Chapter One

An Overview of the Financial System

Definition of the financial system
The financial system is a collection of markets, institutions, laws & regulations, and
techniques through which:-
 Bonds, stocks, and other securities traded
 Interest rates determined, and
 Financial services produced & delivered.
The financial system of nations might be either bank based, for instance, in the case of
Ethiopia or market based as in modern economies.
In spite of the differences, the primary task of any financial system is to move scarce
loanable funds from those who have saved to those who borrow for consumption &
investment purposes.
In general, the financial system makes funds available for lending & borrowing (credit).
The financial system determines:
 The cost of credit, and
 The volume of credit that will be available to pay for goods/services.
The events in the financial system have powerful impact upon the health of the nation's
economy. In this regard, when credit becomes more costly and less available, then
 Total spending for goods & services falls; and
 Businesses cut back production and reduce their investment, because of which
unemployment rises & the economy's growth slows down.
In contrast, when the cost of credit declines and loanable funds become more readily
available, then
 Total spending in the economy increases;
 More jobs are created; and
 The economy's growth accelerates.

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An overview of the financial system
Components of the Financial System

There are five components in the financial system those are:

1.  Money
2. Financial institutions(Banks, Insurance companies, and Mutual funds);
3. Financial instruments (Loans, Stocks, and Bonds); 
4. Financial markets (New York Stock Exchange and Tokyo Stock Exchange ); and
5. Central banks (Like the National Bank of Ethiopia (CBE)).
1. Money: is defined as anything that is generally accepted in payment for goods and
services or in the repayment of debt. Monetary theory ties changes in the money
supply to changes in aggregate economic activity and the price level.
2. Financial Institutions are institutions that channel funds from individuals with
surplus funds to those desiring funds but have shortage of it. Among other services,
they allow individuals to earn a decent return on their money while at the same time
avoiding risk; e.g., Banks, Insurance companies, Finance companies, Investment
banks, Mutual funds,.

Banks are financial institutions that accept deposits and make loans. Banks make the
monetary system a lot more efficient by reducing our need to carry a lot of cash. People
have tended to use checks instead of cash for large purchases and bills. Innovations also
reduce such bank-related inconveniences of time spent standing in line at the bank,
writing checks, or visiting the ATM.

3. Financial Instruments

“Securities” is a name that commonly refers to financial instruments that are traded on
financial markets. A security (financial instrument) is a formal obligation that entitles
one party to receive payments and/or a share of assets from another party; e.g., loans,
stocks, bonds. Even an ordinary bank loan is a financial instrument.

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An overview of the financial system
4. Financial Markets

Financial markets are mechanisms that allows people to easily buy and sell(trade)
financial securities (such as stocks and bonds), commodities (such as precious metals or
agricultural goods), and other fungible items of value at low transaction costs and at
prices that reflect; e.g., Luxemburg stock Exchange, New York Stock Exchange, U.S.
Treasury's online auction site for its bonds. Financial markets such as stock market and
bond market are essential to promote greater economic efficiency by channeling funds
from who do not have productive use of fund (savers) to those who do
(investors). While well-functioning financial markets promote growth, poorly
performing financial markets can be the cause of poverty. Thus, activities in financial
markets may increase or decrease personal wealth. Activities in financial markets affect
business cycle.

 5. Central Banks

A central bank is a governmental body that regulates financial institutions, controls the
supply of money and credit in the economy, handles the government’s finances, and
serves as the bank to commercial banks. Commercial banks deposit some of their
reserves at the central bank, and the central bank is the "Lender of last resort" to
commercial banks in times of crisis.

Monetary policy is the management of the money supply and interest rates and is
conducted by a nation's central bank.

Fiscal policy involves decisions about government spending and taxation.

 Budget deficit is the excess of expenditures over revenues for a particular year
 Budget surplus is the excess of revenues over expenditures for a particular year
 Any deficit must be financed by borrowing
 Budgets deficits can be a concern because deficits can result in higher rates of
monetary growth and they might ultimately lead to higher inflation

1.2 The Role/Functions of the Financial System in an Economy

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An overview of the financial system
 1. Saving Role/Function
The system of financial markets and institutions provides a conduit for the public’s
savings. Bonds, stocks, deposits, and other financial claims sold in the money and
capital markets provide a profitable, relatively low-risk outlet for the public’s
savings. Those savings flow through financial markets into investments so that
more goods and services can be produced in the future which increases society’s
standard of living. When savings flow decline, however, the growth of investment
and living standards tends to elevated.
 The savings function of any financial system supplies the vital raw
material of funds to invest so that economic growth and living
standards can flourish.
2. Liquidity Role/ Function
It is a means of raising funds by converting securities and other financial assets into
cash balances. The financial system provides liquidity for savers holding financial
instruments but who are in need of money. In modern society, money consists of
mainly deposits held in banks and is the only financial instrument possessing of
perfect liquidity. Money can be spent as it is without the necessity of converting it
into some other form.
 NB: However money generally earns the lowest rate of return of all
assets traded in the financial system, and its purchasing power is
seriously eroded by inflation. That is why savers generally minimize
their holdings of money and hold bonds and other financial assets
until spend able funds really are needed.

