Chapter one

Introduction to the Financial System

Chapter contents
1. An Introduction to Financial system
2. The role of financial system in the econ-
omy
3. Financial assets: role and properties
4. Financial markets: role, classifications
and participants
5. Lending and borrowing in the financial
system
3
1.1. Introduction to Financial system
Finance Terms
Finance: proper management of
money
Money: current medium of exchange
or means of payment
Credit or loan: a sum of money to be
returned normaly with interest.
 1.1. Introduction to Financial sys-
temeconomic development of any country de-
 The
pends upon existence of well organized financial
system.
 The word “system”, in the term “financial sys-
tem”, implies a set of complex and closely con-
nected or interlined institutions, agents, prac-
tices, markets, transactions, claims, and liabili-
ties in the economy.
 The financial system acts as a connecting link
between savers of money and users of money
and thereby promotes faster economic and in-
dustrial growth.
Financial system---------
 Financial development is linked to eco-
nomic growth.
 The role of financial system is to facilitate
production, employment, and consump-
tion.
 Financial system encourages saving, pro-
vides funds for investment and facilitate
transaction for goods and services.
 The resources are funneled through the
system so the resources flow to their most
 People and firms are known as the end user of the system
whose desire is to lend and to borrow.
 The end-users of most of financial systems have a
choice between three broad approaches.
 1st , they may decide to deal directly with one another
 2nd they may decide to use one or more of many organized mar-
kets
 3rd may decide to deal via institutions or ‘intermediaries
 An efficient functioning of the financial system, facili-
tates the free flow of funds to more productive activi-
ties & promotes investment.
 Thus, the financial system provides:
 Intermediation b/n savers & borrowers
 Promotes faster economic development.
1.2. Definition of Financial System
Financial System: is a set of financial instrument,
Financial Markets, Financial institutions, and
Regulatory and supervisory bodies established to
facilitate the flow of funds from savers to in-
vestors (Mishkin F.).
Financial system is a system that allows the ex-
change of fund between financial market partici-
pants; such as lenders, investors, and borrowers .
Financial Markets and Financial institutions are the
cornerstones of the overall financial system.
 1.3. Components of Financial System
The financial system has six parts, each of which plays a fun-
damental role in our economy.
Those parts are:
Money,
That allow
Financial Market funds to be al-
Financial Institution located, in-
vested, or
Financial Instruments and moved be-
Government regulatory agencies, and tween eco-
nomic sectors.
Central banks.
 Financial System…
 We use money to pay for our purchases and to store
our wealth.
 We use financial instruments, to transfer resources
from savers to investors and to transfer risk to those
who are best equipped to bear it.
 Stocks, mortgages, and insurance policies are examples of fi-
nancial instruments.
 financial markets allows us to buy and sell financial
instruments quickly and cheaply
 Financial System…
 Financial institutions provide a myriad of services,
including access to the financial markets and collec-
tion of information about prospective borrowers to en-
sure they are creditworthy.
 Government regulatory agencies are responsible
for making sure that the elements of the financial sys-
tem—including its instruments, markets, and institu-
tions—operate in a safe and reliable manner.
