CHAPTER ONE

AN OVERVIEW OF FINANCIAL SYSTEM

Learning Objectives:
After completing this chapter, you will be able to:
 Define financial system.
 Distinguish the components of financial system;
 Explain the direct and indirect financing mechanism;
 Identify the properties of financial assets
 Lending and borrowing in the financial system
 Describe the role of financial Market

The financial system of an economy provides the means to collect money from the people who have it
and distribute it to those who can use it best. Hence, the efficient allocation of economic resources is
achieved by a financial system that allocates money to those people and for those purposes that will
yield the greatest return. Financial system is a system that aims at establishing and providing a regular,
smooth, effective and efficient linkage between depositors and investors. Therefore, financial system
is the collection of markets, individuals, laws, polices, conventions, techniques and institutions
through which bonds, stocks, and other securities are traded, interest rates are determined and financial
services are provided and delivered. The word “system” in the term “financial system” implies a set
(group) of complex and closely connected or intermixed institutions, agents, practices, markets,
transactions, claims, and liabilities within an economy.

1.1 Basic Components of Financial System

A financial system refers to a system which enables the transfer of money between investors and
borrowers. Financial system has five basic components. They are:
 Financial Institutions
 Financial Markets
 Financial Instruments (Assets or Securities)
 Financial Services

Financial Instruments

Financial Institutions Financial Services

Components of
Financial System

Financial Markets Money

Figure 1: Five Basic Components of Financial System

1. Financial Institutions
Financial institutions facilitate smooth working of the financial system by making investors and
borrowers meet. They mobilize the savings of investors indirectly via financial markets, by making
use of different financial instruments as well as in the process using the services of numerous financial

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services providers. They offer services to organizations looking for advises on different problems
including restructuring to diversification strategies. They offer complete array of services to the
organizations who want to raise funds from the markets and take care of financial assets for example
deposits, securities, loans, etc.

2. Financial Markets
A financial market is the place where financial assets are created or transferred. It can be broadly
categorized into money markets and capital markets. Money market handles short-term financial
assets (less than a year) whereas capital markets take care of those financial assets that have maturity
period of more than a year. The key functions are:
 Assist in creation and allocation of credit and liquidity.
 Serve as intermediaries for mobilization of savings.
 Help achieve balanced economic growth.
 Offer financial convenience.
One more classification is possible: primary markets and secondary markets. A primary market
handles new issue of securities in contrast secondary markets take care of securities that are presently
available in the stock market. Financial markets catch the attention of investors and make it possible
for companies to finance their operations and attain growth. Money markets make it possible for
businesses to gain access to funds on a short term basis, while capital markets allow businesses to gain
long-term funding to aid expansion. Without financial markets, borrowers would have problems
finding lenders. Intermediaries like banks assist in this procedure. Banks take deposits from investors
and lend money from this pool of deposited money to people who need loan. Banks commonly
provide money in the form of loans.
3. Financial Instruments
This is an important component of financial system. The products which are traded in a financial
market are financial assets, securities or other type of financial instruments. There is a wide range of
securities in the markets since the needs of investors and credit seekers are different. They indicate a
claim on the settlement of principal down the road or payment of a regular amount by means of
interest or dividend. Equity shares, debentures, bonds, etc., are some examples.
4. Financial Services
Financial services consist of services provided by Asset Management and Liability Management
Companies. They help to get the necessary funds and also make sure that they are efficiently deployed.
They assist to determine the financing combination and extend their professional services up to the
stage of servicing of lenders. They help with borrowing, selling and purchasing securities, lending and
investing, making and allowing payments and settlements and taking care of risk exposures in
financial markets. These range from the leasing companies, mutual fund houses, merchant bankers,
portfolio managers, bill discounting and acceptance houses. The financial services sector offers a
number of professional services like credit rating, venture capital financing, mutual funds, merchant
banking, depository services, book building, etc. Financial institutions and financial markets help in
the working of the financial system by means of financial instruments. To be able to carry out the jobs
given, they need several services of financial nature. Therefore, financial services are considered as
the 4th major component of the financial system.
5. Money
Money is understood to be anything that is accepted for payment of products and services or for the
repayment of debt. It is a medium of exchange and acts as a store of value.

