CHAPTER ONE

AN OVERVIEW OF FINANCIAL SYSTEM

What is Financial System?

 Complete and complex ever changing set of rules, regulations, procedures, policies, practices, conducts; role of
institutions (financial institution), governments, policy makers and central bank taken together may be called
financial system.
 Financial system is a set of complex and closely interconnection of institutions, markets, directives, agents,
practices, transactions, claims and liabilities relating to financial aspects of an economy.
 Financial system is the scheme which established for the purpose of providing a standard, smooth, effective and
efficient linkage between surplus units (lenders) and deficit units (borrowers) in the economy.
 It is a mechanism that allows the people to easily buy & sell financial assets (such as; stocks and bonds) in the
financial markets.
The financial system does have its impacts on individuals, businesses, corporations and governments alike. At times in
your life, you will be a saver and at other times, you may be a borrower. The financial system channels funds from
savers to borrowers and makes it possible for both to achieve their objectives. When the financial system works
efficiently, it leads to better health of the economy.
According to the structural approach, the financial system of an economy consists of three main components:
1) financial markets;
2) financial instruments;
3) financial intermediaries (financial institutions); and
According to the functional approach, financial markets facilitate the transfer of funds between the investors who
wish to invest and firms that need to obtain funds. Financial institutions are the key players in the financial markets
and they perform the function of intermediation and thus determine the flow of funds. Financial instrument is an asset
which is expected to provide future benefits in the form of a claim to future cash. The financial regulators perform the
role of monitoring and regulating the participants in the financial system. The following figure presents a typical
structure of financial system in the country:

Financial System

Financial Markets Financial Institutions Financial Financial

Instruments Regulators

Figure 1.1: The structure of financial system

 Financial market is a market where financial instruments/financial assets are bought and sold.
 Financial institutions are an intermediary who channels the funds’ of surplus units into loans for deficit units, or
investment.
 Financial instruments are also called securities, which are expected to provide future benefits in the form of a
claim to future cash.
Financial regulation is an intervention made by an authorized body, in most case central bank, to ensure the fair
treatment of market participants. One of the key aims of financial regulation is to ensure business disclosure
of accurate information for investment decision making. When [Link] information is disclosed only to

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 partial set of investors, those gained unlimited information may have major advantages than other groups
of investors those gained little information.
Each of the components plays a specific role in the economy. By channeling funds from savers to investors with good
projects through financial intermediary, the financial system increases overall productivity for the economy and leads
to a rise in living standards.
The financial system plays the key function in the economy by stimulating economic growth, influencing economic
performance of the actors, affecting economic welfare. This is achieved by financial infrastructure, in which
entities with funds allocate those funds to those who have potentially more productive ways to invest those funds. A
financial system makes it possible a more efficient transfer of funds. As one party of the transaction may possess
superior information than the other party, it can lead to the information asymmetry problem and inefficient allocation of
financial resources. By overcoming the information asymmetry problem the financial system facilitates balance
between those with funds to invest and those needing funds.
Functions of Financial Systems
Financial systems perform the essential economic function of channeling funds from units who have saved surplus
funds to units who have a shortage of funds. The units who have saved can lend funds: they are known as lender-
savers. The units with a shortage of funds must borrow funds to finance their spending: they are the borrower-
spenders. The most important lender-savers are usually households; while the typical borrower-spenders are firms and
the government.
The channeling of funds from savers to spenders is very important for two reasons:
 First, lender-savers (with excess of available funds) do not frequently have profitable investment opportunities,
while borrower-spenders have investment opportunities but lack of funds.
 Second, even for purposes other than investment opportunities in businesses, borrower-spenders may want to
invest in excess of their current income or to adjust the composition of their wealth (reconciliation of the
preferences for current versus future consumption).
In direct finance, borrower-spenders borrow funds directly from lenders in the financial markets by selling them
securities. In indirect finance, a financial intermediary stands between the lender-savers and the borrower-spenders: the
intermediary helps to transfer funds from one to the other. This suggests that financial markets and intermediaries are
alternatives that perform more or less the same function but in different ways (and perhaps with different degrees of
success). Note, however, that the process of indirect finance, known as financial intermediation, is the most important
way of transferring funds from lenders to borrowers. This contrasts with the attitude of the media to focus mainly on
financial markets.
Another important function of a financial system is the monetary function. The financial system provides a variety of
payment mechanisms e.g. cheques, debit cards and credit cards to enable one party to pay another. The introduction of
money into the economy enables savers and spenders to separate the act of sale from the act of purchase and allows
them to overcome the main problem of barter, which is the ‘double coincidence of wants’ (each of the two parties
involved in a transaction has to want simultaneously the good the other party is offering to exchange).
Financial systems also provide mechanisms for risk to be transferred. For example insurance contracts allow a party
such as a firm or household to transfer the risk of loss of wealth due to theft or fire to another party such as an
insurance company. The firm or household will pay a fee (insurance premium) for this transfer. The insurance
company, by providing a large number of insurance contracts, is better able to manage the risk than an individual firm
or household as they can obtain benefits of pooling and diversification. Thus a more efficient allocation of risk results.
In short, the main functions of financial systems are to:
 provide the mechanisms by which funds can be transferred from units in surplus to units with a shortage of
funds in order to directly or indirectly facilitate lending and borrowing.
 enable wealth holders to adjust the composition of their portfolios
 provide payment mechanisms

