Chapter One

Introduction To Financial System

 The Financial System
• Finance is the art and science of managing money.
Virtually all individuals and organizations earn or raise
money and spend or invest money.
• Finance is concerned with the process, institutions,
markets, and instruments involved in the transfer of
money among individuals, businesses and governments.
• A financial system is a set of institutions, such as banks,
insurance companies, and stock exchanges, that permit
the exchange of funds.
• Provides for efficient flow of funds from saving to
investment by bringing savers and borrowers together via
financial markets and financial institutions.
 Cont’d
• The evolution of the financial system has been
interlinked with the growth of technology and
macroeconomics.
• The financial system has travelled to Universal
banking from barter system of pre-industrial
period.
 Cont’d

• A financial system may be defined as a set of

institutions, instruments and markets which fosters
savings and channels them to their most efficient use.
• The system consists of individuals (savers),
institutions, intermediaries, markets and users of
savings (government, public and private sector
entities).
• Economic activity and growth are greatly facilitated
by the existence of a financial system developed in
terms of the efficiency of the market in mobilizing
savings and allocating them among competing users.
 Cont’d
• Financial System comprises, a set of sub-systems of
financial institutions, financial markets, financial
instruments and Financial services.
• Therefore, a financial system is defined as an
intermediary function that facilitates the flow of
funds from the areas of surplus to the areas of
deficit.
• In other words, a financial system is a system that
aims at establishing and providing a regular,
smooth, effective and efficient linkage between
depositors and investors.
 Cont’d
• The term financial system is a set of inter-related
activities and services working together to achieve some
pre-determined purpose.
• The financial system comprises of a variety of
intermediaries, markets and instruments. It provides the
principal means by which savings are transformed in to
investments.
• Given its role in the allocation of resources, the efficient
functioning of the financial system is critical to a modern
economy.
• The primary function of the financial system is to provide
a link between savings and investment for the creation of
new wealth and to permit portfolio adjustment in the
 Flows of Funds Through the Financial System
• When borrowers directly borrow funds from the
lenders in the financial markets by issuing variety of
securities, which are claims against the future
earnings and assets of borrowers is known as Direct
Financing.
Examples:
1. When a corporation raise money from any
economic unit by issuing common stock.
2.Bond issue to the general public by government of
Ethiopia to finance different developmental and
transformational investment plans.
 Cont’d
• Usually financial markets allow funds to flow from
economic units who lack productive investment
opportunities to those economic units who have
them.
• Therefore, financial markets are critical for
producing efficient allocation of capital, which
contributes to higher production and efficiency for
the overall economy.
• Financial markets improve the well being of
consumers by allowing them to time their
purchases better.
 Cont’d
• When borrowers indirectly borrow funds from the
lenders in the financial markets through the use of
financial intermediaries is known as an Indirect
Financing.
• The process of indirect finance using financial
intermediaries is called Financial Intermediation.
• E.g. Suppose you have excess money of Br1000 and
saved it at D/Markos Dashen Bank branch. It may not be
possible for somebody, an investor who resides in
Bahirdar to search for you in D/markos Town and make
use of your excess money of Br.1000 without the
intervention of Dashen Bank Bahirdar Branch.
• In addition to this, even if he had the knowledge of you
in person, his requirement for funds of Br 2500 may not
be compatible to the excess money that you have Br
1000.
• It is, therefore, a best solution to go for Dashen Bank
Bahirdar Branch where a portfolio of funds from various
individual and institutional savers can be found ready
for use to borrowers.
 Budget positions creating financial needs of
economic units: Surplus or deficit.
• Surplus spending units ( SSUs) have income for
the period that exceeds spending, resulting in
savings.
– Other words for “SSU” are saver, lender, or
investor.
– Most SSUs are households.
• Deficit spending units (DSUs) have spending
for the period that exceeds income.
– Another word for “DSU” is “borrower”.
– Most DSUs are businesses or governments.
Financial claims arise as SSUs lend to DSUs.