The Role of the Financial System in the Economy

Therefore, whether simple or complex, all financial systems perform at least one basic function. They
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move scarce funds from those who save and lend (surplus-budget units) to those who wish to borrow
and invest (deficit-budget units). The following are some roles played by financial system to enhance
the economic growth of a country.
Facilitate the flow of funds from the savers to the investors: The first goal is to facilitate the flow of
funds from the savers (those entities having a surplus of funds) to the investors (those entities with a
deficit of funds). 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. Most financial systems have evolved
gradually from direct finance toward indirect finance. Let see them one by one as follows:
A) 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. That means the investors sell their
shares of stock or others directly to the general public in an Initial Public offerings (IPO).

Direct Finance

Borrower or Spenders Saver or Lenders

Funds
(Deficit budget units) (Surplus budget units)

Primary securities (stocks, bonds,

notes,

Primary Secondary
Securities securities
Financial
intermediarie
s
Loanable funds Loanable funds

Indirect Finance
Figure 2: the flow of funds in the financial system (direct and indirect finance)
The principal lenders or 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- 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 this 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
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 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.

B) 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-Spenders Primary Saver-Lenders

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

Figure 3: the flow of funds in the financial

system (semi-direct finance)

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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 is 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. Dealer is also an individual or institution that 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 favorable 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.
C) Indirect Finance: 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 channeling funds from lenders to borrowers, (see figure 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. Allowing economic agents to share risks:

There are many risks that have very costs but low likelihood of occurring such as natural disasters, early
death, failure of a business and others. Risk averse (opposing something strongly) peoples prefer to
share these risks rather than bear them alone. The risk management function in the financial system is
exercised in different ways which is the most common on the insurance industries.

2. To generate liquidity:
There are two notions of liquidity concepts. These are:
a. The market liquidity of an asset (real or financial assets): It is the ease with which it may be
traded.
b. The funding liquidity: is the ability of an entity to come-up with cash on a short notice. For example,
firms holding cash on its balance sheet or a person/individual with cash in its wallet has a high degree of
funding liquidity.

1.2 Financial Assets

Asset is any possession that has value in an exchange. Assets are commonly known as anything with a
value that represent economic resources or ownership that can be converted into something of value
such as cash. Asset classified in to three as tangible, intangible and financial assets.
A. Tangible Assets (Physical Assets or Real Assets): Physical assets have a physical characteristics
or location such as buildings, equipment, inventories etc. Physical assets are tangible assets and
can be seen and touched, with a very identifiable physical presence. The value of tangible asset
depends on particular physical properties, example: buildings. That means their physical condition
is relevant for the determination of market value. Physical assets provide continuous stream of

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 services. Physical assets wear out or subject to depreciation. They usually experience a reduction
in value due to wear and tear of the asset through continuous use known as depreciation, or may
lose their value in becoming obsolete, or too old for use. Certain tangible assets are also
perishable, such as a container of apples, or flowers that need to be sold soon in order to ensure
that they do not perish and lose their value.
B. Intangible assets: Intangible asset represents legal claims to some future benefit. Their value bears
no relation to the form, physical or otherwise in which the claims are recorded. Example, good
will, patents, copyrights, royalties, etc.
C. Financial Assets: Financial assets represent a financial claim with a right to some cash. They
represent a claim against the income or wealth of a business firm, household, or unit of
government represented usually by a certificate of receipt or other legal document and usually
created by the lending of money (credit transactions). Simply, it is a claim on the issuer’s future
income or assets. Therefore, financial assets are intangible, meaning that they cannot be seen or
felt and may not have a physical presence except for the existence of a document that represents
the ownership interest held in the asset. It is important to note that the papers and certificates that
represent these financial assets do not have any intrinsic value (the paper held is only a document
certifying ownership and is of no value). The paper derives its value from the value of the asset
that is represented.

