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,

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various types of financial assets, market participants and lending and borrowing process
in the system.

2. Financial system and its components

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.
• Financial System
Financial Institutions
Regulatory
Intermediary
Banking
Non-banking
Non-intermediary
Others
Financial Markets
Organized
Primary
Capital Markets
Equity/Stock Market
Debt Market
Derivative Market
Unorganized
Secondary
Money Markets
Financial Instruments
Financial Services

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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.

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

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 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 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

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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
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

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generates the flow of production (goods and services) in return for a flow of payments in
the form of money.

Land &natural
resources Flow of production
Capital & equipment
Labor & managerial Goods and
skills Flowservices sold to the
of payments
public
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.

The former British Prime Minister William Gladstone expressed the importance of
finance for the economy in 1858 as follows: "Finance is, as it were, the stomach of the
country, from which all the other organs take their tone”.

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Economists still hold conflicting views regarding the underlying mechanisms that explain
the positive relation between the degree of development of the financial system and
economic development. Some economists just do not believe that the finance-growth
relationship is important. According to this view, economic development creates
demands for particular types of financial arrangements, and the financial system responds
automatically to these demands. Other economists strongly believe in the importance of
the financial system for economic growth. They address the issue of what the optimal
financial system should look like. Overall, the notion seems to develop that the optimal
financial system, in combination with a well-developed legal system, should incorporate
elements of both direct, market and indirect, bank-based finance. A well-developed
financial system should improve the efficiency of financing decisions, favoring a better
allocation of resources and thereby economic growth (www.ecb.int).

Economic development is partially dependent on the financial system to help mediate the
transfer of money to areas of the economy that need it most. The financial system has a
number of key functions, which help facilitate these shifts in money that are important for
sustainable economic growth.

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

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

1. 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.

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  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 cab be simply
illustrated as follows

Saving mobilization Capital Formation Investment Economic growth

economic development Improved living standard of citizens

2. Business Growth: - Businesses may expand their operations or finance growth by

issuing debt instruments called bonds. Bonds are bought and sold through the
financial system. Bond markets allow businesses to access investor capital to finance
their growth, while bond investors have an opportunity to profit from helping finance
business expansion.
3. Government Expenditure: - Governments may finance programs or deficit spending
through the financial system by issuing bonds to raise money. Investors may buy
government bonds to own a part of government debt, and collect interest payments
from the government. In turn, the government has the money it needs to continue to
function.
4. A good financial system has the following six functions
i. Clearing and settling payments
ii. Pooling resources and subdividing shares
iii. Transferring resources across time and space
iv. Managing risk
v. Providing information
vi. Dealing with incentive problems

4. Financial assets: role and properties

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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, 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

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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 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.

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 2. The bid-ask spread charged by the market maker, what is commonly referred
to as thickness of the market.
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.

Expected return

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 or thin
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. time until last cash flow
9. Return Predictability:- This depends on the risk-return profile of an asset, Nominal
return and real returns.

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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
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.
5. Financial markets: role, classifications and participants
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
In addition to the two economic functions earlier Financial markets provide three
additional 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,

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3. It reduces the cost of transacting. There are two costs associated with transacting
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:
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

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 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
Money Market- for short-term funds (less than a year)
I. Organized (Banks)
II. Unorganized (money lenders)
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 Issues Market
ii. Stock Market
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, BSE, LSE 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;

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 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), Nikkei and Ethiopian Commodities
Exchange are examples of organized exchanges.

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

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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 WB, the European investment bank, the ADB)
 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.
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.

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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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 CHAPTER TWO
FINANCIAL INSTITUTIONS IN THE FINANCIAL SYSTEM

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

 Define financial institution
 Explain functions of financial institutions
 Explain financial intermediaries and their role
 Classify depository and non-depository financial institutions
 Explain the principal risks of financial industries

2.1. Financial institutions

Institutions which permit indirect lending include both deposit-taking and non-deposit-
taking institutions. Financial institutions are the firms that provide access to the financial
markets; they sit between savers and borrowers and so are known as financial
intermediaries. A financial institution acts as an agent that provides financial services for
its clients. In generally, financial institutions serve as intermediaries by channeling the
savings of individuals, business, and governments into loans and investments. The
primary suppliers of funds to financial institutions are individuals; the primary demanders
of funds are firms and governments.

2.2. Functions of Financial Institutions

Financial institutions provide a service as intermediaries of the capital and debt markets.
These institutions provide services related to one or more of the following:

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  Transforming financial assets acquired through the market and constituting them
into a different, and more widely preferable, type of asset-which becomes their
liabilities.
 Exchanging of financial assets on behalf of customers (Broker & dealer
functions)
 Exchanging of financial assets for their own account
 Assisting in the creation of financial assets for their customers, & then selling
those financial assets to other market participants(underwriting)
 Providing investment advice to other market participants.
 Managing the portfolios of other market participants.
2.3. Financial intermediaries and their roles
In a world of perfect financial markets there would be no need for financial
intermediaries (middlemen) in the process of lending and/or borrowing (Costless
transactions, Securities can be purchased in any denomination and Perfect information
about the quality of financial instruments).
A financial intermediary is defined as a bank when it performs both savings
mobilisation and lending. If a financial intermediary is only active on “one side of the
balance sheet” (i.e. it offers deposits but does not lend out to the public, or it offers loans
but gets funding from sources other than private savings) it is classified as a
non-bank financial intermediary. Many financial institutions play the role of a financial
intermediary. Services provided by financial intermediaries
• Information
• Liquidity
• Reduced Transaction Costs
• Transmission of Monetary Policy
• Credit Allocation
• Payment Services
• Intergenerational Wealth
Transfer

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Role of financial intermediaries (economic functions):

1. Transfer funds from savers to depositors: - funds transfer from surplus units to deficit units through
financial markets directly or indirectly through financial institutions.
2. Maturity intermediation: - In the absence of a CB, the borrower would have to borrow for a short term, or
find an entity that is willing to invest for the length of the loan sought, and/or investor who makes deposits
in the bank would have to commit funds for longer length of time than they want. The CB by issuing its own
financial claims in essence transforms a longer-term asset into a shorter-term one by giving the borrower a
loan for the length of time sought and the investor/depositor a financial asset for the desired investment
horizon.
3. Reducing risk via diversification: - Attaining cost-effective diversification in order to reduce risk by
purchasing the financial assets of financial intermediary is an important economic benefit.
4. Reducing the cost of contracting; and information processing:- reduce cost of writing loan contracts
(contracting cost) , cost of time to process the information about the financial asset & its issuer or cost of
acquiring such information (information processing costs) and cost of enforcing the terms of the loan
agreement. All this activities requires professionals the employment of such professionals is cost effective
for financial intermediaries.
5. Providing a payment mechanism: - Most transactions made today are not done with cash. Instead
payments are made using checks, credit cards, debit cards, and electronic transfer of funds. These methods
for making payments called payment mechanisms are provided by certain financial intermediaries.
2.4. Classifications of Financial Institutions
2.4.1. Depository and non-depository financial institutions.

