CHAPTER – ONE

AN OVERVIEW OF FINANCIAL SYSTEM

1.1. An overview of the Financial System

Financial system is a system that aims at establishing and providing a regular, smooth,
effective and efficient linkage between depositors and investors. In other words we may define
financial system as: A set of complex and closely connected instructions, agents, practices,
markets, transactions, claims, and liabilities relating to financial aspects of an economy.
The financial sector plays a vital role in the economy because it helps money be efficiently
channeled from savers to prospective borrowers, making it much easier for firms to obtain
financing for profitable investment in new capital and for individuals to borrow against their
future income (e.g. to buy a house or car). Had it not been the existence of financial markets
and financial institutions, major components of the financial system, borrowers would have to
borrow directly from savers. Probably not much borrowing would take place at all, as most
would-be borrowers would tend to have a hard time finding individuals able and willing to
loan them. Without much borrowing or corporate finance, the economy would surely be a lot
less developed, as few businesses would be able to raises funds to invest in new plant and
equipment.
1.1.1. Features of Financial System
 Financial system provides an ideal linkage between depositors and investors. It
encourages savings and investment.
 Financial system facilitates expansion of financial markets over space and time.
 Financial system promotes efficient allocation of financial resources for socially
desirable and economically productive purposes.
 Financial system influences both the quality and the pace of economic development

1.1.2 Goals of Financial system

A. The first goal of financial system is to facilitate the flow of funds from saver to
investor
The first goal of the financial system (FS) is to facilitate the flow of funds from savers (entities
with a surplus of funds) to investors (entities with a deficit of funds). A financial systems
channels fund from the segment/s of the economy where there excess resources to where the
fund is really required to financing various corporate and personal investments in two different
forms.

1. Direct Financing
When an agent uses direct finance, funds are provided to the investors directly, without the use
of an intermediary. This means that investors sometimes sell shares of stock directly to the
public in an initial public offer (IPO). For example the recent phenomenon in our country
demonstrates that companies are offering share to the general public to establish a giant sugar,
cement and other factories that require a huge amount of money.

2. Indirect Financing
Most of the time in countries where the financial system is dominated by financial institutions
or the development of the financial markets is at a lower level, it is hardly possible to investor
to obtain fund directly from savers, in this case the financial system facilitate the flow through
financial intermediaries. A financial intermediary is a firm like a bank that pools the savings of
many economic agents (house hold, government) and then passes those funds through to
agents (borrowers/investors) that want to invest them.
The intermediary in this case is the middleman, not the ultimate source of funds.

B. The second goal of the Financial System is to allow economic agents to share risks.
There are many risks that have very high costs but low likelihood of occurring such as natural
disasters, early death, failure of a business, and others. Risk averse people prefer to share these
risks rather than bear them alone. The risk management function in the financial system is
exercised in different ways the most common on is the insurance industries.

C. The third main goal of the FS is to generate liquidity

There are two notions of liquidity concepts. The first is the market liquidity of an asset (real
or financial) is the ease with which it may be traded. Here are the key characteristics of liquid
assets:
• Standardized
• Value is well understood by all
• Many potential buyers and sellers
The financial system enhances market liquidity of financial assets by standardizing them in the
form of standardized instrument in which potential buyers and sellers can easily traded on it
using adequate information supplied by the financial system. In a developed financial system
Intermediaries such as brokers and dealers enhance market liquidity

The second notion of liquidity, funding liquidity, is the ability of an entity to come up with
cash on short notice. For example, firm holding cash on its balance sheet, or a person with
cash in their wallet, has a high degree of funding liquidity.

Firms and households need funding liquidity to have the option to make investments on short
notice. The financial system supplies this liquidity with currency (government supplied),
demand deposits (supplied by banks) & lines of credit (also mainly supplied by banks).

