YOM Institute of Economic

Development

Course Title: Financial Institutions and Investment Management

Course Code: MBA 542
Credit Hours: 2
 Part-I
An Overview of Financial System
Learning Objectives
• Explain the role of a financial system
• Describe the main classes of financial instruments
issued in a financial system
• Understand how financial markets work (bond, stock and
foreign exchange markets)
• Understand the purpose of financial markets
• Discuss the flow of funds between savers and
borrowers, including direct and intermediated
finance
• Understand the types of financial intermediaries
 Concepts of Financial System
Financial system comprising complex and closely
interconnected financial markets, financial institutions,
regulations and techniques through which financial assets are
sold and financial services delivered.
• It is the system that allows the transfer of money between
savers (SSU) and borrowers (DSU)
• Financial systems are crucial to the allocation of resources in
a modern economy.
• Thus; Financial system of any country consists of three
components:
– Financial Institutions and
– Financial Markets.
– Financial Instruments
 Concepts… (cont’d)
Generally speaking a financial system;
• Channels funds from lenders to borrowers
• Creates liquidity and money
• Provides a payments mechanism
• Provides financial services such as insurance
and pensions
• offers portfolio adjustment facilities
 Concepts… (cont’d)
• Financial institutions, as part of the financial
system, facilitate the flow of funds from savers
(surplus agents) to borrowers (deficit agents) in the
most efficient manner.
• Financial institution or financial intermediaries :
– Channel funds from surplus units to deficient units
– Take deposits from savers (surplus units) and lend
these funds to potential investors (deficit agents)
• Financial intermediaries are institutions that
borrow funds from people who have saved and
make loans to other people.
 Concepts… (cont’d)
• The job of bringing DSUs and SSUs together can be
done by;
1. Direct Financing: Direct transfers of money and
securities occur when a fund seeking entity/business
sells its stocks or bonds directly to savers, without
going through any type of financial intermediary.
 Concepts… (cont’d)
2. Indirect Financing or Intermediation Financing:
They purchase direct claims with one set of
characteristics (e.g. term to maturity, denomination)
from DSUs and transform them into indirect claims
with a different set of characteristics, which they sell to
the SSU.
 Types of Financial institutions

a. Formal Financial institutions are those that are

subject not only to general laws and regulations
but also to specific regulations and supervision.
include:
• Development Banks ( both public and Private)
• Commercial Banks (Both public and Pvt)
• Savings banks and postal saving banks
• Non-bank financial intermarries (insurance companies
etc)
Types of Financial institutions ( cont’d)

b. Semi-formal institutions are those that are formal in

the sense of being registered entities subject to all
relevant laws, including the commercial law, but
informal insofar as they are, with few exceptions,
not under bank regulation and supervision:
– free to set their own interest rate,
– free from minimum capital requirement unlike
banks,
– their operations are not subject to supervision of
national Banks, etc
 Types of Financial institutions
( cont’d)
Examples
– Credit unions
– Multipurpose cooperatives
– (some) Self-help groups, such as edirs
 Cont’d….
c. Informal providers (generally not referred to as
institutions) are those to which neither special
bank law nor general commercial law applies,
and whose operations are also so informal that
disputes arising from contract with them often
cannot be settled by recourse to the legal
system.
 Informal Providers…(cont’d)

• Informal providers consist of:

• Money lenders
• Traders, landlords, and the like (as money lenders)
• (most) self-help group such as Edir in Ethiopia
• Rotating and saving credit associations (like equup
in Ethiopia)
• Families and friends
 Roles of Financial Intermediaries
• Most important function = to assist in the transfer of
funds from surplus agents to deficit agents.
In assisting this process a financial intermediary
undertakes several economic functions:
I. the provisions of a payments mechanism;
II. maturity transformations;
III. Risk diversification
IV. Protection Function
V. Policy Function
VI. Information Function
VII.Transfer Function
VIII.Reformatory Functions -introducing innovative financial assets
IX. liquidity provisions; and
X. reduction of transaction, information and search costs.
 i. Provision of Payment Mechanism

• Facilitate the payments of funds by cash & non-

cash means such as cheques, credit cards, electronic
transfers, Letter of Credit etc

• an effective payments system is essential to the health of a

modern economy- among domestic agents and between
domestic and foreign agents
 ii. Maturity Intermediation
(transformation) role
• FIs convert short term liabilities to long-term
assets.
• Surplus agents typically wish to have their surplus
funds redeemable at short notice,
– for example certain deposit are payable upon demand,
others have specific maturity date.
 Maturity…(Cont’d)
• Deficit agents (investors) wish to borrow funds
over long-term horizon.