3. Wealth Role/Function

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 It is a means to store purchasing power until needed at a future date for spending
on goods and services. For the business and individuals choosing to save, the
financial instruments sold in the money and capital markets provide an excellent
way to store wealth (to preserve value or hold purchasing power) until funds are
needed for spending in the future periods.

 While we might choose to store our wealth in things” (e.g. automobiles

and clothes), such items are subject to depreciation and often carry great
risk of loss.

However, bonds, stocks, deposits and other financial instruments, do not wear out
overtime, usually generate income, and normally, their risk of loss is less as compared
to many other forms of stored wealth.
4. Credit Role/Function
The role of credit is to provide a continuous supply of credit for the business,
consumers and governments; to support both the consumption and investment
spending in the economy. Example, Governments borrow funds to construct public
facilities and to cover daily expenses until tax revenues flow in.
5. Payments Role/ Function:
It provides a mechanism for making payments to purchase goods and services; certain
financial assets, mainly checking accounts and now negotiable order of withdrawal
accounts, serve as a medium of exchange in the making of payments. Example: Credit
cards (plastic credit cards) give the customer instant access to short-term credit but also
is widely accepted as a convenient means of payment. Debit card (plastic debit cards) -
is used today to charge a buyer’s deposit account for purchasing of goods and services
and transfer the proceeds instantly by wire to the seller’s account.

 Debit cards and other electronic means of payment, including computer

terminals at homes, offices, and stores are likely to displace checks and
other pieces of paper as the principal means of payment.
6. Risk Role/Function:

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An overview of the financial system
Financial markets and the diverse financial instruments traded in those markets allow
investors with the greatest taste for risk. It provides a means to protect business,
consumers, and Governments against risk to people, property and income. The
financial markets offer business, consumers and Governments protection against life,
health, property and income risks.
 Example: Life insurance policy
Thus, capital markets allow the risk that is inherent to all investments to be borne by
investors most willing to bear that risk. This allocation of risk also benefits the firms that
need to wise capital to finance their investments. When investors can self-select into
security types with risk-return characteristics, that best suits their preferences, each
security can be sold for the best possible price. This facilitates the process of building
the economy’s stuck of real assets.
 Example: More optimistic or risk-tolerant investors buy shares of stock.
The more conservative individuals buy bonds.

7. Policy Role/Function:
In recent decades, the financial market has been the principal channel through which
the Federal Government has carried out its policy of attempting to stabilize the
economy and avoid excessive inflation.
Types of Financial Markets and Their Roles
A financial market is a broad term describing any marketplace where buyers and sellers
participate in the trade of assets such as equities, bonds, currencies and derivatives.
Financial markets can be found in nearly every nation in the world. Some are very
small, with only a few participants, while others - like the New York Stock Exchange
(NYSE) and the Forex markets - trade trillions of dollars daily. Investors have access to a
large number of financial markets and exchanges representing a vast array of financial
products.

Capital Markets

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An overview of the financial system
A capital market is a market that allows supplier and demanders of long term funds (i.e.
funds with maturity exceeds one year) to make transactions. It is market for long term funds and
a market which deals long term investment.

Money Market: The money market is a segment of the financial market in which
financial instruments with high liquidity and very short maturities are traded. The
money market is used by participants as a means for borrowing and lending in the
short term, from several days to just under a year. Money market securities consist of
negotiable certificates of deposit (CDs), Bankers’ Acceptances, U.S. Treasury bills and
Commercial paper. Money market investments are also called cash investments because
of their short maturities.

The money market is typically seen as a safe place to put money due the highly liquid
nature of the securities and short maturities. Because they are extremely conservative,
money market securities offer significantly lower returns than most other securities.