 central banks monitor and stabilize the economy.
 National bank of Ethiopia is our central bank
 Core Functions of a Financial System
1. The investment chain
2. Risk Management
3. Payment systems
4. Providing information
 1. The investment chain
 Through the investment chain, savers and borrowers
are brought together.
 Savers provide financing to businesses,
 and businesses that wish to grow offer opportunities for
savers to take part in the growth and resulting potential
returns.
 The efficiency of this chain is critical to allocating
what would otherwise be un invested capital to
businesses
………….that can use it to grow their enterprises
 1. The investment chain…..
 Pooling resources and subdividing shares
 Financial systems enable multiple investors to contrib-
ute to projects that no one of them alone could afford.
 Transferring resources across time and space.
 Firms in one industry, or in one location, may seek to
invest surplus funds in other industries or at other lo-
cations.
 2. Managing Risk
 Financial systems provide ways for in-
vestors to exchange, and thereby to con-
trol, risks.
 For example,
 insurance enables the pooling of risks,
 hedging enables the transfer of risk to specula-
tors,
 diversification exploits low correlations that may
exist among risky projects
 3. Payment systems
 Financial systems provide mechanisms that facili-
tate exchanges of goods and services, as well as
assets,
 followed by settlement, transferring ownership in return
for the agreed remuneration.
 It is an essential requirement for commercial activi-
ties to take place and for participation in interna-
tional trade and investment.
 4. Providing information
 One of the most prominent friction in the financial
market is asymmetric information.
 Asymmetric Information- refers the gap b/n the information to the
buyer and the seller.
 Financial markets, institutions and intermediaries pro-
duce useful information of potential borrowers to in-
vestors.
 Financial systems enable price discovery
– that is, for those who wish to trade to observe the prices (rates of
exchange) at which agreements can be made.
– other information, for example about expectations of future asset
price volatility, can be inferred from market prices.
 Financial Assets/Instrument/
 Are claims by lenders against income or wealth of
borrowers, represented usually by a certificates.
 It is issued by party raising funds, acknowledging a
financial commitments, and entitling the holders to
specified future cash flows. e.g. stocks, bonds, insur-
ance policy, bank loan, notes and etc…
 Financial instruments specify payment will be made
at some future date.
 Financial instruments specify certain conditions under
which a payment will be made.
Function of Financial Instrument
I. Financial instrument act as a means of payment (like
money)
 Employees take stock options as payment for working.
II. Financial instrument act as a stores of value (like
money)
 Financial instrument generate increase in wealth that are
larger than from holding money
 Financial instrument can be used to transfer purchasing
power into the future contract.
III. Financial instrument allow for the transfer of the risk
(unlike money)
 Future and insurance contracts allow one person to trans-
fer risk to another.
Characters of Financial Instrument
 Do not provide physical services to owners, instead pro-
vide a stream of (expected) cash flows.
 Do not depreciated unlike physical goods.
 Their physical condition or forms is usually not relevant
in determining their market value.
 Their cost of transportation and storage is low.
 Financial assets are fungible- they can be easily changed
in forms and substituted for other assets.
 Financial Systems - Approaches