• SSU’s claim against DSU is liability to DSU and

asset to SSU.
• One’s liability is another’s asset: What is
payable by one is receivable by another.
• Assets arising this way are “financial assets.”
The financial system “balances”-total financial
assets equal total liabilities.
 Direct Financing: The simplest way for
funds to flow.
• DSU and SSU find each other and bargain
• SSU transfers funds directly to DSU
• DSU issues claim directly to SSU
• Preferences of both must match as to-
-Amount
-Maturity
-Risk
-Liquidity
 Institutional arrangements common in direct
finance.
• Private placements are simplest.
• Investment bankers “underwrite” new issues
of securities.
• Brokers and dealers bring buyers and sellers of
direct claims together.
Indirect Financing (“Financial Intermediation”):

• Financial intermediaries “transform” claims:

– raise funds by issuing claims to SSUs;
– use funds to buy claims issued by
DSUs.
• Claims can have unmatched characteristics:
– SSU has claim against intermediary;
– Intermediary has claim against DSU.
 Objectives of Financial System
• The main objective of the financial system is
to serve as an agent of socio-economic
development in various sectors of the
economy (Industry, service, and agriculture)
• The first and foremost task of any financial
system is to accelerate the growth of the
economy.
 Cont’d
Speeding up economic growth
Rapid industrialization
Project finance
Price control and stability
support to infrastructure, trade and rural
development
Human development
Support housing, education and health
Provides liquidity
 Functions of Financial System
• Economic growth and development of any country
depends upon the strength of its financial system.
• Thus, a financial system can be said to play a
significant role in the economic growth of a country
by mobilizing the surplus funds and utilizing them
effectively for productive purposes.
• The function of Financial system cab be simply
illustrated as follows
Saving mobilization Capital Formation
Investment Economic growth economic
development Improved living standard of
 Functions of Financial System

• Financial system is the mirror reflection of an

economy. The performance of any economy to a
large extent is dependent on the performance of
the financial institutions.
 Functions of Financial System
• A good financial system has the following six
functions
1. Clearing and settling payments
2. Pooling resources and subdividing shares
3. Transferring resources across time and space
4. Managing risk
5. Providing information
6. Dealing with incentive problems
 cont’d
1. Clearing and settling payments
• “A financial system provides ways of clearing
and settling payments to facilitate the
exchange of goods and services.”
• Financial institutions, now a days, provides
different payment system. For example,
ATMs, credit cards, debit cards, Smart cards
e.t.c
 cont’d
2. Pooling resources and subdividing shares
• “A financial system provides a mechanism for
pooling of funds to undertake large-scale
indivisible enterprise or for subdividing of shares in
enterprises to facilitate diversification”.
• Securitization is an efficient vehicle for pooling
non-traded securities and subdividing by selling
claims on the pool on the market
For Example: Asset backed securities.
 cont’d
3. Transferring resources across time and space
• “A financial system provides ways to transfer
economic resources through time, across
geographic regions and, among industries.”
• The financial intermediaries transfer resources across
time and space, thus allowing investors and consumers
to borrow against future income and meet current
needs.
• As a result, there is an efficient separation of
investment & financing horizons (maturity).
• In other words, short-term deposits used to finance
long-term lending and rollover loans for financing
 Cont’d
4. Managing risk
• “A financial system provides ways to manage
uncertainty and control risk.”
• For instance, by facilitating diversifications,
financial intermediaries allow savers to
maximize returns to their assets and to reduce
risks.
 cont’d
5. Providing information
• “A financial system provides price information
that helps co-ordinate decentralised decision-
making in various sectors of the economy.”
• That is, by providing a mechanism for
appraisal of the value of the firm, financial
systems allow investors to make informed
decisions about the allocation of their funds
(specially stock and foreign exchange market)
 cont’d
6. Dealing with incentive problems
• “A financial system provides ways to deal
with the incentive problems when one party
to a financial transaction has information
and the other party does not, or when one
party is an agent for another.”
 The role of financial resource in an economy

