FMI CHAPTER-01 FINANCIAL INSTITUTION & MARKETS HAND-OUT FOR ACFN 2ND YEAR

STUDENTS

CHAPTER ONE
1.1 An overview of the Financial System
Introduction
Financial System:
“The Financial System provides a mechanism whereby an individual unit (which may be a
household or a firm) that is an SSU may conveniently make funds available to DSUs who intend
to spend more than their current income”. Financial System is comprised of Financial Markets
and Financial Institutions.
1.2 Functions (roles) performed by Financial System in the economy:
The Financial System and its major component (Financial Markets) perform the following
functions:
(1) Savings function: The global system of Financial Markets and Institutions provides a
connecting link for the savings of the public. Bonds, stocks and other financial claims sold in
money and capital markets provide a profitable outlet for the public savings. These savings flow
through the financial markets into investment so that more goods and services can be produced.

(2) Wealth function: The financial instruments sold in the money and capital markets provide
an excellent way to store wealth (i.e. to preserve the value of assets held) until they are needed
for spending. Though there is a general preference to store the value of wealth in the form of
real assets (such as buildings, automobiles), yet they are subject to depreciation and loss in value.
Contrarily, the financial instruments do not have wear and tear, and they have the chance of
generating regular income and appreciate in value over time.

(3) Liquidity function: Financial Markets in the financial system provide a convenient means
of converting the financial instruments into cash, with ease and without loss of time. Money
possessed in the form of bank deposits are the most liquid form of assets. For other financial
instruments, the financial markets provide a ready market for who wish convert them back into
cash.

(4) Credit function: Financial markets furnish credit to finance consumption and investment
spending. Credit consists of a loan of funds in return for a promise of future payment.
Consumers need credit to buy home, groceries, other services, and to pay outstanding debts.
Business houses need credit to stock the goods, construct new shops, meet payrolls, and pay
dividend to their stockholders. Similarly, governments need credit provide public facilities.

(5) Payments function: The financial system provides a mechanism for making payments for
goods and services. Certain financial assets serve as a medium of exchange in making payments.

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 FMI CHAPTER-01 FINANCIAL INSTITUTION & MARKETS HAND-OUT FOR ACFN 2ND YEAR
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(6) Risk Protection function: By selling insurance policies, the financial markets offer
protection against life, health, property, and income risks of businesses, consumers and the
governments. The money and capital markets are used by businesses and consumers to “self-
insure” against risk, by building up wealth as protection against future losses.

(7) Policy function: In the recent times, the financial markets have been the principal channel
though which government has carried out its policy of attempting to stabilize the economy.
Governments can influence the borrowing and spending plans of the public, by altering the
interest rates and the availability of credit. This in turn influences the growth of jobs,
production, and prices.
1.2 Financial Assets
Meaning, Characteristics, and Kinds

1.2.1 What is a Financial Asset?

A Financial Asset is a “claim against the income or wealth of a business firm, household, or unit
of government, represented usually by a certificate, receipt, or other legal document, and usually
created by the lending of money”.
1.2.2 Characteristics of Financial Assets:
 Financial Assets do not provide a continuing stream of services to the owner as does a home
or a machinery or an automobile.
 Financial Assets are wanted because they promise future returns to their owners.
 Financial Assets serve as a store of value (purchasing power).
 There is no question of ‘depreciation’ for financial assets, since they do not wear out like
physical goods.
 Their physical condition or form is generally not relevant in determining their market value
(price).
 They have little or no value as a commodity (for they are generally represented by a piece of
paper, i.e. certificate or contract, or by information stored in a computer file).
 The cost of transport and storage of financial assets is low.
 Financial Assets are fungible, i.e. they can be easily changed in form and interchanged (or
substituted) for other assets.

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 FMI CHAPTER-01 FINANCIAL INSTITUTION & MARKETS HAND-OUT FOR ACFN 2ND YEAR
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1.2.3 Kinds of Financial Assets:

Though there are thousands of different financial assets, they can broadly be categorized into:
(1) Money,
(2) Equity,
(3) Debt Securities, and
(4) Derivative Securities.
1. Money - is the legal currency of any country, ETB in Ethiopia, USD in America, INR in
India.
2. Equity - (also known as Stock) is in the form of Common Stock and Preferred Stock.
3. Debt Securities - may be classified as Bonds, Notes, and Accounts Payable. Another
classification may be Negotiable debt securities, and Non-negotiable debt securities. Those
debt securities which can be converted into another debt or equity are known as Negotiable
debt securities, e.g. Convertible Bonds. Those which cannot be so converted are Non-
Negotiable debt securities, e.g. Passbook Savings Accounts in Banks.
4. Derivative Securities - form the fourth category of Financial Assets. By the very
name, one can understand that Derivative securities are those whose formation is dependent on
the original securities. They have a market value that is tied to or influenced by the value or
return on a financial asset. Examples include futures contracts, options, and swaps.
1.2.4 Money as a Financial Asset
What is Money?
Any financial asset that is generally accepted in payment for purchase of goods and services is
money. That’s why it is BIRR as money in Ethiopia, RUPEE in India, and YEN in Japan. Thus,
currency issued by NBE in Ethiopia, by the FED-Reserve in US, are different forms of Money.
Checking accounts in US are considered to be money, for they are freely accepted in payment for
purchase of any good or service in the US.

Functions/Services performed by Money:

 It serves as a Standard of Value for all goods and services.
 It serves as a medium of exchange. It is usually the only financial asset which virtually
every business, household, and government will accept in payment for goods and
services.
 It serves as a Store of Value – a reserve of future purchasing power. Purchasing power
can be stored in currency or in checking account until the time is right to buy.
 It functions as the only perfectly liquid asset in the financial system. (An asset is considered
to be liquid, if it possesses three characteristics: price stability, ready marketability, and
reversibility.)

