Financial Markets and Institutions

Chapter One: - An overview of Financial System

Leaning Objectives
At the end of the chapter students/learners will be able to.
 Identify the role of financial system in the economy
 Distinguish financial asset role and properties
 Recognize financial markets role, classifications and participants
 Acquaint with the concepts of lending and borrowing in the financial system

1. Introduction

This chapter is designed to introduce you to the basic concepts of the Financial Systems. This
chapter deals with the role of financial system in the economy, financial assets and its
characteristics, financial markets role, classification and participants and finally discuss about
lending and borrowing in the financial systems.

1.1. The role of Financial System in the Economy

Financial system performs the essential economic function of channelling funds from people
who have saved surplus funds by spending less than their income to people who have a shortage
of funds because they wish to spend more than their income.

Why is this channelling of funds from savers to spenders so important to the economy? The
answer is that the people who save are frequently not the same people who have profitable
investment opportunities available to them, the entrepreneur’s. Let’s first think about this on a
personal level. Suppose that you have saved Birr 10,000 this year, but no borrowing or lending is
possible because there are no financial systems. If you don’t have an investment opportunity that
will permit you to earn income with your savings, you will just hold on to the Birr 10,000 and
will earn no interest. However, Germew the carpenter has a productive use for your Birr 10,000.
He can use it to purchase a new tool that will shorten the time it takes him to build a house, there
by earning an extra Birr 2000 per year. If you could get a touch with Germew, you could lend
him t Birr 10,000 at an interest of 10% per year, and both of you would be better off. Because

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In the absence of financial system, you and Geremew the carpenter might never get together.
Without financial system, it is hard to transfer funds from a person who has no investment
opportunities to one who has them; you would both be stuck with the status quo, and both of you
would be worse off. Financial markets are thus essential to promoting economic efficiency.

The existence of financial systems is also beneficial even if someone borrow for a purpose other
than increasing production in a business. Say that you are recently married, have a good job, and
want to buy a house. You can earn a good salary, but because you have just started to work, you
have not yet saved much. Over time you would have no problem saving enough to buy the house
of your dreams, but by then, you would be too old to get full enjoyment from it. Without
financial system, you are stuck; you can’t buy the house and will continue to live in your tiny
apartment.

If a financial system were set up so that people who had built up savings could lend you the
money to buy the house, you would be more than happy to pay them some interest in order to
own a home while you are still young enough to enjoy it. Then, you had saved up enough funds;
you would pay back your loan. The overall outcome would be such that you would be better off,
as would the persons who made you loan. They would now earn some interest, where as they
would not if the financial system did not exist.

Financial systems have such an important function in allowing funds to move from people who
lack productive investment opportunities to people who have such opportunities. By doing so, a
financial system contributes to higher productive and efficiency in the overall economy. It also
directly improve the well- being of consumers by allowing them to time their purchases better,
they provide funds to young people to buy what they need and can eventually afford without
forcing them to wait until they have saved up the entire purchase price. The Financial system that
is operating efficiently improves the economic welfare of everyone in the society.
1.1.1. The Flow of Funds in the Financial System (Financial Transactions)
Financial systems are never static; they change constantly in response to shifting demands from
the public, the development of technology and changes in laws and regulations. Competition in
the financial market place forces financial institutions to respond to public need by developing
new, better quality, and more convenient financial services.

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Whether simple or complex, all financial systems perform at least one basic function. They move
scarce funds from those who save and lend (surplus-budget units) to those who wish to borrow
and invest (deficit-budget units). In the process, money is exchanged for financial assets however
the transfer of funds from savers to borrowers can be accomplished in at least three different
ways. These are: - direct finance, semi-direct finance, and indirect finance.
i. Direct Finance
Borrowers borrow funds directly from lenders in financial markets by selling them securities
(also called financial instruments).Borrowers and lenders meet each other and exchange funds in
return for financial assets. It is the simplest method of carrying financial transactions. You
engage in direct finance when you borrow money from a friend and give him or her IOU (a
promise to pay) or when you purchase stocks or bonds directly from the company issuing them.
We usually call the claims arising from direct finance primary securities because they flow
directly from the lender to the ultimate users of funds.

