or reduce portfolio risk.
Terms

 Long/buy position
 Buyer of the contract, receive commodity in the future
 Short/sell position
 Seller of the contract, provide commodity in the future
 Speculators
 Gamble on price fluctuations and hope to profit
 Hedgers
 Eliminate the risk of price fluctuations
Derivative Securities Markets
 Although many, they fall into two basic categories:
(1) Forwards are contracts that set a price for something to be delivered in the future.
(2) Options are contracts that allow, but do not require, one or both parties to obtain
certain benefits under certain conditions.

Exercise (a)
You enter a long forward contract at a price of 50. What is the payoff in 6 months for
prices of $40, $45, $50, $55?
40 – 50 = -10
45 – 50 = -5
50 – 50 = 0
55 – 50 = 5

Hedging and speculation

 Hedging involves taking an offsetting position in a derivative in order to balance any

gains and losses to the underlying asset.
 Hedging attempts to eliminate the volatility associated with the price of an asset by
taking offsetting positions contrary to what the investor currently has.

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  If someone bears an economic risk and uses the futures market to reduce that risk,
the person is a hedger.

Speculation
 The main purpose of speculation is to profit from betting on the direction in which an
asset will be moving.
 Speculators make bets or guesses on where they believe the market is headed.
 For example, if a speculator believes that a stockis overpriced, he or she may short sell
the stock and wait for the price of the stock to decline, at which point he or she will buy
back the stock and receive a profit.
 A person or firm who accepts the risk the hedger does not want to take is a
speculator.

Types of Derivative Securities

(1) Options:
 The purchaser of an Option has rights (but not obligations) to buy or sell the asset
during a given time for a specified price (the "Strike" price).
 An Option to buy is known as a "Call," and an Option to sell is called a "Put.”
 The seller of a Call Option is obligated to sell the asset to the party that
purchased the Option.
 The seller of a Put Option is obligated to buy the asset.

(2) Forward Contracts

 In a Forward Contract, both the seller and the purchaser are obligated to trade
a security or other asset at a specified date in the future.
 The price paid for the security or asset may be agreed upon at the time the
contract is entered into or may be determined at delivery.
 Forward Contracts generally are traded OTC.

(3) Futures
 A Future is a contract to buy or sell a standard quantity and quality of an asset or
security at a specified date and price.
 Futures are similar to Forward Contracts, but are standardized and traded on
an exchange, and are valued daily.
 The daily value provides both parties with an accounting of their financial
obligations under the terms of the Future.
 Unlike Forward Contracts, the counterparty to the buyer or seller in a Futures
contract is the clearing corporation on the appropriate exchange.
 Futures often are settled in cash or cash equivalents, rather than requiring
physical delivery of the underlying asset.

(4) Swaps

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  A Swap is a simultaneous buying and selling of the same security or obligation.
 Perhaps the best-known Swap occurs when two parties exchange interest
payments based on an identical principal amount, called the "notional
principal amount."
 Swaps are arrangements in which one party trades something with another party.
 The swap market is very large, with trillions of dollars outstanding.

Chapter 3

Financial Institutions and Operation

3.1 Depository Institutions

 Include commercial banks, savings and loan associations, and credit unions.
 Income derived from interest on loans, interest and dividend on securities, and fees
income.
 Are highly regulated because
(1) they mobilize a significant amount of household and business deposits.
(2) they are used as vehicles for executing monetary policy.

Asset / Liability Problem of Depository Institutions

Depository Institutions are exposed to:

 Credit risk - default by borrower or by issuer of security.
 Regulatory risk - adverse impact of regulations on earnings.
 Funding (interest rate) risk - caused by interest rate changes when Depository
Institutions borrow long(short) and lend short(long).

Liquidity concerns
 arises due to short-term maturity nature of deposits.

34
  Depository Institutions should always be ready to satisfy withdrawals and meet loan
demand.
 Sources of funds include:
 attract additional deposit.
 borrow using securities as a collateral.
 sell securities it owns.
 raise short-term funds in the money market.

Sources of funds
 Deposits - savings, demand, time.
 Reserve requirement - portion of deposit kept as a caution against possible
bank illiquidity.
 Non-deposit borrowings.
 Common stock and Retained earnings.

