2.

0 THE FINANCIAL SYSTEM

Research has shown that there is an association between savings and economic
growth. It has been shown that savings result in capital formation (investment) and
eventually higher output level which leads to economic growth and higher standard of
living.

An investment is the current commitment of money or other resources in the

expectation of reaping future benefits. The material wealth of a society is ultimately
determined by the productive capacity of its economy i.e. the goods and services its
members can create. This capacity is a function of the real assets of the economy
i.e. land, buildings, machines, and knowledge that can be used to produce goods and
services.

Individuals can acquire real assets by making savings which will accumulate into
enough amounts to purchase the real assets. Saving implies abstaining from
spending on consumption. Individuals can save on their own, but this would mean
that the money accumulation process would be too slow and the amount of real
assets the individual would accumulate would be insignificant. For a society to
develop there must be meaningful investment in real assets.

The role of transforming individual savings into meaningful investments is played by

the financial system. Financial markets and financial institutions provide the
mechanisms that allow people to save in a manner which enables them earn returns
and thus grow their money. It also enables entrepreneurs to raise the capital they
need to invest in profitable ventures. s

The financial system creates financial assets. In contrast to real assets, financial
assets such as stocks and bonds do not contribute directly to the productive capacity
of the economy. Instead, these assets are the means by which individuals in well
developed economies hold their claims on real assets. Financial assets are claims to
the income generated by real assets. Financial assets enable individuals in a society
to pool their resources together by buying securities issued by firms. The firms use
the money raised to pay for real assets such as plant, equipment, technology,
inventory etc which they use to produce goods and services on a large enough scale
to create substantial returns which are shared among all who contributed to the
acquisition of the real assets through the securities they acquired. In this way the
standard of life of all in the society increases.
 2.1 Function of Financial Markets
Financial markets perform the essential economic function of channelling
funds from households, firms, and governments that have saved surplus
funds by spending less than their income to those that have a shortage of
funds because they wish to spend more than their income. This process can
be presented in the following diagram:

INDIRECT FINANCE

Lender-Savers Financial Intermediaries Borrower-Spenders

FUNDS FUNDS
1. Households 1. Business Firms
2. Business 2. Government
firms F
3. Households
3. Governments U
4. Foreigners
4. Foreigners N
D
S

Financial Markets
FUNDS
FUNDS

DIRECT FINANCE

3.1.1 DIRECT FINANCE

 Here borrowers/spenders borrow directly from saver/lenders in financial
markets.
 This is achieved by the borrowers/spenders issuing financial instruments
(securities) such as bonds and stocks which they sell in financial markets.
 The financial instruments are claims on the future income and assets of
the issuer by the holder of such securities. The securities are thus
liabilities to the borrower/spender and assets to the holder.
 By buying the securities of the borrower/spender, the saver/lenders are
providing funds to the borrower/spender on the understanding that they
will have a share of the profits to be made from the use of the funds while
retaining title to the principal advanced.
3.1.2 INDIRECT FINANCE
 In indirect finance, saver/lenders deposit funds or buy instruments such as
insurance policies etc in financial intermediaries such as commercial banks and
insurance companies.
 The financial intermediaries then lend out the funds to borrower/spenders directly
in the form of loans or buy the borrower/spenders’ financial instruments from
financial markets.
 By lending to borrowers/spenders, the financial intermediary is converting its own
liabilities to its own assets from which it derives a claim on the future income and
assets of the borrower/spenders while maintaining an obligation to the
savers/lenders from which it acquired the funds.
 The process of indirect finance using financial intermediaries, called financial
intermediation, is the primary route for moving from lenders to borrowers.
 Financial intermediaries are a far more important source of financing for
corporations than securities markets are for a number of reasons.
 Financial intermediation reduces transaction costs especially on the part of small
savers. Financial intermediaries can substantially reduce transaction costs
because they have developed expertise in lowering them and by taking
advantage of economies of scale due to their size.
 Financial intermediaries help to reduce the exposure of savers to risk through the
process of risk sharing. They create and sell assets with risk characteristics that
people are comfortable with and then use the funds they acquire to purchase
other assets that may have far more risk. This process of asset transformation
enables financial intermediaries to make profits which they can share with the
small savers.
 Financial intermediaries also promote risk sharing by helping individuals to
diversify their investments thereby spreading risk. This would not be possible if
small savers tried to lend directly to borrowers.
 Financial intermediaries have better information about financial markets than
small savers. This inequality is called asymmetric information. Because of having
better information financial intermediaries can make better investment decisions
than small savers. Small savers are thus saved from adverse selection i.e.
making the wrong investment decision due to information asymmetry.
 Moral hazard is the problem created by asymmetric information after the
transaction occurs. Moral hazard in financial markets is the risk that the borrower
 may use the money in a risky venture which would cause him fail to honour his
obligations to the saver. The fear of moral hazard would deter most small savers
to lend out money resulting failure of funds to be channelled to borrowers. The
existence of financial intermediaries removes the fear of moral hazard hence
enabling funds to be more readily channelled to borrowers.

