FINANCIAL SYSTEM

The financial system provides channels to transfer funds from individuals and groups who have saved
money to individuals and groups who want to borrow money.

Financial system consists of three major components.

1. Financial institutions

2. Financial markets

3. Payment system

Returns Direct Finance

Financial
Market
Funds

Lenders (Saver) Borrowers (spender)

Households Households
Firms Firms
Governments Governments
Foreigners Foreigners

Returns
Funds
Financial
Intermediarie
s
Indirect Finance
Figure: Funds flow through a financial system

FINANCIAL MARKET: It is a market in which funds are transferred from people who have an excess
of available funds to people who have a shortage. Financial markets are structures through which funds
flow.

Chapter 1Economics of financial system Page 1

Type of Financial Market:

On the basis of maturity structure and trading structure of its securities Financial Market can classified
as:

a. Debt and Equity Market

b. Primary and Secondary market
c. Organized and Over the counter market
d. Money and Capital market

Primary and secondary market

Market in which corporations raise funds through new issues of securities. The fund users have new
projects or expanded production needs, but do not have sufficient internally generated funds ( such as
retained earnings) to support these needs. Thus, the fund users issues securities in the external primary
markets to raise additional funds.

Users of Funds Underwriting with

(corporations issuing Initial suppliers of
Investment Bank
debt/equity Funds (Investors)
instruments)
(Where new issues of financial instruments are offered for sale)

Secondary Market
A market that trades financial instruments once they are issued.

Financial Markets Other suppliers of

Securities Brokers funds

(Where financial instruments, once issued, are traded)

- Secondary market offers benefits to both investors (suppliers of funds) and issuing corporations
(users of funds)
- For investors, secondary markets provide the opportunity to trade securities at their market
values quickly as well as to purchase securities with varying risk-return characteristics.
- Issuer does obtain information about the current market value of its financial instruments, and
thus the value of corporation as perceived by investors such as its stockholders through tracking
the prices at which its financial instruments are being traded on secondary markets.

Chapter 1Economics of financial system Page 2

 Debt and Equity Market

A firm or an individual can obtain funds in a financial market in two ways.

(i) By issuing debt instrument, such as a bond or a mortgage, which is a contractual agreement
by the borrower to pay the holder of the instrument fixed amounts at regular intervals until a
specified date ( the maturity date) when a final payment is made.
(ii) By issuing equities, such as common stock, which are claims to share in the net income and
the assets of a business.

Organized and Over the Counter Market

Secondary markets can be organized in two ways.
(i) One is to organize exchanges, where buyers and sellers of securities (or their agents or
brokers) meet in one central location to conduct trades.
(ii) The other method of organizing a secondary market is to have an over the counter market, in
which dealers at different locations have an inventory of securities and stand ready to buy
and sell securities ‘ over the counter” to anyone who comes to them and is willing to accept
their prices.

Money market and Capital market

- The money market is a financial market in which only short-term debt instruments (original
maturity of less than one year) are traded
- The capital market is the market in which longer-term debt (original maturity of one year or
greater) and equity instruments are traded.

FINANCIAL INTERMEDIARIES

Institutions that borrow fund from people who have saved and then make loans to other. E.g. Bank,
Insurance Company, Mutual funds, Pension funds.

The process of indirect finance using financial intermediaries is known as Financial Intermediation.

Type of Financial Intermediaries

1. Commercial Banks:- depository institutions whose major assets are loans and whose major
liabilities are deposits.

2. Thrifts:- depository institutions in the form of savings associations, savings banks and credit
unions. Thrifts generally perform services similar to commercial banks, but they tend to
concentrate their loans in one segment, such as real estate loans or consumer loans.

3. Insurance companies:- financial institutions that protect individuals and corporations from
adverse events.

Chapter 1Economics of financial system Page 3

 4. Securities firms and investment banks:- financial institutions that underwrite securities and
engage in related activities such as securities brokerage, securities trading, and making a market
in which securities can trade.

5. Finance companies:- financial intermediaries that make loans to both individuals and
businesses. Unlike depository institutions, finance companies do not accept deposits but instead
rely on short and long term debt for funding.

