LESSON 1

INTRODUCTION TO FINANCIAL SYSTEMS

Objectives
By the end of the lesson, learners should be able to:

Define financial system

Explain the role of financial systems

Explain the components of a financial system

The Financial System

A financial system no matter how rudimentary is a complex system. It is complex in its

operation such that neither the system itself nor its operation can be measured
accurately. Because of this complexity a simple definition cannot adequately capture
what a financial system is. A financial system comprises financial institutions, financial
markets, financial instruments, rules, conventions, and norms that facilitate the flow of funds
and other financial services within and outside the national economy.

The financial system can be described as a whole system of all institutions, individuals, markets
and regulatory authorities that exist and interact in a given economy. The institutions,
government and individuals form the participants in various markets; money markets
(including foreign exchange) and capital markets (including security) markets. The participant
buy (borrow) and sell (lend) money to different parties at a price (interest or dividend) within
the market, which is determined by the forces of demand and supply.

In a broader aspect a financial system can also be defined as a system that allows the transfer
of money between savers (and investors) and borrowers operating on a global, regional or firm
specific level. According to Gurusam, it is a set of complex and closely interconnected financial
institutions, markets, instruments, services, practices, and transactions.

Financial systems are crucial to the allocation of resources in a modern economy. They channel
household savings to the corporate sector and allocate investment funds among firms; they
allow inter-temporal smoothing of consumption by households and
expenditures by firms; and they enable households and firms to share risks. Since these
functions take place in a market oriented environment, there is a need for an independent
party to enforce rules and contracts and this is the regulator. The main regulatory authorities of
the financial institutions that constitute the financial system of a given economy are the Central
Bank and Capital Market Authority.

THE ROLE OF FINANCIAL SYSTEM IN THE ECONOMY

The financial sector provides six major functions that are crucial for the survival and efficient
operation of any given economy. These functions are outlined below:
1. Providing payment services.
It is inconvenient, inefficient, and risky to carry around enough cash to pay for purchased goods
and services. Financial institutions provide an efficient alternative. The most obvious examples
are personal and commercial checking and check-clearing and credit and debit card services;
each are growing in importance, in the modern sectors at least, of even low-income countries.

2. Matching savers and investors.

Although many people save, such as for retirement, and many have investment projects, such
as building a factory or expanding the inventory carried by a family micro enterprise, it would
be only by the wildest of coincidences that each investor saved exactly as much as needed to
finance a given project. Therefore, it is important that savers and investors somehow meet and
agree on terms for loans or other forms of finance. This can occur without financial institutions;
even in highly developed markets, many new entrepreneurs obtain a significant fraction of their
initial funds from family and friends. However, the presence of banks, and later venture
capitalists or stock markets, can greatly facilitate matching in an efficient manner. Small savers
simply deposit their savings and let the bank decide where to invest them.

3. Generating and distributing information .

One of the most important functions of the financial system is to generate and distribute
information. Stock and bond prices in the daily newspapers of developing countries are a
familiar example; these prices represent the average judgment of thousands, if not
millions, of investors, based on the information they have available about these and all other
investments. Banks also collect information about the firms that borrow from them; the
resulting information is one of the most important components of the capital
of a bank although it is often unrecognized as such. In these regards, it has been said that
financial markets represent the brain of the economic system.

4. Allocating credit efficiently .

Channeling investment funds to uses yielding the highest rate of return allows increases in
specialization and the division of labor, which have been recognized since the time of Adam
Smith as a key to the wealth of nations.

5. Pricing, pooling, and trading risks .

Insurance markets provide protection against risk, but so does the diversification possible in
stock markets or in banks’ loan syndications.

6. Increasing asset liquidity .

Some investments are very long-lived; in some cases – a hydroelectric plant, for example – such
investments may last a century or more. Sooner or later, investors in such plants are likely to
want to sell them. In some cases, it can be quite difficult to find a buyer at
the time one wishes to sell – at retirement, for instance. Financial development increases
liquidity by making it easier to sell, for example, on the stock market or to a syndicate of banks
or insurance companies.

7. Financial systems and economic growth:

Both technological and financial innovations have driven modern economic growth. Both were
necessary conditions for the Industrial Revolution as steam and water power required large
investments facilitated by innovations in banking, finance, and insurance.
Both are necessary for developing countries as they continue their struggle for economic
development. But the effective functioning of the financial system requires, in turn, the
precondition of macroeconomic stability.