3.2 STRUCTURE OF FINANCIAL MARKETS

Financial markets can be categorised in a number of ways:

3.2.1 Debt and Equity markets

Individuals or firms can obtain funds in a financial market in two ways:
 By issuing a debt instrument such as a bond or a mortgage. A debt instrument is
a contractual agreement by the borrower to pay the holder of the instrument fixed
amounts at regular intervals i.e. interest and principal payments until a specified
date (maturity date) when the final payment is made.
o The maturity of a debt instrument is the number of years until the
instrument’s expiration date. This is referred to as the term of the date.
o Short-term debt instruments have a maturity of less than one year.
o Medium-term debt instruments have a maturity of between one year and
ten years.
o Long-term debt instruments have a maturity of more than ten years.
 The second method by which firms can raise funds in financial markets is by
issuing equities, such as common stock (shares).
 The holder of an equity instrument is entitled to the residual profit and assets of
the company. Equity holders are the last to be paid after all debt holders have
been paid.
 Equity holders own part of the company and have the right to vote at the
company’s general meeting in contrast to debt holders who are creditors of the
company.
 Equity holders get a share of the company’s residual profit through dividends
which are paid by the company periodically, usually twice a year if profits are
 available. This is in contrast to debt holders who are paid interest on their debt
whether the company makes a profit or not.
 Equities are considered long-term instruments because they have no maturity
date.

Primary and Secondary Markets

 A primary market is a financial market in which new issue of securities are sold
when they are first introduced onto the market by the issuer. These are the
securities which have not been on the market before. The securities are usually
sold to an underwriter, usually an investment bank, which guarantees a price for
the company’s securities. The underwriter then sells the securities to the public.
 The secondary market is a financial market in which securities which are already
in circulation are traded between different people. A security holder wishing to
dispose of his securities would sell them in the secondary market. Brokers and
dealers are key players in the secondary market.
o Brokers are agents of investors who match buyers with sellers of
securities; they buy and sell securities on behalf of their principals.
o Dealers buy securities from those wishing to sell and sell them to those
wishing to buy; in this way they link buyers and sellers.

The existence of the secondary market makes it easier and quicker to sell these
securities rendering them more liquid and thus desirable as investments than they
would otherwise be. This function enables the raising of funds through issuing
securities much easier.

The activities of the secondary market are the determinants of the prices at which
securities are traded. The secondary market therefore influences the prices at which
securities can be issued in the primary market and therefore influences the amount of
capital companies can raise through issuing of securities.

Secondary markets can be organised in two ways:

o Exchanges, where buyers and sellers of securities meet in one central
location to conduct trades.
 o Over-the-Counter (OTC) Markets where dealers set up shop where they
buy and sell various securities to anyone who comes to them and is
willing to accept their prices.

3.2.2 Money and Capital Markets.

Another way of classifying markets is as money and capital markets.
 The money market is a financial market in which only short-term debt instruments
are traded i.e. debt instruments with original maturity of less than one year.
o Money market securities tend to have smaller fluctuations in prices due to
their short term nature.
o They are prone to very low risk
o They therefore tend to be more widely traded and thus tend to be more
liquid.
 The capital market is a financial market in which long-term debt securities i.e.
with maturity of greater than one year, and equity instruments, are traded. Due to
their long term nature, capital market securities are more risky. These are usually
held by financial institutions.