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  provide mechanisms for risk transfer

Components of Financial System

There are three major entities that compose financial systems. These are financial intermediaries, financial instruments
and financial markets.
A. Financial Market
. Financial markets are markets in which funds are moved from people who have an excess of available funds (and lack
of investment opportunities) to people who have investment opportunities (and lack of funds). Itis forums in which
suppliers of funds and demanders of funds can transact the business directly. They also have direct effects on personal
wealth, and the behaviours of businesses and consumers. Therefore, they contribute to increase the production and the
efficiency in the overall economy. Financial markets (such as bond and stock markets) are markets in which securities
are traded.
Functions of financial markets
1. Enhancing income: financial markets allow lenders earn interest /dividend on their surplus invested funds, thus
contributing to the enhancement of the individual & the national income
2. Transfer of resources: Financial markets facilitate the transfer of real economic resources from lenders to
ultimate borrowers.
3. Productive usage: Financial markets allow for the productive use of the funds borrowed, thus enhancing the
income & the gross national production.
4. Capital formations: financial markets provide a channel through which new savings flow to aid capital
formation of a country.
5. Price determination: financial markets allow for the determination of the price of the traded financial asset
through the interaction of buyers & sellers, i.e., through demand & supply.
To sum up, financial markets facilitates:
 The raising of capital (in the capital market)
 International trade (in the currency market)
 The transfer of risk ( in the derivative market),
 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 unitsand are used to match
those who want capital with those who have it.
Different financial markets serve different types of customers or different parts of the economic sector. Financial
markets also vary depending on the maturity of the securities being traded and the types of assets used to back the
securities. Financial markets can be classified based on different ways. For these reasons it is often useful to classify
markets along the following dimensions:
On the basis of financial claim (stock market vs. debt market), maturity period (money market vs. capital market),
origin (primary market vs. secondary market), time of delivery (future/forward market vs. Spot
market),structure(over-the-counter vs. auction market), and the like.(Note: the detail discussions for this section will
be presented in the third chapter of this course).
B. Financial Institutions
In economies, where financial institutions are less developed, direct fund transfers among individuals are more
common. However, businesses in developed economies, doing a direct transfer of funds are more difficult, and they
find it more efficient to join the services of one or more financial institutions when they want to raise capital or invest
their surplus funds.
Financial institutions are an intermediary who channels the funds’ of surplus units (lenders) into loans for deficit units
(borrowers). They also provides various types of financial functions to the economy(such as; liquidity, redistribution of