The Role of Financial Asset in the Financial System

Financial assets play a vital role in the economic performance of financial institutions and they have
two principal economic functions:
A) Mobilizing/transferring funds from those who have surplus of funds to deficit units who need to
invest in financial assets.
B) Redistributing unavoidable risk associated with the cash flow generated by tangible assets.
Properties of Financial Assets
Financial assets have certain properties which help to determine the intention of investors on financial
assets being traded in financial market. These specific properties distinguish them from physical and
intangible assets. Some of them are:
a) Money ness: 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. It is the characteristic of an asset to be bought and
sold in small portions or fractions. Financial assets are easily divisible compared to physical assets
which are sold or bought in whole quantities. 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. Example, deposits at bank. A firm can deposit
currency in a bank and accept a deposit certificate that can be used to earn a rate of return. When
the need for currency arises, the bank deposit can be withdrawn in the form of currency again and
used as an exchange instrument to buy any other type of asset through which productive activity
can be carried on.
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) without a loss in

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 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.
Example, pension funds. Whereas the less the time taken to convert in to cash is a liquid one.
Example, Deposits in banks.
f) Convertibility: is the ability of the financial assets to be convertible in to other financial assets.
Example, 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.
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.
Tax status: Investors are more concerned with income after taxes than before taxes of financial assets.
All other properties of financial assets remain the same; taxable securities would have to offer a higher
before tax yields to investors than tax exempt securities to be preferred. But, investors with in high
tax brackets benefit most from tax-exempt securities.
The yield/income after tax can be determined using the following formula: Yat = Ybt(1-T) where: Yat-
yield after tax, Ybt-yield before tax and T -Tax rate
Generally, the yield after tax depends on the existing Tax rates.

Financial Markets
Financial Market is a market in which financial assets (securities) such as stocks and bonds can be
bought and sold. Or it is a market in which funds are transferred or mobilized from people (surplus
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.
The Role of Financial Markets in the 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 other.
Financial markets play a pivotal role in allocating resources in an economy by performing following
important functions: Financial markets
 Facilitate price discovery,
 Provide liquidity to financial assets.
 Financial markets transfer risks:
Lending and Borrowing in the Financial System
Business firms, households and governments play a wide variety of roles in modern financial system. It is
quite common for an individual/institution to be a lender of funds in one period and a borrower in the other,
or to do both simultaneously. Indeed financial intermediaries, such as banks and insurance agencies operate
on both sides of the financial market; borrowing funds from customers by issuing attractive financial claims

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and simultaneously making loan available to other customers. Economists John Gurley and Edward Shaw
(1960) point out that each business firm, household or a governmental unit active in the financial system
must conform to the following identity:

R-E= ΔFA - ΔD
(Current income receipts – Expenditures out of current income) = (Change in holdings of financial
assets - change in debt and equity outstanding)
If current expenditure (E) exceeds current income receipts (R), the difference will be made up
by:-
1) Reducing our holdings of financial assets (-ΔFA), for example by drawing money out of a saving
account
2) Issuing debt or stock (+ΔD) or
3) Using some combination of both
On the other hand, if current income receipts (R) in the current period are larger than current
expenditure (E),
1) Build up our holdings of financial assets (+ΔFA) for example, by placing money in a saving
account or buying a few shares of stock
2) Pay off some outstanding debt or retire stock previously issued by the business firm(-ΔD) or
3) Do some combination of both of these steps
It follows that for any given period of time (Example, day, week, month or year), the individual
economic unit must fall in to one of the following three groups.
Deficit Budget Unit (DBU) = net borrower of funds: E>R; and so ΔD>ΔFA
Surplus Budget Unit (SBU) = net lender of funds: E<R; and so ΔD<ΔFA
Balanced Budget Unit (BBU) = neither net borrower nor net lender: E=R; and so ΔD=ΔFA

A net lender of funds (SBU) is really a net supplier of funds to the financial system. He/she
accomplish this function by purchasing financial assets, pay off debts or retiring equity (stock). In contrast a
net borrower of funds (DBU) is a net demander of funds from the financial system; selling financial assets,
issuing new debts or selling new stocks. The business and the government sectors of the economy tend to be
net borrowers (demanders) of funds (DBU); the household sector, composed of all families and individuals,
tend to be a net lender (supplier) of funds (SBU).

QUICK CHECK
1. Explain the financial system, its components and role in an economy
2. Discuss the types of financial institution?
3. List and discuss the types of financial institutions.