The Five Parts of the Financial System

1.Money : A Good which is used as a means of payment for exchanging goods. This has not
always been the case, we once used gold and silver coins as a means of paper.
2. Financial Instruments : A written legal obligations of one party to transfer something of
value to another party at some future date under certain conditions. These obligations usually
transfer resources from savers to investors. Examples: Stocks, bonds,
insurance policies.
3. Financial Markets : Markets where financial instruments are traded. Examples: New York
Stock Exchange, Chicago Board of Trade and Nairobi Stock exchange.
4. Financial Institutions : These entities prov ide services and allow agents access to financial
instruments and markets. Examples: Banks, securities firms and insurance companies.
5. Regulators : Government entity which monitors the state of the economy and conducts
monetary policy. Example: central Bank of Kenya.

LESSON 2
Instruments of capital markets

An Overview of Financial Markets

A Financial Market is an institution or arrangement that facilitates the exchange of financial
assets. They are mechanisms in our society for converting public savings into investments such
as buildings, machinery, infrastructure and inventories of goods and raw materials. This
enables the economy to grow, new jobs to be created and living standards to rise. Financial
markets therefore perform the essential economic function of channeling funds from economic
units which have surplus funds (net savers) to economic units with a net deficit of funds
(investors).

Classification of Financial Markets

There are several basic methods of classifying financial markets as follows:

1. A classification of the markets based on the type of instrument or service as follows:

Debt Markets

Equity Markets

Financial services Markets

2. A broad classification that distinguishes between

Primary &

Secondary Markets

3. A classification of markets based on the term to maturity and liquidity of the instrument. This
method categorizes financial markets into

Money Markets &

Capital Markets

4. A classification of markets according to when the financial instruments being traded will be
delivered. This classification categorizes markets into:

Spot markets

Futures or forward markets

Option markets

5. A classification of markets into open and negotiated markets.

Auction market

Bourse

Over-the-counter market

6.Financial markets can also be classified in terms of the extent of financial intermediation
involved in the sale of the financial instruments as follows:

Direct finance markets

Semi-direct finance markets

Indirect finance markets

1. Debt Markets

This is the most familiar type of market. Here, the lenders provide funds to borrowers for some
specific period of time. In return for the funds, the borrower agrees to pay the lender the
principal loan plus some specified amount of interest. Debt markets are used by individuals to
finance purchases such as houses, cars, home appliances, Corporate borrowers to finance
working capital and new equipment and the central and local governments to finance various
public expenditures. Debt instruments include bonds, mortgages and the various types of bank
loans. These are contractual agreements by the borrower to pay the holder of the instrument
fixed amounts of money at regular intervals until the maturity date, when the final payment is
made. The regular payments contain elements of both principal and interest payments.

2.Equity Markets
This is the market for raising funds by issuing equities such as common stock. Equities are
claims to share in the net income and the assets of a business. Equities usually make periodic
payments in form of dividends to their holders. Holders are residual claimants in that the
corporate must pay all its debt holders before it pays its equity holders. Equities usually have
no maturity dates.

3. Service Markets
These are markets where individuals and corporate can purchase services that enhance the
workings of the debt and equity markets. Banks for example, provide depositors many serv ices
in addition to paying them interest on their deposits. These include money transmission
services, safe deposit facilities, payment services e.t.c. Thus, in addition to participating in the
debt market, by issuing loans banks also provide financial services that provide ‘convenience’ to
consumers in various ways.

Stock brokers also participate in financial markets by competing for the right to help individuals
and corporate bodies buy and sell financial assets such as stocks and bonds. As intermediaries,
brokers receive a fee for performing the service of matching buyers and sellers. Dealers on the
other hand, buy and sell securities on their portfolio, not just matching buyers and sellers.
Another important function of the financial services market is providing consumers, businesses,
and governments with financial risk management services, that is protection against life, health,
property and income risks through sale of various insurance policies.

4. Primary Markets

The primary market is used for trading of new securities that have never before been issued. Its
primary function is raising capital to support new investments or corporate expansions. The
best example of a primary market is the market for corporate Initial Purchase offers (IPOs)
which are used to sell company shares to the public for the first time. Other primary markets
include market for Treasury bills and Treasury bonds.

5. Secondary Markets
These are markets that deal in securities which were issued previously. The chief function of a
secondary market is to provide liquidity to investors – that is, provide an avenue for converting
financial instruments into ready cash. Examples of secondary markets are markets for stocks
and shares and that of long-term bonds.

6. Money Markets
Money markets are financial markets that are used for the trading of short-term debt
instruments, generally those with original maturity of less than one year. The money market is
the place where individuals and institutions with temporary surpluses of
funds meet the needs of borrowers who have temporary fund shortages. Thus, the money
markets enable economic units to manage their liquidity positions. For example, a security or
loan with a maturity period of less than one year is considered a money market instrument.
One of the principle 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.

7. Capital Markets
The capital market is designed to finance long-term investments by businesses, governments
and households. Capital market instruments are mainly longer term debt securities (generally
those with original maturities of more than one year) and equities. Examples include bonds and
shares traded on the stock exchange.