Types of Depository institutions

1. COMMERCIAL BANKS

 Commercial banks are one of the most important depository financial intermediaries
that offer the public both deposit and credit services.
 The name commercial implies the fact that these banks devote a substantial portion of
their resources to meet the financial needs of business firms.
 However, in recent years the services are expanded to consumers and units of
government as well.
 In addition to their traditional services, commercial banks have started to provide fewer
and more innovative services such as investment advice & investment execution and
tax planning to their customers.

Services of commercial banks

35
 Services of commercial bank includes:
 Individual banking
 Institutional banking
 Global banking

1. Individual banking:
Individual Banking, among others, encompasses the following list of services:
 Consumer lending,
 Residential mortgage lending,
 Consumer installment loans,
 Credit card financing,
 Automobile and boat financing,
 Brokerage services,
 Student loans, and
 Individual - oriented financial investment services such as personal trust and
investment services.
2. Institutional banking: - Institutional Banking encompasses loans to nonfinancial
corporations, financial corporation’s (such as life insurance companies), and
government entities (for instance, state and local governments).
3. Global banking: - Global banking covers a broad range of activities involving the
following:
 Corporate Financing, and
 Capital Market and Foreign - Exchange Products and Services.

36
 Corporate Financing: In assisting customers in obtaining funds. Banks provide
bankers acceptances, letters of credit, and other types of guarantees for their
customers.
 Corporate financing also involves advice on such matters as strategies for
obtaining funds, corporate restructuring and acquisitions.
 Capital Market and Foreign Exchange Products and Services :
 Involve transactions where the bank may act as a dealer or broker in a service.
 Similarly, some banks maintain a foreign-exchange operation, where foreign
currency is bought and sold.
Regulation
 by the central bank.
 areas of regulation include,
 Ceilings on deposit interest
 Permissible activities for Commercial Banks
 Capital requirements
Capital requirements
 aimed at preventing insolvency
 banks have high debt to equity ratio
 Risks based capital requirements (Basel I)
 Basel I has two components
(1) Classifying bank capital into Tier 1 and Tier 2 capital
(2) Establishing credit risk wieght for bank assets

Classes of capital
(a) Tier 1 (core) capital includes Common Stockholders‘ equity, certain types of
preferred stock, minority interest in consolidated subsidiaries.
(b) Tier 2 (supplementary) capital includes loan-loss reserves, perpetual debt, certain
types of preferred stock, and subordinated debt.

37
 (2) Credit weights of assets

Risk
Examples of Assets included
Weights

0% - Treasury securities
- Mortgage backed securities issued by government mortgage
institutions

20% - Municipal general obligation bonds

- Mortgage backed securities issued by government sponsored
mortgage institutions

50% - Municipal revenue bonds

- Residential mortgages

100% - Commercial loans and commercial mortgages

- Corporate bonds

 the minimum Tier 1 capital requirement is 4% of book value of assets, and minimum
total capital is 8% of the risk-weighted assets.

Drawbacks of Basel I

 The absence of differentiation between the different risks of private corporations.

 An 8% ratio applying for both a large corporation rated ‘Aa’ and a small business
does not make much sense economically.
 The Basel accord is not risk-sensitive enough.

38
 Short facilities have zero weights, while long facilities have a full capital load,
creating arbitrage opportunities to reduce the capital load.
 This unequal treatment leads to artificial arbitrage by banks, such as renewing short
loans rather than lending long.

Basel II

Aims at:
 ensuring that capital allocation is more risk sensitive;
 enhancing disclosure requirements which will allow market participants to assess
the capital adequacy of an institution;
 ensuring that credit risk, operational risk and market risk are quantified based on
data and formal techniques;
 attempting to align economic and regulatory capital more closely to reduce the
scope for regulatory arbitrage.

Basel II: THREE PILLARS

 FIRST PILLAR: Minimum capital requirements (to addressing risk),

minimum capital requirements, which sought to develop and expand the
standardized rules set out in the 1988 Basel Accord.
 SECOND PILLAR: supervisory review (more thorough and uniform)
supervisory review of an institution's capital adequacy and internal assessment
process.
 THIRD PILLAR: Market discipline (more disclosure). Effective use of disclosure
as a lever to strengthen market discipline and encourage sound banking practices.