1.1.3 Components of Financial System

(A) Financial Institutions: it includes regulators, intermediaries, non-intermediaries and others
(B) Financial instruments: monetary claims like stocks, bonds, and loans
(C) Financial Markets: where those instruments are bought and
sold

Each of the components will have a detail discussion on the subsequent parts of this chapter
and other parts of the module.
1.1.4. Functions of Financial System
A well-developed financial system can have the following functions:
1. Clearing and Settling Payments:
To "finance" something means to pay for it. Payment is usually effected using either money or
credit. A financial system provides ways of clearing and settling payments to facilitate the
exchange of goods, services, and assets. For example: Depository institutions (banks) have
ways of clearing payments like ATM, Credit/ Cash cards.
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.

 The optimal economic scale for production of goods and services is much larger than an
individual, family, or even a village total savings.
 A mutual fund provides full divisibility of securities it holds.
 Securitization is an efficient vehicle for pooling non-traded securities and subdividing by
selling claims on the pool on the market (e.g., asset backed securities).
3. Transferring Resources across Time and Space:
A financial system provides ways to transfer economic resources through time, across
geographic region and, among industries.
 Efficient life-cycle allocations of household consumption.
 Efficient separation of ownership from management
 Connecting capital and ideas
 Makes efficient specialization in production feasibility according to principle of
comparative advantage.
 Efficient separation of investment and financing horizons (maturity)
 Short-term deposits used to finance long-term lending
 Roll over loans for financing infinite projects (e.g. going concern firms)
4. Managing Risks:
A financial system provides ways to manage uncertainty and control risk
 Facilitate the efficient allocation of risk-bearing by creating mechanisms for both
diversification (pooling) and unbundling (and selling) of risks
 Allows separation of providers of real investments (Personnel, plant, equipment) from
providers of risk capital who bears the financial risk of those investments.
5. Providing Information:
A financial system provides price information that helps co-ordinate decentralized decision-
making in various sectors of the economy.
 The invisible hand of the market economy relies totally on prices reflecting the individual
choices.
 Distortions from true market prices lead to inefficient allocations of resources.
 Interest rates and security prices are information used by households in making
consumption-saving decisions, and by firms making investment decisions.
 Prices of traded assets in well functioning, efficient and liquid markets constitute the base
for the valuation of all non-traded assets, relying on the principle of relative pricing
(valuation using comparables).
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 of another.
 Reduces the incentive problems that make financial contracting difficult and costly.
 Arises because parties cannot easily observe or control one another, and because contractual
enforcement mechanism can be impossible, or very costly, to invoke.
 Raising external capital, selling off risks, and risk-sharing arrangements becomes more
costly (or might fail altogether).

1.1.5 Financial assets

An asset is any possession that has value in any exchange. Assets can be classified as:
 Real asset
 Financial asset
A real asset is an entity that generates a flow of goods or services over time. Examples
include land, factories, inventions, business plans, and goodwill with consumers, reputation.
As you can see from the list of examples a real asset can be either tangible or intangible. On
the other hand A financial asset is a legal contract that gives its owner a claim to payments,
usually generated by a real asset. Examples include currency (Birr, dollar, etc), stocks, bonds,
bank deposit, bank loans, options, futures, etc. Financial assets in other words refer to the
different financial instruments on which parties in the financial market traded with. For
financial instruments, the typical future benefit is a claim to future cash. The entity that has
agreed to make future cash payment is called the issuer of the financial assets whereas the
owner of the financial asset is referred to as the investor. In other words in financial market
investors sale financial asset to savers in which the financial asset represents claims to the
payments of a sum of money sometimes in future (repayment of principle) and/or a periodic
(regular or not so regular) payment in the form of interest or dividend. With regard to bank
deposit or government bond or industrial debenture, the holder receives both the regular
periodic payments and the repayment of the principal at a fixed date. Whereas with regard to
ordinary share or perpetual bond, only periodic payments are received (which are regular in
the case of perpetual bond but may be irregular in the case of ordinary share).
For example: If you invested in the share of Buna Bank, a share of Buna Bank stock that
you own gives you a share of the Buna’s assets and the right to receive a share of dividends
(profits), if Buna Bank is paying any. To Buna’s other owners, the stock means a slightly
diluted share of the company's assets for them, and an obligation to include you in their
dividend payments.
From the example above it is possible to learn that a financial asset owed by someone is a
financial liability to the other who issued or sold it.
1.1.6. Principal economic functions of Financial Assets
Financial assets have two basic economic functions
 First, financial assets transfer funds from those parties who have surplus funds to
invest to those who need funds to invest in tangible assets
 As their second function, they 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.
In a competitive economy there will be number of individuals and businesses that have
productive use for more financial resources than they have on hand at a given time. Investment
is impossible if there is no way to obtain fund from other source. Thus availability of outside
resources is critical to the level of investment and thus employment and income in the
economy.
In an economy there will be some individual and entities with fewer profitable investments
than resources and some others who have profitable investments but no necessary fund. The
entities with resources will share it only if they can receive promise to share the investment
return. The financial assets provide this promise which helps the transfer of financial resources
which will lead to the raise in the level of investment and income and wealth of entire
economy.
Unfortunately the return on investment is risky. If the party who make the investment bears all
the risk the incentive to undertake investment may be limited. If the risk can be redistributed
or shared with the supplier of fund then the incentive to go through investment is enhanced.
Thus financial assets provide mechanism of sharing risk and enhance the investment in the
economy.

