CHAPTER ONE

FINANCIAL SYSTEM

The financial system is defined as a set of arrangements embracing the lending and borrowing of funds
by non-financial economic units and the intermediation of this function by financial institutions to
facilitate the transfer of funds to provide additional money when required, and to create markets in
debts instruments so that the price and allocation of funds are determined efficiently.

This definition identifies the four elements of financial system. Firstly, the lenders and borrowers i.e.,
the non-financial economic units, secondly, the financial institutions, which intermediate, to a large
degree, the lending and borrowing process, thirdly, financial instruments which are created to satisfy
the various needs of the participants. Finally, it includes the financial markets (i.e. the institutional
arrangements and conventions that exist for the issue and trading (dealing) of financial instruments).

1.1 What Is Financial Institution?

Financial Institution is an institution whose primary activity is buying, selling and holding financial assets.
It is institution that collects funds from public or other institutions and invests them in financial assets. It
exists for the primary purpose of facilitating the intermediation process. Financial intermediation is the
process of acquiring surplus funds from economic units for the purpose of making available such funds
to deficit economic units.

1.2 Functions of Financial Institutions

Financial institutions play the following among other things:

1. Providing a payments mechanism

Most transactions made today are not done with cash instead payments are made using checks,
credit cards and electronic transfers of funds. These methods for making payments are provided by
certain financial institutions.

A debit card differs from a credit card in that in the latter case, a bill is sent to the credit card holder
periodically (usually once a month) requiring payments for transactions made. In the past in the case
 of a debit card, funds are immediately withdrawn (that is, debited) from the purchaser’s account at
the time the transaction takes place.

Credit card- is a plastic card with magnetic strip on it. It authorizes the holder to buy goods /services
on credit.

2. Transforming Maturity
The financial institutions (e.g. banks) perform the valuable functions of converting funds that savers
are willing to lend for only short period of time into funds the financial institution themselves are
willing to lend to borrowers for longer periods.

Maturity transformation function of financial institution has two implications. First, it provides
investors with more choices concerning maturity for their investments; borrowing has more choices
for the length of their debt obligations. Second, because investors are naturally reluctant to commit
funds for a longer period of time, they will require that long-time borrowers pay a higher interest
rate than on a short –time borrowing. A financial institution is willing to make long-term loans, and
at a lower cost to the borrower than an individual investor would, by counting on successive
deposits providing the funds until maturity. Thus, the second implication is that the cost of long-
term borrowing is likely to be reduced.

3. Reducing risk through diversification

Consider the example of an investor who places funds in an investment company. Suppose that the
investment company invests the funds received in the stock of a large number of companies. By
doing so, the investment company has diversified and reduced its risk. Investors who have a small
sum to invest would find it difficult to achieve the same degree of diversification because they don’t
have sufficient funds to buy shares of a large number of companies.

Because financial institutions acquire funds from large numbers of surplus units and provide funds
to large number of deficit units, substantial diversification is effected and the risk of financial loss is
reduced.

The diversification is the holding of many (rather than a few) assets reduces risk. Because all assets
don’t all behave in the same way at the same time, therefore, the behavior of one asset will on
some occasions cancel out the behavior of another.
 Financial institutions (intermediaries) also offer the risk reducing benefits of management expertise
since they do have a manpower t6hat specializes in credit risk assessment and monitoring
borrowers.

4. Reducing transaction costs

FIS do benefits from economies of scale because their large size operations.

Given the size of majority of financial institutions, they are able to benefit from economies of scale
in a number of areas. These include.

 Economies in the administration associated with taking in deposits and making loans,
due to these transactions becoming routine.
 Economies in the employment of specialist personnel since the volume of business will
allow such people to be fully employed.
 Economies in the acquisition and interpretation of financial information.

Financial institutions are able to do maturity transformation by virtue of the ‘law of large numbers.’
This principle involved is that where there are a large number of lenders, the probability of all of
those lenders wishing to withdraw the maximum amount of their deposits at the same time is
extremely small. While there will be individual depositors who do wish to withdraw the whole of
their deposits on a particular day, this will be balanced by new deposits and by the majority of
deposits being left untouched.