Basel III
 Overall design of the capital and liquidity reform package, now referred to as "Basel
III".
 Minimum liquidity standard introduced by Basel III is the Net Stable Funding Ratio.

39
  This requirement, which takes effect as a minimum standard by 1 January 2018, will
promote longer-term funding mismatches and provide incentives for banks to use
stable funding sources.

2. SAVINGS AND LOAN ASSOCIATIONS (S & Ls)

 Established to provide finance for acquisitions of homes.

 Can be mutually owned (by depositors) or have corporate stock ownerships.
 ASSETS include:
 mortgages, mortgage-backed securities, and government securities.
 consumer loans, non-consumer loans and municipal securities.

FUNDING
 Saving and time deposits.
 NOW (Negotiable Order of Withdrawal) – pays interest.
 Borrow from the federal home loan banks.

3. CREDIT UNIONS
 Established by people with a common bond.
 Can be cooperatives or mutually owned.
 Established to satisfy saving and borrowing needs of their members.

Sources of funds
 Deposit by members called shares
Assets
 Consumer loans extended to members
3.2 Non-depository Institutions

1. INSURANCE COMPANIES

40
 Make payments, for a price, when a certain event occurs
 Life and non-life insurance companies

Characteristics

 Insurance policy and premium

 Surplus and reserves
 Components of profits: Underwriting income and investment income

(a) Life insurance companies

 Insurance against death or retirement.

 Liabilities and liability risk: a liability risk arises when an insured desires to let the
policy lapse due to policy rate falling below market rate.
 Investments in equity and debt securities.

Types of life insurance policies

 Protection against risk of death (term life).

 Life insurance with investment component (whole life policy / Universal life /
variable life).
 Insurance against risk of life designed for pension programs (annuity).
 Pure investment oriented vehicles / guaranteed investment contract.

(b) Non-life insurance companies

 Property and casuality insurance.

 They provide protection against:
 Loss, damage, or distruction of property.
 Loss or impairment of income producing ability.
 Claims for damages by third parties.
 Loss from injury or death due to occupational accidents.
 Liabilities are of short-term maturity compared with life insurance companies.

41
  The amount and timing of liabilities is uncertain.

2. PENSION FUNDS
 A fund established for payment of retirement benefit.
 Pension plans can be established by both governmental and private
organizations.
 They can be defined contribution plan or defined benefit plan or combination
of the two.

(1) Defined contribution plans:

 Contributions are defined, but not the benefits.
 Sponsors do not guarantee any certain amount upon retirement.
 Payment depends on investment performance of the asset.
 Employee bears risk of investment.
(2) Defined benefit plans:

 Benefits are defined.

 Amount of benefit is determined based on length of service and earnings of
the employee.
 All investment risks are borne by plan sponsors.

(3) Hybrid pension plans

 Contributions are defined with a guaranteed minimum benefit.

 In case the fund does not generate sufficient growth to attain pre-set level of
benefit then the employee is obliged to add amount of the deficit.
 Investment risk is shared.

3. INVESTMENT COMPANIES

 Sell shares to the public and invest the proceed in diversified portfolio of
securities.

42
 Securities may include common stock, government bonds, corporate bonds, or
money market instruments.
 Reduce risk through diversification.
 Lower cost of contracting and information processing.

Chapter 4
Risk Management in Financial Institutions

43
 Chapter 5

Regulation of Financial Institutions

I. Points from Chapter one

 Most important function of Financial Institutions is to assist in the transfer of
funds from surplus agents to deficit agents. In assisting this process a financial
intermediary undertakes several economic functions:
 The provisions of a payments mechanism;
 Maturity transformations;
 Risk transformations;
 Liquidity provisions; and
 Reduction of transaction, information and search costs.

1. Introduction

 The financial sector plays the following role in the economy:

 Financial Institutions are responsible for enormous amount of investors’
money.
 They run the payment system upon which a modern economy is crucially
dependent.
 The financial sector is the major employer and can be a significant foreign
exchange earner for the country.
 The financial sector is in charge with the crucial role of allocating financial
capital to its most productive use.
 The government, as agent of the public has major interest in the operations of the
Financial Institutions.