1.1.7. Properties of Financial Assets

Financial assets have their own typical characteristics that differentiate them from non
financial assets. These characteristics are listed below
1. Money-ness:
 Some financial assets are used as a medium of exchange or used in settlement of
transaction. These assets are called money.
 Those financial assets which can be transformed into money at little cost, delay or risk can
also be considered as money.
For example: Checking account, Treasury-bill –easily converted, and other money market
instruments  Therefore, money-ness is clearly a desirable property for investors.
In other words we can say it as the ability of the financial assets to act as medium of exchange
or sell for settlement of claims is termed as money-ness.
2. Divisibility and Denomination:
Divisibility relates to the medium size at which a financial asset can be liquidated and
exchanged for money or the extent to which fractional amounts of an asset can be sold and
bought. The smaller the size, the more the financial asset is divisible.
For example:
(1) Physical assets are often indivisible (cars).
(2) A financial asset such as deposit at a bank is infinitely divisible but other financial
assets have varying degrees of divisibility depending on their denomination, which
is the dollar value of the amount that each chapter of the asset will pay at maturity.

Therefore, all financial assets can be treated as divisible.

In other words we can say the minimum size at which a financial asset can be liquidated and
exchanged for money is known as divisibility. This depends on size, transfer lot and
denomination of financial asset.
3. Term of Maturity:
It is the length of time until final payment, or the owner is entitled to demand liquidation.
Maturity may be uncertain for some financial instruments or assets. In other words we can say
liquidity. For example
 How easily are the assets converted to cash? Or
 It refers to the speed with which the asset can be sold.
Simply liquidity refers ability to convert an asset into cash without any loss of money and
time. In other words how much the seller will lose if they wish to sell the asset immediately
decides the liquidity and illiquidity.
4. Convertibility:
Is asset convertible to another type of asset? In some cases, the conversion takes place within
one class of financial assets, as when a bond is converted into another type of bond. In other
situation, one financial asset can be converted into other financial asset, for example, a
corporate convertible bond is a bond that the bondholder can change in to equity.
5. Currency:
If cash flow is not in domestic currency, exchange rate fluctuations affect value of cash flow in
domestic currency. Thus, to reduce foreign exchange risk, some issuers have issued dual
currency securities. For example, some issuers pay an interest in one currency but principal or
redemption value in another currency i.e., interest in Sudan Dinar and Principal in US Dollar.
In other words we can say the financial assets are mostly denominated in one currency e.g., in
US dollar or Euro etc. Some issuers will also issue dual currency securities to reduce the
foreign currencies risk of the investor.
6. Risk/ Return Predictability:
Most assets have some risks. Investors are risk takers, so must be compensated for taking the
risk. Some of the risks include:
 Risk of default: not receiving promised cash flows in full and/ or on time.
 Interest rate risk: fluctuations in the interest rate cause the value of assets to fluctuate. All
debt securities carry some interest rate risk.
 Currency exchange risk: exchange rate fluctuations affect value of non domestic asset.
 Regulatory risk: changes in law affect the tax treatment of asset prospects of an issuer of
assets.
The uncertainty of the risks increases with time horizon.