8. Spot Markets
A spot market is one in which securities or financial services are traded for immediate delivery
(usually within one or two business days. Advanced stock exchange markets for equities and
spot foreign exchange markets operate in this manner.

9.0 Futures or Forward markets

A futures or forward market trades contracts calling for future delivery of financial instruments.
The purpose of such contracts is to reduce risk by agreeing on a price today rather than waiting
to buy spot in future when the price of the asset being purchased might have risen.

10. Option Markets

Option markets make it possible to trade in options, to buy a selected range of stocks and
bonds. Options are agreements (contracts) that give an investor the right (but not the
obligation) to either buy from or sell designated securities to the writer of the option at a
guaranteed price at any time during the life of the contract. Options, just like futures are a risk
management mechanism. They give investors the chance of limiting losses while preserving the
opportunity to make substantial profits.

11. Open versus Negotiated Markets

Open markets refer to the situation where financial instruments e.g corporate bonds are sold in
the open market to the highest bidder and bought and sold any number of times before they
mature and are paid off. On the other hand, the negotiated market refer to a situation whereby
the instruments are sold to one or a few buyers under private contract. Bank Loans are a type
of assets that can be said to be traded under negotiated market conditions.

12. Direct, Semi Direct and Indirect Finance

Direct Finance
Direct finance refers to the situation in which borrowers borrow money directly from lenders in
return for financial assets. This means that there are no financial intermediaries involved in the
transaction. The financial assets issued in these situations are usually primary securities like
stocks, bonds, notes, e.t.c which are issued directly to the lender. Examples include company
shares sold through private placing and commercial paper issued by large corporate bodies .
Direct finance instruments are also referred to as instruments of financial disintermediation
due to the fact that no intermediaries are involved in the transactions. Dir ect finance is the
simplest method of carrying out financial transactions. It however has a number of serious
limitations as follows

 Both the borrower and lender must be desirous of exchanging the same
amount of funds at the same time
 The borrower must be willing to accept the borrower’s IOU which may be
risky or slow to mature
 There must be a coincidence of wants between surplus and deficit – budget
units in term of amount and form of a loan; without this fundamental
coincidence, direct finance breaks down.
 Both the lender and the borrower must frequently incur substantial
information costs simply to find each other.

Semi-direct Finance
This is the kin to the situation that prevailed in the early history of most financial systems. Here,
some individuals and business firms become securities brokers and dealers whose principal
function is to bring surplus and deficit budget-units together, thereby reducing information
costs. There is a difference between a broker and a dealer in securities. A broker is merely an
individual or financial institution who provides information concerning possible purchases and
sales of securities. Either a buyer or a seller can contact a broker whose job is simply to bring
buyers and sellers together. A dealer on the other hand although also an intermediary between
buyers and sellers, actually acquires the seller’s securities in the hope of marketing them at a
later time at a favorable price. Dealers take a ‘position of risk’ when they buy the securities for
their own portfolio or when they ‘underwrite’ a security issue by undertaking to buy any
securities that might not be taken up by buyers in a primary sale.

Dealers and brokers assist in reducing costs associated with information search. They also
facilitate the development of a secondary market for the securities. Despite these advantages
semi-direct finance has limitations. The ultimate lender still winds up holding the borrowers’
securities and therefore, the lender must be willing to accept the risk and maturity
characteristics of the borrower’s IOU. There also must be a fundamental coincidence of wants
and needs between surplus and deficit budget units for semi-direct financial transactions to
take place.

Indirect Finance
This is a financing situation that is carried out in with the help of financial intermediaries, a
situation that attempts to reduce the limitations of direct and indirect finance. Financial
intermediaries in financial markets include commercial banks, insurance companies, credit
unions, finance companies, pension funds, microfinance institutions, e.t.c. Financial
intermediaries serve both ultimate borrowers and lenders but in a much more complete way
than brokers and dealers do. Financial intermediaries issue securities of their own- secondary
securities – to ultimate lenders and at the same time accept IOUs from borrowers – primary
securities.
Secondary securities include familiar facilities like checking and savings accounts, life insurance
policies, and shares in a mutual fund. Common characteristics of these instruments include

 They generally carry low risk of default

 They can be acquired in small denominations, affordable by savers of limited
means
 For most part, secondary securities are liquid and can therefore be converted
quickly into cash with little risk of significant loss.

Financial intermediaries accept primary securities from those who need credit and, in doing so,
take on financial assets that many savers, especially those with limited funds and limited
knowledge of the market would find unacceptable. One of the benefits of the development of
efficient financial intermediation (indirect finance) has been to smooth out consumption
spending by households and investment spending by businesses over time, despite variations
in income. Intermediation makes savings and borrowing easier and safer. Financial
intermediation also permits a given amount of saving in the economy to finance a greater
amount of investment than
would have occurred without intermediation.