44
 For these reasons, the government has consistently intervened to regulate and
control the activities of Financial Institutions.

II. Some Facts

1. Large portion of bank loans are either originated by government agencies or carried
government guarantees.
 Example: There are government loan programs for small businesses, for
housing, for exports, and for a host of other worthy causes.
2. There are (were) Financial failures everywhere:
 In 1990s crises in financial institutions have rocked Chile, Hong Kong, Malaysia,
and many other economies.
 The world has not yet recovered from the financial crises of 2008/2009.
 These crises resulted into the slowdown of world economy and were result of
poor government regulations.
 The financial institutions lent money on projects that could not
generate adequate return-negative returns were extremely high.
 Thais shows that Financial Institutions failed to allocate resource to the
activities of highest return.
3. The stock market is, first and foremost, a forum in which individuals can exchange
risks.
 It affects the ability to raise capital, but in the end, (unless is monitored) it is
perhaps more a gambling casino than a venue in which funds are being raised to
finance new ventures and expand existing activities.

III. Market Failure

 A market is said to fail if it cannot, by itself, maintain all the requirements for a
competitive situation (low cost and efficiency).

45
  Financial market regulation is justified because the market mechanisms of
competition and pricing could not manage without help.
Two common reason for Market Failure
 The financial crises of the world are believed to be the result of market failures
Economies of scale and Natural monopoly.

1. Economies of scale;
 An industry exhibits economies of scale if large producers can produce at a
lower cost than small ones.
 As a result of economies of scale, large firms can lower prices below the costs of
small ones, driving smaller firms out of business.
 Economies of scale can cause an industry to become concentrated- dominated
by a few large firms.
 In concentrated industry, collusion to restrain competition becomes easier, and
efficiency suffers.
 For example, because of economies of scale,
 The automobile industry in the USA becomes highly concentrated after
World War II.
 By the 1960s, the ‘big four’ dominated the market. Tacit collusion allowed
them to raise their prices and they had little incentive to lower costs or to offer
new products.
2. Natural Monopoly: Another enemy of competition is natural monopoly.
 Economies of scale and natural monopoly are reasons for market failure - the
failure of a free market to produce efficiency.
 When the market fails to produce efficiency, there may be a case for
government intervention.
 The competitive markets theories are based on the premise that there is perfect
flow of information in the market.
 But in reality there is imperfect flow of information.
 For example, investors (buyers of securities) and the management of the
firms (sellers) have unequal opportunity to information about:

46
 - Solvency of the Financial Institutions
- Financial and operating performance results
- Management and its philosophy

IV. The Rational for Government Intervention

 The following are some of the frequently cited failures requiring intervention to
correct (Keith p 434):
 The externalities problem.
 The problem of asymmetric information.
 The Principal - agent Problem.

4.1 Rational - Externalities Problem

 The Financial system provides a payment mechanism for the entire
economy and Financial Institutions play a pivotal role of linking both
users and lenders of funds.
 This means that problem in the Financial sector can potentially have a
disastrous effect on the entire economy.
4.2 Rational - Problem of Asymmetric Information
 Asymmetric information means investors and managers are subject to uneven access to
or uneven possession of information.
 The management and directors of a company as well as Financial Institutions have more
information than the investors (suppliers of fund) on:
 Soundness of the company
 Its likely policies
- This could lead to problems such as insider-trading and the concealment of
relevant information from investors
 For this reason the following regulations are necessary:
 A law that prohibits insider trading.

47
  Regulation on disclosure requirements.
 Obliging companies to make public a great deal of financial information to
potential and actual investors.
4.3 Rational: The principal - Agent Problem
 Managers and directors are agents of shareholders and investors (principals).
 There is potential problem that the directors and managers could pursue their own
interest at the expense of the shareholders and investors.
- For this reason they are obliged to disclose information on the financial
performance of the company and are subject to rules on their own dealings.
4.4. Rational - The moral hazard Problem
 By moral hazard we mean that an insurance against an event occurring will make the
event more likely to occur than if the event was not insured against.
 For example, a deposit insurance protection scheme will guarantee investors their
funds should a deposit taking institution get into difficulty.
 However, this may encourage depositors to channel more of their funds into risky
Financial Institutions which are more likely to run into problems and there by lead
to a higher loss of deposit than the case no deposit protection insurance policy
exists.