5. Reallocating Income
Financial institutions (intermediates) are able to pool small individual pockets of savings for ultimate
investment in real assets.

6. Providing Insurance service

A financial institution (insurance company and pension fund) provides a means to protect business,
consumers, and governments against risks to people, property, and income.

1.3 Types of Financial Institutions

There are categorically two types of financial institutions. These are depository institutions and non-
depository institutions.
A. Depository institutions
Depository institutions are financial institutions that raise loanable funds by selling deposits to
the public. They accept deposits from individuals and firms and use these funds to participate in
the debt market, making loans or purchasing other debt instruments such as Treasury bills.

The major types of depository financial institutions are commercial banks, saving and loan
associations, mutual saving banks, and credit unions. Their main liabilities (sources of funds) are
deposits, and their main assets are loans.

a. Commercial Banks
Commercial banks are business corporations that accept deposits, make loans, and sell other
financial services, especially to other business firms, but also to households and governments.
They are the largest and most important depository institutions. They have the largest and most
diverse collection of assets of the depository institutions. Their main source of funds is demand
deposits (i.e., checking account deposits) and various types of saving deposits (including time
deposits and certificates of deposit). The major use of funds by commercial banks is making
loans. They are assets of the commercial bank. These loans could include real estate loans and
loans to businesses and automobile loans. The remaining commercial banks’ assets include
securities (primarily federal government bonds), vault cash, and deposits at the central bank.

b. Savings and Loans Associations

Savings and loans associations (S &Ls) were originally designed as mutual associations, (i.e.,
owned by depositors) to convert funds from savings accounts into mortgage loans. They are the
predominant home mortgage lender in the UnitedState, making predominantly local loans to
finance the purchase of housing for individuals and families. The purpose was to ensure a
market for financing housing loans. Today, the distinction between S &Ls and commercial banks
is minimal. However, S &Ls continue to hold a less diversified set of assets than commercial
banks do.

c. Mutual Savings Banks

Mutual savings banks are much like savings and loans, but are owned cooperatively by members
with a common interest, such as company employees, union members, or congregation
members.
 d. Credit Unions
Credit unions are nonprofit associations accepting deposits from and making loans to their
members, all of whom have a common bond, such as working for the same employer. Credit
unions are organized as cooperative depository institutions, much like mutual savings banks.
Depositors are credited with purchasing shares in the cooperative, which they own and operate.
Like savings and loans, credit unions were originally restricted by law to accepting savings
deposits and making consumer loans. Recent regulatory changes allow them to accept
checkable deposits and make a broader array of loans.

B. Non-depository Institutions
In contrast to depository institutions, non-depository institutions do not accept checkable
deposits. They are financial institutions that fund their investment from the sale of securities or
insurance. With one exception that will be noted shortly, you cannot simply write a “check” to
withdraw funds a non-depository institution.

Non-depository institutions serve various functions in financial markets, ranging from financial
intermediation to selling insurance against risk. The following are some of the types of non-
depository financial institutions.

1. Financial Brokers
a. Investment Banks: sell new securities for companies. They don’t hold deposits, or make
loans
b. Brokerage Houses or Firms: buy/sell old securities on behalf of individuals.

Brokerage firms serve the valuable function of linking buyers and sellers of financial assets. In this
regard, they function as intermediaries, earning a fee for each transaction they create. Modern
brokerage firms such as compete with depository institution in the deposit market, where they
attract depositors with money market mutual funds. Nonetheless, brokerage firms are not formally
considered depository institutions because their main function is to service as brokers in the
secondary debt and equity markets.