3.0 FINANCIAL INTERMEDIATION

Most people do not enter financial markets directly but use financial intermediaries.
Commercial banks are the financial intermediary we meet most often in
macroeconomics, but mutual funds, pension funds, credit unions, savings and loan
associations, and to some extent insurance companies are also important financial
intermediaries.

When people deposit money in a bank, the bank uses the funds to make loans to
home buyers for mortgages, to students so they can pay for their education, to
business to finance inventories, and to anyone else who needs to borrow. A person
who has extra money could, of course, seek out borrowers himself and bypass the
intermediary. By eliminating the middleman, the saver could get a higher return. Why,
then, do so many people use financial intermediaries? The following are the reasons
why financial intermediaries are crucial in a financial system.

 Transaction costs
Transaction costs are a major problem in financial markets.

o Usually individuals have small amounts of money to invest. The cost of

investing say in stocks or bonds in the form of brokerage charges and
commissions would be too high relative to the amount being invested.
o An individual wishing to lend money to another is faced with the prospect
of losing the money and hence will want to protect himself by drawing up
a contract agreement. The legal costs of drawing up such an agreement
would be too high relative to the amount of money being loaned out.
o The cost of trying to identify a reliable borrower is too restrictive to an
individual lender.
o Because individuals have small amounts to save, it is impossible to
diversify investments hence individuals run the risk of putting all their eggs
in one basket.

Financial intermediaries are able to reduce transaction costs considerably.

o Economies of scale. Financial intermediaries pool together funds from

many savers which they re-invest. By making huge investments financial
intermediaries reduce the cost per unit of investment hence the
transaction costs for each individual investor who contributed to the pool
is considerably much smaller than it would have been had he made the
investment arrangement as an individual.

Because of their large resources, financial intermediaries are able to

invest in systems for processing transactions more efficiently e.g. through
the use of computer and telecommunications technologies which can
handle large volumes of transactions thereby lowering the cost per
transaction. Because of the lower transaction costs, financial
intermediaries are able to provide their customers with liquidity services,
services that make it easier for their customers to conduct transactions.

o Diversification of investments

Financial intermediaries pool together funds from many savers which they
re-invest. Because they have a large pool of funds, financial
intermediaries are able to invest in a variety of investments e.g. stocks
and bonds of different companies in different industries. Such a diversified
 portfolio diversifies away risk. Individual investors are thus indirectly
diversifying their investments through the intermediary and thus face a
minimal amount of risk than if they invested individually.

o Asset transformation

Intermediaries create and sell assets with risk characteristics that people
are comfortable with e.g. banks provide checking accounts, savings
accounts etc which have very low risk to the account holder; the
intermediaries then use the funds they acquire by selling these assets to
purchase other assets that may have far more risk e.g. stocks and bonds.
Low transaction costs enable financial intermediaries to do this at low cost
hence they are able to earn higher returns from the more risky assets
than they pay to the small savers with the less risky assets, in this way
financial intermediaries are able to make a profit. More importantly asset
transformation involves converting short-term more liquid and less risky
investments of the savers into long-term more risky investments which are
necessary to finance firms for investment in long term capital assets.
Asset transformation provides greater liquidity to small savers while
affording longer-term borrowing to firms.

 Asymmetric information

Information is very important in decision-making. The problem in financial

markets is that lenders and borrowers often do not have the same information.
Many lenders do not know much about the borrowers; their financial
performance, cash flows, how risky their operations are, what returns are
expected from their investments etc. This disparity in information availability
between lenders and borrowers is called asymmetric information. Asymmetric
information has two woes:

o Adverse selection. The danger that a lender may select the wrong
borrower; a borrower who has greater risk of making a loss and not
paying back amounts borrowed plus interest.
 o Moral hazard. The danger that the borrower, after obtaining the money,
might engage in activities which are undesirable from the lender’s point of
view because they make it less likely that the loan will be paid back.

Both adverse selection and moral hazard are deterrents to the lenders’ motivation to
lend. The existence of asymmetric information with the concomitant adverse
selection and moral hazard means that transfer of funds from lenders to borrowers is
potentially threatened.

Tools to help solve adverse selection problem

The elimination of asymmetric information can solve the adverse selection

problem. This could be done by making full information about the individuals and
firms seeking funds to finance their investment activities available to lenders.