• In the absence of commercial banks, the borrower

would have to borrow for a shorter term or find
an entity willing to invest for longer period –
which is difficult (costly, time consuming, and
risky if the deficit agent undertakes by
himself/herself)
 Maturity Intermediation (Cont’d)
• A financial intermediary such as a commercial
bank typically accepts investors’ fund on a short-
term basis and channel these funds to long-term
borrowers.

• The process of converting short-term liabilities

(deposits) into longer- term assets (Loans) is
known as maturity transformation
Maturity Intermediation (Cont’d)
• In the absence of financial intermediary there would
less exchange between surplus and deficit agents since
the short-term liquidity requirements of surplus agents
would fail to coincide with the long-term capital
requirements of deficit agents.

• Thus, FIs help to increase fund transfers in the

economy at reduced cost, risk and time
Maturity Intermediation (Cont’d)

Q. How FIs are able to perform maturity

transformation?
– How banks manage to provide long-term
loans while their liability (deposit) is short-
term, i.e, the saving deposit could be
withdrawn at short notice?
 Maturity…(Cont’d)

Ans. Because they deal with a large number

of deficit and surplus agents.
– This means that their inflow and outflow of
funds is fairly predictable, so they can operate
with a relatively low level of liquid reserves
– Netting system
 iii. Risk Diversification Role
• Surplus agents need complete protection for their capital

• On the other hand borrowers need capital to finance in

risky investment projects
• Thus, the demands of the two agents contradict
each other.

• If a surplus agent lends directly to a deficit agent, this

would leave the them heavily exposed to the risk of
default by the deficit agent.
 Risk Diversification-cont’d
• In the absence of financial intermediaries, firms
(borrowers) might find it very difficult to their
financial requirements, as savers would be
reluctant to put their funds at risk.

• Therefore;
• Financial intermediaries can play an important
part in transforming the low risk requirement of
savers into meeting the risk-finance requirements
of firms (borrowers). How??
 Risk Diversification-cont’d
• A financial intermediary that receives funds from many
surplus agents can pool these funds lend to a large
number of deficit agents-diversification

• By doing so, FI reduce risks:

– Making a relatively large number of small loans rather than a
small number of large loans
– FIs lend funds to different sectors of the economy, so that it
will not excessively affected by problems in any particular
sector.
 Risk Diversification-cont’d
– FIs have their own specialists who can screen
out high-risk borrowers.

– FI is more skilled in charging an appropriate

interest rate to compensate for the risk involved
than the individual surplus agent- individual
lender or company.

– FI have their own capital base which provides

protection for savers.
 iv. Liquidity role
• Liquidity refers to the ease with which an
asset can be converted into cash.

• Deposit-taking institutions ensure savers

almost instant access to their funds
 iv. Liquidity role
• Liquidity refers to the ease with which an
asset can be converted into cash.

• Deposit-taking institutions ensure savers

almost instant access to their funds
 Liquidity role (cont’d)
• Deposit-accepting institutions are able to
provide liquidity by maintaining:
– liquid balances after forecasting their net outflow/
inflow of funds
– they have a large number of depositors,
– withdrawal of funds is reasonably predictable and
– the inflow of fund is also reasonably predictable
based on the maturity structure of the loan portfolio.

– Deposit-taking institutions are therefore able to

ensure liquidity provision without maintaining
large balances in relation to total deposits.
 v. Reduction of contacting, search and information
costs role
• What must be considered when lending money ????
– The cost of acquiring and processing the information
about the borrower (known as information processing
costs).
– The cost of loan contracts - contracting costs.

• Most surplus agents lack the time, skill and

resources to find and analyse prospective deficit
agents and draw up and enforce the necessary
legal contracts.
 Reduction of cost-cont’d
• FIs such as banks provide cost effective
intermediation:
– financial intermediaries benefit from considerable
economies of scale;
• because they are looking for many prospective
investment opportunities,
• they can devote resources to recruiting and training
high-quality staff to assist in the process of finding
suitable deficit agents.
 Reduction of cost-cont’d
– They draw up standardized contracts or they can
recruit legal counsel as part of professional staff to
write contracts involving more complex transaction

– The investment professionals can monitor compliance

with the terms of the loan agreement and take any
necessary action to protect the financial intermediary.
 Other roles FI

• Protection Function e.g insurance

• Policy Function
• Information Function
• Transfer Function
• Reformatory Functions – introducing inovitive financial
assets/ instruments
 Types of Markets
• Markets are the channel through which buyers and
sellers meet to exchange goods, services, and
resources.
• There are essentially three types of markets
functioning within the economic system. These are:
1. Factor Markets -Consuming units sell their labor,
managerial skill, and other resources to get
income. Land ,labor and capital
2. Product Markets -purchase goods & services in
product market
3. Financial Markets- are markets in which financial
assets (securities) are traded
 Financial markets
• Financial market is often used to refer just to
the markets that are used to raise finance.
• Bond markets
• Stock Markets
• Foreign exchange markets
• Derivatives markets (Forwards, futures and
options markets) – benchmark
 Financial Mkt cont....