Figure 1.1; the flow of funds in the financial system (direct and indirect finance)
The principal lender- savers are households, but business enterprises and the government
(particularly state and local government), as well as foreigners and their governments, sometimes
also find themselves with excess funds and so lend them out. The most important borrower-

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spenders are business and the government (particularly the federal government) but households
and foreigners also borrow to finance their purchases of cars, furniture, and houses.

 The following can be visible draw backs of direct financing system:-

i) Both borrower and lender must desire to exchange the same amount of funds at the
same time.
ii) The lender must be willing to accept the borrower’s IOUs (a promise to pay), which
may be quite risky, illiquid or slow to mature.
iii) There must be a coincidence of wants between surplus and deficit – budget units in
terms of the amount and form of a loan. Without that fundamentals coincidence, direct
finance breaks down.
iv) Both lender and borrower must frequently incur substantial information costs simply to
find each other.
v) The borrower may have to contact many lenders before finding the one surplus – budget
unit with just the right amount of funds and willingness to take on the borrower’s IOU.
ii. Semi direct Finance
Early in the history of most financial systems, a new form of financial transaction appears which
we call semi direct finance.

Borrower- Primary Saver-Lenders

Primary
Spenders Security brokers
Securities (Surplus
(Deficit Budget Proceeds of security and dealers Securities
Units) Flow of Budget Units)
sales (less fees and
commission) funds

Figure 1.2; the flow of funds in the financial system (semi-direct finance)
Here, some individuals and business firms become securities brokers and dealers whose essential
function is to bring surplus and deficit budget units together – thereby reducing information
costs.

 Broker: An individual or institution that provides information concerning possible

purchases and sales of securities. Either a buyer or a seller of securities may contact a
broker, whose job is simply to bring buyers and sellers together.

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 Dealer: Also serves as a middle man between buyers and sellers, but the dealer actually
acquires the seller’s securities in the hope of marketing them at a more favourable price.
Dealers take a position of risk because by purchasing securities outright for their own
portfolios, they are subject to risk of loss if those securities decline in value.

iii. Indirect Finance/Financial Intermediation

The limitations of both direct and semi direct finance stimulated the development of indirect
finance carried out with the help of financial intermediaries. The process of indirect finance
using financial intermediaries (institutions), called financial intermediation, is the primary route
for channelling funds from lenders to borrowers, (see figure 1.1 above)
Financial intermediaries issue securities of their own or buy securities issued by corporations and
then sell those securities to investors.
Examples of such securities include: checking and saving accounts, health, life and accident
insurance policies, retirement plan and shares in mutual fund.
1) They generally carry low risk of default
2) The majority can be acquired in small denominations
3) They are liquid (for most) and can be easily converted into cash with little risk of
significant loss for the purchaser.

1.1.2. Financial Intermediaries /Institutions

The principal financial institutions /intermediaries fall in to three categories; depository
institutions (banks), contractual and savings institutions, and investment institutions
i. Depository institutions (banks)
These are financial institutions that accept deposit from individuals and institutions and makes
loans. They include commercial banks and thrift institutions (savings and loan associations,
mutual savings banks, and credit unions.)
ii. Contractual savings institutions
These are financial institution such as insurance companies and pension funds, which acquire
funds at periodic intervals on contractual basis
Since they can predict with reasonable accuracy how much they will have to pay out in benefits
in the coming years, they don’t have to worry as much as depository institutions about losing
funds.
iii. Investment intermediaries

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These are financial institutions which sale shares to individuals and use these funds to invest n a
pool of assets. Example: mutual funds, investment banks, money market mutual funds etc.

1.1.3. Why are Financial Intermediaries and Indirect Finance so Important in

Financial System?

As shown in figure 1.1. Funds also can move from lenders to borrowers by a second route called
indirect finance because it involves a financial intermediary that stands between the lender-
savers and the borrower-spenders and helps transfer funds from one to the other. A financial
intermediary does this by borrowing funds from the lender-savers and then using these funds to
make loans to borrowerspenders.