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Depository institutions are financial intermediaries that accept deposits from individuals and institutions and
make loans. These institutions make direct loan to the entities and invest in securities. Their income is generated
from the loans they make and the securities they purchased (interest spread or margin) and fee income.
depository institution can accommodate withdrawal and loan demand: by attracting additional deposit, Use
existing securities as collateral for borrowing from federal agency or other financial institution such as
investment bank, and Raise short term funds in the monetary market. Depository financial institutions include;
Commercial banks, saving and loan associations, saving banks and Credit unions.
2.4.1.1. Commercial banks
Commercial banks are owned by private investors (stockholders), or by companies (bank holding companies).
Commercial banks are “for profit” organizations their objective is to make a profit. Commercial banks provide
numerous services in our financial system. These can be classified as follows
a) Individual banking: - encompasses 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. Interest income and fee income are generated from mortgage lending
and credit card financing. Fee income is generated from brokerage services.
b) Institutional banking: - Loans to nonfinancial corporations, financial corporations and governmental
entities.
c) Global banking:- It is in the area of global banking that banks began to compete head to head with
investment banking (or securities) firms. Global banking covers a broad range of activities involving
corporate financing and capital market and foreign exchange products and services. Corporate financing: -
involves first is procuring of funds for a bank’s customers and the second one is that advice on strategies for
obtaining funds, corporate restructuring, and acquisitions. Capital market and foreign exchange products and
services involve transactions where the bank acts as a dealer or a broker in a service. Most global banking
activities generate fee income rather than interest income.
Sources of funds for banks:
1. Deposits:-
 Demand deposits (checking account) pay no interest and can be withdrawn upon demand.
 Saving deposit pay interest, typically below market rates, don not have specific maturity, and usually
can be withdrawn upon demand.
 Time deposit also called certificate of deposit, have a fixed maturity date and pay either a fixed or
floating interest rate.

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2. Non-deposit borrowing: - includes borrowing from the Federal Reserve through the discount window and
borrowing by issuance of securities in the money and bond markets.
3. Issuing common stock
4. Retained earnings.

Regulators of commercial banks: - Because of the special role that commercial banks play is the financial
system, banks are regulated & supervised by federal & state government entities.

2.4.1.2. Saving and Loan Association (S&Ls)

S&Ls are either mutually owned or have corporate stock ownership. Mutually owned means there is no stock
outstanding, so technically the depositors are the owners. Like banks, the S&Ls may be chartered under either
state or federal statute. At the federal level, the primary regulator of S&Ls is the director of the office of thrift
supervision (OTS), created in 1989 by FIRREA. Like banks, S&Ls are known subject to reserve requirements
on deposits established by the Fed.
2.4.1.3. Saving Banks
Saving banks are institutions similar to, though much older than, S&Ls. They can be either mutual owned
(mutual saving banks) or stockholder owned. Asset structures of saving banks are similar with that of S&Ls.
The principal assets of saving banks are residential mortgages. The principal sources of funds for saving banks
are deposits. It offer similar deposits with S&Ls but the ratio of deposit with that its total asset is greater than
S&Ls. Deposits can be insured by either the bank insurance fund or savings association insurance fund.
2.4.1.4. Credit Unions
They are either cooperative or mutually owned. The members deposit is called shares and the distribution paid
to the members is in the form of dividends, not interest. They are the only financial institutions that are tax-
exempt and can be chartered either by the states or by the federal government. The principal sources of funds for
saving banks are deposits. It offer similar deposits with S&Ls but the ratio of deposit with that its total asset is
greater than S&Ls. Deposits can be insured by either the bank insurance fund or savings association insurance
fund.
2.4.2. Non-depository institutions.
Non depository Institutions are institutions that serves as an intermediary between savers and borrowers, but
does not accept deposits. It includes financial service corporations, insurance companies, investment banks,
investment companies, mutual fund and exchange trade funds.
2.4.2.1. Financial Services Corporations:

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Financial Services Corporation is in the lending or financing business, but they are not commercial banks. One
well known financial service corporation is GE capital, the finance unit of the General Electric Corporation. GE
capital provides commercial loans, financing programs, commercial insurance, equipment leasing, and other
services in over 35 countries around the world. GE capital also provides credit services to more than 130 million
customers that range from retailers, auto dealers, consumers offering products and services from credit cards to
debt consolidation to home equity loans.
2.4.2.2. Insurance Companies
Insurance companies sell insurance to individuals and businesses to protect their investments. They collect
premium and hold the premium in reserves until there is an insured loss and then pay out claims to the holders
of the insurance contracts. Later, these reserves are deployed in various types of investments including loans to
individuals, businesses and the government.
2.4.2.3. Investment banks
Are specialized financial intermediaries that help companies and governments raise money and provide advisory
services to client firms on major transactions such as mergers. Firms that provide investment banking services
include Bank of America, Goldman Sachs, Morgan Stanley and JP Morgan Chase.
2.4.2.4. Investment companies
Investment companies are financial institutions that pool the savings of individual savers and invest the money
in the securities issued by other companies purely for investment purposes.
2.4.2.5. Mutual Funds and Exchange Traded Funds (ETFs)
Mutual funds are professionally managed according to a stated investment objective. Individuals can invest in
mutual funds by buying shares in the mutual fund at the net asset value (NAV). NAV is calculated daily based
on the total value of the fund divided by the number of mutual fund shares outstanding. Mutual funds can either
be load or no-load funds. The term load refers to the sales commission that you pay when acquiring ownership
shares in the fund. These commissions typically range between 4.0 to 6.0%. A mutual fund that does not charge
a commission is referred to as a no-load fund.
An exchange-traded fund (ETF) is similar to a mutual fund except that the ownership shares in the ETF can be
bought and sold on the stock exchange. Most ETFs track an index, such as the Dow Jones Industrial Average or
the S&P 500, and generally have relatively low expenses.
Mutual funds and ETFs provide a cost-effective way to diversify and reduce risk. If you had only $10,000 to
invest, it would be difficult to diversify since you will have to pay commission for each individual stock.
However, by buying a mutual fund that invests in S&P 500,you can indirectly purchase a portfolio that tracks

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500 stocks with just one transaction. Alternatively, you might purchase an ETF, such as SPDR S&P 500 (SPY),
which tracks S&P 500.