2. Investment Institutions
 a. Mutual Funds. Get money from small savers (individuals), who buy shares in the fund; they in
turn invest in variety of stocks, bonds, etc.; allow the individuals to “pool” their savings, diversify
(avoid risk). Mutual funds sell shares to investors, and invest the proce4eds in a wide choice of
assets. They pool funds of savers and make them available to business and government
demanders. They obtain funds through sale of shares and uses proceeds to acquire bonds and
stocks issued by various business and government units. They create a diversified and
professionally managed portfolio of securities to achieve a specified investment objective, such
as liquidity with high return. Some mutual funds, called money market mutual funds, invest in
short-term, safe assets like Treasury bills and large bank certificates of deposit. Largely for
historical reasons, money market mutual funds are not considered depository institutions even
though shareholders are often allowed to write checks on their accounts.
b. Finance Companies: like banks, they use people’s savings to make loans to businesses, but
instead of holding deposits, they sell bounds and commercial paper.

3. Contractual Intermediaries: they hold and store individuals’ savings over long term. These are
insurance companies and pension funds.

a. Insurance Companies. Insurance companies protect individuals against risk. Life insurance
companies accept regular payments from individuals in exchange for contracted payments in
the event of the insured’s’ death. They are financial service firms selling contracts to customers
that promise to reduce the financial loss to an individual or family associated with death,
disability, or old age. By insuring a large pool of individuals, life insurance companies can consult
actuarial tables and predict very accurately what percentage of the insured individuals will die
each year. Because of this, life insurance companies hold long-term bonds. They also hold
substantial quantities of commercial real estates.

The bulk of life insurance Company assets are not in loans. This is sharp contrast to both
commercial banks and savings and loans. Furthermore, the assets insurance-companies hold are
purchased with insurance premiums rather than deposits. Thus, it is not possible to write a
check against an insurance policy.

Other insurance companies, called fire and casualty insurance companies, insure against loss
from fire, theft, and accident. If you own a car or a house, you probably have purchased this
 type of insurance. Insurance claims on these policies are somewhat less easy to predict. More
important, the duration of the liability (e.g., the “life expectancy” of your car) is lower than for
life insurance, so these companies usually invest in more liquid, shorter-term assets.

b. Pension Funds. Pension funds are financial service firms selling retirement plans to their
customers in which savings are set-aside in accounts established in the customers names and
allowed to accumulate at interest until those customers reach retirement age. Private and
government including federal, state, and local) pension funds provide retirement income to
employees covered by the pension plan. Funds are collected by regular contributions from
employees, usually via payroll deduction. Since the funds flowing in are not demand deposits,
you cannot write a check against your balance in a pension fund. Like life insurance companies.
These institutions can accurately predict payouts and hence can hold long-term assets. They
hold portfolios consisting mostly of stocks and bonds. The returns on these assets are paid out
to participating individuals when reach retirement age.

Financial Intermediation

The process of borrowing and lending through intermediaries like banks, mutual funds, etc. is called
FINANCIAL INTERMEDIATION or INDIRECT FINANCE. All of the above types of financial institutions,
except for financial brokers, are financial intermediaries.

As a source of funds for American businesses, indirect finance is far more common than direct finance.
Why don’t people just borrow and lend money to each other directly? Why is financial intermediation so
common? Two main reasons:

(1) Transactions costs (time and money spent carrying out financial transactions) are often
prohibitively high for individual borrowers and lenders. Financial intermediaries, by handling a
large volume of such transactions, develop an expertise that allows them to make additional
transactions much more cheaply than you or I could. Financial intermediaries, by contrast, reach
economies of scale—by doing a lot of business, they reach a point where the cost per dollar of
transactions becomes smaller and smaller.
(2) Asymmetric information: The borrower has much better information about his ability and
intention to repay than the lender does-> this makes lending money very RISKY. Is the borrower
a good credit risk? Once the loan is made, is the borrower going to engage in very risky activities
 that will make it unlikely that you get repaid? If you’re thinking about loaning someone money
but aren’t sure about the answers to those questions, then you’re probably not going to loan
the person any money. A bank, on the other hand, employs a number of specialists who are
expert in sniffing out whether or not a potential borrower is credit-worthy.

Financial Assets Vs Real Assets

Everything that you own is either financial or real asset. The money in your wallet is a financial asset.
Your calculator is a real asset. All of the assets in an economic system are either financial or real.