Primary Markets vs. Secondary Markets

A primary market issues new securities on an exchange. Companies, governments and
other groups obtain financing through debt or equity based securities. Primary markets,
also known as "new issue markets," are facilitated by underwriting groups, which
consist of investment banks that will set a beginning price range for a given security
and then oversee its sale directly to investors. The primary markets are where investors
have their first chance to participate in a new security issuance. The issuing company or
group receives cash proceeds from the sale, which is then used to fund operations or
expand the business. The secondary market is where investors purchase securities or
assets from other investors, rather than from issuing companies themselves. The
Securities and Exchange Commission (SEC) registers securities prior to their primary
issuance, then they start trading in the secondary market on the New York Stock
Exchange, Nasdac or other venue where the securities have been accepted for listing
and trading.
The secondary market is where the bulk of exchange trading occurs each day. Primary
markets can see increased volatility over secondary markets because it is difficult to
accurately gauge investor demand for a new security until several days of trading have
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An overview of the financial system
occurred. In the primary market, prices are often set beforehand, whereas in the
secondary market only basic forces like supply and demand determine the price of the
security.

The Stock Markets:

A stock (a common stock) represents a share of ownership of a corporation, or a claim
on a firm's earnings/assets. Stock markets allow investors to buy and sell shares in
publicly traded companies. They are one of the most vital areas of a market economy as
they provide companies with access to capital and investors with a slice of ownership in
the company and the potential of gains based on the company's future performance.

 Bond Markets: A bond is a debt investment in which an investor loans money to an

entity (corporate or governmental), which borrows the funds for a defined period of
time at a fixed interest rate. Bonds are used by companies, municipalities, states and
local governments to finance a variety of projects and activities. This market is
alternatively referred to as the debt, credit or fixed-income market.
The bond markets are important because they are the markets where interest rates are
determined
Derivatives Markets: The derivative is named so for a reason: its value is derived from
its underlying asset or assets. A derivative is a contract, but in this case the contract
price is determined by the market price of the core asset. If that sounds complicated, it's
because it is. The derivatives market adds yet another layer of complexity and is
therefore not ideal for inexperienced traders looking to speculate. However, it can be
used quite effectively as part of a risk management program.

Examples of common derivatives are forwards, futures, options, swaps and contracts-

for-difference (CFDs).

Forex Market: The foreign exchange market is where funds are converted from one
currency into another. The foreign exchange rate is the price of one currency in terms of
another currency. The foreign exchange market determines the foreign exchange rate. 
The Forex is the largest market in the world in terms of the total cash value traded, and
any person, firm or country may participate in this market. There is no central

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An overview of the financial system
marketplace for currency exchange; trade is conducted over the counter. The Forex
market is open 24 hours a day, five days a week and currencies are traded worldwide
among the major financial centers of London, New York, Tokyo, Zürich, Frankfurt,
Hong Kong, Singapore, Paris and Sydney.

Global Financial System

A brief definition of the global financial system (GFS) is: The financial
system consisting of institutions, their customers, and financial regulators that act on a
global level. The IMF (the organization at the center of the system) defines it as
"...various official and legal arrangements that govern international financial flows in
the form of loan investment, payments for goods and services, interest and profit
remittances
The most prominent public international financial institutions are:
The International Monetary Fund keeps tabs of international balance of
payments accounts of member states. The IMF acts as a lender of last resort for
members in financial distress, e.g., currency crisis, problems meeting balance of
payment when in deficit and debt default. Membership is based on quotas, or the
amount of money a country provides to the fund relative to the size of its role in the
international trading system.
The World Bank aims to provide funding, take up credit risk or offer favorable
terms to development projects mostly in developing countries that couldn't be
obtained by the private sector. The other multilateral development banks and
other international financial institutions also play specific regional or functional
roles.
The World Trade Organization settles trade disputes and negotiates international
trade agreements in its rounds of talks (currently the Doha Round).
The Bank for International Settlements (BIS) in Basel Switzerland, which is both a
bank as well as an intergovernmental organization for central banks worldwide. It
publishes global bond market capitalization data.
The World Economic Forum, a Swiss "non-profit" foundation based
in Geneva meeting annually Davos.

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An overview of the financial system
The most prominent private international financial institutions are:

The Institute of International Finance (IIF), a trade organization of the world's

largest commercial banks and investment banks.
The World Federation of Exchanges (WFE) which publishes global stock
capitalization information in annual reports. 
The Global Financial Markets Association(GFMA), which consists of European,
Asian and North American financial market associations:

The Association for Financial Markets in Europe (AFME) in London and Brussels,
the Asia Securities Industry & Financial Markets Association (ASIFMA) in Hong
Kong, and the Securities Industry and Financial Markets Association (SIFMA) in
New York and Washington DC.

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An overview of the financial system