 Private production and sale of information

Some private companies collect and publish information that distinguishes good from
bad firms and then sell it. The system of private production and sale of information
does not completely solve the problem of adverse selection because of what is called
the free-rider problem. Some people are able to access the information without
paying for it hence impeding the ability of the information providing firms to make a
profit. The effect of this is that private firms do not supply enough information on the
marketplace to alleviate the problem of adverse selection.

 Government regulation to increase information

Governments attempt to alleviate the asymmetric information problem by passing

laws and regulations requiring companies to disclose information about themselves.
Regulation of financial markets and financial institutions in Malawi is by government
through the Reserve Bank of Malawi which governs through the following Acts:

o Reserve Bank of Malawi Act(Chapter 44:02)

o Exchange Control Act(Chapter 45:01)
 o Banking Act
o Capital Market Development Act (Chapter 46:06)

Although government regulations lessen the adverse selection problem, it does not
eliminate it. Even when firms provide information to the public about their sales,
assets, or earnings, they still have more information than investors. It is possible for
firms to employ accounting methods that obscure pertinent details without breaking
the law, hence information published by companies, which most of the times satisfies
the minimum disclosure requirements may not tell everything that needs to be known
about a company.

 The role of financial institutions

Financial intermediaries such as banks develop expertise in the production of

information about firms so that they can sort out good credit risks from bad ones.
Banks are able to profit from the information they gather because they avoid the free-
rider problem by primarily making private loans rather than buying securities that are
traded in the open market hence it is difficult for others to see what the bank is doing.
Financial institutions thus invest a lot in acquiring information about prospective
borrowers and are thus able to assess potential borrowers better.

Financial institutions such as banks usually get collateral from people and firms
which borrow from them, in this way funds loaned out are secured hence reducing
the risks that emanate from adverse selection.

Financial institutions thus play a very important role in removing the fear of adverse
selection in financial markets and thus facilitate the transfer of funds from lenders to
borrowers.

Tools to help solve the moral hazard problem

Moral hazard affects the choice between debt and equity contracts. People who buy
shares in a company (equity) become owners of the company but do not participate
in the day to day running of the company which is done by appointed directors who
are not owners of the company. Moral hazard arises because the directors have
more information about the company than the equity holders, and they can carry on
activities which are not in the best interest of the shareholders (agency problem).
One way in which equity holders can try to alleviate the agency problem is through
the engagement of independent auditors to audit the company frequently. This is
however very expensive and it is possible for auditors not to detect some subtle
frauds and mismanagement. This makes equity contracts less desirable; as a result
stocks are not the most important source of external financing for companies.

Governments also try to alleviate the moral hazard problem through laws and
regulations which force companies to adhere to standard accounting principles which
make profit verification easier. They also pass laws which impose stiff criminal
penalties on people who commit the fraud of hiding and stealing profits. However
these methods can only be partly effective because it is not easy to detect such
frauds since managers can use crafty methods that make it difficult to find or prove
fraud.

Financial intermediaries such as venture capital firms play a role in alleviating moral
hazard problems. Venture capital firms pool the resources of their partners and use
the funds to help budding entrepreneurs start new businesses. The venture capital
firm then acquires equity share in the company. Because verification of earnings and
profits is so important in eliminating moral hazard, venture capital firms insist on
having several of their own people participate as members of the board of directors
of the company which is the managing body of the company; this alleviates the fear
of moral hazard and thus facilitates the motivation of people to invest in the equity
capital of firms.

Issuing marketable debt securities is also not the primary way in which most
businesses finance their operations except for very large corporations. This is due to
the fact that more information is readily available for large corporations than for small
firms hence moral hazard problem is greater for smaller firms than for large firms.
Most small firms therefore rely on indirect finance hence the importance of financial
intermediaries.

Financial intermediaries alleviate the problem of moral hazard by:

o Requiring the borrower to have a certain amount of his own money in the
firm before he can be allowed to borrow. This ensures that the borrower
has a greater net worth in the business and is thus likely to act more
prudently.
o Monitoring and enforcement of restrictive covenants. Financial
intermediaries usually tie the borrower to agreements which restrict the
 borrower’s use of the money borrowed and have mechanisms for
inspecting the borrower to ensure that the money borrowed is used for
acceptable purposes as per the restrictive agreement.
o Requiring the borrower to provide collateral for amounts borrowed.