1.2. An overview of Financial Markets

A market refers to an institution or arrangement that facilitates the purchase and sale of goods
& services. Financial markets are structures through which funds flow (Saunders and Cornett,
2004). Financial markets such as the bond and stock markets are important in channeling
funds from people who don't have a productive use for them to those who have shortage and
who do (Mishkin and Eakins, 2006). Well functioning financial markets are a key factor in
producing high economic growth, and poorly performing financial markets are reasons that
many countries in the world remain desperately poor. Activities in financial markets also have
direct effect on personal wealth, the behavior of businesses and consumers, and the cyclical
performance of an economy (Mishkin and Eakins, 2006). Fabozzi and Modigliani (2003)
identified the following economic functions of financial markets:
1. the interaction of buyers and sellers in the financial market determines the price of the
traded security or equivalently the required return on the financial instrument is
determined
2. because financial markets provide a mechanism for an investor to sell financial
securities, it offers liquidity
3. Financial markets reduce the search and information costs (e.g. advertizing to sell
or purchase a financial instrument) of transacting.
1.2.1. Classification of Financial Markets
There are feive ways that one can classify financial markets: (1) nature of the claim, (2)
maturity of the claims, (3) new versus seasoned claims, (4) cash versus derivative instruments,
and (5) organizational structure of the market.
1. On the basis of the nature of the claim: Debt Markets Vs Equity Market
The claims traded in a financial market may be either for a fixed dollar amount (debt
instruments) or a residual amount (equity instruments). Financial markets can be classified
according to the nature of the claim as debt market and equity/stock market. Financial markets
in which debt instruments are traded are called debt or generally bond markets whereas
Financial markets in which equity instruments are traded, stock or equity markets. Classifying
financial market based on the nature of claim may create confusion as to where to categorize
some claims having the property of both debt and equity such as preferred stock.
Preferred stock represents an equity claim that entitles the investor to receive a fixed dollar
amount. Consequently, preferred stock has in common characteristics of instruments classified
as part of the debt market and the equity market.

2. On the basis of the maturity of the claims: Money Markets Vs Capital Markets
A second way to classify financial markets is by the maturity of the claims. For example, a
financial market for short-term financial assets is called the money market, and the one for
longer maturity financial assets is called the capital market. The traditional cutoff between
short term and long term is one year. That is, a financial asset with a maturity of one year or
less is considered short term and therefore part of the money market. A financial asset with a
maturity of more than one year is part of the capital market. Under this classification the major
focus is to identify a typical market for debt security on the bases of their maturity. At this
juncture you can realize that dent instruments with short term maturity are traded in the money
market whereas debt instruments with long term maturity will be traded in Equity Market.
3. On the basis of whether the claims are a new issue or seasoned
claims: Primary Market Vs Secondary Market
A third way to classify financial markets is by whether the financial claims are new issued.
When an issuer sells a new financial asset to the public, it is said to “issue” the financial asset.
The market for newly issued financial assets is called the primary market. For instance
corporations raise funds through new issues of financial instruments such as stocks and bonds
in a primary market for new projects or expand the existing companies. As it will be
discussed on the six chapter of this chapter in Ethiopian context private companies can issue
only equity securities and recently attempt has been exerted to raise equity fund from the
general public or ultimate saver in the form of initial public offer (IPO). Bond in the primary
market can be issued only by government to finance different development projects and
support the government finance; however as compared to the equity securities the debt
securities in Ethiopia are very rare
After a certain period of time, the financial asset is bought and sold (i.e., exchanged or traded)
among investors. The market where this activity takes place is referred to as the secondary
market. Secondary market is very essential to keep the financial asset at most liquidity as well
to make participants of the secondary market to be well informed about the value of the traded
securities.