V. Objectives of Government Regulation

 The government is responsible for the following activities:
 Consumer protection
 Ensuring bank solvency
 Improving macroeconomic stability
 Ensuring Competition
 Stimulating growth
 Improving the allocation of resources

VI. Types of Government Regulations

1. Disclosure Regulation:

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  This regulation requires issuers of securities to make public a large amount of
financial information to actual and potential investors.
 This reduces, if not to avoid problem of information asymmetric and agency
problems.

2. Financial Activities Regulation

 This regulation restricts insider trading by insiders who are corporate officers and
others in positions who know more about a firm’s prospects than general public.
 Insider trading is another problem posed by asymmetric information.
 This is because there may be possibility that members of exchange may be able,
under certain circumstances, to collude and defraud the general investing public.
3. Liquidity requirement
 Such regulations aim to ensure that unnecessary problems do not arise due to
insufficient liquidity to meet depositor's demand.
 For this reason commercial banks are expected (legally required) to maintain a
prudent level of cash reserve as a ratio of their deposit to meet withdrawal demands
known as the reserve ratio.
4. Capital Adequacy requirement (long run solvency)
 Liquidity requirements are essentially about maintaining adequate short-term
cash to meet demand for deposit withdrawals.
 Solvency is, however, a medium to long-term concept concerning the ability of an
institution to meet its liabilities as they fall due.
 The need to maintain sufficient Equity Capital to ensure that the Financial Institution
is regarded as a solvent and remains so even if there are losses on its assets can
therefore serve a useful purpose.
5. Regulation of foreign Participants
 Such regulation limits the role foreigner firms can play in domestic markets and
their ownership or control of Financial Institutions.
6. Licensing regulations
 Financial Institutions should be licensed.

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  This helps to prevent undesirable individuals from running Financial Institutions
and to ensure that Financial Institution does not act recklessly with investors’
funds.

VII. Regulation of the Commercial Banking (CBs) sector

 Because of the special role that Commercial Banks play in the financial system, banks
are regulated and supervised by governments.
The common regulations include:
1. Safety and soundness regulation
a. Minimum Capital requirement for Commercial Banks (CBs)
b. Capital Adequacy
c. Liquidity requirement
d. Portfolio diversification
e. Guarantee fund
2. Ceiling imposed on interest rate payable on deposits
3. Geographical restriction on branch banks
4. Permissible activates for CBs
5. Credit Allocation regulation
6. Consumer protecting regulation
7. Investor protecting regulation
8. Entry and chartering regulation.

1. Safety and soundness Regulation

 Objective of soundness regulation:
 To protect depositors and borrowers against the risk of commercial bank failures
- for example, due to a lack of diversification in asset portfolio.
a. Minimum Capital requirement for CBs
 Financial Institution wanting to formalize must have a minimum amount of
equity capital to support their activities.
 Ethiopia

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  The minimum paid up capital that shall be required to obtain a banking
business license shall be 500 Million Birr, (revised) which shall be fully
paid in cash and deposited in a bank in the name and to the account of
the bank under formation.
b. Capital Adequacy - refers to the level of capital in an organization that is available to
cover its risk.
 Capital adequacy standards refer to the percentage of assets that is financed by
debt or it refers to the maximum level of debt versus equity (degree of
leverage) that the Financial Institution can have.
 All Financial Institutions are required to have a minimum amount of equity
capital relative to the value of their assets.
 A minimum capital ratio effectively constrains the leverage of a CB -
 since highly leveraged CBs may be more prone to credit, interest rate
risk, and other shocks and thus, to the risk of failure.
 This means in the event of loss of assets, the organization would have to
sufficient funds of its own (rather than borrowed from depositors) to cover the
loss.