1. Participants in the Financial Markets

 Banks and non-banking financial institutions
 Investors and speculators
 Individuals and Corporations
 Local and International Governments
Generally financial Markets;
 Enable participants to invest surplus funds by buying
securities
 Enable participants to raise required funds by issuing
securities
 Allocate savings efficiently to ultimate users
 Types of Financial Markets
• Depending on the characteristics of financial claims being
traded and the needs of different investors.
1. Money Market and Capital Market
A. money market is designed for the making of short-term loans/ short
term claims within one maturity period
• The money market may be further subdivided into:
 Treasury bill Market
 Certificates of Deposit (CD’s) (some CD’s)
 Commercial Paper
 Banker Acceptance
 Foreign Exchange Markets
 Types of Financial Markets Cont....

B. Capital Market -Financial instruments in the

capital market have original maturities of long-term
more than one year and range in size from small
loans to multimillion dollar credits.
• The capital market is designed to finance long-term
investments by businesses, governments, and
household.
• Trading of funds in the capital market makes
possible the construction of factories, highways,
schools, and homes.
 Types of Financial Markets CONT...

• The capital market is divided into several

sectors, each having special characteristics:
Residential and Commercial Mortgage Loans
Consumer Loan
Government bonds and government notes
Corporate stock
Corporate Notes and Bonds
 Types of Financial Markets CONT…
2. Primary Markets and Secondary Markets
• The Primary Market- is for the trading of new securities
– Initial public offering (IPO) refers to the
process of offering shares of a private
corporation to the public in a new stock issuance
• Secondary Market deals in securities previously
issued.
• Its chief function is to provide liquidity to security
investors- that provide revenue for converting financial
instruments into cash.
 Money and the Payment System
• Money is anything generally accepted as a medium of
exchange.
• According to the nature of transaction or exchange, a given
community’s economy may be classified as:
A. Barter economy - Barter is a system in which people sell
goods and services in order to obtain other goods and
services through direct exchange
– moneyless economy
B. Money Economy - It is an economy in which transaction
and exchange is made through the medium of money
 Motivations for holding Money
1. The Transactions Motive: represents the demand
for money in order to purchase goods and
services.
2. Precautionary Motive: Some money also must be
held as a reserve for future emergencies and to
cover extraordinary expenses.
3. Speculative Motive: demand for money to be able
to take advantage of future price changes in favour
of the purchaser (stems from uncertainty about the
future prices).
 Characteristics of Money

• Acceptability
• Scarcity/Limited Supply
• Divisibility
• Homogeneity
• Portability
Four Players in the Money Supply
Process
– Central bank
– Banks (depository institutions)
– Depositors
– Borrowers
 Central Banks
• Nature of Central Banks:
– A central bank, reserve bank, or monetary
authority is a banking institution granted the
exclusive privilege to lend a government its
currency.
– A central bank is the apex bank in a country. It is
called by different names in different countries:
• Reserve bank of India,
• The bank of England
• The federal Reserve System in America
• The Bank of France in France
• National Bank of Ethiopia in Ethiopia etc.
 Functions of Central Bank
1. Regulator of currency
2. Banker, Fiscal Agent and Advisor to the Government
3. Custodian of Cash reserve of Commercial Banks
4. Custody and Management of Foreign Exchange
Reserves
5. Lender of Last resort
6. Controller of Credit
1. Central Bank: Regulator of Currency
• It is the bank of issue. It has monopoly of notes (legal
tender money) issue.
• This monopoly of issuing notes has the following
benefits:
– Uniformity in the notes issued which helps in facilitating
exchange and trade.
– Enhances stability in the monetary system and creates
confidence among the public
– The central bank can restrict or expand the supply of cash
according to the requirement of the economy
 2.Central Bank as Banker, Fiscal Agent and
Advisor to the Government
• As banker to the government the central bank:
– bank keeps the deposits of the government and makes payment
on behalf of the government (state and/or central)
– But it does not pay interest on gov’t deposits
– It buys and sells foreign currency on behalf of the government.
– It keeps the stock of gold of the government
• Thus, it is the custodian of government money and
wealth.
 2. Central Bank as Banker, Fiscal Agent and Advisor to
the Gov’t ….Cont’d
• As fiscal agent of the gov’t Central bank:
– Makes short term loans to the gov’t
– It floats loans, pays interest on them, and finally
repays them on behalf of the gov’t
– Thus, it manages the entire public debt
 2. Central Bank as Banker, Fiscal Agent and
Advisor to the Gov’t ….Cont’d
• As Advisor of the gov’t the central bank
– Advises the gov’t on issues such as:
• economic and monetary matters as controlling inflation or
deflation,
• devaluation or revaluation of the currency,
• Deficit financing
• Balance of payment etc
 3. Central Bank : Custodian of Cash
Reserve Requirement of Comm Banks
• Commercial Banks are required to keep reserve equal to
a certain percentage of both time and demand deposits
with the Central bank.