4. Based on the cash versus derivative instruments

Some financial assets are contracts that either obligate the investor to buy or sell another
financial asset or grant the investor the choice to buy or sell another financial asset. Such
contracts derive their value from the price of the financial asset that may be bought or sold.
These contracts are called derivative instruments and the markets in which they trade are
referred to as derivative markets. For example A share of Ford Co. stock is a “pure financial
asset,” while an option to buy Ford shares is a derivative security whose value depends on the
price of Ford stock. The array of derivative instruments includes options contracts, futures
contracts, forward contracts, swap agreements, and cap and floor agreements. As far as these
markets are the newest of the financial security markets in the world they are mostly traded in
developed financial markets.

4. Based on organizational structure of the market

Although the existence of a financial market is not a necessary condition for the creation and
exchange of a financial asset, in most economies financial assets are created and subsequently
traded in some type of organized financial market structure. A financial market can be
classified by its organizational structure.
These organizational structures can be classified as auction markets and over-the-counter
markets.
In addition to the above five classifications made by Fabozi (2004), there are some other ways
of classifying a financial markets. As you have observed from the above discussion the
classification are not all mutually exclusive rather the possibility in which one market may
include securities traded in one or more other markets is very high. Therefore in the following
parts of this section some the classification in which you will have an additional and in depth
discussion on the subsequent chapters in the module are given as follows:
 Spot versus futures markets. Spot markets are markets in which assets are bought or sold
for “on-thespot” delivery (literally, within a few days). Futures markets are markets in
which participants agree today to buy or sell an asset at some future date. For example, a
farmer may enter into a futures contract in which he agrees today to sell 5,000 kg of coffee
six months from now at a price of Birr 45 a kilogram. On the other side, an international
coffee processing companies looking to buy coffee in the future may enter into a futures
contract in which it agrees to buy soybeans six months from now.