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various risks, etc). Financial institutions differ from non-financial business organizations(such as; manufacturing
companies) in respect of their products; i.e. the former deals in financial assets such as bonds, equity, loans securities
and so on, while the latter deal in real assets such as machinery, equipment, real estate and so on.
Financial intermediary is the special financial entity, which performs the function of efficient allocation of funds, when
there are conditions that make it difficult for lenders or investors of funds to deal directly with borrowers of funds in
financial markets. Financial intermediaries/ institutions includes: commercial banks, savings & credit associations,
microfinance institutions, credit unions, insurance companies, regulated investment companies, investment banks, and
pension funds. On the basis of their primary functions, these financial institutions are broadly divided into three major
categories, namely; depository institutions, and non-depository institutions. (Note: Detail discussions of this section
will be presented in chapter 2)
On the basis of their formality, financial institutions also classified as formal financial institutions, semi-
formalfinancial institutions and informal financial institutions.
C. Financial Instruments
Financial instruments (also called securities) are financial claims on the issuer’s future income or assets. They
represent financial liabilities for the issuer/seller security (borrower or issuer of the financial claim) in return for
money received; and financial assets for the buyer (lender or investor in the financial claim). Governments,
corporations and individuals raise funds to finance their activities by issuing debt instruments and equity instruments.
Any transaction related to financial instrument includes at least two parties:
i) the party that has agreed to make future cash payments and is called the issuer;
ii) the party that owns the financial instrument, and therefore the right to receive the payments made by the issuer,
is called the buyer/investor.
Functions of Financial Assets
Financial assets provide the following two key economic functions.
 Transfer of Funds: financial assets allow the transfer of funds from those entities, who have surplus funds to
invest to those who need funds to invest in tangible assets;
 Redistribute the Unavoidable Risk: they redistribute the unavoidable risk related to cash generation
among deficit and surplus economic units.
Types of Financial Instruments
Financial instruments can be classified into two broad groups: debt instruments and equity instruments. Note that
there are also derivative instruments (such as futures, options and swaps), which are financial instruments that derive
their value from the value of some other financial instruments or variables.
Debt instruments are instruments that promise the payment of given sums to the investor. Examples of debt
instruments are bills, notes and bonds (described below).
Equity instruments are instruments that represent claims to shares in the net income and assets of a firm, and they do
not have a maturity date. In terms of economic rights, equity claims differ from debt instruments for several reasons.
 First, firms are not contractually obliged to make periodic payments to equity holders: the payment of dividends
is a discretionary decision of the firm.
 Second, firms must pay all their debt holders before they make any payment to equity holders: therefore equity
holders are residual claimants.
As a result, equity claims are riskier than debt instruments. In addition to economic rights, equity claims confer
ownership rights to equity holders. The presence of ownership rights is in contrast with bondholders, who have no
ownership interest but are rather creditors of the firm. Ownership rights have two main implications.

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  First, equity holders can benefit from any increase in the income or asset value of the company. In the case of
stock price increases (decreases) on the financial market, equity holders can obtain high capital gains (losses),
whereas this is very unlikely by investing in bonds.
 Second, equity holders have the right to vote for directors or on certain issues. The proportion of economic and
ownership rights is different between common stocks and preferred stocks (as discussed below).