• Financial systems, i.e. financial intermediaries and

financial markets, channel funds from those who
have savings to those who have more productive
uses for them.
• They perform two main types of financial service
that reduce the costs of moving funds between
borrowers and lenders, leading to a more efficient
allocation of resources and faster economic growth.
• These are the provision of liquidity and the
transformation of the risk characteristics of assets
• The development of any country depends on the
economic growth the country achieves over a period
of time. Economic growth deals about investment
and production and also the extent of Gross
Domestic Product in a country. Only when this
grows, the people will experience growth in the
form of improved standard of living, namely
economic development
• In the financial system funds flow from those who
have surplus funds to those who have a shortage of
funds, either by direct, market-based financing or by
indirect, bank-based finance. The former British
Prime Minister William Gladstone expressed the
importance of finance for the economy in 1858 as
follows: "Finance is, as it were, the stomach of the
country, from which all the other organs take their
tone."
• The financial system comprises all financial
markets, instruments and institutions.
• The following are the roles of financial system in
the economic development of a country.
1. Savings-investment relationship
• To attain economic development, a country needs
more investment and production. This can happen
only when there is a facility for savings. As, such
savings are channelized to productive resources in
the form of investment. Here, the role of financial
institutions is important, since they induce the
public to save by offering attractive interest rates.
These savings are channelized by lending to various
business concerns which are involved in production
and distribution.
2. Financial systems help in growth of capital market
• Any business requires two types of capital namely, fixed
capital and working capital. Fixed capital is used for
investment in fixed assets, like plant and machinery. While
working capital is used for the day-to-day running of
business. It is also used for purchase of raw materials and
converting them into finished products.
• Fixed capital is raised through capital market by the
issue of debentures and shares. Public and other financial
institutions invest in them in order to get a good return with
minimized risks.
• For working capital, we have money market, where short-
term loans could be raised by the businessmen through the
issue of various credit instruments such as bills, promissory
notes, etc.
3. Government Securities market
• Financial system enables the state and central
governments to raise both short-term and long-term
funds through the issue of bills and bonds which
carry attractive rates of interest along with tax
concessions. The budgetary gap is filled only with
the help of government securities market. Thus, the
capital market, money market along with foreign
exchange market and government securities market
enable businessmen, industrialists as well as
governments to meet their credit requirements. In
this way, the development of the economy is
ensured by the financial system.
4. Financial system helps in Infrastructure and Growth
• Economic development of any country depends on the
infrastructure facility available in the country. In the
absence of key industries like coal, power and oil,
development of other industries will be hampered. It is
here that the financial services play a crucial role by
providing funds for the growth of infrastructure industries.
Private sector will find it difficult to raise the huge capital
needed for setting up infrastructure industries. For a long
time, infrastructure industries were started only by the
government in India. But now, with the policy of
economic liberalization, more private sector industries
have come forward to start infrastructure industry. The
Development Banks and the Merchant banks help in
raising capital for these industries
5. Financial system helps in development of Trade
• The financial system helps in the promotion of both domestic
and foreign trade. The financial institutions finance traders and
the financial market helps in discounting financial instruments
such as bills. Foreign trade is promoted due to per-shipment
and post-shipment finance by commercial banks. They also
issue Letter of Credit in favor of the importer. Thus, the
precious foreign exchange is earned by the country because of
the presence of financial system. The best part of the financial
system is that the seller or the buyer do not meet each other
and the documents are negotiated through the bank. In this
manner, the financial system not only helps the traders but also
various financial institutions. Some of the capital goods are
sold through hire purchase and installment system, both in the
domestic and foreign trade. As a result of all these, the growth
of the country is speeded up.
6. Employment Growth is boosted by financial system
• The presence of financial system will generate more
employment opportunities in the country. The money
market which is a part of financial system, provides
working capital to the businessmen and manufacturers due
to which production increases, resulting in generating more
employment opportunities. With competition picking up in
various sectors, the service sector such as sales, marketing,
advertisement, etc., also pick up, leading to more
employment opportunities. Various financial services such
as leasing, factoring, merchant banking, etc., will also
generate more employment. The growth of trade in the
country also induces employment opportunities.
Financing by Venture capital provides additional
opportunities for techno-based industries and employment.
7. Financial system helps in fiscal discipline and control
of economy
• It is through the financial system, that the government
can create a congenial business atmosphere so that
neither too much of inflation nor depression is
experienced. The industries should be given suitable
protection through the financial system so that their credit
requirements will be met even during the difficult period.
The government on its part, can raise adequate resources
to meet its financial commitments so that economic
development is not hampered. The government can also
regulate the financial system through suitable legislation
so that unwanted or speculative transactions could be
avoided. The growth of black money could also be
 Components of Financial system in brief

• Financial Institutions: organizations that act as mobilizers

and depositors of savings and as purveyors of credit or
finance. It is also called financial intermediaries) &
facilitate flows of funds from savers to borrowers.
• Financial markets : are the centers or arrangements that
provide facilities for buying and selling of financial claims
and services. Markets for financial instruments, also
called financial claims or securities.
• Financial Instruments: are financial assets being traded in
a financial market
• Financial services : are various functions and services that
are provided by financial institutions in a financial system.
 Financial Markets

• A financial market can be defined as the market in

which financial assets are created or transferred. As
against a real transaction that involves exchange of
money for real goods or services, a financial
transaction involves creation or transfer of a
financial asset.
• The place where people and organizations wanting
to borrow money are brought together with those
having surplus funds is called financial market. It
may or may not have a particular physical existence.
 Function of Financial Markets

