FINANCIAL INSTITUTIONS, INSTRUMENTS

AND MARKETS (ACFN 562)

Lectured By
Asnake Minwyelet (MSC.,PhD)
Assistant Professor

DEBRE MARKOS UNIVERSITY

COLLEGE OF BUSINESS AND
ECONOMICS
DEPARTMENT OF ACCOUNTING AND
FINANCE
 Chapter One

Introduction to Financial System

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 Contents in Chapter One

– An Overview of the Financial system

– The Functions of Financial Systems
– Financial Institutions
– Financial Services and Instruments
– Financial Markets
– Financial regulation
– Real assets and Financial assets
– Characteristics of financial assets
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 1.1. An Overview of the Financial system

• Finance is the art and science of managing money.

• Finance is concerned with the process, institutions,

markets, and instruments involved in the transfer of money

among individuals, businesses and governments (Gitman ,

2006).

• The financial sector is all about the wholesale, retail, formal

and informal institutions in an economy offering financial

services to customers, businesses and other financial

institutions.
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• Therefore, in its broadest definition, it includes
everything from banks, stock exchanges, and
insurers, credit unions, microfinance institutions
and money lenders.
• A financial system may be defined as a set of
institutions, instruments and markets which
fosters savings and channels them to their most
efficient use.

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• The system consists of individuals (savers),
intermediaries, markets and users of savings
(government, public and private sector entities).
• Financial System comprises, a set of sub-systems of
financial institutions, financial markets, financial
instruments and services, which help in the formation
of capital.
• Therefore, a financial system is defined as a function
as an intermediary and facilitates the flow of funds
from the areas of surplus to the areas of deficit.
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• In other words, a financial system is a system that
aims at establishing and providing a regular,
smooth, effective and efficient linkage between
depositors and investors.
• Economic activity and growth are greatly
facilitated by the existence of a financial system
developed in terms of the efficiency of the market
in mobilizing savings and allocating them among
competing users (Machiraju, 2008).
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 Features of Financial System

1. Financial system provides an ideal

linkage between depositors and
investors. →It encourages savings and
investment.
2. Financial system facilitates expansion of
financial markets over space and time.

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• 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.

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3. Financial system promotes efficient
allocation of financial resources for
socially desirable and economically
productive purposes.

4. Financial system influences both the

quality and the pace of economic
development.
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 1.2. Functions of Financial System

• A good financial system has the following

functions
1. Clearing and settling payments
2. Pooling resources and subdividing shares
3. Transferring resources across time and space
4. Managing risk

5. Providing information
6. Dealing with incentive problems
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1. Clearing and settling payments

• “A financial system provides ways of clearing and

settling payments to facilitate the exchange of
goods and services.”
• Financial institutions, now a days, provides
different payment system.
• For example, depository institutions (like
banks) provide ATMs, credit/debit cards.
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 2. Pooling resources and subdividing shares

• “A financial system provides a mechanism for pooling of funds

to undertake large-scale indivisible enterprise or for
subdividing of shares in enterprises to facilitate
diversification”.

• The financial system provides a variety of mechanisms

(such as security market and financial intermediaries)
through which individual households can pool
(aggregate) their wealth in to large amount of capital for
use by business firms
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• So the financial system provides an opportunity
to households or individual savers to participate
in large-scale indivisible investments.
• Mutual funds that hold stocks and bonds are
good example of financial intermediaries that
provide virtually full divisibility in subdividing
the individual unit size the traded securities
they hold.

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 3. Transferring resources across time and space
• “A financial system provides ways to transfer economic
resources through time, across geographic regions and
among industries.”
• The financial intermediaries transfer resources
across time and space, thus allowing investors and
consumers to borrow against future income and
meet current needs.
• As a result, there is an efficient separation of
investment & financing horizons (maturity).
• In other words, short-term deposits used to finance
long-term lending and roll-over loans for financing
infinite projects
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 4. Managing risk
• “A financial system provides ways to manage
uncertainty and control risk.”
• For instance, by facilitating diversifications,
financial intermediaries allow savers to
maximize returns to their assets and to reduce
risks.
• Minimizing information asymmetry

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 5. Providing information
• “A financial system provides price information that
helps co-ordinate decentralised decision-making in
various sectors of the economy.”
• That is, by providing a mechanism for appraisal
of the value of the firm, financial systems allow
investors to make informed decisions about the
allocation of their funds.

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• In addition to facilitating trading of financial
instruments, capital markets provide information
useful for decision making.
• For example, interest rate and security prices are
information that households or their agents use in
making consumption-saving decision and in choosing
the portfolio allocation of their wealth.

