Financial Markets and Institutions

CHAPTER ONE: AN OVERVIEW OF FINANCIAL SYSTEM

INTRODDUCTION
This unit will discuss about what a financial system is, its roles, functions and usefulness in
an economic development endeavor. It will elaborate on the types of actors that appear in the
financial system, the purpose and objectives of coming to the financial system and the likely
choice they make in appearing to the system will be discussed.
Unit Objectives
Upon completion of this unit, you will be able to;
 Describe what a financial system is
 Determine what the role and functions of a financial system are
 Identify how financial systems help mobilize capital
 Explain the role of financial system regulators
1.1 The role of the Financial System in the Economy
Financial system is a system comprising complex and closely interconnected financial markets,
financial institutions, regulations and techniques through which financial assets are sold and
financial services delivered. It exists in every country regardless of depth and complexity.
It is the system that allows the transfer of money between savers and borrowers. Savers are
known as surplus spending units (SSUs) and borrowers are deficit spending units (DSUs). For
a given budget period, any unit within a group can have one of three possible budget positions:
 A balanced budget position, where income and planned expenditures are equal
 A surplus position, where income for the period exceeds planned expenditures
 A deficit position, where expenditures for the period exceed receipts

Financial systems are crucial to the allocation of resources in a modern economy. The financial
system of nations might be either bank based (financial institution based), for instance, in the
case of Ethiopia or market based as in modern economies. They channel household savings to
the corporate sector and allocate investment funds among firms.

A Financial system is a set of rules and regulations that allows acquisition and selling of
financial assets between and among seekers of finance, suppliers of finance and those
intermediating the transaction. The system is a necessary phenomenon for an economy for it
facilitates creation and utilization of credit and financial assets. Thus, the main function of
financial system particularly in a free market, is to allocate scarce capital to those who can
commit it to the most productive and profitable uses.

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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
The Financial System and Resource Allocation
Businesses often need capital to implement growth plans; governments require funds to
finance building projects; and individuals frequently want loans to purchase cars, homes, and
education. Where can they get this money? Fortunately, there are some individuals and firms
with incomes greater than their expenditures. In contrast most individuals and firms are both
borrowers and lenders. For example, an individual might borrow money with a car loan or a
home mortgage but might also lend money through a bank savings account. In the aggregate,
individuals are net savers and provide most of the funds ultimately used by nonfinancial
corporations. Although most nonfinancial corporations own some financial securities, such as
short-term Treasury bills, nonfinancial corporations are net borrowers in the aggregate. It
should be no surprise to you that the federal, state, and local governments are also net
borrowers in the aggregate (although many foreign governments, such as those oil-producing
countries, are actually net lenders). Banks and other financial corporations raise money with
one hand and invest it with the other. For example, a bank might raise money from individuals
in the form of a savings account and then lend most of that money to business customers. In
the aggregate, financial corporations borrow slightly more than they lend. Transfers of capital
between savers and those who need capital take place in different ways.
Transferring funds from Surplus Units to Deficit Units
The purpose of the financial system is to transfer funds from SSUs to DSUs in the most
efficient manner possible, either for investment in real assets or for consumption. 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. The entity/business delivers its securities to
savers, who in turn give the firm the money it needs.
In direct financing, DSUs and SSUs exchange money and financial claims directly –
DSUs issue financial claims on themselves and sell them for money to SSUs. The SSUs
hold the financial claims in their portfolios as interest bearing assets. The financial
claims are bought and sold in financial markets.

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The claims issued by the DSU are called direct claims and are typically sold in direct
credit markets, such as the money or capital markets: Direct financing gives SSUs an
outlet for their savings, which provides an expected return, and DSUs no longer need to
postpone current consumption to forgo promising investment opportunities for lack of
funds. Thus, direct credit markets increase the efficiency of the financial system.
The following diagram depicts the transfer of funds between those seeking it and those
suppliers.
Direct Financing
Financial Assets/Bonds & Stocks Fund Providers/
Fund Seekers/ Surplus Budget
Budget Deficit Units
Units Funds/Money

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. This transformation process is called intermediation. Firms that
specialize in intermediation are called financial intermediaries or financial institutions.
The following diagram depicts the transfer of funds between those seeking it and those
who have spare of it and want to allow others use it involving intermediation.
Indirect Financing
Financial Assets/Bonds & Stocks

Financial Fund Providers/

Fund Seekers/ Intermediaries Surplus Budget
Budget Deficit  Institutions Units
Units