 Private versus public markets. Private markets, where transactions are negotiated
directly between two parties, are differentiated from public markets, where standardized
contracts are traded on organized exchanges. Bank loans and private debt placements with
 insurance companies are examples of private market transactions. Because these
transactions are private, they may be structured in any manner that appeals to the two
parties. By contrast, securities that are issued in public markets (for example, common
stock and corporate bonds) are ultimately held by a large number of individuals. Public
securities must have fairly standardized contractual features, both to appeal to a broad
range of investors and also because public investors do not generally have the time and
expertise to study unique, nonstandardized contracts. Their wide ownership also ensures
that public securities are relatively liquid. Private market securities are, therefore, more
tailor-made but less liquid, whereas publicly traded securities are more liquid but subject to
greater standardization.
 Commodity markets/Commodities exchanges: “Open and organized marketplace where
ownership titles to standardized quantities or volumes of certain commodities (at a
specified price and to be delivered on a specified date) are traded by its members; such as
fuels, metals, and agricultural commodities exchanges”. The Ethiopian Commodity
Exchange (ECX) can be taken as example of such a market.
Foreign exchange markets, which facilitate the trading of foreign exchange. For funds
to be transferred from one country to another, they have to be converted from the currency
in the country of origin (say, Dollars, Euros or Yuan ) into the currency of the country they
are going to (say, Birr). The foreign exchange market is where this conversion takes place,
and so it is instrumental in moving fund between countries.
1.3. An overview of Financial Institutions
1.3.1. Financial institutions
Financial institutions serve as intermediaries by channeling the savings of individuals,
businesses, and governments into loans or investments. They are major players in the financial
marketplace, with a huge financial asset of most economies under their control. They often
serve as the main source of funds for businesses and individuals. According to Saunders and
Cornett (2004) financial intermediaries are also defined as companies whose primary function
is to intermediate between lenders and borrowers in the economy. Financial institutions
perform the essential functions of channeling funds from those with surplus funds to those
with shortages of funds. Some financial institutions accept customers’ savings deposits and
lend this money to other customers or to firms. In fact, many firms rely heavily on loans from
institutions for their financial support. Financial institutions are required by the government to
operate within established regulatory guidelines.
Financial institutions are what make financial markets work. Without financial institutions,
financial markets would not be able to move funds from who save to people who have
productive investment opportchapteries; and thus have important effects on the performance of
the economy as a whole. The most important financial institution in the financial system of an
economy is the central bank, the government agency responsible for the conduct of monetary
policy (Mishkin and Eakins, 2006). In addition to this, institutions in the financial system
include; commercial and savings banks, insurance companies, mutual funds, stock and bond
markets, credit unions and non-formal financial institutions (that are common in least
developed countries including Ethiopia).
The major services of financial institutions as identified on Fabozi (2004) are to one or more
of the following
1. Transforming financial assets acquired through the market and constituting them into a
different and more preferable type of asset—which becomes their liability. This is the
function performed by financial intermediaries, the most important type of financial
institution.
2. Exchanging financial assets on behalf of customers.
3. Exchanging financial assets for their own account.
4. Assisting in the creation of financial assets for their customers and then selling those
financial assets to other market participants.
5. Providing investment advice to other market participants.
6. Managing the portfolios of other market participants.
Financial intermediaries include: depository institutions that acquire the bulk of their funds by
offering their liabilities to the public mostly in the form of deposits; insurance companies (life
and property and casualty companies); pension funds; and finance companies. The second and
third services in the list above are the broker and dealer functions. The fourth service is
referred to as securities underwriting. Typically, a financial institution that provides an
underwriting service also provides a brokerage and/or dealer service
Some nonfinancial businesses have subsidiaries that provide financial services. For example,
many large manufacturing firms have subsidiaries that provide financing for the parent
company’s customer. These financial institutions are called captive finance companies.