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 6. Dealing with incentive problems
• “A financial system provides ways to deal with the
incentive problems when one party to a financial
transaction has information and the other party does
not, or when one party is an agent for another.”
• A well-functioning financial system reduces the
incentive problem that make financial contracting
difficult and costly.

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• These problems arise because parties to
contracts can’t easily observe or control one
another and contractual enforcement
mechanisms are not costless to invoke.
• These contractual “frictions” take a variety of
forms: Moral hazard and adverse selection, and
information asymmetry.

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 Components of Financial System

• The financial system or the financial sector of

any country contains five major components:
 Financial Institution
 Financial Market
 Financial Instrument

 Financial Service

 Financial regulation
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1. Financial Institutions:
• They are those that provide credit and credit
related services.
• They act as moblizers and transferors of
savings or funds from surplus unit to deficit
units.
• They deal in financial assets, accept deposits,
grant loans and invest in securities.
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• They buy and sell financial instruments
and are responsible for generating
financial instruments.
• They are regulated by a regulatory body.

Eg. All commercial banks are regulated

by NBE.

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 Intermediary institutions: intermediate between
savers and investors; they lend money as well as
mobilize savings; their liabilities are towards the
ultimate savers, while their assets are from the
investors or borrowers. Eg. All Commercial Banks

 Non-intermediary institutions do the loan

business but their resources are not directly
obtained from the savers.
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 Banking and non-banking financial institutions
have few things in common:
– They participate in the economy’s payments
mechanism i.e., they provide transaction
services.
– Their deposit liabilities constitute a major part
of the national money supply.
– Create deposits or credits.

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• Banks, subject to legal reserve requirement, can
advance credit by creating claims against
themselves, while non-banking financial institution
can lend only out of resources put at their disposal
by the savers.

• Therefore, the former is known as ‘’creator’’ of credit

and the latter as mere ‘’purveyor’’ of credit.
Example: Banking financial institution: All commercial banks.
Non-banking financial institution: Insurance company.
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ii. Financial Instruments:
• Financial claims such as financial assets and
securities dealt in a financial market are
referred to as financial instruments.
• They are documents through which funds are
collected.
• Eg. Government bonds, corporate bonds,
common stock etc.
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 iii. Financial Markets:
• They facilitate buying and selling of
financial claims, assets, services, and
securities.
• In financial markets funds or savings are
transferred from surplus units to deficit
units.
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• Financial market is classified into unorganized and
organized markets or primary and secondary
markets or money and capital markets.
1. Organized market
 There are set of rules and regulations governing financial
dealings.
 Financial instruments are not limited in supply.
 Financial assets are standardized in supply.
 There is high degree of institutionalization and
instrumentalization.
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 2. Unorganized market
• Has no adequate regulation relating to financial dealings.
• Financial instruments are limited in supply.
• Financial instruments are non-standardized in character.
• The settlement mechanism is not effective and
institutionalization.
• Example: Indigenous bankers and money lenders. They are
active in the small town and village where farmers and small
traders do not have an access to the modern banks.

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Primary Market
• Primary market deals in issues of new financial claims
or new securities, where the ultimate investors issue the
securities to the ultimate depositor.

Secondary Market
• Secondary market deals in purchase and sale of
securities, which have already been issued and are
outstanding.
• It provides liquidity to the outstanding or existing
securities.
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Money Market
• Money market deals with short-term instruments/
financial assets.
• All of which have a maturity period of up to one
year.
• It comprises call money market, treasury bill
market, commercial paper market etc.

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Capital market
• Capital market deals in long term
securities with maturity period above one
year.
• It comprises stock market, government
bond market etc

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Debt Market:
• It is a market where debt securities (like
bond) are traded.
Equity Market:
• It is a market where equity securities (like
common stock) are traded.

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 iv. Financial Services:
– Financial services comprise of various
functions and services that are provided by
financial institutions in a financial system.
Eg. Leasing, factoring, underwriting,
depository, housing finance etc.

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V. Financial regulation
• Financial system of any country are among the
heavily regulated sectors of the economy.
• It is the process in which there is a monitoring of
the financial institutions by body that is directed
by the government in an effort to achieve
macroeconomic goals through monetary policies
as well as other measures permissible by law.

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 Real Vs Financial assets

• Assets are things that people own.

• Generally assets can be classified in to two broad classes as Real

and Financial assets

• The distinction between these terms is easiest to see from an

accounting viewpoint.

• A real asset does not have a corresponding liability associated

with it, although one might be created to finance the real asset.