I) Bond: Bonds are instruments that represent long-term contract under which a borrower agrees to make payment of
interest and principal, on specific dates, to the holders of the bond. Bonds represent debt owed by the issuer to the
investor. They are claims that normally pay periodic interest (coupon payments) until the maturity date, and pay back
the par value (face value) to the investor at the maturity date. The coupon payments are usually based on a fixed
interest rate. The interest rate is the cost of borrowing or the price paid for the rental of funds (usually expressed as a
percentage).
Bonds can be classified into two main categories: zero coupon bonds and coupon bonds. Zero coupon bonds are
instruments under which a borrower promises, at the current time, to pay one specified nominal sum (face value) to the
lender at one specified future date. In return, at the current date the borrower receives the price of a zero coupon bond
that must be lower than the face value. Thus, zero coupon bonds are also known as discount bonds. Clearly, with
positive interest rates, the price of a zero coupon bond must be lower than the face value.
Coupon bonds are contractual agreements by the borrowers to make regular payments (known as coupons or interest)
until a specified date (the maturity date), when the amount borrowed (principal) is repaid. The maturity is the time to
the expiration date of the debt instrument.
Certain bonds also have options embedded in them. These embedded options will provide the issuer or holder with
extra rights over and above the usual. Examples include callable bonds, puttable bonds and convertible bonds.
There are three main classes of institutions that issue bonds: national governments, local governments and
corporations. In short we can as corporate bonds and government bonds.
 Government bonds: are the bonds that are issued by the government to finance budget deficit.
 Corporate bonds: as the name implies, it is issued by corporations/companies to finance capital assets.
II) Treasury Bills: are short-term debt instruments issued by governments to finance budget deficits. The issuers pay a
predetermined amount at maturity and have not interest payment, but they effectively pay interest by initially selling at
a discount, that is, at a price lower than the face value at the maturity.
Features of TB
1. Issuer: it is issued by the government for raisings short-term funds for bridging temporary gaps between
revenue and expenditure.
2. Liquidity: it enjoys high degree of liquidity
3. Monetary Mgt: TBs serve as an important tool of monetary management used by the central bank of the
country to influence liquidity in to the economy.
III) Commercial paper: Commercial paper is a short-term debt instrument which is issued by well known, high
creditworthy corporations for raising short term financial resources from money market.
Characteristics of CP
 They are unsecured debts of corporate.
 They are issued in the form of promissory notes.
 They are redeemable at par to the holder at maturity, i.e., they are issued at discount to face value.
 They are issued by top rated corporate (credit worthy companies) .
The marketability of the CPs is influenced by the rates prevailing in the call money market & the foreign exchange
market, i.e., attractive rates in call money market affects the demand of CPs.

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VI) Certificate of Deposit (CD): It is a certificate or book issued by banks certifying that the holder has deposited
some money in the bank. Fixed deposits are good examples. CD is a financial document showing that a person or
organization has a specified sum on deposit at a bank, usually for a specific period, at special interest rate.

Features of CD
 Negotiable instrument: CDs are negotiable time deposit certificate issued by commercial banks /financial
institution at discount.
 Maturity: They have a specified maturity date. The maturity period of CDs ranges from 15 days to one year.
VII) Repurchase Agreement (Repo or 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. (eg. 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 in the future at a
higher price.
VIII) Shares/Stocks: are equity claims on the net income and assets of a corporation. They are issued by corporate
firms to raise fund. The buyers of stock become owners of the company. Typically there are two class of stock;
common stock and preferred stock.
i. Common Stock:
 It entitles the investor to receive dividends distributed by a company.
 Investors have a claim to a pro rata share of the net assets value of a company in case of liquidation.
 Common stock can also be known as residual claim. i.e., it obligates the issuer of the financial assets to pay
the holder an amount based on earnings, if any, after holder of debt instruments have been paid.
Advantages and disadvantages of Common Shares
Equity capital is the most important long term source of financing. It offers the following advantage.
1. Permanent Capital: Since ordinary shares are not redeemable, the company has no liability for cash out flow
associated with its redemption.
2. Borrowing base: Lenders generally lend in proportion to the company's equity capital. By issuing ordinary
shares, the company increases its financial capabilities because it can borrow additional funds. Thus, the
amount of equity capital increases the borrowing limit of a company.
3. Dividend Payment Discretion: A company is not legally obliged to pay dividend. In times of financial
difficulties, it can reduce or suspend payment of dividend. Thus, it can avoid cash outflow associated with
ordinary share.
Common stock has the following limitation:
1. Cost: Equity capitals have a higher cost at least for two reasons;
a. Dividends are not tax deductible as an interest payment.
b. Flotation costs on ordinary shares are higher than those on debt.
2. Risk: Equity shares are riskier from investors' point of view as there is uncertainty regarding dividend and
capital gains. Therefore, the equity holders require a relatively higher rate of return.
3. Earnings dilution: The issue of new ordinary shares dilute the existing shareholders' earning per share if the
profit is not increase in equal proportion with the increase in number of ordinary shares.
4. Ownership dilution: The issuance of new ordinary shares may dilute the ownership and control of the existing
shareholders. That means the issuance of ordinary shares can change the ownership.