• It is on the basis of these reserve that central bank

transfers funds from one bank to another to facilitate
clearing of checks.

• The central bank acts as the custodian of the cash

reserve requirement of commercial banks and helps in
facilitating their transactions.
 4.Central Bank:
Custody and Mgt of Foreign Exchange
• It keeps and manages the foreign exchange reserve of
the country
• It sells gold at fixed price to the monetary authority of
other countries
• It buys and sells foreign currencies at international
prices.
• It fixes the exchange rates within narrow limits in
keeping its obligation as a member of IMF.
• It manages exchange control operations by supplying
foreign currencies to importers and persons visiting
foreign countries on business, studies, etc in keeping
with the rules laid down by the gov’t.
 5.Central Bank: Lender of Last resort
• As lender of last resort, the central bank grants
accommodations in the form of re-discounts and
collateral advances to commercial banks, bill
brokers, dealers, or other financial institutions

• This facilities help such institutions in order to help

them in times of stress so as to save financial
structure of the country from collapse.
 6.Central Bank: Controller of Credit
• This is the most important function of the central bank in
order to control inflation and deflation.
• It adopts quantitative methods and qualitative methods.
• Quantitative methods aim at controlling the cost and
quantity of credit by adopting:
– Bank rate policy
– Open market operation and
– By variation in reserve ratio of commercial banks
6.Central Bank: Controller of Credit…. Cont’d
• Qualitative methods of Central banks include the
supervising and controlling of commercial
banks:
– Selective credit control
– Issue of licences
– The regulation of branch expansion
– To see that every bank maintains the minimum paid up
capital and reserve as provided by law
– Inspection or auditing the accounts of banks
 Central Bank and Objectives of Credit
Control
• The credit control is the means to control the lending
policy of Commercial banks by the central bank to
achieve the following objectives:
– To stabilize the internal price level
– To stabilize the rate of foreign exchange
– To protect the outflow of gold
– To control business cycles
– To meet business needs
– To have growth with stability.
Additional roles of NBE
– To approve the appointment of chairpersons and
directors of such banks in accordance with the rules
and qualifications
– To control and recommend merger of weak banks in
order to avoid their failures and to protect interest of
depositors
– To recommend nationalization of certain banks to the
government in public interest.
– To publish periodical reports relating to different
aspects of monetary and economic policies
 Monetary and Fiscal Policy
• Monetary policy is the management of the money
supply and interest rates.
– Conducted in Ethiopia by the National Bank of
Ethiopia.

• Fiscal policy is government spending

and taxation.
– Budget deficit is the excess of expenditures over
revenues for a particular year
– Budget surplus is the excess of revenues over
expenditures for a particular year
– Any deficit must be financed by borrowing

1-57
 Monetary Policy (MP)
• Definition of MP:
– MP refers to credit control measures adopted by
central banks of a country

– MP refers to a policy employing central bank’s

control of the supply of money as an instrument for
achieving the objective of general economic policy.

– MP= any conscious action undertaken by the

monetary authorities to change the quantity,
availability, or cost … of money
 Objectives or Goals of MP
• The following are the Principal objectives of
Monetary Policy:
– 1. Price Stability
– 2. Economic Growth
– 3. Balance of Payment
– 4. Full Employment
 Instruments of MP
• The monetary authority use different instruments to
achieve the objectives of MP of their country.

• They are divided in to two categories:

– 1. A Quantitative, general or indirect includes:
• Bank rate variations,
• Open market operations, and
• Changing reserve requirements.

• They are meant to regulate the overall level of credit

controls in the economy through commercial banks.
 Instruments of MP…Cont’d
– 2. Qualitative, selective or direct- ( include
changing margin requirement, and regulation of
consumer credit). They aim at controlling specific
types of credit.
 Actors in Economy

1. Households
2. Business Firms
3. Government
End of part-I
 Group Assignment (25%)
1. Describe the Ethiopian Financial System:
Evaluation, Nature, Structure and Distribution.
2. Discuss the Rules & Regulations Governing the
Operations of Financial Institutions in Ethiopia
– Entry conditions
– Regulatory Standards
– Banking Service in Ethiopia
– Insurance Business in Ethiopia

Submission date –August 20/2021