The process of indirect finance using financial intermediaries, called financial intermediation, is
the primary route for moving funds from lenders to borrowers. Why are financial intermediaries
and indirect finance so important in financial markets? To answer this question, we need to
understand the role of transaction costs, risk sharing, and information costs in financial
markets.

i. Transaction cost
The time and money spent in carrying out financial transactions are a major problem for people
who have excess funds to lend. Financial intermediaries can substantially reduce transaction
costs because they have developed expertise in lowering them and because their large size allows
them to take advantage of economies of scale, the reduction in transaction costs per dollar of
transactions as the size (scale) of transactions increases. For example, a bank knows how to find
a good lawyer to produce an airtight loan contract, and this contract can be used over and over
again in its loan transactions, thus lowering the legal cost per transaction. Because financial
intermediaries are able to reduce transaction costs substantially, they make it possible for you to
provide funds indirectly to people with productive investment opportunities.
In addition, a financial intermediary’s low transaction costs mean that it can provide its
customers with liquidity services, services that make it easier for customers to conduct
transactions. For example, banks provide depositors with checking accounts that enable them to

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pay their bills easily. In addition, depositors can earn interest on checking and savings accounts
and yet still convert them into goods and services whenever necessary.

ii. Risk Sharing

Another benefit made possible by the low transaction costs of financial institutions is that they
can help reduce the exposure of investors to risk that is, uncertainty about the returns investors
will earn on assets. Financial intermediaries do this through the process known as risk sharing
They create and sell assets with risk characteristics that people are comfortable with, and the
intermediaries then use the funds they acquire by selling these assets to purchase other assets that
may have far more risk. Low transaction costs allow financial intermediaries to share risk at low
cost, enabling them to earn a profit on the spread between the returns they earn on risky assets
and the payments they make on the assets they have sold. This process of risk sharing is also
sometimes referred to as asset transformation because, in a sense, risky assets are turned into
safer assets for investors. Financial intermediaries also promote risk sharing by helping
individuals to diversify and thereby lower the amount of risk to which they are exposed.
Diversification entails investing in a collection (portfolio) of assets whose returns do not always
move together; with the result that overall risk is lower than for individual assets.
(Diversification is just another name for the old adage, “don’t put all your eggs in one basket.”)
Low transaction costs allow financial intermediaries to do this by pooling a collection of assets
into a new asset and then selling it to individuals.
iii. Asymmetric Information
If one party often doesn’t know enough about the other party to make accurate decisions, we call
there is asymmetric information. It creates two major problems; adverse selection and moral
hazard.
a) Adverse selection ; this is the problem created by asymmetric information before the
transaction occurs .Due to lack of information parties who are most likely to produce an
undesirable (adverse) outcome may be selected , who are unlikely to pay back the
loan .This leads to credit risk or risk of default.

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b) Moral hazard ;this problem is created by asymmetric information after the transaction
occurs .This means after taking the loan ,the borrower might engage in activities that are
undesirable or immoral. This makes again the probability of the loan to be paid back less.
The problems created by adverse selection and moral hazard can be minimized by financial
intermediaries. They can screen out good from bad credit risk thereby reduce losses due to
adverse selection. They develop experts in monitoring and evaluating the parties they lend to,
thus reduce risks associated with moral hazard.
 Techniques to Solve the Problem of Adverse Selection
a) Private production and sale of information
The solution to the adverse selection problem in financial market is to eliminate asymmetric
information by furnishing people funds with details about the individuals or firms seeking to
finance their investment activities .One way to get this material to saver- lender is to have private
companies which collect and produce information, distinguishes good from bad credit risk and
sell it to purchasers of securities. The problem in such tool is ‘’free rider problem ‘’, this occurs
when people who don’t have paid for takes advantage of information that other people have paid.
This discourages the private production and sale of information.
b) Government regulation
Government could produce information to help investors distinguish good from bad firms and
provides it to the public free of charge. This solution, however, would involve
In releasing negative information about firms, a practice might be politically difficult.
The second possibility to regulate financial markets is that government can enforce;
 To adhere to standard accounting principle
 To disclose information about their sales, assets, and earnings.
c) Financial intermediaries
Financial intermediaries such as banks become an expert on the production of information about
firms so that it can sort out good credit risk from bad ones then it can acquire funds from
depositors and lend to potential investors.
d) Collateral and net worth
Property promised to the lender if the borrower defaults reduces the consequences of adverse
selection because it reduces the lenders losses in the event of loss. In case of default the lender
can sell the collateral.