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 FMI CHAPTER-01 FINANCIAL INSTITUTION & MARKETS HAND-OUT FOR ACFN 2ND YEAR
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Importance of Money as a Financial Asset:

 Acceptability of money for all transactions (Legal Tender)
 Negotiability (it can be converted for any other financial asset or real asset)
 Measure of Wealth (it serves as a measure of one’s wealth)
 Non-perish ability (even stored for long time, it does not perish – may be there could be
value fluctuations due to market conditions)
1.3 The Concept of lending and borrowing
1.3.1 Concept of ‘Saving
Our expenditure is continuous and ongoing, while our income is received only periodically
(usually monthly). This lack of synchronization between the receipt of income and expenditures
(one is periodical and the other is persistent) calls for a better management of our resources, i.e.
money. Whatever we spend (out of earnings) towards the purchase of goods and services for our
personal and family use is called consumption spending. Income that is not spent on
consumption is called ‘saving’. Such savings will either be invested in Real Assets or
Investment Goods (such as the house we buy or build), and in Financial Assets (such as Bank
Deposits, Stocks and Bonds, and money).

1.3.2 Meaning of SSUs and DSUs

We know that not every household will have excess of income over expenditure, viz., saving.
The other can also be the reality, that is, some households would have their expenditure
exceeding their income. In the case of the latter, they have to find the means of ‘financing’ their
deficit. Thus, ‘Surplus Spending Units (SSUs)’ are those households (and firms) whose
income exceeds their spending. That means, SSUs spend (towards consuming goods and
services) less than their current income and they have surplus funds to buy investment goods
(which may be real or financial assets). On the other hand, ‘Deficit Spending Units (DSUs)’ are
those households (and firms) whose spending exceeds their income. Obviously, the DSUs have
deficit and they need to find means to finance their deficit.
1.4 Three Types of Finance
1.4.1 Direct finance
Financial Markets are the markets where SSUs can lend their funds directly to DSUs. In other
words, Financial Markets are the markets in which spending units trade financial claims (SSUs
by lending their surplus funds and DSUs by borrowing for their deficit). This activity of SSUs
lending their funds directly to DSUs is called ‘Direct Finance’. For example, the Ethiopian
Telecommunications Corporation may issue corporate bonds (may be to finance plant expansion
all over the country), and one Admasu from Dilla can purchase some these bonds out of his
surplus income (which is not spent on consuming goods and services for his household). So, in
this case, there is direct financing provided by the SSU (here Mr.Admasu, an household) to the

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DSUs (here the ETC). Another example of Direct Finance is the buying of shares and stocks of
a corporation in the financial market.

1.4.2 Indirect finance

Financial Institutions are those firms that provide financial services to SSUs and DSUs. The
most important Financial Institutions are the Financial Intermediaries. Financial Intermediaries
are those financial institutions (such as Banks) which borrow from SSUs for the purpose of
lending to DSUs. The Surplus Spending Units park their surplus funds (in the form of Bank
Deposits) out of which the Financial Intermediaries lend the Deficit Spending Units to meet their
deficit (excess of expenditures over their income). Thus, the Financial Intermediaries serve a
connecting link between SSUs and DSUs. This activity of SSUs lending their surplus funds
through financial intermediaries to DSUs to meet their deficit is called ‘Indirect Finance’. For
example, Mr.Admasu may choose to park his surplus funds in Commercial Bank of Ethiopia at
Dilla and the CBE may use these funds to lend to one its business customer. So, in this case,
there is indirect financing through the Financial Intermediary (Commercial Bank of Ethiopia)
who acts as the connecting link between the SSU (Admasu) and the DSU (Business Customer
who needs finance). Here, an important point to observe is though it is the funds of Admasu
(SSU) which is lent by CBE to the Business Customer (DSU), the DSU owes repayment to the
Financial Intermediary (CBE) and not to the SSU.

1.4.3 Semi-Direct Finance

Remember that a financial intermediary is one which intermediates funds transfer between the
SSUs and the DSUs, by creating secondary securities. The financial intermediaries obtain the
funds from the SSUs and offer their own securities (such as Deposit Certificates, Insurance
Contracts, Pension Contracts, which are commonly known as Secondary Securities) as financial
claims to the SSUs. They then provide the funds to the DSUs (in the form of advances) and
accept the securities issued by DSUs (such as Stocks and Shares, Bonds and Debentures,
Treasury Bills, which are widely known as Primary Securities) as financial claims on the
DSUs. Thus they carry out ‘financial intermediation’.
There are Financial Institutions which do not act as Financial Intermediaries. They are financial
institutions which facilitates funds transfers from SSUs to DSUs without creating securities on
their own. They simply act as conduit pipe between the SSUs and DSUs. For example, a
security broker in Addis Ababa may provide the services of procuring shares offered by a newly
formed Share Company to an investor situated in Mekelle, for a commission or service charge.
In this context, the security broker does not create a secondary security (like the one created by
financial intermediaries), but simply transfers the security of the DSU (the share company) to the
SSU (the investor in Mekelle). This kind of financial transaction is known as ‘Semi-Direct
Finance’, which is facilitated by ‘Financial Institutions which are not financial intermediaries’.

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FMI CHAPTER-01 FINANCIAL INSTITUTION & MARKETS HAND-OUT FOR ACFN 2ND YEAR
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=The end of chapter one=

HAVE A NICE STUDY TIME!!!

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