1.3.2. Role of Financial Institutions

Obtain funds by issue of financial claims and they invest those funds in the financial
instruments issued by other participants. The investment made by the financial intermediaries,
their assets, can be in the form of loans or securities. Thus the financial intermediaries plays a
basic role of transforming the financial assets which are less desirable for large part of public
into other financial assets, their own liability, which are widely preferred by public. The
intermediaries perform the following economic function: 1. Risk reduction through
diversification
2. Maturity intermediation
3. Reduce the cost of contracting
4. Information Production
5. Providing payment mechanism
Each of this listed functions are discussed in brief below:
1. Risk reduction through diversification:
By choosing portfolio of investment rather than investing all one’s resources in a single asset,
the financial intermediary reduces the total risk to which they are expensed. Even if
individuals can also do this on their own, they may not be able to do this as cost effective as
institutions depending on the amount of funds they have to invest.
2. Maturity Intermediation:
Financial intermediaries provide the service of intermediating across maturity or borrowing
short and lending long.
This means that they accepts fund from investors who desire to lend their funds for short
period and they gives those funds to their borrowers who desire a long maturity. Maturity
intermediation presents two implications to financial markets:
(a) Investors have more choice concerning the maturity of their investment; borrowers have
more choice for length of their debt obligation.
(b) Counting up on successive short term deposits (which has a lower interest rate) providing
fund until maturity, the financial institutions can provide fund to borrowers at a rate lower
than that offered by individual investors.
3. Reduces the cost of contacting:
Intermediaries can reduce the cost of writing and understanding financial contract. They can
also reduce the cost of monitoring the activities of the contracting parties to ensure that the
terms of contract are observed. This is possible by appointing professional by financial
intermediaries as investment of funds are their normal business and they have large amount of
fund to be invested. The intermediaries can promise better service to lenders compared to
borrowers of the fund.
4. Information Production:
Financial intermediaries provide the services of production of information about the value of
assets. Intermediaries expend considerable resources in collecting, processing, analyzing and
interpreting facts and opinions about future profitability and financial strength of the firm they
are financing. Intermediaries can also hire specialists in the production of the information. The
collection and analysis of information is important to them as their success depends on the
management of investment based on their information.
5. Providing a payment mechanism
Most of the business transactions made today is not done with cash. Instead payments are
made using checks, credit cards, debit cards, and electronic transfer of funds. Financial
intermediaries provide these methods of making payments
1.3.3. Types of Financial Intermediaries or Financial Institutions
Financial institutions are divided into three types:
1. Depository Financial Institutions
2. Non-Depository Financial Institutions
3. Investment Companies
1.3.3.1. Depository Institutions
Depository institutions are financial intermediaries that accept deposits usually demand
deposits and savings deposits from customers and invests those funds in loans and securities.
Deposits are liabilities of these institutions. With the fund raised through deposits they make
direct loans to various entities. Their income comes from the loans they make and securities
they purchase. One key characteristics of a depository institution is that its liabilities include
various deposits, such as time, saving, or checking accounts. Further, most depository
institutions also specialize in asymmetric information problems specific to loan markets. They
include commercial banks (or simply banks), savings and loan associations (S&Ls), savings
banks, and credit unions. It is common to refer to depository institutions other than banks as
“thrifts.” Depository institutions are highly regulated and supervised because of the important
role that they play in the financial system. Each of them is briefly discussed in the following
part:
A) Commercial banks
Commercial banks accumulate deposits from savers and use the proceeds to provide credit to
firms, individuals, and government agencies. Thus they serve investors who wish to “invest”
funds in the form of deposits. Commercial banks use the deposited funds to provide
commercial loans to firms and personal loans to individuals and to purchase debt securities
issued by firms or government agencies. They serve as a key source of credit to support
expansion by firms. Historically, commercial banks were the dominant direct lender to firms.
In recent years, however, other types of financial institutions have begun to provide more
loans to firms.
Like cost other types of firms, commercial banks are created to generate earnings for their
owners. In general, commercial banks generate earnings by receiving a higher return on their
use of funds than the cost they incur from obtaining deposited funds. For example, a bank may
pay an average annual interest rate of 4 percent on the deposits it obtains and may earn a return
of 9 percent on the funds that it uses as loans or as investments in securities. Such banks can
charge a higher interest rate on riskier loans, but they are then more exposed to the possibility
that these loans will default.
Although the traditional function of accepting deposits and using funds for loans or to purchase
debt securities is still important, banks now perform many other functions as well. In
particular, banks generate fees by providing services such as travelers’ checks, foreign
exchange, personal financial advising, and other service in the financial market. Thus
commercial banks in a well developed financial system are able to offer customers “one stop
shopping.”
B) Savings Banks and Savings and Loan Associations
Saving Banks and Savings and Loan Associations are depository institutions that
traditionally have specialized in extending mortgage loans to individuals who wish to purchase
homes. Just as there is asymmetric information in business loan deals, a person who wants a