Funds/Money
 Regardless of the financing method, the goal is to bring the parties together at the least
possible cost and with the least inconvenience.
Actors in Economy
In a given economy, production, consumption and exchanges are carried out by basic economic
units.
 Households: make consumption decisions and own factors of production. They provide
firms with factor services in production and buy finished goods and services from firms for
consumption.
 Business Firms: make production decisions include what goods are to be produced, how
these goods are to be produced and what prices to charge. They employ the various factors

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of production and they sell finished goods for pursuit of profit to the households for
consumption and to the government.
 Government: The government collects taxes from citizens, buys goods from firms and
distributes those goods to citizens individually or collectively. It also redistributes
purchasing power between households and it’s goal is satisfying collective need of citizens.
Businesses, the Government and Individual households need funds to make investment or
even to consume. When they have more needs than the resources available to them, they look
for fund suppliers. On the other hand, when they have excess funds than what they require,
they look for opportunities where they can make invest into. These three, individual
households, firms, and the government are important actors in every economic system. They
appear in the financial system as either fund seekers or surplus budget units. Even
simultaneously, some of the households become fund seekers while other households become
surplus budget units. Same is true for business firms too.

Often the entity needing capital is a business, and specifically a corporation, but it is easy to
visualize the demander of capital being a home purchaser, a small business, a government
unit, or others.
Hence, in a well-functioning economy, the above three actors transact between and among
themselves to cater for their demands. In such economic system, capital/funds will flow
efficiently from those who supply capital to those who demand it. This transfer of capital can
take place in the two different ways, direct and indirect, as indicated on the diagram above.
1.2 Functions of the Financial System
From the foregoing discussions, it becomes possible to narrate that the financial system
performs some vital functions to the economy, which tend to enhance the performance of the
economy toward its growth and development. Such functions include the following:
 Saving Function: An important function of a financial system is to mobilize savings and
channelize them into productive activities. It is through financial system the savings are
transformed into investments. The global system of financial markets and institutions
provides a conduit for the public’s savings. Bonds, stocks, and other financial claims sold
in the money and capital markets provide a profitable, relatively low-risk outlet for the
public’s savings, which flow through the financial markets into investment so that more
goods and services can be produced (i.e., productivity will rise), increasing the world’s
standard of living. When savings decline, investment and living standards begin to fall in
those nations where savings are in short supply.
 Liquidity Function: The most important function of a financial system is to provide
money and monetary assets for the production of goods and services. Monetary assets are
those assets which can be converted into cash or money easily without loss of value. All

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activities in a financial system are related to liquidity-either provision of liquidity or

trading in liquidity.
For wealth stored in financial instruments, the global financial marketplace provides a
means of converting those instruments into cash with little risk of loss. The world’s
financial markets provide liquidity (immediately spendable cash) for savers who hold
financial instruments but are in need of money.

In modern societies, money consists mainly of currency and deposits held in banks, credit
unions, and other depository institutions and are the only financial instrument
possessing perfect liquidity. Money can be spent as it is without the necessity of
converting it into some other form. However, money generally earns the lowest rate of
return of all assets traded in the financial system, and its purchasing power is seriously
eroded by inflation. That is why savers generally minimize their holdings of
money and hold other, higher-yielding financial instruments until they really need
spendable funds.
 Payment Function: The global financial system also provides a mechanism for making
payments for purchases of goods and services.
Certain financial assets-including currency, non-interests-bearing checking accounts
(referred to as demand deposits), and interest-bearing checking accounts (referred to as
negotiable order of withdrawal or NOW accounts)still serve as a popular medium of
exchange in making payments all over the globe. Also high on the payments list plastic
debit and credit cards issued by banks, credit unions, and retail stores. In the case
of credit cards, the customer receives instant access to short-term credit when contracting
for purchases of goods and services. If present trends continue, electronic means of
payment, including computer terminals in homes, offices, and stores and digital
cash (accessed by an encoded plastic card) will eventually replace checks and other pieces
of paper as the principal means of paying in the future. Indeed, electronic means of
payment are growing rapidly today while checks and other paper-based means of payment
are declining in volume.
 Protection Function/ Risk Function: The financial markets offer businesses,
consumers, and government’s way to manage uncertainty and control risk against life,
health, property, and income risks. These guarantees are accomplished through the sale of
life, health insurance and property insurance policies. Policies marketed by life insurance
companies indemnify a family against possible loss of income following the death of a loved
one. Property casualty insurers protect their policyholders against an incredibly wide
array of personal and property risks, ranging from ill health and storm demand to
negligence on the highways. In addition to making possible the sale of insurance policies,