The capital asset ratio (Capital/Assets) measures the ratio of a bank’s value of primary
or core capital to the book value of its assets.
 The lower of this ratio, the more highly leveraged the bank is:
- Ratio of 5% or higher = well capitalized
- A 4% or more = adequately capitalized
- < 4% = undercapitalized
- < 3% = significantly undercapitalized
- < = 2% critically undercapitalized
c. Liquidity requirement
 Liquidity refers to the amount of available cash (or near cash) relative to
Financial Institutions demand for cash.

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  Holding relatively small amount of liquid assets exposes a CB to increased
illiquidity and insolvency risk (inability to meet required payment on liability
such as deposit withdrawal).
 Therefore, regulators have imposed minimum liquid asset reserve
requirements on CBs maturity period.
 Any licensed bank shall maintain liquid assets of not less than 25%
(twenty five percent) of its total current liabilities.
 The level of liquidity requirement depends on the stability of the market.
 In Ethiopia
"Current liabilities" shall mean the sum of demand (current) deposits, savings
deposits and time deposits and similar liabilities with less than one-month.
d. Portfolio diversification
 This refers to Financial Institutions’ need to ensure that they have not
concentrated their portfolio in one geographic sector or one market segment.
 In USA, for example, CBs are prohibited from making loans exceeding 10%
of their equity capital funds to any one company or borrower.
 A bank that has 6% of its assets funded by its own capital (therefore 94% by
liabilities) can lend no more than 0.6% of its assets to any one borrower).
e. Guarantee fund (Government Safety net)
Introduction
 Uncertainty about the health of the banking system in general can lead to run on
banks, both good and bad, and the failure of one bank can hasten the failure of others
(referred to as the contagion defect) e.g the failure of Lehman Brothers in USA.
- Bank runs = simultaneous runs (rush) of depositors of a given bank to
withdraw when they feel that there is a problem in that bank.
- Bank panic = Simultaneous run on many banks when depositors lose faith in
the general financial system.
- When depositors lose faith in general banking,
- The financial system can be paralyzed, and the consequence of the economy
can be severe.
- Example = Great depression of 1930s which was result of bank panic.

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 - Widespread default on loans caused many banks to fail.
 Deposit insurance mitigates a rational incentive depositor otherwise have to
withdraw their fund at the first time hint of trouble.
 With full insured deposits, depositors don’t worry about the bank’s health -
because their deposits will be worth 100 cents on the dollar no matter what.
2. Ceiling imposed on interest rate payable on deposits
 No interest payable on demand account.
 Countries impose ceiling on the maximum interest rate that could be paid by
banks on deposits other than demand (checking) account.
3. Geographical restriction on branch banks
 Some federal or local states prevent large banks from expanding
geographically and thereby forcing out or taking over smaller banking entities,
possibly threatening competition.
4. Permissible activities for CB investment
 Example of Ethiopia (see directive no Directive No. SBB/12/1996 and Directive
No. SBB/30/2002 and).

Directive No. SBB/12/1996: Limitation on Investment of Banks

1. No bank shall engage in insurance business but may hold up to 20% in an

insurance company and up to a total of 10% of the bank’s equity capital in such
business.
2. Banks are prohibited from engaging directly in non-banking businesses such as
agriculture, industry, and commerce.
3. A bank may hold shares in a non-banking business only up to 20% of the
company’s share capital and total holdings in such business shall not exceed10% of
the bank’s net worth.
4. A bank’s equity participation in another bank shall be subject to prior
authorization by National Bank of Ethiopia.
5. No bank shall commit more than 20% of its net worth in real estate acquisition
and development other than for own business premises without prior approval of
the National Bank of Ethiopia.

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 6. A bank may not invest more than 10 % (ten percent) of its net worth in other
securities.
7. The aggregate sum of all investments at any one time (excluding investment in
government securities) may not exceed 50% of the bank’s net worth, without prior
approval by the National Bank of Ethiopia.
8. Dealing in securities shall be done by banks only through a limited liability
subsidiary company wherein the holding of the bank shall not exceed 10% (ten
percent) of its equity capital.