Real assets include the entire useful things: houses, cars, clothes, factories, machines and every other
valuable thing. Real assets are valued because they are useful, but not so, with financial assets. Financial
asset usually have no intrinsic value of its own. Instead, their benefit to the owner depends on the issuer
of the asset meeting certain obligations or fulfilling certain expectations. Financial liability: the obligation
that the issuer of an asset has to pay the owner/buyer of that asset.

Ex.: A 10-year, Br. 1000 government bond. Government must pay back Br. 1000 + interest.

Ex.: a dollar bill. It’s the Federal Reserve’s (central bank’s) liability, since the Fed must make sure that the
value of that dollar doesn’t depreciate too much and must maintain a stable currency.

A financial instrument, or a security, is a more general term for a financial asset/liability.

Financial asset is a claim against the income or wealth of a business firm, individual, or unit of
government, represented usually by a certificate, receipt, or other legal document. Familiar examples
included stocks, bonds, insurance policies, deposits held in a commercial bank, credit union or saving
bank. Financial assets have no inherent or intrinsic usefulness. They do have value only because they
present claims to something real-present claims and/or future claims. The value of financial assets rests
on the existence of valuable real assets or services, which the financial asset owner ultimately will
receive.

Financial assets don’t provide a continuing stream of services to their owners as do real assets. These
are sought after because they promise future return to their owner and serve as a store of value
(purchasing power).
A number of other features make financial assets unique. They can’t be depreciated because they don’t
wear out like physical assets. Moreover, their physical condition or form usually is not relevant in
determining their market value (price). A stock certificate is not more or less valuable, for example,
because of the size or quality of paper it is printed on or whether it is frayed around the edges. Because
financial assets are generally represented by a piece of paper (certificate or contract) or by information
stored in a computer file, they have little or no value as a commodity, and their cost of transport and
storage is low. Finally, financial assets are fungible-they can easily be changed in form and substituted
for other assets. Thus, a bound or a stock usually can be quickly converted into cash at low cost and then
subsequently converted in to any other asset the holder desires.

Financial Market

Charged with many different functions, the financial system fulfills its various roles through markets
where financial claims and financial service are traded. These markets may be viewed as channels
through which funds flow, continually being draw upon by demanders of funds and continually being
replenished by suppliers of funds. Financial markets are where individuals and institutions come
together in order to trade financial assets.

Functions for financial markets

The three major functions of financial markets are:

 To provide price information about the financial assets traded on them; The interaction of
buyers and sellers of financial assets generates price (showing the required returns on the
various types of funds involved) which provide signals as to how the available funds should be
allocated between competing uses.
 To offer liquidity in the broad sense of providing marketability financial asset, hence allowing
wealth holders to alter their portfolio easily
 To reduce the costs of buying and selling financial assets. This comprises:

 Search costs relating to the expenditure of time and resource associated with finding a
suitable trading partner.
 Information costs incurred when assessing the relative merits of a financial asset,

Types of Financial Markets

The financial markets may be classified as follows:

The Money Market versus the Capital market

The flow of funds through the financial markets may be divided into different segments, depending
upon the characteristics of financial claims being traded and the needs of different groups. One of the
most important divisions in the financial system is between the money market and the capital market.

Money Market: The money market is designed for the making of short-term loans. It is, the institution
through which individuals and institutions with temporary surpluses of funds meet borrowers who have
temporary funds shortages. Thus, the money market enables economic units (principally business firms
and governments) to manager liquidity. By convention, a security or loan maturing within one year or
less is considered to be a money market instrument. One of the principal functions of money market is
to financial the working capital needs of corporations and to provide governments with short term funds
in lieu of tax collections.

Capital Market: Capital market is designed to finance long term investments by businesses,
governments and households. Trading of funds in the capital market makes possible the construction of
factories, schools and homes. Financial instruments in the capital market have original maturities of
more than one year and range in size from small loans to very large credits.