6. Mutual funds:- financial institutions that pool financial resources of individuals and companies
and invest those resources in diversified portfolios of asset.

7. Pension funds:- financial institutions that offer savings plans though which fund participants
accumulate savings during their working years before withdrawing them during their retirement
years.

Nepalese Scenarios

• Central Bank: - Nepal Rastra Bank.

• Commercial Banks:- 27

• Development banks:-63

• Finance companies:-78

• Micro finance development bank :-17

• Cooperatives licensed by NRB:-16

• NGO’s with the limited banking services(FINGO):-45

• Insurance companies:-25

• Security exchange center:-1

• CIT:-1 & EPF: 1

Life Insurance Companies

1. Rastriya Beema Samsthan  

2. National Life Insurance Company Limited  

3. Nepal Life Insurance Company Limited  

4. Life Insurance Corporation (Nepal) Limited  

5. American Life Insurance Company Limited  

Chapter 1Economics of financial system Page 4

 6. Asian Life Insurance Company Limited

7. Gurans Life Insurance Company Limited 

8. Surya Life Insurance Company Limited

9. Prime Life Insurance Company Limited

Non Life Insurance Companies

1. Nepal Insurance Company Limited  

2. The Oriental Insurance Company Limited 
3. National Insurance Company Limited
4. Himalayan General Insurance Company Limited 
5. United Insurance Company (Nepal) Limited 
6. Premier Insurance Company (Nepal) Limited  
7. Everest Insurance Company Limited
8. Neco Insurance Limited
9. Sagarmatha Insurance Company Limited
10. Alliance Insurance Company Limited 
11. NB Insurance Company Limited
12. Prudential Insurance Company Limited
13. Shikhar Insurance Company Limited
14. Lumbini General Insurance Company Limited
15. NLG Insurance Company Limited
16. Siddartha Insurance Limited

Chapter 1Economics of financial system Page 5

Type of Intermediary Primary Liabilities Primary Assets
(source of funds) ( Uses of Funds)
Depository Institutions
 Commercial Banks Deposits Business and consumer loans,
mortgages, government securities
 Mutual saving banks Deposits Mortgages
 Credit Unions Deposits Consumer loans
Contractual Saving Institution
 Life Insurance Company Premium from policies Corporate bonds, and mortgages
 Fire Insurance Company Premium from policies Corporate bonds, and mortgages,
stocks
 Pension funds Employer and employee Corporate bonds, and stock
contributions
Investment Intermediaries
 Mutual funds Shares Stocks, bonds
 Finance Company Commercial paper, Consumer and business loans
stock, bonds

FINANCIAL INSTRUMENTS

Financial instruments are the vehicles by which financial markets channel funds from savers to
borrowers and provide return to them.

Money Market Instruments:

1. Treasury Bills (T-Bill):

Securities sold by the federal government with initial maturities of less than one year. They are
considered as a risk free securities.

2. Commercial Paper:

Short term, unsecured promissory notes, generally issue by known business firms and financial
institutions. Default risk is small, but the interest rate is higher than T-Bill.

3. Bankers’ Acceptances

A short-term promissory note drawn by a company to pay for goods on which a bank guarantees
payment at maturity. Usually used in international trade.

4. Negotiable Bank Certificate of Deposit

CD is a fixed-maturity instrument sold by a bank to depositors; it pays principal and interest at

maturity.

Chapter 1Economics of financial system Page 6

Capital Market Instruments:

1. Treasury Securities:

Intermediate-term and long term securities sold by the federal government to finance the budget
deficits.

2. Government Agency Securities

3. Stocks
4. Corporate Bonds
5. Mortgages
6. Commercial Bank Loans

SERVICE PROVIDED BY THE FINANCIAL SYSTEM

Services Benefiting suppliers of fund

1. Monitoring costs- aggregation of funds in a FI provides greater incentives to collect a firm’s

information and monitor actions. The relatively large size of the FI allows this collection of
information to be accomplished at a lower average cost

2. Liquidity and price risk- FIs provide financial claims to household savers with superior
liquidity attributes and with lower price risk

3. Transaction Cost services:- FI’s size can result in economies of scale in transaction costs.

4. Maturity intermediation:- FIs can better bear the risk of mismatching the maturities of their
assets and liabilities.

5. Denomination Intermediation:- FIs such as mutual funds allow small investors to overcome
constraints to buying assets imposed by large minimum denomination size.