Faced with end users desire (lend or borrow),

there are three approaches:
1. First, they may decide to deal directly with one
another.
2. Second, they may decide to deal via markets
3. Third, they may decide to deal via intermedi-
aries.
Financial Intermediation and the Flow of Funds
Lenders and Borrowers
•Lenders are the ultimate providers of savings (can be re-
ferred to as investors in that they expend cash on the acquisi-
tion of financial assets such as bonds and shares and real or
tangible assets such as land, buildings, gold, and paintings)
•Borrowers are the ultimate users of those savings
•Both are non-financial entities and are referred to as surplus
and deficit economic units respectively
Financial Intermediation and the Flow of Funds
• Lenders and borrowers can be categorized into four sectors:
• Household (individuals and families; it is also includes private
charitable, religious and non-profit bodies as well as unincorpo-
rated businesses such as farmers and professional partnerships)
• Business or corporate (all non-financial firms or companies pro-
ducing and distributing goods and services)
• Government (central and provincial governments as well as
• local authorities)
• Foreign (all individuals and institutions situated in the rest of the
world)
Flow of Funds Through a Financial
System
 Indirect Finance:
 Funds that flow through financial intermediaries, such as depository institu-
tions, insurance companies and mutual funds. These institutions work as a
channel of indirect financing by pooling saver funds then invest (or lending)
those funds through to businesses and others that need them.
 Direct Finance:
 Funds that flow directly lenders to borrowers with the assistance of institu-
tions that provide brokerage services (research and advice, retirement
planning, tax tips, execution of trades) . These institutions work as a chan-
nel of direct financing, in which businesses and governments can raise
funds directly from lenders in financial markets (IPOs).
Flow of Funds Through a Financial
System
 Financial Markets
 In a market economy, the allocation of
economic resources is driven by the out-
come of many private decisions
 Prices are signals that direct economic re-
sources to their best use
 Financial Markets…
 Two types of markets in an economy:
1. The market for products (manufactured goods and
services)
2. The market for factors ( labor and capital)
 Our focus is one part of the factor market, the
market for financial assets……financial market
 Financial Markets….
 A financial market are places or networks
where financial instrument are exchanged
(i.e.» traded).
 Financial markets are markets in which
funds are transferred from people and firms
who have an excess of available funds to peo-
ple and firms who have a need of funds.
 Financial Markets…
 Financial markets, such as bond and stock mar-
kets, are crucial in an economy.
 These markets channel funds from savers to
investors, thereby promoting economic effi-
ciency.
 Well functioning financial markets, such as the
bond market, stock market, and foreign exchange
market, are key factors in producing high eco-
nomic growth.
 Financial Markets…
 Debt markets, or bond markets, allow governments, corpora-
tions, and individuals to borrow to finance activities.
 In this market, borrowers issue a security, called a bond, that
promises the timely payment of interest and principal over
some specific time horizon.
 The interest rate is the cost of borrowing.
 There are many different types of market interest rates, in-
cluding mortgage rates, car loan rates, credit card rates, etc.
 Financial Markets…
 The stock market is the market where common stock (or
just stock), representing ownership in a company, are
traded.
 Companies initially sell stock (in the primary market) to raise
money. But after that, the stock is traded among investors
(secondary market).
 The foreign exchange market is where international curren-
cies trade and exchange rates are set.
 Foreign exchange (FX) markets are the largest of all
financial markets, with average daily turnover in ex-
cess of US$5 trillion.
 FUNCTIONS OF FINANCIAL MAR-
KET
Financial markets provide the following three major
economic functions:
1.1. price discovery
2.Liquidity
3.Reduced transaction cost
*search cost & information costs
* Contracting and Monitoring cost
*Cost of incentive problem
 FUNCTIONS OF FINANCIAL MARKET
Price discovery
 The interactions of buyers and sellers in a
financial market determine the price of the
traded asset.
Determine the required return on a fi-
nancial asset.
 FUNCTIONS OF FINANCIAL MARKET

Liquidity Function
 Provide a mechanism for an investor to
sell a financial asset when circumstances ei-
ther force or motivate him / her to sell
 While all financial markets provide some

form of liquidity, the degree of liquidity is

one of the factors that characterize different
markets
Functions of Financial Market
 Functions of Financial Market

Reduced Transaction Costs:

◼ This is performed when Financial Market
participants are charged and /or bear the
costs of trading a financial instruments.
Functions of Financial Market
Functions of Financial Market
 3. Classification of Financial Markets
There are several basis for classification of Financial Markets:

2-39 © 2013 Pearson Education, Inc. All rights reserved.

