CHAPTER ONE

AN OVERVIEW OF THE FINANCIAL SYSTEM

Objectives: - At the end of these unit students should be able to:-

 Explain financial system and its components.
 Identify the role of financial sector on the economy
 Explain classification of financial asset its role & properties
 Explain financial market, role classification & its participants
 Identify how lending and borrowing in the financial system is performed

1. Introduction

The financial sector mobilizes savings and allocates credit across space and time. It provides not
only payment services, but more importantly products which enable firms and households to
cope up with economic uncertainties by hedging, pooling, sharing, and pricing risks. An efficient
financial sector reduces the cost and risk of producing and trading goods and services and thus
makes an important contribution to raising standards of living.

Financial systems can reduce information and transaction costs that arise from an information
asymmetry between borrowers and lenders. In credit markets an information asymmetry arises
because borrowers generally know more about their investment projects than lenders.

The financial system consists of financial market, financial institutions, financial instruments,
financial services and regulations. The impact of the financial system on the real economy is
subtle and complex. Thus, the direct impact of financial institutions on the real economy is
relatively minor. Nonetheless, the indirect impact of financial markets and institutions on
economic performance is important. Therefore, this chapter focuses on definition and
components of financial system, their role in the economy, various types of financial assets,
market participants and lending and borrowing process in the system.

2. Financial system and its components

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The financial system is the system that allows the transfer of money between savers and
borrowers. Financial system is a system that aims at establishing and providing a regular,
smooth, effective and efficient linkage between depositors and investors. Financial system is a
set of complex and closely connected instructions, agents, practices, markets, transactions,
claims and liabilities relating to financial aspects of an economy.

Components of the financial system are financial Institutions, regulatory bodies, intermediaries,
banks, non-financial institutions, financial Markets, Capital Markets, Equity/Stock Market, Debt
Market, Derivative Market, Money Markets, Financial Instruments and financial services

It comprises a set of complex and closely interconnected financial institutions, financial markets,
instruments, services, practices, and transactions the supervisory bodies responsible for their
regulation. Financial System (or financial sector or financial infrastructure) includes all savings
and financial opportunities and financial institutions which provide savings and financing
opportunities.

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2.1. Users of financial system

The end-users of the system are households, business firms and government whose desire is to
lend and to borrow.

Structures Savings Real Investment (Non-financial)

Households Personal income- Purchase of durables, purchase of home,

spending on apartments etc…
consumption
Businesses Total sales-operating Purchase of equipments + Purchase of
expenses + Non-cash Inventory + Construction of new
expenses Business facilities etc…
Government Receipt from budget- Construction new public facilities etc…
. recurrent expenditure

The end-users of most financial systems have a choice between three broad approaches to
link excess fund units and deficit units.
1. Without using financial institutions and financial markets: - savers and lenders may
decide to deal directly, though this, is costly, risky, inefficient and, consequently, not very
likely.
2. Use one or more organized financial markets. In these markets, lenders buy the liabilities
issued by borrowers. If the liability is newly issued, the issuer receives funds directly from
the lender. More frequently, however, a lender will buy an existing liability from another
lender. In effect, this re-finances the original loan, though the borrower is completely
unaware of this ‘secondary’ transaction. The best-known markets are the stock exchanges
in major financial centers such as London, New York and Tokyo. These and other markets
are used by individuals as well as by financial and non-financial firms.
3. Borrowers and lenders may decide to deal via institutions or ‘intermediaries’. In this
case lenders have an asset–a bank or building society deposit, or contributions to a life
assurance or pension fund – which cannot be traded but can only be returned to the
intermediary. Similarly, intermediaries create liabilities, typically in the form of loans, for

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 borrowers. These too remain in the intermediaries’ balance sheets until they are repaid.
Intermediaries themselves will also make use of markets, issuing securities to finance some
of their activities and buying shares and bonds as part of their asset portfolio.

What activities are performed in a given financial system?

Channels funds from lenders to borrowers: - Financial systems are crucial to the allocation of
resources in a modern economy. They channel household savings to the corporate sector and
allocate investment funds among firms. They allow inter temporal smoothing of consumption by
households and expenditures by firms and enable households and firms to share risks. These
functions are common to the financial systems of most developed economies. Yet the form of
these financial systems varies widely (en.wikipedia.org).