Hedge funds:- are similar to mutual funds but they tend to take more risk and are generally open only to high
net worth investors. Management fees also tend to be higher for hedge funds and most funds include an
incentive fee based on the fund’s overall performance, which typically runs at 20% of profits.
Private Equity Firms:- Private equity firms include two major groups: Venture capital (VC) firms and
Leveraged buyout firms (LBOs).
a) Venture capital firms raise money from investors (wealthy individuals and other financial institutions)
that they then use to provide financing for private start-up companies when they are first founded.
b) Leveraged buyout firms acquire established firms that typically have not been performing very well with
the objective of making them profitable again and selling them. An LBO typically uses debt to fund the
purchase of a firm.
2.5. Risks in Financial Industry
In generally financial institutions faces the following risks;

1. Credit or default risk: - is the risk that a direct DSU issuer will not pay as agreed, thus affecting the rate
of return on a loan or security.
2. Interest rate risk: - is the risk of fluctuations in a security's price or reinvestment income caused by
changes in market interest rates.
3. Liquidity risk: - is the risk that the financial institution will be unable to generate sufficient cash flow to
meet required cash outflows.
4. Foreign exchange risk: - is the risk that foreign exchange rates will vary in the future affecting the profit of
the financial institution.
5. Political risk: - is the cost or variation in returns caused by actions of sovereign governments or regulators.

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 CHAPTER THREE
INTEREST RATE IN THE FINANCIAL SYSTEM

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

 Define the term interest rate
 Explain theories of interest rates
 Describe term structure of interest rate and types of yield curve
 Explain the determinants of term structure of interest rate
 Explain theories on determinants of the shape of the term Structure
3.1. Introduction
Money is often loaned to people the price of money loaned is called interest rate and usually expressed as a
percentage of the nominal money borrowed. It is also referred as the price paid by a borrower to a lender for the
use of money that will be used during some time period then returned.
3.2. Theories of interest rate
3.2.1. Fisher’s theory (Classical Approach)

Fisher analyzed determination of level of interest rate in an economy by investigating why people save and
why others borrowed. We outline his theory in context of very simplified economy. That economy contains
only, individual who consume and save with their current income, Firms that borrow unconsumed income and
invest and market where saver make loan to borrower and project in which firm invest.
Factors that influence Savings decision includes marginal rate of time preference, income and reward for
saving. Similarly,
factors that influence borrowing decision include marginal productivity of capital and rate of interest. Under
this theory equilibrium Rate of Interest: determined by interaction of supply and demand function.

Interest rate
S

QE
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Savings /investment
As cost of borrowing and reward for lending the rate must be reach at point where total supply of saving and
total demand of borrowing fund for investment is equal. The equilibrium level of the interest rate as a result, of
the interaction of saver’s willingness to save and borrowers demand for investment funds or the
interaction of the saver’s marginal rate of time preference and borrowers marginal productivity of
capital. Fisher’s Law shows the relationship between inflation and interest rate as; observable nominal rate of
interest is composed of two unobservable variables (the real rate of interest and the premium for expected
inflation.
The Fisher’s classical theory neglects certain practical matters, such as the power of the government (in
concert with depository institutions) to create money and the government’s often large demand for borrowed
funds, which is frequently immune to the level of the interest rate. Also, Fisher’s theory does not consider the
possibility that individuals and firms might invest in cash balances. Expanding Fisher’s theory to encompass
these situations produces the loanable funds theory of interest rates.

3.2.2. The Loanable Funds Theory (Neo-classical approach)

The loanable funds theory is an extension of Fisher’s theory and proposes that equilibrium rate of interest
reflects demand and supply of funds, which depends on saver’s willingness to save, borrower’s
expectations regarding the profitability of investing, and government’s action regarding money supply.
This view argues that the risk–free interest rate is determined by the interplay of two forces the demand
and the supply of loanable funds. The demand for loanable funds consists of demand for funds by firms,
governments, and households (or individuals) which carry out a variety of economic activities with those
funds. This demand is negatively related to the interest rate (except for the government’s demand, which
may frequently not depend on the level of the interest rate). The supply of loanable funds stems from firms,
governments, banks and individuals. Supply is positively related to the level of interest rates, if all other
economic factors remain the same. With rising rates, firms and individuals save and lend more, and banks are
more eager to extend more loans.

3.2.3. The Liquidity Preference Theory

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This theory was proposed by the English economist John Maynard Keynes (1936). Liquidity preference
theory explains how interest rates are determined based on the preferences of households to hold money
balances rather than spending or investing those funds. This theory analyzes the equilibrium level of
interest rate through the interaction of the supply of money and public’s aggregate demand for holding
money. Keynes assume that most people hold wealth in only two forms: money and bond.
For Keynes, money is equivalent to currency and demand deposits which pay little or no interest but liquid and
may be used for immediate transaction. Bond represent abroad Keynesian category and include long term,
interest paying financial assets that are not liquid and that pose some risk because their price varies
inversely with interest rate level. Demand for Money Balances (reasons why public hold wealth in money
form): Transactions demand, Precautionary demand, and Speculative demand. For Keynes, the Supply of
Money is fully under control of the central bank. Equilibrium Rate of Interest at the point total demand for
money equals to total supply.

The equilibrium rate of interest can change if there is change in any variable affecting the demand and
supply curves. On the demand side, Keynes recognized importance of two such variables: the level of income
and the level of prices for goods and services. A rise in income with no other variable changing raises the
value of money’s liquidity and shift the demand curve to the right, increasing the equilibrium interest rate.
Because people want to hold amount of real money or monetary units of specific purchasing power, a
change in expected inflation would also shift the demand curve to the right and raise the level of interest
rate. The supply curve can shift, in Keynes's view, only by action of central bank. The central bank’s power
over interest rate arises because of its ability to buy and sell securities (open market operation), which can alter
the amount of money available in the economy. Generally, Keynes thought that an increase in money supply
would, by shifting supply curve to the right, bring about a decline in the equilibrium interest rate and vice versa.
Changes in the Money supply and Interest Rates
A change in the money supply has three different effects up on the level of interest rate.
A) Liquidity effect : with demand unchanging, the increase in the money supply amounts to a rightward shift
of the supply and cause a fall in the equilibrium interest rate and vice versa.