Services Benefiting the Overall Economy

1. Money Supply Transmission;- Depository institutions are the conduit through which monetary
policy actions impact the rest of the financial system and the economy in general.

2. Credit allocation:- FIs are often viewed as the major and sometimes only source of financing
for a particular sector of the economy, such as farming and residential real estate.

3. Intergenerational wealth transfers:- FIs , especially life insurance companies and pension
funds, provide savers with the ability to transfer wealth from one generation to the next.

4. Payment services:- efficiency with which depository institutions provide payment services
directly benefits the economy.

Chapter 1Economics of financial system Page 7

 PAYMENTS

There are two general methods of trading

(i) Credit Trading

(ii) Cash Trading

Cash trading involves the exchange of value for value. Credit trading involves the exchange of value
for promises.

Both Trading has problems and financial system addresses the following problems in payment:-

Reducing the costs of payment in Cash

Financial system knows the discomfort of the cash transaction; such as people require the
security against theft, secure transportations, counting of large amount of the currency, and
authentication of each bill.

Warehouse banks

Banks that keep depositor’s cash in the storage, allowing the depositors to make payments by
transferring title to the deposited cash rather than by transferring the cash itself.

Clearing House

Clearing is the process for checks in which checks drawn on one bank are offset against checks
drawn on another. For clearing of payments amount banks is organized through an association called
the clearing house.

Bank deposits as Money

When the large amount is made, it is based on the ownership transfer on the deposit rather than
paying cash amount. It has substantially reduced the transaction cost.

Fractional Reserve Banking

Fractional reserve bank is the bank that holds reserves of cash equal to only a fraction of its
deposit liabilities. Borrower would have deposit without ever having deposited any cash with the
bank.

Bank deposits become IOUs

IOUs is the promise by bank to pay on demand a certain sum of rupees. (Cash in vault)

Chapter 1Economics of financial system Page 8

MARKET FAILURE

Cause of market failure

1 Composition problem

 Banking panics: like fearing the bank will fail

 Stock market Crash: A large and sudden drop in securities prices
 Price-level instability: inflation and deflation

2 Excessive risk taking:

Bank makes risky loans. If the loan goes bad, a bank may fail.

GOVERNMENT INTERVENTION (Provide Financial Regulation)

Reasons for government intervention are:

1. Maintenance of Financial Stability

Financial stability is define as a situation where the financial system operates with no serious failures or
undesirable impacts on the present and future development of the economy as a whole, while showing a
high degree of resilience to shocks.

2. Provision of Information.

Government has intervened in the financial markets to require issuers of financial instruments to
disclose information about their financial condition and to impose penalties on issuers that do not
comply.

3. Advancement of economical and other objective

a. Controlling the money supply
b. Consumer protection

TECHNOLOGY ADOPTED IN FINANCIAL MARKET

1. Delegation 2. Credit Substitution

3. Pooling 4. Netting

Delegation

To trade you need to find a trading partner and negotiate terms. If the trade involves a promise, you must
gather and process information, write up a contract, and monitor compliance. It may be less costly to
delegate this work than to do it all yourself.

Chapter 1Economics of financial system Page 9

Delegation is the assignment of authority and responsibility to another person to carry out specific
activities. In financial market, delegation means appointing of someone to act for the others in a
transaction. A depositor delegates to a bank or some other intermediary the work of making a loan.

The most obvious example of delegation is indirect lending; a depositor delegates to a bank or some
other intermediary the work of making a loan. But there is a delegation too in direct lending; lenders
delegate to an underwriter the task of setting up a loan and to a trustee the task of monitoring
compliance with the contract.

Delegation reduce the risk and transactions cost because of

 Many of the costs of a transaction are indivisible. A loan of $10000 involves much the same
work as a loan of $10 million. When many lenders lend to a single borrower, the delegate can
do the work once for all of them, rather than each having to do the work independently.
 Delegation allows specialization. An individual lender may lend only occasionally, and so
acquire little expertise. The delegate, representing many lenders and lending often, acquires
experience and know how.
 The delegate is in a stronger bargaining position. Because lending is concentrated in his
hands, the delegate can negotiate better terms. Because the borrower is more likely to do repeat
business with the delegate than with a single small lender, the borrower has more of an
incentive to behave well.
 Revealing information to a single delegate may be more acceptable to the borrower than a
more general disclosure to the public at large.