Provides a means of making payments: - In most cases this is the responsibility of deposit-
taking institutions (or a subset of them). Such institutions are usually members of a network (a
‘clearing system’) and accept instructions from their clients to make transfers of deposits to the
accounts of other clients. Traditionally this was done by issuing a paper instruction (a ‘cheque’)
but today it is done increasingly by electronic means.
Creates liquidity and money: - Liquidity is the ability to buy or sell an asset quickly and at a
known price. Liquidity requires marketability and price continuity, which, in turn, requires
depth. Marketability: refers to likelihood (probability) of being sold quickly. The expected
price should be fairly certain, based on the recent history of transaction prices and current bid-
ask quotes. Price continuity: which means that prices do not change much from one transaction
to the next unless substantial new information becomes available. Depth: which means that
numerous potential buyers and sellers must be willing to trade with securities (Many
participants)

Provides financial services in order to avoid uncertainty: - mostly such service is carried out
by insurance companies.
Portfolio diversification: - Pension funds, unit trusts and investment trusts all offer savers the
opportunity to accumulate a diversified portfolio of financial assets.
3. The role of financial sectors in the economy

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The basic function of the economic system is to allocate scarce resources –land, labor,
managerial skill and capital-to produce goods and services needed by the society. The high
standard of living depends on the nation’s economy. Any economic system must combine inputs-
labor, land, and other natural resources, managerial skill and capital in order to produce outputs-
in the form of goods and services. Therefore, the economy generates the flow of production
(goods and services) in return for a flow of payments in the form of money.

In modern economy households provide labor, managerial skills, land and natural resources.
Households are the consuming units of goods and services. Business firms and governments also
pay for income in the form of salaries, wages, rents royalties, dividends and others. Business
firms and governments are producing units. Most income received by the households is spent to
purchase of goods and services. Therefore, the financial system and the economy are highly
interrelated.

Therefore, the primary task of financial institutions is to move scarce loanable funds from those
who save to those who borrow for consumption and investment by making funds available for
lending and borrowing, the financial system provides the means where by modern economy
grow and increases the standard of living much of the credits thus obtained goes to purchase of
equipment, machinery, construction of dams, bridges, highways, factories and schools, and etc…
without the financial system and the credit it supplies, the economy will not grow as fast as
possible. The financial system determines both the cost of credit and how much credit will be
available to pay for goods and services we purchased daily.

The financial system has a powerful impact upon the health of nation’s economy. When credit
becomes costly and less available, total spending for goods and services generally falls. As a
result unemployment rises and the economic growth slows down. On the other hand, when the
cost of credit declines and loanable funds become more readily available, the opposite will
happen.

Overall roles the financial system plays in the economic development of a country

1. Savings: The ability by which claims to resources are set aside and become available for the
other purposes.

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2. Finance: The activity by which claims to resources are either assembled and placed in the
hands of investors. or Loans: - Money in deposit accounts, like savings accounts, is used to
provide loans for a wide range of projects to people and businesses. Mortgages, car loans and
student loans are financed largely by deposits in banks, savings institutions and credit unions.

3. Investment: The activity by which resources are actually committed to production.

 The process of saving, finance and investment involves financial institutions, markets and
instruments and services.
 Above all, supervision, control and regulation are equally important. Thus, financial
management is an integral part of the financial system.

 Economic growth and development of any country depends upon the strength of its
financial system.
 Thus, a financial system can be said to play a significant role in the economic growth of a
country by mobilizing the surplus funds and utilizing them effectively for productive
purposes.

The function of financial system can be simply illustrated as follows

 Saving mobilization
 Capital Formation
 Investment
 Economic growth
 Improved living standard of citizens

FINANCIAL ASSETS: ROLE AND PROPERTIES

An asset is any possession that has value in an exchange. An asset can be classified as tangible
and intangible. A tangible asset is one whose value depends on particular physical properties
example buildings, land and machinery. Intangible assets, are in contrast, represent legal
claims to some future benefit. Their value bears no relation to the form, physical or otherwise,