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B) Income Effect: it is well known that change in the money supply affect the economy. Decline in the supply
would tend to cause a contraction. An increase in the money supply generally speaking is economically
expansionary: more loans are available and extended; more people are hire or work longer consumers and
producers purchase more goods and services. Thus money supply changes can cause income in the system to
vary. Because demand for money is function of income, a rise in income shift demand function. Increase
amount of money that the public will want to hold at any level of the interest rate.

C) Price Expectations Effect: although an increase in the money supply an economically expansionary policy,
the resultant increase depends substantially on the amount of slack in the economy at the time of Federal
action. If economy, is operating at less than full strength an increase in the money supply can stimulate
production, employment and output. If the economy is producing all or almost all of the goods and services
it can, then increase in the money supply will largely stimulate expectation of a rising level of prices for
goods and services. Thus, the price expectations effect usually occurs only if the money supply grows in
time of high output. Because the price level affects the demand function, the price expectations effect is an
increase in the interest rate because the demand for money balance shifts upward.

3.3. The term structure of interest rate

In finance, the yield curve is the relation between the level of interest rates (cost of borrowing) and the time to
maturity, known as the “term of the debt for a given borrower in a given currency. More formal mathematical
descriptions of this relation are often called the term structure of interest rates. The term structure of interest
rates is the variation of the yield of bonds with similar risk profiles with the terms of those bonds. The yield
curve is the relationship of the yield to maturity (YTM) of bonds to the time to maturity, or more accurately, to

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duration, which is sometimes referred to as the effective maturity. In most cases, bonds with longer maturities
have higher yields.
Type of yield curve
a) Normal yield curve
It is one in which longer maturity bonds have a higher yield compared to shorter term bonds due to the risks
associated with time. It has a positive slope this positive slope reflects investor expectation for the economy to
grow in the future and, importantly, for this grow to be associated with a greater expectation that inflation will
rise in the future rather than fall. This expectation of higher inflation leads to expectations that the central bank
will tighten monetary policy by raising short term interest rates in the future to slow economic grow and dampen
inflationary pressure.
b) Step yield curve
Historically, the 20 year Treasury bond yield has averaged approximately two percentage points above that of 3-
month treasury-bills. This type of curve can be seen at the beginning of an economy expansion (or after the end
of the recession). Here, economic stagnation will have depressed short term interest rates; however, rates begin
to rise once the demand for capital is re-established by growing economic activity.
c) Flat or humped yield curve
A flat yield curve is observed when all maturities have similar yields, whereas a humped curve results when
short term and long term yields are equal and medium term yields are higher than those of the short term and
long term. A flat curve sends signal of uncertainty in the economy. This mixed signal can revert to a normal
curve or could result into an inverted curve.
d) Inverted yield curve
An inverted yield curve occurs when long term yields fall below short term yields, which can be a sign of
upcoming recession. An inverted curve has indicated a worsening economic situation in the future.

3.4. The Determinants of the Structure of Interest rates

There is not one interest rates in the economy. Rather, there is a structure of interest rates. The interest rate that a
borrower will have to pay depends on a myriad of factors. Some of these factors include;
a) Term to Maturity: - The remaining life of a financial instrument. In bonds, it is the time between when the
bond is issued and when it matures (maturity date), at which time the issuer must redeem the bond by paying
the principal (or face value).

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b) Features of a Bond: - A bond is an instrument in which the (issuer/borrower) promises to repay to the
lender/investor the amount borrowed plus interest over a specified time.
• Maturity of a bond- Term to maturity
• Principal value, par value, maturity value, redemption value or face value.
• Coupon rate is the interest rate the issuer agrees to pay each year the annual amount of such payments is
called coupon.
c) Yield on a bond: - the yield on a bond investment reflects the coupon interest rate that will be earned plus
either any capital gain or loss that will be realized from holding the bond to maturity. The yield to maturity
widely accepted measure of the rate return on bond. It is defined as the interest rate that makes present value
of the cash flow of a bond equal to the bonds market price. In generally, the correct price of a bond
(financial asset) can be expressed as;
3.5. Theories on determinants of the shape of the term structure
a) Pure Expectations Theory
Yields on bonds with different maturities are based only on expectations of future short-term rates. Ignores price
risk and reinvestment risk. The interest rate on a long-term bond will equal an average of the short-term interest
rates that people expect to occur over the life of the long-term bond Buyers of bonds do not prefer bonds of one
maturity over another; they will not hold any quantity of a bond if its expected return is less than that of another
bond with a different maturity. Bonds like these are said to be perfect substitutes. Example Let the current rate
on one-year bond be 6%. You expect the interest rate on a one-year bond to be 8% next year. Then the expected
return for buying two one-year bonds averages (6% + 8%)/2 = 7%. The interest rate on a two-year bond must be
7% for you to be willing to purchase it.
b) Liquidity Theory
Yields on bonds with different maturities are based only on expected future rates plus a liquidity premium that
increases with maturity. Term structure might be normal or flat. Presupposes that all lenders want to lend short-
term and all borrowers want to borrow long-term. In reality, there are lenders for short and long-terms and
borrowers for short and long-terms.
c) Preferred Habitat Theory
Yields on bonds with different maturities are based only on demand and supply at each maturity. Term structure
might be normal, inverted, humped, or flat. Issuers and buyers of bonds have maturity preferences but will shift
to other maturities if the prices or yields are attractive enough. Yields are completely unrelated to expectations
of future rates. Investors are likely to prefer short-term bonds over longer-term bonds.
d) Market Segmentation Theory

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 Yields on bonds with different maturities are based only on demand and supply at each maturity. Term structure
might be normal, inverted, humped, or flat. Issuers and buyers of bonds have maturity preferences and will not
shift to another maturity because each maturity is a separate market. Yields are completely unrelated to
expectations of future rates. Bonds of different maturities are not substitutes at all. If investors have short
desired holding periods and generally prefer bonds with shorter maturities that have less interest-rate risk, then
this explains why yield curves usually slope upward.