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The firm’s asset and liability can perform a similar role as collateral. If a firm has high net worth,
even if it engages in investments that it to have negative [profit and defaults on its debt
payments, the can take title to the firms net worth and sell it off. In addition, the more net worth
a firm has, the less likely it is to default.

 Techniques Used to Solve the Problem of Moral Hazard

The following are the major tools in solving the problems associated with moral hazard
a) Production of information and monitoring
The creditor can be engage in particular type of information production; monitoring the firm’s
activities , auditing the firm frequently and checking on what the firm is generally doing.
b) Government regulations to increase information
Government can also minimize moral hazard problems by forcing firms to adhere to standard
accounting principles.. They also pass laws to impose criminal penalties on people who commit
the immoral or undesirable acts.
c) Net worth
When the borrower’s net worth is higher, the risk of moral hazard will be greatly reduced
because the borrowers themselves have a lot to lose. The greater the borrowers net worth, the
greater the borrowers incentive to behave in such away that the lender expects and desires
d) Monitoring and enforcement of restrictive covenants
A lender can insure that the borrower uses the money for the purpose intended by writing
provisions (restrictive covenants) into the debt contract that restrict the firm’s activities.
Restrictive covenants can encourage the borrowers to engage in desirable activities that makes
the more likely to be paid back. It also requires a borrowing firm to provide information about its
activity periodically in the form of reports.
e) Financial intermediation
As we have seen before the intermediaries making private loans receive the benefits of
monitoring and enforcement will work to shrink the moral hazard problems in debt contracts.
And the concept of moral hazard has provided us additional reason why financial intermediaries
play a more important role in channelling funds from saver to borrower than marketable
securities do.

1.2. Role of Financial Assets and Its Properties

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Assets can be classified as tangible or intangible. A tangible e asset is one whose value depends
on particular physical properties—examples are buildings, land, or machinery. Intangible assets,
by contrast, represent legal claims to some future benefit. Their value bears no relation to the
form, physical or otherwise, in which these claims are recorded.

Financial Assets are different from real or physical assets. Physical asset markets (also called
“tangible” or “real” asset markets) are those for products such as wheat, coffee, real estate,
computers, and machinery. Financial asset markets, on the other hand, deal with stocks, bonds,
notes, mortgages, and other claims on real assets, as well as with derivative securities whose
values are derived from changes in the prices of other assets. Buying share of any
Bank/insurance is a “pure financial asset,” while an option contract to buy this share after
three/six month is an example for derivative security whose value depends on the price of shares
in stock markets.

Therefore, the financial assets are the representations of real assets and they don’t have physical
usefulness. They only represent values of an underlying asset. Hence, essentially, stocks and
bonds are pieces of papers that represent values and claims. They are commonly called financial
instruments, like Common Shares; Preference Shares; Government Bonds; Corporate Bonds; etc.
The financial assets can be grouped into two main categories such as debt instruments and equity
instruments. The various debt instruments being used for financial transactions in financial
market includes treasury bill, commercial papers, bonds, debentures , certificate deposit etc. and
the equity instruments/claims includes shares preferred stock/share, common stock and
convertible bond.

i) Role of Financial Asset

Financial assets have two principal economic functions. The first is to transfer funds from
those who have surplus funds to invest to those who need funds to invest in tangible assets.
The second economic function is to transfer funds in such a way as to redistribute the
unavoidable risk associated with the cash flow generated by tangible assets among those
seeking and those providing the funds. However, as we will see, the claims held by the final
wealth holders are generally different from the liabilities issued by the final demanders’ of