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the money and capital markets have been used by businesses and consumers to “self-
insure” against risk; that is, holdings of wealth are built up as protection against
future losses. The financial system permits individuals and institutions to engage in
both risk sharing and risk reduction. Risk sharing occurs when an individual or insurance
transfers risk exposure to someone willing to accept that risk (such as an insurance
company), while risk reduction usually takes place when we diversify our wealth across a
wide variety of different assets so that our overall losses are likely to be more limited.
 Policy Function: The financial system has been the principal channel through which
government has carried out its policy of attempting to stabilize the economy and avoid
inflation. By manipulating interest rates and the availability of credit, government can
affect the borrowing and spending plans of the public, impacting the growth of jobs,
production, and prices.
 Information Function: A financial system makes available price-related information
that helps coordinate decentralized decision-making in various sectors of the economy.
This is a valuable function helping those who need to take economic and financial
decisions. Financial markets disseminate information for enabling participants to develop
an informed opinion about investment, disinvestment, reinvestment or holding a
particular asset.
 Transfer Function: A financial system provides a mechanism for the transfer of the
resources across geographic boundaries.
 Reformatory Functions: A financial system undertaking the functions of developing,
introducing innovative financial assets/instruments services and practices and
restructuring the existing assets, services etc. to cater the emerging needs of borrowers
and investors (financial engineering and re-engineering).

1.3 Types of Markets

Markets are the channels through which buyers and sellers meet to exchange goods, services,
and resources.

This exchange determines what goods and services will be produced and in what quantity. The
marketplace is dynamic. It must respond continuously not only to changes in consumers’
tastes, but also to the introduction of new goods and services, often associated with new
technology. How did the resources of the economy get redeployed to produce those new goods?
This shift in production was accomplished in the marketplace through changes in the price of
goods and services being offered. If the price of an item rises, for example, this stimulates
business firms to produce and supply more of it to consumers. In the long run, new firms may
enter the market to produce those goods and services experiencing increased demand and

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rising prices. A decline in price, on the other hand, usually leads to reduced production of a
good or service, and in the long run some less-efficient suppliers may leave the
marketplace. Markets also distribute income. In a pure market system, the income of an
individual or a business firm is determined solely by the contribution each markets reward
superior productivity and sensitivity to consumer demands with increased profits, higher
wages and other economic benefits. Of course, in all economies, government policies also affect
the distribution of income and the allocation of other economic benefits.

There are essentially three types of markets functioning within the economic system. These
are:
 Factor Markets: Consuming units sell their labor, managerial skill, and other
resources to get income. The factor markets allocate factors of production such as land,
labor, and capital and distribute income in the form of wages, rental income, and so on
to the owners of productive resources.
 Product Markets: Consuming units use their income obtained from the factor
markets to purchase goods & services in product market. Food, shelter, automobiles,
etc. are among the many goods and services sold in the product markets.
 Financial Markets: are markets in which financial assets (securities) are traded.

Product Markets Sales/Service Revenue

Expenses for products

Goods & Services Goods & Services

Funds Funds

Consuming Units Financial Markets Producing Units

Financial Assets Financial Assets

Flow of inputs
Salary, Rent, Wage Income Flow of inputs
Salary, Rent, Wage Expense

Factor Markets

Diagram showing flow of inputs, products and finance among participants

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1.4 Financial Markets

A financial market is a market that brings buyers and sellers together to trade in financial
assets such as stocks/shares, bills of exchange, bonds, futures and options, foreign
currencies, etc. Funds are transferred in financial market when one party purchases financial
assets previously held by another party. Financial markets facilitate the flow of funds thereby
allow financing and investing by households, firms and government agencies.

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)
The financial markets are the heart of the global financial system, attracting and allocating
savings and setting interest rates and the prices of financial assets (stocks, bonds, etc.).
Modern economies require enormous amounts of investment to produce the good and services
demanded by consumers. Investment increases the productivity of labor and leads to a
higher standard of living. However, investment often requires huge amounts of funds, far
beyond the resources available to a single individual or institution. By selling financial claims
(such as stocks and bonds) in the financial markets, large amounts of funds can be raised
quickly from the pool of saving accumulated by households, businesses, and governments. The
unit carrying out investment then hopes to repay its loans from the financial marketplace by
draw on future income. Indeed, the money and capital markets make possible the change of
income for future income and the transformation of savings into investment so that production,
employment, and income can grow, and living standards can improve. Those who supply funds
to the financial markets receive only promises in return the loan of their money. These
promises are packaged in the form of attractive financial claims and financial services, such as
stocks, bonds, deposits, and insurance. Financial claims promise the supplier of funds a
future flow income in the form of dividends, interest, or other returns. However, suppliers of
funds to financial system expect not only to recover their original funds but also to
earn additional income as a reward for waiting and assuming risk. The role of the financial
markets in channeling savings into investment is absolutely essential to the health of the
economy. For example, if households set aside saving and those funds are not returned to the
spending stream through investment by businesses and governments, the economy will begin
to contract. The amount of in paid out by business firms and governments will not be matched
by funds paid those same sectors by households.