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in which these claims are recorded. Financial assets are intangible assets the typical benefit or
value is a claim to future cash. An entity that has agreed to make future cash payments is called
the issuer of financial asset. The owner of the financial asset is investor. In this course we will
use the terms financial asset, financial instrument, and security interchangeably.
Examples of financial assets
• A loan by Dashen Bank (investor) to an individual (issuer/borrower) to purchase a car
• A Treasury bond issued by National Bank of Ethiopia
• A bond issued by the government of Ethiopia (for the Grand Renaissance Dam)
• A bond issued by A.A City Municipal
• share of common stock issued by Abyssinia Bank, e.t.c

4.1. Tangible (Real) assets Vs Financial assets:

Financial assets have some contrasting features with real assets. Some of the differences are;
1. Material wealth of the society is determined by the productive capacity of its economy –the
goods and services that can provide to its members. This productive capacity is the function
of the real assets of the economy-land building, equipment and machine, knowledge, workers
etc. nevertheless, financial assets such as stocks and bonds do not directly contribute to the
productive capacity of the economy. Shares of stock are no more than sheets of papers. They
do not represent society’s wealth.
2. Real assets appear only on the left side (asset side) of the balance sheet. The financial assets
appear always on both sides of the balance sheet.

Owner Issuer

Assets Liability

3. Financial assets are created and destroyed in the ordinary course of business Eg. When loans
are paid off both the financial asset and financial liability cease to exist. In contrast, real
assets are destroyed only by accident or wear out over time.
4. Real assets are income –generating assets, where as financial assets define the allocation of
income or wealth among investors. Individuals can choose either consuming their

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 endowments of wealth today or investing for the future. When they invest for the future they
may choose to hold financial assets, the money a firm relieves when it issues securities (sell
them to investors) is used to purchase real assets. Ultimately then, the returns of financial
assets comes from the income produced by the real assets that are financed by the issuance of
securities. In this way, it used to view financial assets as a means by which individual hold
their claims on real assets.
5. The physical condition of financial assets is not relevant in determining their market value
(price). A stock certificate is not more or less valuable. Whereas, physical conditions (size,
quality quantity) are so much important while determining value of real assets.

4.2. The role of financial assets

Financial assets have two economic functions.
1. Transferring funds from those who have surplus to invest to those who need funds to
invest in an intangible asset.
2. Transferring 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 the
funds. (shifting of risk)

4.3. Properties of financial assets

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1. Moneyness: - In any economy money consists of currency and all forms of deposits that
permit check writing. Other assets, though are not money, are very close to money in the
sense that they can be transformed into money without cost, delay or risk. They are referred
to as near money. They include time and savings deposit and security issued by government
called Treasury bill. Moneyness is a clearly a desirable property for investors.
2. Divisibility: - Divisibility relates to minimum size in which a financial asset can be
liquidated and exchanged for money. Smaller the size, the more the financial asset is
divisible. A financial asset such as deposits can typically infinitely divisible but other
financial assets have varying degrees of divisibility depending on their denominations.
3. Reversibility: - refers to the cost of investing in financial assets and then getting out of it and
back into cash again. Consequently, reversibility is called turnaround cost or round trip cost.
A financial asset such as deposit with a bank is highly reversible because there is no cost for
adding to or withdrawing from it. For financial assets trade in organized markets or with
market-makers, the relevant round trip cost is the so called ask–bid spread. The spread
charged by the market maker varies from one asset to another reflecting primarily the amount
of risk that the market maker is assuming by ”making” a market.
Market making risk can be related to two forces
1. The variability of price as measured by some measure of dispersion.
2. The bid-ask spread charged by the market maker, what is commonly referred to as
thickness of the market.

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4. Cash flow :- The return that an investor will realize by holding financial assets depends on
all cash distributions that the financial asset will pay to its owners; this includes dividends on
shares and coupon payments (interests) on bonds. The return also includes the repayment of
principal on debt security and the expected sale price of a stock.
5. Convertibility: - Some assets are convertible into other assets. In some cases conversion
takes place within the same class of assets. For example, a bond is converted into another
bond. In other situations the conversion spans classes. Example:- A corporate convertible
bond is converted to equities. Preferred stocks can be converted to common stocks.
6. Currency:- With increased globalization of financial markets securities are issued in
different countries. Volatility of exchange rates has significant impact on cash flow.
7. Liquidity:- How much the sellers stand to lose if they wish to sell immediately against
engaging in costly and time consuming search. Liquidity depends on
 Nature of asset-who issues it, how much etc.,
 Quantity of the assets
 Whether the market is thick (a market with large participants) or thin (a market with
small participants)
8. Term to Maturity:- For a bond, the date on which the principal is required to be repaid. It is
the length of period until the date at which the instrument is scheduled to make its final
payment. The time until last cash flow.
9. Return Predictability:- This depends on the risk-return profile of an asset, Nominal return
and real returns.
10. Complexity:- Some financial assets are complex in the sense that they are actually
combination of two or more simpler assets. A complex asset is one that provides options for
the issuer or the investor, or both, and so represents a combination of simpler assets.
11. Tax status:- Taxes differ from financial asset to financial asset depending on
the type of issuer, the length of the time asset held, the nature of owner etc., Pension funds,
coupon payments on municipal bonds are generally free of taxation.