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funds because of the activity of financial intermediaries that seek to transform the final
liabilities into the financial assets that the public prefers.
ii) Characterstics/Properties of Financial Asset
Financial assets have certain properties/characteristics which help to determine the intention of
investors on financial assets being traded in financial market. Some of these are:
a) Moneyness-some of the financial assets are used as a medium of exchange to settle
transactions and they termed /serve as money. This characteristic is a clearly desirable one
for investors in the market.
b) Divisibility and denomination-divisibility relates to the minimum size in which a financial
asset can be liquidated and exchanged for money. The smaller the size, the more the
financial asset is divisible. Financial assets have varying degree of divisibility depending
on their denomination.
c) Reversibility- is the cost of investing in financial securities and then getting out of it and
back in to cash again. This property also called round trip cost. eg: deposits at bank
d) Term to maturity-is the length of the interval until the date when the instrument is
scheduled to make its final payment, or the owner is entitled to demand liquidation.
e) Liquidity; it is the degree in which financial assets can easily be liquidated (sold) withouta
loss in value. For this term most scholars argued that there is no uniformly accepted
definition, but according to Professor James Tobin liquidity is defined in terms of “How
much sellers stand to lose if they wish to sell immediately as against engaging in a costly
and time-consuming search”. Any financial asset which takes more time to convert in to
cash is termed as illiquid asset. E.g.: Pension funds. Whereas the less the time taken to
convert in to cash is a liquid one. e.g.: Deposits in banks.
f) Convertibility; is the ability of the financial assets to be convertible in to other financial
assets. E.g. A corporate convertible bond is a bond that the bond holder can change in to
equity shares.
g) Currency: Most financial assets are denominated in one currency, such as US dollar or
Yen, and investors must choose them with that feature in mind.
h) Cash flow and return predictability: Are turn that an investor will realize by holding a
financial asset depends on the cash flow that is expected to be received. This includes
dividend payments on stocks and interest payments on debt instruments.

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i) Complexity; some financial assets are complex in the sense that they are actually
combinations of two or more simpler assets. To find the true value of such an asset, one
must decompose it in to its component parts and price each component separately.
j) Tax status:- The returns on various financial assets are subject to tax status because they
are taxable earnings. The tax authorities are interested in collection of taxes on earnings
from financial assets as securities which are regarded as incomes for investors. However,
the tax status on financial assets varies from one economy to another. The rate of such
taxes on financial assets is also subject to variation from time to time depending on the
interest of the government which must be adhered to by the tax authorities. The tax status
on financial assets also differs from one type of security to another depending on the nature
of the issuing companies or institutions such as Federal, State, or local government. For
instance, tax on treasury bills is zero in Ethiopia while it is 10% on dividend from share
companies.
1.3. Roles of Financial Markets, Classifications and Participants

Financial markets are places or circumstances that permit and facilitate the trade of financial
assets. The stock exchanges, the bond markets are good examples of financial markets. It is a
market in which funds are transferred or mobilized from people (transfer units) having an excess
of available funds to those people (deficit) units with a shortage of funds to invest. As a market
for financial claims, the main actors are households, business (including financial institutions),
and government units that purchase/sell financial asset. In short those participants are broadly
categorized in to surplus and deficit units. Financial markets provide quite a lot of benefits who
come and transact assets. They will get funds if they need any provided they fulfil what is
required of them. They offload excess funds on to profitable opportunities. Financial markets
contribute a lot to the development of countries’ economies. The various debt instruments being
used for financial transactions in financial market includes treasury bill, commercial papers,
bonds, debentures , certificate deposit etc. and the equity instruments/claims includes shares
preferred stock/share, common stock and convertible bond.
i) Role of Financial Markets in Financial System
We have defined a financial market as a market for creation and exchange of financial assets. If
you buy or sell financial assets, you will participate in financial markets in some way or the

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other. Financial markets play a pivotal role in allocating resources in an economy by performing
three important functions:
a) Financial markets facilitate price discovery the continual interaction among numerous buyers
and sellers who use financial markets helps in establishing the prices of financial assets. Well
organized financial markets seem to be remarkably efficient in price discovery. That is why
financial economists say” if you want to know what the value of a financial asset is, simply
look at its price in the financial market”.
b) Financial markets provide liquidity to financial assets. Investors can readily sell their
financial assets through the mechanism of financial markets. In the absence of financial
markets which provide such liquidity, the motivation of investors to hold financial assets will
be considerably diminished. Thanks to transferability and negotiability of securities through
the financial markets, it is possible for companies and other entities to raise long term funds
from investors with short term and medium term horizons. While one investor is substituted
by another when a security is transacted, the company is assured of long term availability of
funds.
c) Financial markets considerably reduce transaction costs. The two major costs associated
with transacting are search costs and information costs. Search costs comprise of explicit
costs such as the expenses incurred on advertising when one wants to buy or sell an asset and
implicit costs such as the effort and time one has to put to locate a customer. Information
costs refer to costs incurred in evaluating the investment merits of financial assets.