• Financial assets have a corresponding liability but real assets

do not.
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• A financial asset carries a corresponding liability somewhere.
If an investor buys shares of stock, they are an asset to the
investor but show up on the right side of the issuer
corporation’s balance sheet.
• A financial asset, therefore, is on the left-hand side of the
owner’s balance sheet and the right-hand side of the issuer’s
balance sheet.
• Real assets of a business can be building, land, machinery, real
estate, inventory, and so on.
• Financial assets may take forms like deposits, loans, securities,
and so on.
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 Characteristics of Financial Assets
1. Money-ness

• Some financial assets are used as a medium of exchange or

in settlement of transactions. These assets are called money.

• Those financial assets which can be transformed in to

money at little cost, delay or risk can also be considered as
money.

• For example, money and cash deposited in a checking

account can be used as a medium of exchange.

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2. Divisibility and denomination
– Divisibility relates to the minimum size at which a
financial asset can be liquidated and exchanged for
money. Or
– Minimum amount to sell or purchase an asset or the
extent to which fractional amounts of an asset can
be sold and bought.

– The smaller the size, the more the financial asset

is divisible.
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• For example, physical assets such as car, building etc are

often indivisible.

• A financial asset such as a deposit at a bank is infinitely

divisible but other financial assets have varying degrees of

divisibility depending on their denomination, which is the

dollar value of the amount that each unit of the asset will pay

at maturity.
• money, deposits -- $.01
• bonds -- $1000 to $10,000
• commercial paper -- $25,000

• Therefore, all financial assets can be treated as divisible.

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3. Reversibility

– It refers to the cost of investing in a financial asset and

then getting out of it and back in to cash again.

– i. e., cost of investing in asset, then selling it for cash.

Simply it refers to round-trip cost.

• Example: A financial asset such as a deposit at a bank is

obviously highly reversible because there is no charge for

depositing and withdrawing from it. Thus, deposits -- cost

close to zero.
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• Bonds, stocks -- commissions and bid/ask
spread of dealers.
• Bid-Ask spread is the difference between the
price that a market maker is willing to sell a
financial asset for (the price it is asking) and
the price that a market maker is willing to
buy a financial asset for (biding price).

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• Reversible costs are small for thick markets (with
a lot of buying/selling) but larger for thin
markets. A '' thin market'' is one which has few
trades on a regular or continuous basis.
– Treasury bills have a thick market, small company
stocks have a thin market

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4. Cash flows and return predictability
– The return that an investor will realize by holding
a financial asset depends on the cash flow that is
expected to be received.
– What cash flows are you promised as owner of
this asset? dividends, face value payment, resale
price.

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– When are the cash flows promised?

• Both size and timing of cash flows are

important.
• Therefore, the predictability of the expected
return depends on the predictability of the cash
flow.
• So it is a basic property of financial assets.

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5. Term of Maturity
– It is the length of time until final payment, or the
owner is entitled to demand liquidation.
– Maturity may be uncertain for some financial
instruments or assets.
– For example; common stock and non-redeemable
preferred stock and certain for some financial assets
like Treasury bill, bonds, commercial paper etc.

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6. Convertibility
– Is asset convertible to another type of asset?
– In some cases, the conversion takes place within one
class of financial assets, as when a bond is converted
in to anther bond.
– In other situation, one financial asset converted in to
other financial asset, for example, a corporate
convertible bond is a bond that the bond holder can
change in to equity.
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7. Currency
– If cash flow is not in domestic currency, exchange rate
fluctuations affect value of cash flow in domestic
currency.
– Thus, to reduce foreign exchange risk, some issuers
have issued dual currency securities. For example,
some issuers pay an interest in one currency but
principal or redemption value in another currency.
i.e., Interest in Sudan Dinar and principal in US dollar.

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8. Liquidity
How easily are the assets converted to cash? OR
It refers to the speed with which the asset can be sold.
How easy is the asset to buy/sell?  How cheap is it the asset to
buy/sell?

•Example: Treasury securities - very liquid; real estate--not very

liquid.

•Ordinary deposits at a bank are perfectly liquid because the bank

has a contractual obligation to convert them at par on demand. In
contrast, private pension fund may be regarded as totally illiquid
because these can be cashed only at retirement.
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9. Risk/ return predictability
– risk = variability in return
• Most assets have some risk

• Investors are risk averse, so must be

compensating for taking on risk
• Risk of default--not receiving promised cash
flows in full and/or on time

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• Interest rate risk: fluctuations in the interest rate

cause the value of assets to fluctuate

– All debt securities carry some interest rate risk

• Currency exchange risk: exchange rate

fluctuations affect value of non domestic asset.

• Regulatory risk: changes in laws affect the tax

treatment of asset or prospects of an issuer of

assets. Uncertainty increases with time horizon

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 End of Chapter one

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