How delegate to be trust?

 Bonding: Banks fund a part of their lending with their own capital. If loans go bad, the bank is
first to bear the loss, having its own money at stake gives the bank an incentive to do its work
well.
 Reputation: the general estimation in which someone is held by the public. A bank with a
reputation for soundness attracts more deposits and has to pay less for them.

Credit Substitution

In many cases delegation is combined with credit substitution. A bank substitutes its own credit for
the credit of the borrower: depositors lend to the bank rather than to the ultimate borrower.
Replacement of the credit of one party to a transaction with the (superior) credit of a financial
institution.

Credit substitution works because the promise of the bank, insurance company, or futures exchange
is more acceptable than the promise of the ultimate trading partner. This is so for two reasons:

Chapter 1Economics of financial system Page 10

 a. Reputation:- the financial institution’s reputation for keeping its promises is essential to its
business.

b. The second reason is that the financial institution may be better able to keep its promises. The
principal reason for this is pooling.

Pooling

Combination of assets or liabilities in ways that reduce risk and improve liquidity.

Funds that a group of investors put together to invest for mutual benefit. A major example of a
pooled fund is a mutual fund.

A group of financial instruments that may be placed into the same investment vehicle. A major
example is a mortgage pool, which consists of mortgages that are divided up and placed into large
groups to be sold as securities.

One reason pooling works is diversification. Another is netting.

Netting

Offsetting of one transaction against another to reduce the number of transactions that actually need
be executed. It lower the cost of transfer. Example: the clearing of checks

The physical transfer of currency is costly: the netting of banks’ obligations to one another reduces
the need for physical transfer and so reduces costs.

Netting also creates liquidity. For example, a bank can hold relatively illiquid assets because it can
meet withdrawals out of new deposits, without having to liquidate the underlying assets. By netting
new deposits and withdrawals, it reduces the need to buy and sell the underlying assets.

Chapter 1Economics of financial system Page 11

 INDIRECT LENDING

Advantages

1. Informational advantages

2. Pooling to make large loans

3. Gains from specialization

4. The value of a continuing relationship

5. Diversification

6. Liquidity

Chapter 1Economics of financial system Page 12

GOVERNMENT INTERVENTION AND MARKET FAILURE

The government plays an important role in creating the environment in which the financial system
operates.

1. The government provides the legal system.

2. The government controls the level of interests rates and the behavior of the price level through its
control of monetary and fiscal policy.

3. In addition to creating a suitable environment for the financial system, the government may
intervene directly in its operation. It may set the rules for financial institutions and markets, and
it may intervene in other ways that affect the financial system.

EFFICIENCY

In general, efficiency means doing something as well as possible.

POTENTIAL GAINS FROM LENDING

1. EFFECT OF TRANSACTIONS COSTS

2. CONTRIBUTION OF THE FINANCIAL SYSTEM

The contribution of financial system (in terms of lending) is the sum of all the gains from all the loans it
helps to arrange. The financial system is efficient in lending when the sum of all the gains from lending
is as large as possible.

CONDITIONS FOR EFFICIENCY IN LENDING

If lending is to be efficient, three conditions must be satisfied:

1. Pricing must be competitive

2. Transactions costs must be minimized

3. The financial system must be integrated

Chapter 1Economics of financial system Page 13

MARKET FAILURE AND INEFFICIENCY

A lack of efficiency of the financial system is undesirable because it reduces our national income. The
free market left to itself, may fail to produce efficiency. If this is so, there may be a case for government
intervention.

A major reason why the free market might fail to produce efficiency is insufficient competition. There
are two common reasons why the free market may fail to produce sufficient competition-

1. Economies of scale

2. Barrier to entry

Economies of Scale

An industry exhibits economies of sale if large producers can produce at lower cost than small ones. As
a result of economies of scale, large firms can lower their prices below the costs of small ones, driving
smaller firms out of business. Economies of scale can cause an industry to become concentrated-
dominated by a few large firms.