 To bring lenders and borrowers together to make

both of them better-off.
 Efficient allocation of capital, which increases production
 Improve the well-being of consumers by allowing them
to time purchases better
 Financial Institutions/Intermediaries
• Institutions that perform the essential function of
channeling funds from those with surplus funds to
those with shortages of funds (e.g. banks, thrifts,
insurance companies, securities firms and
investment banks, finance companies, mutual funds,
pension funds)
Function of Financial Intermediaries: Indirect Finance
• Lower transaction costs (time and money spent in
carrying out financial transactions).
– Economies of scale
– Liquidity services (checking account)
• Reduce the exposure of investors to risk
– Risk Sharing (Asset Transformation: packaging risky
assets into safer ones for investors)
– Diversification by pooling and issuing new assets
 Cont’d

• Deal with asymmetric information problems

– (before the transaction) Adverse Selection: try to avoid
selecting the risky borrower.
• Gather information about potential borrower.
– (after the transaction) Moral Hazard: ensure borrower
will not engage in activities that will prevent him/her to
repay the loan.
• Sign a contract with restrictive covenants.
 Financial Instruments
Financial Instruments: The written legal obligation of
one party to transfer something of value, usually
money, to another party at some future date, under
certain conditions.
– The enforceability of the obligation is important.
– Financial instruments obligate one party (person,
company, or government) to transfer something to
another party.
– Financial instruments specify payment will be made at
some future date.
– Financial instruments specify certain conditions under
which a payment will be made.
 cont’d

• Contracts related to the transfer of funds from surplus to

deficit budget units.
• Financial claims are also called financial assets and
liabilities, securities, loans, financial investments.
• For every financial asset, there is an offsetting financial
liability.
– Total receivables equal total payables in the financial system.
– Loans outstanding match borrowers' liabilities
• Financial markets offer opportunity for:
– Financing for DSUs (primary)
– Financial investing for SSUs (primary and secondary)
– Providing liquidity via trading financial claims in
secondary markets
 Uses of Financial Instruments
• Three functions:
– Financial instruments act as a means of payment
(like money).
• Employees take stock options as payment for
working.
– Financial instruments act as stores of value (like
money).
– Financial instruments allow for the transfer of risk
(unlike money).
• Futures and insurance contracts allows one
person to transfer risk to another.
 Financial Regulation
• Financial system of any country are among the
heavily regulated sectors of the economy.
• The following are three main reasons for regulating
the financial system.
1. To increase information available to investors
2. To ensure the soundness of the financial system &
3. To improve control of monetary policy
 1. Increasing information available to investors

• Asymmetric information creates adverse selection

and moral hazards to innocent investors in the
market.
 Another reason FIs exist is to reduce the impact of
asymmetric information.
 One party lacks crucial information about another
party, impacting decision-making.
 We usually discuss this problem along two fronts:
adverse selection and moral hazard.
 Cont’d
 Adverse Selection
1. Before transaction occurs
2. Potential borrowers most likely to produce adverse
outcome are ones most likely to seek a loan
3. Similar problems occur with insurance where unhealthy
people want their known medical problems covered
 Cont’d
• Moral Hazard
1. After transaction occurs
2. Hazard that borrower has incentives to engage in
undesirable (immoral) activities making it more likely
that won’t pay loan back
3. Again, with insurance, people may engage in risky
activities only after being insured
4. Another view is a conflict of interest
 Cont’d
 Financial intermediaries reduce adverse selection
and moral hazard problems, enabling them to make
profits.
 Because of their expertise in screening and
monitoring, they minimize their losses, earning a
higher return on lending and paying higher yields to
savers.
 Cont’d
• To avoid these problems, governments often
establish regulatory institutions that require
organizations to issuing securities to disclose certain
information about their sales, assets, and earnings
to public and restrict insider trading in corporations.
• In additions individuals and institutions engaging in
such acts are severely penalized.
2. Ensuring the soundness of the financial system

• To enhance investors’ trust in the financial markets

by ensuring the soundness of the financial system
the following regulatory acts can be taken:
1. Restrictions on entry into the financial
institutions industry
2. Adequate Disclosures by FIs
3. Restrictions on assets and activities
4. Introduction of deposit insurance
5. Limits on competition
3. Improving control of monetary policy
• Government uses a regulatory tool of reserve
requirements to improve control of the money
supply in the economy.
• RR makes it obligatory for depository institutions to
keep a certain portion of their deposit in their central
bank account.
• RRs help central governments to exercise more
precise control over the money supply.
 The End!
Thank you
For your attention!!!