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The basic function of financial markets is to channel funds from savers who have an excess of
funds to spenders who have a shortage of funds. Financial markets can do this either through
direct finance, in which borrowers borrow funds directly from lenders by selling them
securities, or through indirect finance, which involves a financial intermediary that stands
between the lender-savers and the borrower-spenders and helps transfer funds from one to the
other. This channeling of funds improves the economic welfare of everyone in of everyone in the
society. Because they allow funds to move from people who have no productive investment
opportunities to those who have such opportunities, financial markets contribute to economic
efficiency. In addition, channeling of funds directly benefits consumers by allowing them to
make purchases when they need them most.
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
1.5 Types of Financial Markets
The flow of funds around the world may be divided into different segments, depending on the
characteristics of financial claims being traded and the needs of different investors.
1.5.1 Money Market and Capital Market
Financial Markets are classified as money and capital markets on the basis of maturity of
financial assets issued in the market.
i. Money Market: The money market is designed for the making of short-term loans/
short term claims within one maturity period. Money market enables economic
units to manage their liquidity position. 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 the money market is to finance the working capital needs of
corporations and to provide governments with short-term funds in lieu of tax
collections. The money market also supplies funds for speculative buying of securities
and commodities. 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 the money market.

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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, etc.
ii. 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. The principal suppliers and demanders of funds in the capital market are
more varied than in the money market. Families and individuals, for example, tap
the capital market when they borrow to finance a new home. Governments rely on
the capital market for funds to build schools and highways and provide essential
services to the public. The most important borrowers in the capital market are
businesses of all sizes that issue long-term debt instruments representing claims
against their future revenues in order to cover the purchase of equipment and the
construction of new facilities. Ranged against these many borrowers in the capital
market are financial institutions, such as insurance companies, mutual funds,
security dealers, and pension funds that supply the bulk of capital market funds.
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

1.5.2 Primary Markets and Secondary Markets

A. The Primary Market is for the trading of new securities. Its principal function is
raising financial capital to support new investment in buildings, equipment, and
inventories. You engage in a primary-market transaction when you purchase shares of
stock just issued by a company or borrow money through a new mortgage to purchase a
home.

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B. 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. If you sell shares of stock or bonds you have been holding for some time to a
friend or call a broker to place an order for shares currently being traded on the
American, London, or Tokyo stock exchanges, you are participating in a secondary-
market transaction. The volume of trading in the secondary market is far larger than 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 security prices in the secondary market usually leads to a similar rise in prices on
primary-market securities, and vice versa. This happens because many investors readily
switch from one market to another in response to differences in price or yield.

1.6 Financial Institutions (Overview)

Financial institutions are institutions that provide the market function of matching borrowers
and lenders or traders. They play a great role in moving/ channelling funds from saving sector
(saving-surplus unit) to investment sector (deficit units).
 Financial Functions:
 Providing the borrower with funds so as to enable them carry out their investment plans
 Providing lenders with earning assets so as to enable them earn wealth
 Providing Liquidity
 Promoting Savings
 Promoting Investment

1.7 Money and the Payment System

Money is anything generally accepted as a medium of exchange. It is anything used to pay for
goods and services or settle debts as it derives value from being legal tender, or it is anything
that is generally recognized and accepted as payment in the exchange process.
A payment system is a system used to settle financial transactions through the transfer of
monetary value. This includes the institutions, instruments, people, rules, procedures,
standards and technologies that make it exchange possible. It consists of a paper-based
mechanism for handling checks and drafts and a paperless mechanism such as electronic fund
transfers for handling electronic commerce.
Money is, therefore, anything that is used as a means of facilitating transaction and exchange
in a given community. According to the nature of transaction or exchange, a given community’s
economy may be classified as: Barter economy and monetary economy.

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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. Thus, a barter economy is a
moneyless economy. It is also a simple economy where people produce goods either for self-
consumption or for exchange with other goods which they want. It was found at large in
primitive societies. The difficulties of a barter system;
 Lack of double coincidence of wants
 Lack of a common measure of value
 Indivisibility of certain goods
 Difficulty in storing value
 Difficulty in making differed payments/credit sales
 Lack of specialization

A barter economy is a type of economy in which transactions or exchanges in a community

carried out without the use of money as a medium of exchange. Barter involves the direct
exchange of one good for some quantity of another good or service.