Chapter Four
Financial Markets in the Financial System
Objective: - After this chapter students would be able to understand
 Organization and Structure of Markets
 Classification of Financial Markets
 Financial market instruments
 Foreign Exchange Markets
 The derivative market
4.1. Organization and structure of financial Markets
The term market here refers the place where buyers and sellers of financial assets are joining together. A
Financial market is a mechanism that allows people to easily buy and sell (trade): financial securities (such as
stocks and bonds). Financial markets facilitate the flow of funds in order to finance investments by corporations,
governments and individuals. Financial institutions are the key players in the financial markets as they perform
the function of intermediation and thus determine the flow of funds.
4.2. Classification of financial markets

Financial Markets

By nature of By nature By issuance By Delivery By Organizational

claim maturity of claim time structure

Debt Equity Money Capital Primery Seconda Cash/ Derivati ETM OTC
mkt mkt mkt mkt mkt ry mkt spot ve mkt mkt mkt
mkt

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4.3. Financial market instruments
4.3.1. Money market instruments
Financial market that includes financial instruments that have a maturity or redemption date that is one year or
less at the time of issuance includes the following financial instruments.
a) Treasury bills:- are Short-term debt obligations of a national government issued to cover current
government budget shortfalls (deficit) and to refinance maturing government’s debt. T-bills are sold through
an auction process. T-Bills are generally regarded to be risk free instruments since the government
guarantees to pay their face value upon maturity. They are highly liquid instruments which mean that
holders can easily convert their bills into cash if the need arises. A treasury bill is a discount security, that is,
upon issue the security is sold at a discount to its face value. Since a bill makes no coupon payments, the
holder expects to gain from capital appreciation.
b) Certificate of Deposit (CDs):- CD is a time deposit with banks. CD is a bank-issued, fixed maturity,
interest- bearing time deposit that specifies an interest rate and maturity date. A CD is issued by a deposit
taking institution, usually a bank, to acknowledge that a specified sum of money has been deposited with the
institution. They have a specified maturity date and attract a specified rate of interest. Time deposit may not
be withdrawn on demand. The bank pays interest and principal to the depositor only at the end of the fixed
term of the CDs.
Advantage of CDs to depositors
 Depositors have tradable (negotiable) deposit (assets)
 Depositors get guaranteed rate of interest
Advantage of CDs to Banks
 Guaranteed deposit for fixed period
c) Commercial Papers (CPs):- CPs are unsecured promissory notes issued by companies with strong credit
rating to raise short-term cash often to finance working capital requirement has a fixed maturity; They are
liability to the issuing company usually sold at a discount from face; Issuer pays the face value to holders
of the security at maturity. Difference between the face value and selling price is an implicit interest to the
holder.
d) Repurchase Agreement (Repo or Rp):- RP is an agreement involving the sale of securities by one party to
another with a promise to repurchase the securities at a specified price and on a specific date in the future.
Individuals or firms with temporary idle or excess capital buy short term securities (e.g. T-bills) from their
banks in order to earn small return until the money is needed. The bank then agrees to repurchase the T-bills

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 in the future at a higher price. In effect, a repurchase agreement is a collateralized loan with the seller
handing over the security as collateral. If the specified day is the following day, it is known as an overnight
repo; any longer time horizon is known as a term repo. The agreement will specify both the sale price and
the repurchase price from which the interest cost can be derived. The difference between the purchase
(repurchase) price and the sale price is the dollar (birr) interest cost of the loan
e) Bankers Acceptance (BA):- it is a vehicle created to facilitate trade transaction. BA is a time draft payable
to the seller of goods with payment guaranteed by bank. The transaction in which BA are created include
The import of goods into a country, The export of goods from a given country, The storing and shipping of
goods between two foreign countries, The storing and shipment of goods between two entities of the same
country (e.g between two Ethiopians in different regions). It is sold on a discount basis just as T-bills and
commercial papers.
4.3.2. Federal funds: - Federal Funds are short-term funds transferred between financial institutions usually
for no more than a day. For example, one commercial bank with short of reserves, may borrow from
another bank that has a surplus Federal funds are deposits held by banks and other depository institutions
at the Federal Reserve; these are immediately available funds that institutions borrow or lend, usually on
an overnight basis. They are lent for the federal funds rate. Commercial banks trade federal funds on the
form of excess reserves held at their local Federal Reserve Bank.
4.3.3. Capital market instruments
Capital market instruments are a debt and equity instrument which matures greater than one year. They have far
wider price fluctuations than money market instruments and are considered to be fairly risky instruments. The
principal capital market instruments are;
a) Stocks:- are equity claims on the net income and assets of corporations. A share of a stock in a corporation
represents ownership. A stockholder owns a proportionate interest in the company consistent with the
percentage of outstanding stock held. Stockholders are owners in contrast with the bondholder who is a
creditor of the firm. Investors can get return from a stock in two ways; the price of the stock raises over time
and the corporation pays the stock dividend. Being owner they have the right of residual claims and the right
to vote. There are two types of stocks
i) Preferred stock
ii) Common stock
b) Bonds: - Major issuers of bonds are federal state and local governments (Treasury bonds in US, gilts in the
UK, Bunds in Germany) and firms, which issue corporate bonds. Bonds issued by State and local bonds also
called municipal bonds issued to finance expenditures on schools roads and other large programs or projects.