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ii. Preferred Shares
Preference share is often considered to be a hybrid security since it has many features of both ordinary shares and
debentures. It is similar with ordinary share in:
1. The non- payment of dividend does not force the company to insolvency.
2. Dividends are not deductible for tax purpose.
3. In some cases, it has no fixed maturity date.
It is similar with debenture (bond) in:
1. Dividend rate is fixed.
2. Preference shareholders have claims on income and assets prior to ordinary shareholders.
3. They do not share in the residual earnings.
4. They do not have voting rights.
Features of preference share:
1. Claims on income and assets: Preference shares are a senior security as compared to ordinary shares. It has
prior claim on the company's income in the event of distribution dividend and prior claim on assets in case of
liquidation.
2. Fixed dividend: The amount of preference dividend is fixed. That is, it will be equal to the dividend rate
multiplied by the par value.
3. Cumulative dividend: Preference shares are requiring that all past unpaid preference dividend be paid before
any ordinary dividends are paid. This feature is a protective device for preference shareholders.
Advantages and disadvantages of Preference shares
Preference shares have the following advantages:
1. Risk less leverage advantage: Preference share provides financial leverage advantages since preference
dividend is a fixed obligation. This advantage occurs without a series risk of default. The non-payment of
preference dividend does not force the company into insolvency.
2. Dividend postponability: Since preference shares can postpone payment of dividend, it provides some
financial flexibility to the company.
3. Fixed dividend: The preference dividend payments are restricted to the stated amount. Shareholders do not
participate in excess profit as do the ordinary shareholders.
4. Limited voting rights: Preference shareholders do not have voting rights except in case of dividend arrears
exist.
Preference shares have the following limitations:
1. Commitment to pay dividend: Preference dividend cannot be omitted, they have to be paid because of their
cumulative nature.
2. Non-tax deductibility of dividend: Preference dividend is not tax deductible. Thus, it is costlier than
debenture.

Risks in Financial Industry

There are different types of risk that the investors in financial industry may face. Some these are:
(i) Interest Rate Risk: Interest rates risk is the possibility that a fixed income debt instrument will decline in value as
a result of a rise in interest rates. Whenever investors buy securities that offer a fixed rate of return they are
exposing them themselves to interest rate risk. This is true for bonds and preferred stocks.

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(ii) Reinvestment Risk: Another risk that investors face is reinvestment risk, which is the risk of having to reinvest
proceeds at a lower return rate than the rate the funds were previously earning. One of the main ways this risk
presents itself is when interest rates fall over time and callable bonds are exercised by the issuers.
(iii) Inflation Risk: Also known as purchasing power risk. Inflationary risk the chance that the value of an asset or
income will eroded as inflation shrinks the of a country’s currency. Put another way, it is the risk that future
inflation will cause the purchasing power of cash flow from an investment to decline.
(iv) Credit/Default Risk: Credit risk refers to the possibility that a particular bond issuer will not be able to make
expected interest rate payment and/or principal repayment.
(v) Liquidity Risk: While there is almost always a ready market for government bonds, corporate bonds are
sometimes entirely different animals. There is a risk that an investor might not be able to sell his or her corporate
bonds quickly due to a thin market with few buyers and sellers for the bond.
(vi) Political or legal risk: This is the risk that government or some other relevant authority imposes some new tax or
legal restriction on the security you have already bought.
(vii) Event risk: These are things like natural or industrial disasters or major corporate actions; takeovers,
restructurings and so on. They are outside the control of the issuer or the market but if they are significant enough
they can obviously have an effect on the issuers’ ability to meet its obligations.

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