Directive No. SBB/30/2002: Amendment of Limitation on Loans to Related Parties

4.1 Banks shall not extend loans to related parties on preferential terms with respect
to conditions, interest rates and repayment periods other than the terms and
conditions normally applied to other borrowers.
4.2 The aggregate sum of loans extended or permitted to be outstanding directly or
indirectly to one related party at any one time shall not exceed 15% of the total
capital of the bank.
4.3 The aggregate sum of loans extended or permitted to be outstanding directly or
indirectly to all related parties at any one time shall not exceed 35% of the total
capital of the bank.

5. Credit Allocation regulation

 This supports the CB’s lending to socially important sectors such as housing and
farming. The regulations may require a CB:
 To hold a minimum amount of assets in one particular sector of the economy or
 Set maximum interest rate, prices, or fees to subsidize certain sectors.
6. Consumer protecting regulation
 CBs should serve the society without discrimination - age, race, sex, or income,
religious.
7. Investor protection Regulation:
 Various laws protect investors against abuses such as insider trading, lack of
disclosure, outright malfeasance, and breach of fiduciary responsibilities.

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 Chapter 6
Ethiopian financial markets and institutions

Chapter contents
 Ethiopian financial markets
 Ethiopian financial institutions
 Financial regulation in Ethiopia

6.1 Ethiopian financial markets

I. Money markets
 Is where short term securities are traded.
 Securities traded in this market include:
 Government treasury bills
 Time deposits
 Interbank loans
(i) Government Treasury bills
 Are debt instruments issued by the federal government.
 Have maturities of 28 days, 91 days, 182 days, and 364 days.
 Are sold at a discount through non-competitive auction.
 Banks and non-bank firms participate in the Treasury bill market.
 Non-bank firms include insurance companies, social security agency,
corporations and the like.
 Banks have been the primary investors in government treasury bills buying 89%
of bills in 2006 and 74% in 2007.
 However, non-bank firms became major investors since 2008 with 93% in 2008
and 67% in 2009.

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  The weighted average yield on treasury bills has increased from 5.3% in 2006 to
7.9% in 2009

Time deposits (CDs)

(ii) Time deposits (CDs)
 Issued by commercial banks
 Investors include other banks, non-bank financial institutions, private
corporations, public enterprises, and retail customers.
 It accounted for 7.1% of total deposit in 2006 and 4.5% in 2009.
 Time deposits are kept with varying maturities of a few months to more than 2
years.
(iii) Interbank loan Market
 Commercial banks borrow from each other.
 It began operation in September 1998.
 Since then a total of Br 292mill interbank loan has been extended between
November 2000 and April 2008.
 The maximum interbank loan was made in 2003 by the amount of Br 93.43mill.
 No interbank loan has been extended since 2008.
 Term of interbank loan ranges from overnight to 5 years
 Interest on interbank loan ranges between 7% to 11%.
 Lenders included CBE, AIB, BoA, and NIB.
 Borrowers included NIB, Wegagen and Awash
II. Capital Markets
Why Capital Markets?
 Enhanced saving mobilization.
 Help in resource allocation.
 Promote efficient financial system.
 Help term transformation and improve capital structure.

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  Allow deconcentration of ownership.
 Improve accounting and auditing standards.
 Attract Foreign Direct Investment (FDI).
 Provide effective tools for monetary and fiscal policy.
 Help privatization efforts.
 No capital market in Ethiopia
 Despite an intense pressure from entrepreneurs, academicians and international
financial institutions such as IMF & WB, the Ethiopian government didn’t want
to establish capital markets in the country. (Go to List of SEs in Africa).
 But capital market instruments are offered to investors informally. Eg. Stocks
and bonds.
III. Bonds
 Are issued by public enterprises (EEPCO and Ethio Telecom), state/regional
governments, and Development Dank of Ethiopia (DBE).
 During 2009/10 bonds by the total amount of Br10.86 bill were issued of which
nearly half is by EEPCO.
 Value of bonds outstanding by June 2011 totaled Br 40.3 bill compared to 27.7
Bill in 2010.
IV. Stocks
 Despite absence of capital markets, financial institutions and corporations
directly issue their stocks to the general public.
 Due to absence of a secondary market, investors seek the help of the original
issuers when they want to sell their stocks.
 Stocks of banks are highly demanded than non-bank financial institutions.
V. Mortgages
 Mortgage loans are extended by construction and business bank (CBB), and
Commercial Bank of Ethiopia (CBE).
 CBE has been extending mortgage loans to condominium owners.
 The banks do not have any options other than keeping the mortgage loans until
maturity.