Normally, if prices are above costs, this will attract new firms into the industry. However, economies of
scale are a barrier to entry. If the entering firm is small, its cost will be high relative to those of existing
firms, and it will find it hard to compete. To compete successfully, a new entrant must match the
existing firms in size.

Natural monopoly

An industry is a natural monopoly if costs would be minimized if the industry consisted of a single firm.
If an industry is a natural monopoly, it will eventually become very concentrated. As a result, the
remaining firms, or firm, will be able to raise prices and will be under little pressure to further lower
costs.

Economies of scale and natural monopoly are reasons for market failure- the failure of a free market to
produce efficiency.

When the market fails to produce efficiency, there may be a case for government intervention

GOVERNMENT INTERVENTION TO ELIMINATE MARKET FAILURE

Chapter 1Economics of financial system Page 14

 1. Intervention to promote competition

When competition is lacking, and the inefficiencies become obvious, there are calls for the
government to do something.

a. One approach is to prevent firms from exploiting their market power to raise
prices. (using Antitrust laws). These laws prohibit include

1. Collusion to fix prices or divide up markets

2. Charging different prices to different customers for the same product

b. Another approach to promoting competition is to attack excessive concentration.

The idea is that an industry composed of many small firms should naturally be
competitive. The government has the power to reduce concentration by breaking
up existing large firms in an industry. It also has the power to prevent
concentration by blocking mergers and acquisitions.

c. One way to keep the monopoly from exploiting its market power to raise prices it
can charge. For example power companies are allowed to be monopolies, but
public utility commissions regulate their rates. Such industries are known as
regulated monopolies.

d. Another way to prevent the abuse of market power by a natural monopoly is for
the customers to own it. A monopoly owned by its customers has no reason to set
its price above cost. E.g. clearing house owned by banks they serve

e. Nationalization – government takeover of a firm or industry. In principle, the

government should run the firm or industry in the public interest rather than trying
to extract monopoly profits.

2. Intervention to lower costs

In some cases, a government can be more successful than the private market at overcoming
problems and at lowering transactions costs. Governments have means not available to private
insurers. They can eliminate adverse selection by forcing everyone to buy the insurance. They
can use the tax system to spread risk widely. For example, when a government provides disaster
relief, it covers the cost by levying an “assessment “ on all taxpayers.

STABILITY

A financial system is for the functioning of an economy. Developed modern economies are so dependent
on the proper functioning of their financial systems that a breakdown can be disastrous.

The stability of the financial system is therefore a vital concern of government policy.

Chapter 1Economics of financial system Page 15

The three principal type of instability are

1. Bank runs and banking panics

2. Securities market crashes

3. Price-level instability

Bank runs and banking panics

Problems at a bank undermine depositor confidence, and depositors rush to withdraw their money. Since
the rule is first come, first served, everyone wants to be first. When reserves- a fraction of total deposits
are exhausted, the bank can no longer honor its promise of liquidity, and it must close its doors.

A bank run is obviously bad for the bank involved, but it need not have much effect on the economy.
However, a banking panic- a run on the banking system as a whole – is another matter. When depositors
lose faith in banks in general, the financial system can be paralyzed, and the consequences for the
economy can be severe.

Securities market crashes

Secondary markets provide liquidity for holders of direct securities. A pool of investors holds claims to
illiquid underlying assets. The secondary market nets the sales of those wishing to liquidate their claims
against the purchases of those wishing to acquire claims. As with banks, however, if everyone wishes to
liquidate at once, netting becomes impossible. If this happens in a secondary market, prices of securities
drop precipitously. There is a crash.

Price level instability

Price- level instability can take either of two forms. A continuing rise in prices is called an inflation. A
continuing and sustained fall is called a deflation.

In both inflation and deflation, lending suffers. A loan is an exchange of money now for a promise of
money in the future. Inflation reduces the value of the promised money in terms of what it will actually
buy; deflation increases it.

As a result, unexpected inflation hurts lenders and benefits borrowers; unexpected deflation has the
opposite effect. Uncertainty about possible future inflation or deflation makes loans riskier both for
borrowers and for lenders and therefore makes lending less attractive.