Financial markets: role, classifications and participants

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A financial market is a market where financial assets are exchanged (traded). Although the
existence of a financial market is not a necessary condition for the creation and exchange of a
financial asset, in most economies financial assets are created and subsequently traded in some
type of financial market. Those participants with receive more money than they spend are
referred to as surplus units (investors). Those participants who spend more money than they
receive are referred to as deficit units (borrowers).
5.1. Role of Financial Markets
Financial markets provide three economic functions.
1. The interactions of buyers and sellers in a financial market determine the price of the traded
asset. Or, equivalently they determine the required return on a financial asset. As the
inducement for firms to acquire funds depends on the required return that investors demand,
it is this feature of financial markets that signals how the funds in the economy should be
allocated among financial assets. This is called the price recovery process.
2. Financial markets provide a mechanism for an investor to sell a financial assets. Because of
this feature, it is said that a financial market offers liquidity, an attractive feature when
circumstances either force or motivate an investor to sell. If there were not liquidity, the
owner would be forced to hold a debt instrument until it matures and an equity instrument
until the company is either voluntarily or involuntarily liquidated. While all financial markets
provide some form of liquidity, the degree of liquidity is one of the factors that characterize
different markets,
3. It reduces the cost of transacting. There are two costs associated with transaction. These are
search costs and information costs. Search cost represent explicit costs, such as money spent
to advertise one’s intention to sell or purchase a financial asset, and implicit costs such as the
value time spent in locating a counter party. The presence of some form of organized market
reduces search costs. Information costs are costs associated with assessing the investment
merits of a financial asset, the amount and the likelihood of cash flow expected to be
generated. In an efficient market, prices reflect the aggregate information collected by all
market participants.
5.2. Classification of Financial Markets
1. By the type of financial claim:

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a) Debt Market:- The debt market is the financial market for fixed claims (debt instruments)
and the most common method of getting fund. A contractual agreement by the borrower to
pay the holder of the instrument fixed amount of money at regular intervals (I + P) until a
specified date, when a final payment is made.
Debt market classification based on time period
 Short-term: If its maturity is less than a year
 Intermediate-term: if its maturity is between one and ten years
 Long-term: if its maturity is ten years or longer
b) Equity market:- The equity market is the financial market for residual claims (equity
instruments).
 Are claims to share in the net income and net assets of a business?
 Make periodic payments (dividends) to their holders and are considered long-term
securities because they have no maturity date.
 Owning stock means that you own a portion of the firm and thus have the right to vote on
issues important to the firm and to elect its directors.
2. By the maturity of claims
a) Money market:- The market for short term financial claims is referred to as the money
market, and only short-term debt instruments (generally those with original maturity of less
than one year) are traded. Money market Short-term securities have smaller fluctuations in
prices than long-term securities, making them safer investments. As a result, corporations
and banks actively use the money market to earn interest on surplus funds that they expect to
have only temporarily

b) Capital market:- The market for long term financial claims is called the capital market.
Longer term debt (generally those with original maturity of one year or greater) and equity
instruments are traded. Capital market securities, such as stocks and long-term bonds, are
often held by financial intermediaries such as insurance companies and pension funds, which
have little uncertainty about the amount of funds they will have available in the future.
Capital Market- for long-term funds
i. Primary Market
ii. Stock Market