mortgage loan may or may not become a bad risk after receiving the loan. And so there are
adverse selection and moral hazard problems specific to mortgage lending.
C) Credit Union
The credit unions are the smallest of all depository institution. A credit union is a depository
institution that accepts deposits from and makes loans only to a closed group of individuals.
To be a member of a credit union and eligible for its services, a person usually must be
employed by a business with which the credit union is affiliated. Most credit unions specialize
in making consumer loans, although some have branched into mortgage loan business.
1.3.3.2 Non-Depository Financial Institutions
Non-depository or contractual intermediaries bundles the provision of some other
contractual services, with the investment of funds e.g., insurance companies.
1.3.3.2.1. Insurance company
Insurance companies specialize in trying to limit adverse selection and moral hazard problems
unique to efforts insure against possible future risks of loss. They issue policies, which are
promises to reimburse the holder for damages suffered in the event of a “bad” event, such as
an auto accident.
The detail discussion on how insurance companies provide the reduction of adverse selection
and moral hazard problem will be discussed on the subsequent chapter on financial institution
in this chapter the aim is just to introduce you with what insurance companies are doing in the
financial system and their taxonomy .
1.3.3.2.2. Types of Insurance Companies
There are two basic kinds of insurance companies classified on the basis of the major types of
insurance policies they are offering.
A. Life insurance companies: charge premiums for policies that insure people against the
financial consequences associated with death. They also offer specialized policies, called
annuities, which are financial instruments that guarantee the holder fixed or variable
payment at some future date.
B. Property and casualty insurers: insuring against risks relating to property damage and
liabilities arising from injuries or deaths caused by accidents or adverse natural events.
 Property and casualty insurance companies offer policies that insure individuals and
businesses against possible property damages or other financial losses resulting from
injuries or deaths sustained as a result of accidents, adverse weather, earthquakes and soon.
Most insurance companies especially here in Ethiopia are formed by combining the above two
types of insurance services, as a result in the current financial system of Ethiopia expect the
newly introduced life insurance company all other financial institutions are selling both life
and non life insurance policies.
1.3.3.2.3 Pension Funds
Pension funds are institutions that specialize in managing funds that individuals have put away
to serve as a nest egg when they retire from their jobs and careers. Part of what many workers
get paid is in the form of contributions that their employers make to such funds.
The key specialty of pension funds is creating financial instruments called pension annuities.
These are similar to the annuities offered by life insurance companies. But life insurance
annuities usually are intended as supplements to a person’s income at some fixed point in the
future, Whether or not a pension is working at the time. In contrast, pension annuities apply
only to the future event of retirement. Most people regard pension annuities as their main
source of future income after requirement.
Why do people use the services of pension funds instead of saving funds on their own? One
reason certainly is asymmetric information, because those who operate pension funds may be
better informed about financial instruments and markets than those who save for retirement.
But there is another reason that probably is more important. This is the existence of economies
of scale. Many people would find it very costly to monitor the instruments they hold on a day-
by-day basis throughout their lives. Pension funds do this for many people at the same time,
thereby spreading the costs across large numbers of individuals.
Pension funds exist to protect future pensioners from losses on their retirement savings. Hence,
they specialize in monitoring capital market instruments for risks that might arise from adverse
selection and moral hazard problems experienced by issuers.
1.3.3.2.3. Mutual Funds
A Mutual fund is a mix of redeemable instruments, called “shares” in the fund. These shares
are claims on the returns on financial instruments held by the fund, which typically include
equities, bonds, government securities, and mortgage backed securities.
Mutual funds usually are operated by investment companies, which charge shareholders fees
to manage the funds.
One reason for the growth of mutual funds is that many share holders believe that Investment
Company managers know best how to balance risks and returns on their behalf. This makes
shareholders willing to pay fees for the manager’s knowledge and skill.
There is more important reason, however, for the growth of mutual funds. Like pension funds,
mutual funds take advantage of financial economies of scale. Mutual fund shareholders
typically pay lower fees to investment companies than they might have to pay brokers to
handle their funds on a personal basis. The reason is that mutual fund managers can spread the
costs of managing shareholders’ funds across all the shareholders.
1.3.3.2.4. Finance Companies
A finance company also specializes in making loans to individuals and businesses. Finance
companies, however, do not offer deposits. Instead, they use the funds invested by their
owners or raised through issuing other instruments to make loans to households and small
businesses. Many finance companies specialize in making loans to people and firms that
depository institutions regard as high risks.
1.3.3.2.5. Investment Banking firms
Investment Banking is financial institutions that underwrites and distributes new investment
securities and helps businesses obtain financing. Investment banking houses in the US such as
Goldman Sachs or Credit Suisse Group provides a number of services to both investors and
companies planning to raise capital. Such organizations:
(a) help corporations design securities with features that are currently
attractive to investors, (b) then buy these securities from the corporation, and
(c) resell them to savers.
Although the securities are sold twice, this process is really one primary market transaction,
with the investment banker acting as a facilitator to help transfer capital from savers to
businesses.