B. Money Economy: A money economy is a well-developed economy. It is an economy in

which transaction and exchange is made through the medium of money. This economy is a
monetary economy and production is more for sale than consumption. Money introduced in
an economy so as to eliminate the above stated difficulties of barter system.

Functions of Money:
 Money as Medium of Exchange: Each person accepts money as the means of
payment because he is confident that others will accept it in payment from him. A
countries legal system also enforces the acceptance of national currency in
discharge of all payments.
 Money as Unit of Value or Account/Standard of Value: Indications of relative values
between goods and services
 Money as Measure of liquidity
 Money as Store of value

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Motivations for holding Money

 The Transactions Motive: represents the demand for money in order to purchase
goods and services. Because inflows and outflows of money are not perfectly
synchronized in either timing or amount and it is costly to shift back and forth
between) money and other assets, businesses, households, and governments must
keep some cash in their custody or in demand accounts simply to meet daily
expenses.
 Precautionary Motive: Some money also must be held as a reserve for future
emergencies and to cover extraordinary expenses. This precautionary motive arises
because we live in a world of uncertainty and cannot predict exactly what expenses or
opportunities will arise in the future.
 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
 It should be generally acceptable by virtue of its intrinsic value,
 Because of government decree and
 Because of convention
 Scarcity/Limited Supply
 To be scarce its supply must remain in the borderline of its demand
 It should not be too scarce so as to limit trade
 There must be some controlling mechanism by the government put in place with
a view to ensure progressively adequate supply of it.
 Divisibility: It must be capable of being divided into the smallest fraction or unit
without the loss in its value.
 Homogeneity: Each and every unit should be exactly the same as every other unit.
Otherwise, people would prefer to hold more valuable unit and would release the less
valuable unit, thereby destabiling its supply and demand conditions.
 Portability: Each unit should have small weights compared to its value so that it
could easily carried as necessary.
 Durability: It should not be a wasting asset, either physically or in terms of its
value. No one wants to hold wasting or perishable asset. Most of the commodities
used as money early days failed in durability criteria. Example, salt bar cannot be
durable money because it is sensitive to changes in climate and its value also alter
with the distance from the salt mining place.

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 Recognizability: In order to avoid unfair practice of cheating it has to be

recognizable by its size, colour, texture etc.

Generally, money is important because it simplifies the exchange of goods and services and
because changes in the money supply can affect the level of economic activity and the rate of
inflation. The money supply is regulated by the monetary authorities. The quality of money
demanded by the society depends on different factors such as the transaction motive, the
precautionary motive, the speculative motive.
The money supply is also depends on such factors as:
 The monetary base,
 The community’s choice,
 Cash reserve ratio and
 Government’s budgetary policy, etc.

1.8 Functions performed by the Financial System and Financial Markets

 Transfer of resources/allocation of resources
 Enhancing Income
 Price Determination
 Capital Formation
 Information
 Risk Function

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Questions for Discussion

Instruction: Read and analyze the following questions carefully and answer them
correctly.
1. List and discuss the functions of a financial system.
2. How a financial system does allocate resources in a given economy?
3. Distinguish between deficit and surplus units.
4. Who would typically purchase a financial claim, a DSU or an SSU?
5. Explain how you believe economic activity would be affected if we did not have financial
markets and institutions.
6. Discuss the advantages to deficit and surplus units of using organised financial markets
and financial intermediaries.
7. What are the other important financial intermediaries in the economy besides banks?
8. Why are financial markets important to the health of the economy?
9. Does it make sense that the typical household is a surplus spending unit (SSU) while the
typical business firm is a deficit spending unit (DSU)? Explain.
10. What are the primary functions of capital markets and the money markets, respectively?
11. Distinguish between
(1) Physical asset markets and financial asset markets,
(2) Spot and futures markets,
(3) Money and capital markets,
(4) Primary and secondary markets, and
(5) Private and public markets.
12. What are the major types of debt instruments traded in the;
 Money markets and
 Capital markets?
13. Is an initial public offering an example of a primary or a secondary market transaction?
14. How does risk sharing benefit both financial intermediaries and private investors?
15. What are the main functions of money?
16. What are characteristics of money?
17. What are the three motives for holding money and describe them in detail.
18. Identify and describe the difference between the types of fund/resource transfers.
19. What is the difference between barter economy and monetary economy?
20. List down and describe major classification of markets and understand what is to be
traded on each market.

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