Besides, in line to the above functions the market can help participants to facilitate:
 the raising of capital/fund (in the capital market)
 international trade (currency /foreign exchange market)
 transfer of risks (in the derivative market)

ii) Classification of Financial Markets

Financial markets are classified under different bases to trade financial assets:
1. Based on Nature of Claim
a) Equity market-is the financial market for residual claims (equity instruments). Example
stock market.

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b) Debt market–the financial market for fixed claims (debt instruments). It is a market in
which securities that require the issuer (the borrower) to pay the holder (the lender)
certain fixed dollar amounts at regularly scheduled intervals until specified time (the
maturity date) is reached, regardless of the success or failure of any investment projects
for which the borrowed funds are used are going to be traded.
2. Based on Seasoning of Claim /issuance of financial asset
a) Primary market-is a market in which newly issued securities are traded.
b) Secondary market-is a market in which previously issued/second hand securities are
traded. Also called after market
3. Based on maturity/term of claims
a) Money market-a market with shortly matured(less than a year) financial securities are
being traded.
b) Capital market- a market with long period matured(greater than a year) financial
securities are being traded.
4. Timing of Delivery
a) Spot/cash market: the market where the delivery occurs immediately the transaction
occurs
b) Derivative market; is the market where the delivery occurs at a pre determined time in
the future.
5. Based on organizational structure
a) Organized exchange market (auction)-is an organized and regulated financial market
where securities are bought and sold at a price governed by demand and supply forces.

It is a market where buyers and sellers of securities (or their agents or brokers) meet in
one central location to conduct trades. Example New York and American stock exchange
b) Over the counter market (OTC) –is a market made through brokers or dealers called
market makers using a negotiation over telephone or computer based networking system.
iii) Participants of Financial Markets

Modern financial markets are characterized by the involvement of a variety of participants with a
wide range of motivations. These include individuals, commercial and investment banks,
financial institutions, investment companies, insurance and pension funds, businesses,
multinationals, local and central government, and international institutions such as the European
Investment Bank (EIB) and the World Bank, Treasuries and central banks. There are also brokers
who act on behalf of a third party and regulators who seek to ensure the smooth functioning of
market activity. The relative importance of the various market participants can vary greatly from
one financial centre to another; over the years, however, there has been a pronounced increase in
the relative importance of institutional investors, a process known as the institutionalization of

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financial markets. Institutional investors, because they buy and sell large volumes of securities,
require a high degree of liquidity so that their trades do not adversely affect the share prices they
deal in.

A broker acts as an intermediary on behalf of investors wishing to conduct a trade; the broker is
the legal agent of the investors. In return for executing a client's instructions, a broker obtains a
commission for his services. Many brokers offer additional services such as investment advice,
research, custody and other services. A market-maker acts as a dealer in a financial security,
quoting both a price at which he is willing to buy a security (the bid price) and a higher price at
which he is willing to sell the security (the ask price). The difference, or spread, between the bid-
ask prices represents a profit margin. Market-makers provide liquidity for the market, a set of
prices for investors and reliable price information.

Arbitrageurs, hedgers and speculators in any financial market there are generally three
different and important participants distinguished by their motivation for trading in the market.

Arbitrageurs Arbitrage has a very specific meaning within the context of financial markets; it is
the process of exploiting price anomaly in order to make riskless guaranteed profits. Arbitrageurs
are economic agents that buy and sell financial securities to make such profits. For example, if
asset A trades at a higher price on market 1 than on market 2, then arbitrageurs will buy the asset
in market 2 at the cheap price and immediately sell it in market 1 at the higher price. The very
act of arbitrage has the effect of lowering the price of asset A in market 1 and raising the price in
market 2, until the price differential and arbitrage opportunity is eliminated. The very fact that
there is a riskless guaranteed profit to be made means that arbitrage opportunities are relatively
rare in today's financial markets. Even when they exist, they usually do so only for a very short
space of time.