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 An important feature of these bonds is that their interest payments are exempted from federal income tax and
generally from state taxes in the issuing state. Commercial bank with their high income tax rate holders
consists of wealthy individuals in high income brackets and insurance companies are the biggest buyers of
these securities. Corporate bonds as well as government bonds vary very considerably in terms of their risk.
Some corporate bonds are secured against assets of the company that issued them, whereas other bonds are
unsecured. Bonds secured on the assets of the issuing company are known as debentures. Bonds that are
not secured are referred to as loan stock. The types of bonds include:
i) Callable and Putable bonds:- callable bonds can be redeemed at the issuer’s discretion prior to the
specified maturity (redemption) date. putable bonds can be sold back to the issuer on specified dates,
prior to the redemption date.
ii) Convertible and non-convertible bonds: - convertible bonds are usually corporate bonds, issued with
the option for holders to convert into some other asset on specified terms at a future date but non-
convertible bonds do not convert in to other assets.
iii) Eurobonds: - Eurobonds are bonds issued in a country other than that of the currency of denomination.
Thus bonds issued in US dollars in London are Eurobonds.
iv) Floating rate notes (FRNs). These are corporate bonds where the coupon can be adjusted at pre-
determined intervals. The adjustment will be made by reference to some benchmark rate (example,
LIBOR), specified when the bond is first issued.
v) Foreign bonds. These are corporate bonds, issued in the country of denomination, by a firm based
outside that country. Thus, a US firm might issue a sterling bond in London.
vi) Index-linked bonds. These are corporate bonds where the coupon can be adjusted to high and variable
rates of inflation.
vii) Junk bonds. Junk bonds are corporate bonds whose issuers are regarded by bond credit rating agencies
as being of high risk.
c) Mortgages:- are loans to households or firms to purchase housing, land or other real structures, where
structures or land serves as collateral for the loan. Saving and loan associations and mutual saving bans have
been the primary lenders in the residential mortgage market, although commercial banks may enter this
market.
d) Consumer and bank commercial loans:- these are loans to consumers for individuals provided by banks,
but in the case of business firms by finance companies also.
4.4. Foreign exchange markets

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The market which facilitates the trading of foreign exchange is called foreign market. For funds to be transferred
from one country to another they have to be converted from the currency in the country of origin into the
currency of the country they are going to. The foreign exchange market is where this conversion takes place, and
so it is instrumental in moving fund between countries.
There are two kinds of foreign exchange rate transactions;
1. Spot exchange rate
2. Forward exchange rate
Foreign currency trades can be executed on a spot or forward basis. The spot rate is the price at which a foreign
currency can be purchased or sold today. In contrast, the forward rate is the price today at which foreign
currency can be purchased or sold sometimes in the future. Because many international business transactions
takes some time to be completed, the ability to lock in a price today at which foreign currency can be purchased
or sold at some future date has definite advantage.
The forward rate can exceed the spot rate on a given date, in which case the foreign currency is said to be selling
at premium in the forward market, or the forward rate can be less than the spot rate, in which case it is selling at
a discount.
4.5. The derivative market
Some financial assets are contracts that either obligate the investor to buy or sell another financial asset or grant
the investor the choice to buy or sell other financial assets. Such contract derives their value from the price of
financial assets that may be bought or sold. These contracts are called derivative instruments and the markets in
which they trade are referred derivative markets. For example, a share of ford co. stock is a pure financial asset
while an option to buy ford shares is a derivative security whose value depends on the price of ford stocks. The
array of derivative instruments includes option contracts, future contracts, forward contracts, swap agreements
and cap and floor agreements. As far as these markets are the newest of the financial security markets in the
world they are mostly traded in developed financial markets.
Role of Derivative Instruments
Derivatives have several uses: (1) hedging interest rate risk and foreign exchange risk; (2) lower transactions
costs than on cash market; (3) faster transactions than on the cash market; (4) greater liquidity than on the cash
market.

Chapter Five: The Regulation of Financial Markets and Institutions

Introduction

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5.1 Explain the purpose of regulation

5.2 Explain the nature of financial system regulation

5.3 Describe the forms of regulation that government have follow

5.4 Examine different kinds of regulation

The financial markets play an important role in many economies and governments around the world have long
deemed it necessary to regulate certain aspects of these markets. Because of differences in culture and
history, different countries regulate financial markets and financial institutions in varying ways, emphasizing
some forms of regulation more than others. Differences also exist in the system of regulation and different
countries adopt different systems of regulation and to regulate financial markets. This chapter, therefore,
discusses the role of governments in their regulatory capacity, the rationale for regulation, forms of regulation
and systems of regulation.
The Role of Government
In their regulatory capacities, governments have greatly influenced the development and evolution of financial
markets and institutions. In this section, we will discuss the role of government in regulation of financial
markets and intuitions.
Governments' Role in Regulation
Governments in most developed economies have created elaborate systems of regulation for financial markets,
in part because the markets themselves are complex and in part because financial markets are important to the
general economies in which they operate. It is important to realize that governments, markets, and
institutions tend to behave interactively and to affect one another's actions in certain ways. Thus, it is not
surprising to find that a market's reactions to regulations often prompt a new response by the government, which
can cause the institutions participating in a market to change their behavior further, and so on
The standard explanation or justification for governmental regulation of a market is that the market, left to it
self, will not produce its particular goods or services in an efficient manner and at the lowest possible cost. Of
course, efficiency and low-cost production are hall marks of a perfectly competitive market. Thus, a market
unable to produce efficiently must be one that is not competitive at the time, and that will not gain that status by
itself in the foreseeable future. Of course, it is also possible that governments may regulate markets that are
viewed as competitive currently but unable to sustain competition, and thus low-cost production, over

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the long run. A version of this justification for regulation is that the government controls a feature of the
economy that the market mechanisms of competition and pricing could not manage without help.
Purposes and Forms of Regulation
• There are various justifications regarding the need for market regulation and this section provides us a
detailed explanation of why regulation of financial markets and insinuations is needed. In addition, this
section also discusses the different forms of regulation.
Justification for Regulation
• The three core justifications for regulation are:
 The protection of investors;
 Ensuring that markets are fair, efficient and transparent; and
 The reduction of systemic risk
• The three justifications for regulation are closely related and, in some respects, overlap; many of the
requirements that help to ensure fair, efficient and transparent markets also provide investor protection and help
to reduce systemic risk. Similarly, many of the measures that reduce systemic risk provide protection for
investors. The aforementioned objectives of regulation are further descried below.
1. The Protection of Investors
• Investors should be protected from misleading, insider trading, and the misuse of client assets. Full
disclosure of information material to investors' decisions is the most important means for ensuring investor
protection. Investors are thereby better able to assess the potential risks and rewards of their investments.
Disclosure requirements, accounting and auditing standards should be in place and they should be of a high and
internationally acceptable quality. Unless investors are accorded sufficient protections they will not have faith in
the system. This lack of faith will be detrimental to build a vibrant and robust capital market.
• If business is meant to thrive and participants to prosper, building up confidence amongst the populace
is highly important. That is why major regulatory concerns were mainly focused on investors. In effect,
regulation in this respect will not only be beneficial to investors but also to companies or corporations who
would be able to expand and make profits in viable stock.
To sum up regulation helps to:
• 1) Solve moral hazard problem-taking up unexpected activities by corporate (borrowers) after mobilizing
funds from the public affecting investors interests. Disclosure requirements are good in this regard.
• 2) Avoid market failures due to asymmetric information. This is because lack of proper information for
investors with regard to direction of the market may give disincentives to stay in the market and they might
move out of the market.