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VI. Foreign Exchange Market
 Foreign currencies are traded through an open auction between NBE and Banks
and among banks in the country.
 Auction is organized by the National Bank of Ethiopia
 Currencies traded in the forex market include:

- US DOLLAR - JAPANESE YEN - SWIDISH KRONER

- EURO - SOUTH AFRICAN RAND - SWISS FRANC
- UAE DIRHAM - CANADIAN DOLLAR - POUND STERLING

6.2 Ethiopian financial institutions

Formal financial institutions
1. Banks
 State owned Vs private.
 Development, Construction, and Commercial banks.
 By June 2010, there were 19 banks, of which 16 were private while 3 are state
owned.
 Banks account for 81% of capital of financial institutions in the country.

Banks (Brief History)

 Bank of Abyssinia established in 1905.
 BoA was dissolved in 1931 and Bank of Ethiopia was set up.
 Many private banks were established after the Italians left.
 State Bank of Ethiopia was founded in 1943 and splitted into NBE and CBE in
1963.
 The Agricultural and Industrial Development Bank (AIDB) was established in
1970 and the Housing and Saving Bank (HSB) in 1975.
 Many private banks and insurance companies were operating in the financial
industry before the 1974 revolution.

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  The derg nationalized all private banks merging them with CBE, and all private
insurance companies with Ethiopian Insurance Company (EIC).
 The banks were used as instruments in exercising socialist economic policy.
 The 1994 banking reform reopened the financial industry to private investors.

2. Insurance companies

SIze of insurers by capital as of June 2010

Ethiopian Insurance. Co.
National Insurance. Co.
Nyala Insurance. Co.
Awash Insurance. Co.
Global Insurance. Co.
Nile Insurance. Co.
Nib Insurance. Co.
Africa Insurance. Cc
Oromia Insurance. Co.
United Insurance. Co.
Lion Insurance. Co.
Ethio-Life Insurance. Co.

0 50 100 150 200 250 300 350 400

3. Micro-finance institutions
 The five largest Micro-Finance Institutions (MFIs); namely
 Amhara
 Dedebit
 Oromia
 Omo and
 Addis Credit and Savings Institutions
 The five largest MFIs account for
 87.4 % of the total capital

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  93.5 % of deposits
 90.4 % of credit
 90.5 % of total assets of the sector.
4. Pension Funds
 Social Security Agency
 Administers pension programs for public sector employees.
 Private firms used to run their own Provident Fund.
 Private sector pension fund has been established through Regulation No
202/2011.

Semi-formal financial institutions

5. Employee Credit & Saving Associations

 Are supervised NOT by the NBE, but by Federal Cooperatives agency.
 Attract deposits.
 Extend consumer loans.
 Invest in shares of companies and run businesses of their own.
Informal financial institutions
6. Iqqub
 Are variants of Rotating Saving and Credit Associations (ROSCAS).
 Established within family and friendship groups.
6.3 Financial market regulation in Ethiopia
 NBE regulats the financial market
 Issues licenses to Banks, Insurance firms, and Microfinance Institutions.
 Regulates the financial sector through issuance of directives.
 Supervises banks, Insurance companies and MFIs.
 NBE regulates the financial market by the power vested upon it through
 The Monetary and Banking Proclamation No. 83/1994.
 It was issued along with The Licensing and Supervision of Banking Business
Proclamation No. 84/1994.
 New Proclamations

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 The National Bank of Ethiopia Establishment (as Amended) Proclamation No.
591/2008.
 Banking business proclamation No. 592/2008.
WHY a NEW Proclamation?
 In 1994 there were only 3 banks all state-owned but in 2008 there were 12 banks of
which 8 were private.
 Loans amounted to only ETB 1.15 bill in 1994 and it reached ETB 26 bill.
 Deposits were ETB 7.7 bill in 1994, and it increased to more than ETB50 bill in
2008.
 Malpractices in the banking sector.
 Unavailability of credit information sharing mechanism.
 Increased pottential for bank failure.

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