Hedgers Hedging is the process of buying or selling a financial asset in order to reduce or
eliminate an existing risk. A hedger is a participant in financial markets who seeks to reduce or
limit some risk by engaging in the purchase or sale of a financial security. Speculators
Speculation is the process of taking on risk in the hope of making a profit.

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A speculator is a participant in financial markets that assumes a risky or 'open' position in

financial securities in the hope of making a profit. For example, if a speculator thinks security A
is underpriced and likely to go up in price, he will purchase the security today and if the security
goes up in price as he expects he will be rewarded with a profit. However, speculation is a risky
business and security A may actually fall in price in which case the speculator will have to 'close'
his position at a loss.

1.4. Lending and Borrowing in the Financial System

Finance means any activity that involves borrowing, lending, or sharing risks. Let’s look at what
happens in a financial market. In a financial market, we have borrowers meeting lenders.
Borrowers are any agents who have investment opportunities, but who lack the cash to get those
projects started. For instance, businesses might have an opportunity to make a profit if they could
only borrow the money and build a factory. The government has the opportunity to build roads
and bridges, but it is going to need to borrow the money to get those projects done. And finally,
homeowners; that is, people who would like to buy a house and live in it, would be happy to do
the transaction, but they are going to have to borrow money in the form of a mortgage before
they can get their house off of the ground. So borrowers are people who have projects, ideas, but
don’t have cash on hand to pull them off.

Lenders on the other hand are people who have surplus cash and are looking for an opportunity
to earn interest. They are looking for an opportunity to earn a rate of return on their money, but
they don’t have projects that they would like to do themselves. Therefore, getting lenders and
borrowers together is an opportunity to make the economic pie bigger, and once these projects
are underway, the borrowers can share their profits with the lenders. That is what happens in a
financial market.

Let’s look at the flow of funds in a financial market. What happens in this financial market is
that lenders send cash to borrowers, so that they can purchase plant, equipment, houses, road
crews, and things like that, to create the assets out of which profits are made. In return, the
borrowers give the lenders an IOU. Now this term, IOU is not an acronym that stands for

Ch-1:-An overview of Financial System 16

 Financial Markets and Institutions

anything, it’s a rebus, and it’s a word picture, IOU money. And an IOU is a financial security, or
a financial instrument. That is, it’s a contract that explains what the lender is entitled to, at what
date in the future, under what circumstances. That is, it tells the world and the lender what
money to expect in the future as a result of this deal that the lender and the borrower have made.
Now there are all different kinds of IOU’s. There are bonds, which are debt contracts that entitle
the lender to a fixed interest payment in the future. And, that is the way that most other loans
work too, even if it is not a bond, the loan entitles you to a fixed interest payment if it is a debt
instrument. There are also particular kinds of loans called treasury bills that are issued by the
United States Government. These are short -term instruments that the government uses to finance
its debt, and they entitle the lender to an interest payment within a year. There are also stock
instruments, and stock or equity contracts entitle the lender to a share of the profits of this
business venture at some date in the future (usually paid in the form of dividends).

Now, the borrower and the lender can get together directly, in which case they are engaging in a
transaction we call direct finance. That is what would happen if you bought a share of IBM stock
directly yourself, from a broker; or if you lent your sister money so that she could buy a car. That
is direct finance, where the borrower and lender deal with one another directly, face to face; or
through a broker. However, rather than going into the world of direct finance, you may want to
reduce your search cost. That is, you may not want to spend time going out and looking for
someone with a good project, plus there are risks involved, if you don’t want to put all of your
eggs in one basket. On top of that you are going to have to draw up a contract, and monitor
compliance and all of that is going to involve a lot of transactions effort that you may want to
spare yourself. Therefore, you are going to go through what is called a financial intermediary.
And that is an agent in the economy that specializes in bringing lenders and borrowers together.

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Ch-1:-An overview of Financial System 17