Chapter 1Economics of financial system Page 16

MARKET FAILURE AND INSTABILITY

Why are financial systems subject to instability?

1. Composition problems

2. Excessive risk taking

3. The role of externalities

Composition problem

Problems that arise out of behavior that is sensible for a single individual but harmful if pursued by all
individuals.

In a banking panic, fearing the banks will fail, individuals rush to ensure their liquidity by withdrawing
their deposits. The result of their actions is the very failure they fear.

Price level instability, too , involves a composition problem. When a single bank increases or decreases
its lending and creates or destroys money, it has little effect on prices. But when al banks do this
together, the general increase or decrease in the quantity of money leads to an inflation or deflation. The
result if harmful, not least to the banks themselves.

Excessive risk taking

Banks make risky loans. If the loans go bad, a bank may fail. If the banks bears all the losses that result
from its failure, it will presumably take these losses into account when making loans ( the expected
return will reward it adequately for the risk it bears).

Suppose though that the failure of the bank triggers a banking panic, which in turn results in a collapse
of the economy. Then the losses due to the bank’s failure greatly exceed those borne by the bank itself.
When these losses are taken into account, the bank’s loan are too risky from the economy’s point of
view.

Role of externalities

Both composition problems and excessive risk taking are examples of a type of market failure known as
an externality. An externality exists when the costs of an individual’s actions are not all borne by the
individual himself. Externalities create an incentive problem. Because the interest of the individual are
not aligned with those of the economy as a whole, the individual will behave in ways that harm the
general good.

Chapter 1Economics of financial system Page 17

INTEVENTION TO PROMOTE STABILITY

What can the government do to help?

There are basically two approaches-

1. Regulation to promote stability

2. Institutions that enhance stability

REGULATION TO PROMOTE STABILITY

Government regulation can combat instability by restricting the individual behavior that causes it. For
example, the government can reduce the chance of bank failure and banking panic by limiting the
freedom of banks to bear risk. It can do this by prohibiting banks from holding certain classes of asset or
from engaging in certain types of activity.

INSTITUTIONS THAT ENHANCE STABILITY

In promoting stability, government intervention can go beyond regulation of individual behavior to the
creation of institutions that enhance stability.

In a bank run or banking panic, many depositors simultaneously wish to convert their deposits into cash.
Banks, with limited reserves of cash, cannot meet this demand. One solution is a source of liquidity
outside the regular banking system to which banks can turn in case of need – a lender of last resort.

One way a lender of last resort can enhance stability is by reassuring depositors. Knowing there is a
lender of last resort, they have less reason to make a run on the bank. A more direct way of reassuring
depositors is for the government simply to guarantee deposits.

OTHER TYPE OF GOVERNMENT INTEVENTION

There are reasons for government intervention in the financial system other than the promotion of
efficiency and stability. These include consumer protection and social policy.

a. Consumer protection

The idea that trade is beneficial rests on the assumption that buyers and sellers know what they
are doing. This assumption fails when one of the parties is much better informed than the other-
that is, when there is asymmetric information. Asymmetric information may be the result of

Chapter 1Economics of financial system Page 18

 differences in expertise: for example, consumers are at an informational disadvantage when they
purchase services from a physician, lawyer or accountant. Or it may be the result of deception or
fraud: one party deliberately conceals information or misleads the other.

Individual borrowers may not understand fully the terms of the obligations into which they are
entering. Traders in securities markets may have access to inside information before it is
available to the general public. In such cases, some sort of government intervention may be
justified to inform and to protect consumers.

There exist extensive regulation designed to protect unsophisticated investors. Securities laws
require issuers of new securities to disclose all relevant information and prohibit trading on
inside information.

b. SOCIAL POLICY

Some government intervention in the financial system is motivated by the desire to improve the
access of disadvantaged groups and individuals to insurance and credit.

One way government does this is through regulation such as the following laws:-

- The equal credit opportunity act of 1974 prohibits discrimination in the granting of credit on
the basis of race, age, national origin, or dependence on public assistance.

- The Community Reinvestment Act of 1977 prohibits lenders from refusing loans purely on the
basis of area of residence.

Chapter 1Economics of financial system Page 19