Who are the principal suppliers and demanders of funds in the money market and capital market? In the
money market commercial banks are the most important institutional supplier of funds (lender) to both
business firms and governments. Non-financial business corporations with temporary cash surpluses
also provide substantial short-term funds to banks, securities dealers, and other corporations in the
money market. On the demand side, the largest borrower in the money market is the central Treasury
of governments, which borrows several billion dollars weekly.

Who are the principal suppliers and demanders of funds in the capital market? The principal suppliers
and demanders of funds in the capital market are more varied than in the money market. The most
important borrowers in the capital market are businesses of all sizes, which issue long term IOUs to
cover the purchase of equipment and the construction of new plans and other facilities. Banks,
insurance companies, and pension funds are the supplier of long-term funds.
The money market and capital market may be further subdivided into smaller markets. Within the
money market, for example, is treasury bills market. Treasury bills are safe and popular investment
medium for financial institutions and corporations of all sizes. Nearly as large in total dollar volume is
the market for negotiable certificates of deposit (CDs) issued by the largest, best known commercial
banks and other depository institutions. Depository institutions use the funds raised from CDs and other
sources to extend loans to corporations and other borrowers. Two other important money market
instruments evidencing loans to corporations are bankers’ acceptances (formal IOUs issued by a firm
and guaranteed by a bank, in case of default by the firm. These are used mostly in the course of
international trade and have been around for centuries and commercial papers-both short-term IOUs
issued by large, well established borrowers of funds.

The capital market, too, is divided into several major sectors, each having special characteristics and its
own collection of suppliers and demanders. For example, the largest segment of the capital market is
devoted to mortgage loans to support the building of homes, apartments, and business structures such
as factories and shopping centers. State and local governments sell their tax-exempt municipal bonds in
another sector of the capital market. Households borrow in yet another segment of the capital market,
using consumer loans to make purchases ranging from automobiles to home appliances. Probably the
best-known segment of the capital market is the corporate stock market. Each share of stock represents
a certificate of ownership in a corporation, entitling the holder to receive any dividends that may be paid
out of current company earnings. Corporations also sell a huge quantity of bonds in the capital market
to raise long-term funds. These securities, unlike shares of stock are pure IOUs, evidencing a debt owed
plus an obligation to pay interest to the holder.

Open Versus Negotiated Markets

Another distinction between markets in the financial system, which is sometimes useful, is that between
open markets and negotiated markets. Open market is an institutional mechanism created by society to
make loans and trade securities in which any individual or institution can participate. For example, some
corporate bonds are sold in the open market to the highest bidder and bought and sold any number of
times before they mature and they are paid off. Negotiated market is an institutional mechanism set up
by society to make loans and trade securities where direct bargaining between a lender and a borrower
sets the terms of trade. In negotiated market, securities generally are sold to one or a few buyers under
private contract and held to maturity. For example, an individual who goes to his or her local banker to
secure a loan for a new car centers the negotiated market for auto loans.

Primary versus Secondary Markets

The financial markets may also be divided into primary markets and secondary markets. The primary
market is for the trading of new securities never before issued. Its principal function is the raising of
financial capital to support new investment in buildings, equipment, and inventories.

Primary market is a financial market where newly issued financial assets are bought and sold (likely to
finance investment in new physical capital, i.e. plant and equipment). You engage in a primary market
transaction when you purchase shares of stock just issued by a company, borrow money through a new
mortgage to purchase a home, or negotiated a loan at the bank to restock the shelves of your business.
In contrast, the secondary market deals in securities previously issued. Its chief function is to provide
liquidity to security investors. That is, it provides an avenue for converting existing stocks, bonds, and
other securities into ready cash. If you sell shares of stock or bonds you have been holding for some time
to a relative or friend or call a broker and place an order for shares currently being traded on stock
exchange market, you are participating in a secondary market transaction.

The volume of trading in the secondary market is far larger than trading in the primary market.
However, the secondary market does not support new investment. Nevertheless, the primary and
secondary markets are closely intertwined. For example, a rise in interest rates or security prices in the
secondary market usually leads to a similar rise in prices or rates on primary market securities and vice
versa. This is because investors frequently shift from one market to another in response to differences in
prices.