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• 3) Limit opportunities for agents to act against the interests of their shareholders. Agents
/managers having special information may use for their own advantage at the expense of shareholders affecting
corporate governance. Thus, regulations such as laws against insider trading could reduce the magnitude of the
problem.
• 4) Regulate investment bankers because, if they are left free, to get more business they may join hands with the
corporate to defraud investor public. Regulations such as code of conduct for investment bankers are helpful to
this end
2. Ensuring that Markets are Fair, Efficient and Transparent

• The fairness of the markets is closely linked to investor protection and, in particular, to the prevention of
improper trading practices. Market structures should not unduly favor some market users over others.
Regulation should detect, deter and penalize market manipulation and other unfair trading practices.

• In an efficient market, the dissemination of relevant information is timely and widespread and is reflected in
the price of securities. The process of regulation should promote market efficiency.

• Transparency may be defined as the degree to which information about trading (both for pre-trade and post-
trade information) is made publicly available on a real- time basis. Pre-trade information concerns the posting of
firm bids and offers as a means to enable investors to know, with some degree of certainty, whether and at what
prices they can deal.

Post-trade information is related to the prices and the volume of all individual transactions actually concluded.
Regulation should ensure the highest levels of transparency

3. The Reduction of Systematic Risk

• Although regulators cannot be expected to prevent the financial failure of market intermediaries,
regulation should aim to reduce the risk of failure (including through capital and internal control requirements).
Where financial failure nonetheless does occur, regulation should seek to reduce the impact of that failure.
Market intermediaries should, therefore, be subject to adequate and ongoing capital and other prudential
requirements. If necessary, an intermediary should be able to wind down its business without loss to its
customers and counterparts or systemic damage.

• Risk taking is essential to an active market and regulation should not unnecessarily stifle legitimate risk
taking. Rather, regulators should promote and allow for the effective management of risk and ensure that capital
and other prudential requirements are sufficient to address appropriate risk taking, allow the absorption of some
losses, and check excessive risk taking.

• Instability may result from events in ones own jurisdiction or in another jurisdiction or occur across
several jurisdictions. So regulators should try to facilitate stability domestically and globally through
cooperation and information sharing. As part of this, one objective of regulation is to restrict the activities of
foreign concerns in domestic markets and institutions which plays an important role in facilitating stability of
the financial system.
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2.2 Forms of Regulation

Corresponding to each rationale for regulation is an important form of regulation.

• Disclosure Regulation

This is the form of regulation that requires issuers of securities to make public a large amount of financial
information to actual and potential investors. The standard justification for disclosure rules is that the
managers of the issuing firm have more information about the financial health and future of the firm than
investors who own or are considering the purchase of the firm's securities. The cause of market failure here, if
indeed it occurs, is commonly described as asymmetric information, which means investors and managers have
uneven access to or uneven possession of information. This is referred to as the agency problem, in the sense
that the firm's managers who act as agents for investors, may act in their own interests to the disadvantage of the
investors. The advocates of disclosure rules say that, in the absence of the rules, the investors' comparatively
limited knowledge about the firm would allow the agents to engage in such practices.

• It is interesting to note that several prominent economists deny the need and justification for disclosure rules.
They argue that the securities market would, without governmental assistance, get all the information necessary
for a fair pricing of new as well as existing securities. One way to look at this argument is to ask what investors
would do if a firm trying to sell new shares did not provide all the data investors would want. In that case,
investors either would refuse to buy that firm's securities, giving them a zero value, or would discount or
underprice the securities. Thus, a firm concealing information would pay a penalty in the form of reduced
proceeds from sale of the new securities. The prospect of this penalty is potentially as much incentive to
disclose as the rules of a governmental agency.

Financial Activity Regulation

It consists of rules about traders of securities and trading on financial markets. A prime example of this
form of regulation is the set of rules against trading by insiders who are corporate officers and others in
positions to know more about a firm's prospects than the general investing public. Insider trading is
another problem posed by asymmetric information, which is of course inconsistent with a competitive
market. A second example of this type of regulation would be rules regarding the structure and operations of
exchanges where securities are traded. The argument supporting these rules rests on the possibility that members
of exchanges may be able, under certain circumstances, to collude and defraud the general investing public.

Regulation of Financial Institutions

This is the form of governmental monitoring that restricts these institutions' activities in the vital areas of
lending, borrowing, and funding. The justification for this form of government regulation is that these financial
firms have a special role to play in a modern economy. Financial institutions help households and firms to save;
they also facilitate the complex payments among many elements of the economy; and in the case of
commercial banks they serve as conduits for the government's monetary policy. Thus, it is often argued that the
failure of these financial institutions would disturb the economy in a severe way.

Regulation of Foreign Participants

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This is that form of governmental activity that limits the roles foreign firms can have in domestic markets and
their ownership or control of financial institutions.

Regulation of Economic Activity

Authorities use banking and monetary regulation to try to control changes in a country's money supply, which is
thought to control the level of economic activity.

Systems of Regulation

• Overview

• Financial institutions, markets and their products are regulated through three major systems of regulation. This
section will discuss each of these systems of regulation separately.

1. Federal/Central Regulation

2. Self Regulatory Organizations (SRO)

Self regulation amounts to a situation where members involved in a financial activity come together and set a
code of rules and regulations to abide by in the conduct of their activities.

SROs are said to be cost effective and stable from political interference. Since SROs follow their own rules and
procedure, they are insulated from government pressure, which makes the system more stable and long lasting.
In contrast to the government bureaucracy, the SROs show more concern and prudent care for the proper
implementation of the standards of fair practice, for their fate is entwined with the proper functioning of the
market. As far as self-regulation is concerned, stock exchanges take the first step through their listing
requirements. Stock exchanges employ quantitative or qualitative listing requirements to screen out participants
in the market.

Establishing government regulatory agencies involves a heavy burden and expense in terms of money, time and
manpower. It also exerts considerable pressure on taxpayers, because running such government agencies
requires raising funds from the public. Hence, SROs can generally be considered as cost effective and stable
which makes them an ideal mechanism for regulation.