 Financial Intermediaries
 Instead of savers lending/investing directly with borrowers, a
financial intermediary (such as a bank) plays as the middle-
man:
 The intermediary obtains funds from savers
 The intermediary then makes loans/investments with borrowers
 This process, called financial intermediation, is actually the
primary means of moving funds from lenders to borrowers.
 More important source of finance than securities markets
(such as stocks).
 Financial Intermediaries…
 Financial intermediary needed because of transac-
tions costs, risk sharing, and asymmetric information
1. Transactions Costs
 Financial intermediaries make profits by reducing
transactions costs.
 Reduce transactions costs by developing expertise
and taking advantage of economies of scale.
 Financial Intermediaries…
2. Risk Sharing
 Financial Intermediaries low transaction costs allow
them to reduce the exposure of investors to risk,
through a process known as risk sharing.
 Financial Intermediaries create and sell assets with lesser
risk to one party in order to buy assets with greater risk
from another party.
 This process is referred to as asset transformation, because in
a sense risky assets are turned into safer assets for investors.
 Financial Intermediaries…
 Financial intermediaries also help by providing
the means for individuals and businesses to di-
versify their asset holdings.
 Low transaction costs allow them to buy a
range of assets, pool them, and then sell rights
to the diversified pool to individuals.
 Financial Intermediaries…
3. Asymmetric Information
 Another reason Financial intermediaries exist is to
reduce the impact of asymmetric information.
 One party lacks crucial information about another
party, impacting decision-making.
 Information Asymmetric and Information Cost
Information are a central element to efficient
market.
When cost of obtaining information is too high, some potential beneficial
transactions do not takes place and market tend to stall.
In most all transactions, the issuer of financial
instruments, borrowers know some information
which the buyer, saver, does not know. This situa-
tion known as asymmetric information.
Asymmetric information in a market of goods,
service or asset refers to difference (“Asymmet-
ric”) between information available to buyer and
information available to sellers.
 CON’T -----------------
Problems arising in markets
due to asymmetric information
typically classified in to two
basic types:
 Adverse selection and
Moral Hazard
 Financial Intermediaries…
 Adverse Selection
 This problem arise before transaction ever occurs.
 Is a problem that arises for a buyer of goods , services, or assets
when the buyer has difficulty of assessing the quality of the
items in advance of purchase.
 Consequently, adverse selection is a problem that arise because
of df (“asymmetric”) information b/t a buyer and seller bf any
purchase agreement takes place.
 It occurs when the seller of financial asset know more than the buyer. Un-
der these conditions, the seller will try to sell low quality asset and hold
high quality ones.
  Solving the adverse selection problem
There are two basic methods for solving problems of
adverse selection.
First, create more information for the investors
(disclosure of the information)
Second, provide guarantees in the form of con-
tracts that can be written such that the owners
of the firms face the same risks as the in-
vestors.
 Financial Intermediaries…
 Moral Hazard
 Arise after transaction occurs
 Is said to exist in a market if, after signing of a purchase agree-
ment between the buyer and seller of good or asset.
 Hazard that borrower has incentives to engage in undesirable
(immoral) activities making it more likely that won’t pay loan
back.
 Again, with insurance, people may engage in risky activities only
after being insured
For example: a car driver may drive faster knowing that the dam-
age on their car will be covered by the insurance company if, they
  Solving the Moral hazard
Methods for Reducing Moral Hazard:
1.Good corporate governance and management
2.Market disciple exercise by depositors and other
creditors
3.Regulatory discipline exercised by supervisory and
in some countries, deposit insurance authorities.
 41

Types of Financial Intermediaries

 LENDING AND BORROWING IN THE FINANCIAL SYS-
TEM
 The economist John Gurley and Edward Show (1960)
point out that each business firm, household, or unit of
government active in the financial system must con-
form to:
R-E = FA –D
Where : R= Revenue
E= Expenditure
▲ FA = Change in holding of financial asset
▲ D= change in Debt or equity outstanding
 LENDING AND BORROWING IN THE FINAN-
CIAL MARKETS
 Business firm, households, and government play
a wide variety of roles in modern financial sys-
tem.
 It is quit common for individuals/institution to be

a lender of funds in one period and borrow in

other period, or to do both simultaneously.
 Indeed, financial intermediaries are operate on

both sides of financial market ; borrowing fund

from customers by issuing attractive financial
claims and simultaneously making loan available
LENDING AND BORROWING IN THE FINANCIAL MAR-
KETS
If current expenditure is exceed current income receipts (R), the def-
erence will be made up by:
Reduce our holding asset –FA, e.g. drawing money from saving account
Issue debt or stock
Using some combination of both
Decision
 Liquidating some (all) of our financial assets
 Issuing debt or equity securities
 Using some combination of both

If our savings (R) exceed our E:

Decision
 Build up our holdings of financial assets
 Pay off some outstanding debt or retire stock
 Lending and Borrowing in the Financial Markets
So, for any given period, individual eco-
nomic unit falls in to one of three groups.
1.Deficit budget unit (DBU): E>R, D>FA
i.e. net borrow of fund
2. Surplus budget unit (SBU): R>E, FA>D,
i.e. Net lender of fund
3. Balanced budget unit (BBU) = R = E, D = FA
i.e. nether net lender nor net borrow
Thank