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 iii. Bond Market
3. Based on whether the claims represent new issues or outstanding issues:
a) Primary Market:- Is a financial market in which new issues of a security are sold to initial
buyers by the corporation or government agency borrowing the funds. Investment bank
(underwrites) new securities: it guarantees a price for corporation’s securities and then sells
them to the public.
c) Secondary market:- is a financial market in which securities that have been previously
issued can be resold. Ex- The NSE & ASE and National Association of Securities Dealers’
Automated Quotation System (NASDAQ). Other examples are foreign exchange markets,
forward markets, futures markets, and options markets. Brokers match buyers with sellers of
securities; Dealers link buyers and sellers by buying and selling securities at stated prices
Secondary markets serve two important functions.
i. The increased liquidity of these instruments then makes them more desirable and
thus easier for issuing firm to sell in the primary market.
ii. Determine the price for primary equities.
4. By the timing of delivery;
a) Cash or Spot market:- A cash or spot market is one where the delivery occurs
immediately and
b) Forward or future market:- A forward or futures market is one where the delivery
occurs at a pre determined time in the future. (derivative market)
5. By the nature of its organizational structure:
a) Exchange Traded market:- An exchange traded market is characterized by a centralized
organization with standardized procedures.
b) Over the counter market:- An over the counter market is a decentralized market with
customized procedures.
Secondary markets can be organized in two ways
One is to organize exchanges, where buyers and sellers of securities (or their agents or brokers)
meet in the central location to conduct trades. Examples: The New York and American stock
exchanges for stocks, the Chicago Board of Trade for Commodities (wheat, corn, silver, and
other raw materials) and Ethiopian Commodities Exchange are examples of organized
exchanges.

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The other method is to have OTC market, in which dealers at different locations who have an
inventory of securities stand ready to buy and sell securities “over the counter” Because over-
the-counter sellers are in computer contact and know the prices set by one another, the OTC
market is very competitive and not very different from a market with an organized exchange.
Many common stocks are traded over-the-counter, although the largest corporations usually have
their shares traded at organized stock exchanges such as the New York Stock Exchange. The
U.S. government bond market, with a larger trading volume than the New York Stock Exchange,
is set up as an over-the-counter market. Other over-the-counter markets include those that trade
other types of financial instruments such as negotiable certificates of deposit, federal funds,
banker’s acceptances, and foreign exchange.

5.3. Market Participants

Participants in the national and global financial markets that issue and purchase financial claims
include
 Household,
 Business entities (corporations & partnership),
 National governments,
 National government agencies,
 State and local government, and
 Supranational (such as World Bank and the European investment bank)
 Regulators of financial market
6. Lending and borrowing in the financial system
Business firms, households and government play a wide variety of roles in modern financial
systems. It is quite common for an individual or institution to be a lender of funds in one period
and borrower in the next, or to do both simultaneously like financial intermediaries such as
banks, insurance companies etc which operates on both side of financial markets, borrowing
funds from customers by issuing attractive financial claims and simultaneously making loans
available to other customers.

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NB: each business firm, household or unit of government active in the financial system must
conform to the following identity.
R-E =FA-D
Current revenue –expenditures out of current revenue =change in holding FAs-change in
debt & equity outstanding
If our current expenditure (E) exceeds our current revenue (R), we usually make up the
difference by,
1. Reducing our holdings of financial assets (-FA). Eg by drawing money out of saving
account.
2. Issuing debt or stock(+D) or
3. Using some combination of both.
If our receipts (R) in the current period are larger than current expenditures (E), we can
1. Build up our holdings of our financial assets (+FA).Eg placing money in saving account,
purchasing new shares of stock or debt.
2. Pay off some outstanding debt or retire stock previously issued by our business firm(-D)
or
3. Do some combination of both.
It follows that for any given period of time (day, week, month, and year) the individual economic
unit must fall into one of the three groups.
1. Deficit budget unit(DBU) or net borrower of funds = E>R and so D>FA
2. Surplus budget unit(SBU) or net lender of funds = R>E and thus FA > D
3. Balance budget unit(BBU) = R=E and thus FA = D
N.B A net lender of funds is really a net supplier of funds to the financial system. It
accomplishes this function by purchasing financial assets, paying off debt, or retiring equity
(stocks). In contrast, a net borrower of funds is a net demander of funds from the financial
system, selling financial assets, issuing new stock or debt. The government and the business
sector of the economy tend to be net borrowers while the household sector composed of all
families and individuals tend to be net lender (supplier) of funds.

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