3. Market Regulation

This approach is also referred to as market action and is in line with the laissez faire approach, which tells us
that the market will take care of itself. In fact, what is meant by market action is that a market should be able to
regulate itself. This is especially with regard to disclosure regulation. As we noted before, proponents of this
approach contend that there is no justification for disclosure regulation by government because the market
would without government assistance get all the information necessary for a fair pricing of new as well as
existing securities through its power to underprice the securities of firms that do not provide all necessary data.

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 Market action tells us that economically efficient disclosure will be made in response to sophisticated investors.
The assumptions of efficient disclosure and sophisticated investors may hold true given the background of the
American System where intuitional investors are rampant. However, even there, the market left alone was
supposedly proved to be a failure leading to a change in the policy of regulatory mechanisms. Then, it needs no
critical analysis to affirm the impracticability of this theory in a developing economy like Ethiopia where the
market is at its embryonic stage thus making the need for issuing government regulations or self-regulation for
stock exchange obvious.

Summary

Regulations of the financial system and its various component sectors occur in almost all countries. The
rationales for regulation are: (1) investor protection; (2) ensuring that markets are fair, efficient and transparent;
and (3) reduction of systemic risk.

A useful way to organize the many instances of regulation is to see it as having five general forms: (1) enforcing
the disclosure of relevant information; (2) regulating the financial activity through rules about traders of
securities and trading on financial markets; (3) restricting the activities of financial institutions and their
management of assets and liabilities; (4) constraining the freedom of foreign investors and securities firms in
domestic markets; and (5) regulating the level of economic activity through control of the money supply.

Different countries adopt different systems of regulation. These systems of regulations include: (1) federal
regulation; (2) self-regulation; and (3) market action.

CHAPTER SIX
FINANCIAL MARET AND INSTITUTION IN ETHIOPIA

INTRODUCTION
6.1 identify financial market and institution
6.1.1 Explain money market and capital market
6.2 identify formal financial institutions in Ethiopia and describe them
6.3 Explain how NBE regulate financial sector in Ethiopia

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6.4 Define commodity exchange market
6.4.1Explain how commodity market work

Evolution of modern institutionalized financial system in Ethiopia started in 1905 following the establishment of
the first bank by historically reminiscent name of Bank of Abyssinia. This Bank introduced for the first time in
Ethiopian financial systems history banking services and instruments such as deposit accounts and export
financing.
In 1980s, the financial system was restructured and reorganized to serve centrally planned economic system
which was created following the change of government in 1974. During this period,
 The Government nationalized all financial institutions in the country and created three specialized banks
(excluding the central bank) and one insurance company.
 Private ownership of financial institutions was prohibited.
 Three state owned banks and the insurance company were administered by the central bank the National
Bank of Ethiopia (NBE). Among the specialized banks,
 Agricultural and Industrial Development Bank (the current Development Bank) was responsible for
financing agricultural and industrial projects with medium and long gestation period,
 Housing and Savings Bank (the current Construction and Business Bank) used to lend for
construction of residential and commercial buildings.
 Commercial Bank of Ethiopia, was the only bank engaged in trade and other short-term financing
activities.
 The only insurance firm, the Ethiopia Insurance Corporation, was responsible for provision of all types of
insurance services.

In 1990s, as a result of the shift from socialist to market economic system, Ethiopia reformed its financial
services industry. While there was no change in the role of institutions:
 Commercial Bank of Ethiopia (as short-term financer),
 Development Bank of Ethiopia (as provider of medium and long term development finance) and
 Ethiopian Insurance Corporation (as provider of both general and life insurance services),
 Construction and Business Bank has been allowed to engage in short-term financing activities.
Ethiopia has conducted financial sector reform following the change in government and economic policy in
1991. It has re-established the national bank of Ethiopia as a central bank and financial market regulator and
opened the bank and insurance sectors for domestic private investment through monetary banking and insurance
supervision laws that are enacted in 1994 and amended in 2008.
It has made interbank money and foreign exchange markets operational as of 1998. It has also introduced a
regulatory regime for microfinance required the formal establishment of microfinance institutions with in the
financial system and required the NBE to promote development of the traditional savings institution of the
society along with the microfinance institutions and to encourage participation of the banks and other financial
institutions in the provision of micro finance by a law enacted in July 1996 and amended in 2009.

Financial markets in Ethiopia

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a) Money market :- is where short term securities are traded instruments traded in the market include
government treasury bill, time deposits and interbank loans
b) Capital market: - no capital market in Ethiopia. Despite an intense pressure from entrepreneurs,
academicians and international financial institutions such as IMF, the Ethiopian government did not want to
establish capital market in the country. But capital market instruments are offered to investors informally
example stocks and bonds.
Financial sectors in Ethiopia
There are three formal financial institutions in Ethiopia
 Banks
 Microfinance institutions
 Insurance companies
Regulation of financial sector in Ethiopia
 Setting minimum interest rate on deposits or the rediscount rate charged from commercial banks
borrowing reserves.
 Setting reserve requirements on various classes of deposit
 Increasing or decreasing commercial banks reserves through open market purchases or sales of
government securities.
 Regulatory actions constrain commercial banks financial activities or to set minimum capital
requirements
 Intervention in foreign exchange markets to buy and sell domestic currency for foreign exchange.
 Decide on levels of required reserves of commercial banks total deposit
6.4. Commodity markets/Commodities exchanges: “Open and organized marketplace where ownership
titles to standardized quantities or volumes of certain commodities (at a specified price and to be
delivered on a specified date) are traded by its members; such as fuels, metals, and agricultural
commodities exchanges” . (businessdictionary.com)

Ethiopian Commodity Exchange (ECX), a vibrant lesson: Ethiopia has established a commodity exchange with the
proclamation no. 550/2007 with an initiative to revolutionize the traditional agriculture through creating a new
marketplace to serve all actors and add value to the primary producers. This market is the first of its kind not only in
Ethiopia but in Africa. Initially, many consider the establishment of this unique platform to all in the agricultural value
chain as madness as they believe it doesn’t work in the 85% uninformed rural and immature infrastructure. But it has
become a rubber bridge bringing diverse partners, from farmers to traders to processors to exporters and consumers.
Then it is praised for its exemplary works of providing reliable end-to-end system and linking financial services,
transportation, etc. Though it is a few years since establishment, EXC has become an institution that many African
nations dream. Therefore, it is a vibrant and lively lesson that the country could learn too much and scale up best
practice to launch the capital market.

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