CHAPTER ONE

AN OVERVIEW OF THE
FINANCIAL SYSTEM
 Chapter Objectives
After studying this chapter, you should be able to:
 Understand and explain the role of financial system in the
economy.
 Describe the types financial assets, their roles and
properties.
 Describe the types of financial markets that facilitate the
flow of funds, their roles and characteristics.
 Understand and explain the importance of financial
regulation in the financial system
 Introduction
 The economic development of any country depends upon
the existence of a well organized financial system.
 A financial system makes efficient transfer of funds by
overcoming the information asymmetry problem between
those with fund surplus units and fund deficit units.
 The financial system is the process by which money flows
from lenders to borrowers.
 The financial system has three components:
1. Financial markets;
2. Financial intermediaries; and
3. Financial regulators.
 Cont.….
 How funds transferred between lenders and borrowers?

 Funds can be transferred between users and savers

directly or indirectly.
 Cont.….
 In direct finance, borrowers borrow funds directly from
lenders in financial markets by selling them
securities/instruments.
 The role of financial system in the economy

 transfer funds from surplus units to deficit units

 redistribute the unavoidable risk
associated with the cash flow generated by tangible assets
among the deficit units and surplus units.
 Financial Concepts
 An understanding of the financial system requires an
understanding of the following important concepts.
 Financial Assets/securities/instruments
 Financial intermediaries/institutions
 Financial Markets
 Financial Regulations
 Financial Assets
 An asset is defined as any resource that is expected to
provide future benefits and has economic value.
 Assets can be classified as:
1. Tangible Assets (e.g. building, land, machinery, etc.)
 their value depend on its physical properties.
2. Intangible Assets
 represents a legal claim to some future economic benefits.
 bears no relation to the form, physical or otherwise, in
which the claims are recorded.
 Cont.….
 Financial assets (financial instrument or Securities) are
claims on the borrower’s future income or assets in the form
of periodical payments (principal, interest or dividend).
 E.g. Treasury Bills, bonds, shares, etc.
 They are dealt in a financial market.
 They are assets for the buyers, but they are liabilities for the
sellers (issuers).
 Cont.….
 For every financial instrument there is a minimum of
two parties
 The issuer/seller
 The party that has agreed to make future cash payments
 The investor/buyer
 The owner of the financial asset and the right to receive the
payments made by the issuer
 Classification of Financial Assets
 Financial assets can be classified
1. Marketable Assets
 can be easily transferred from one person to another
 Examples: shares of listed companies, Government
securities, Bonds of public sector undertakings etc.
2. Non-Marketable Assets
 cannot be transferred easily from one party to another
 Examples: Bank deposits, provident fund, pension fund,
national savings certificates, insurance policies etc.
 Properties of Financial Assets
 Moneyness
 used as virtually a medium of exchange
 Divisibility/denomination
 denominated in smaller sizes
 Reversibility
 ability to be converted back to cash at a lower cost.
 Cont.….
 Term to maturity
 length of time between when the instrument is issued
and its liquidation.
 some instruments are liquidated upon demand by the
creditor
 instruments may be issued with the term of a few days
to so many years.
E.g. Treasury bill vs Bonds
 despite carrying a specific term, financial instruments
may be liquidated prematurely
 Cont.….
 Liquidity
 refers how easy is the asset to buy/sell.

 it also refers to the speed with which the asset can be

sold.
 financial assets differ in terms of degree of liquidity based
on the issuer‘s identity (Microsofts Stocks vs a small
company‘s tock)
 Convertibility
 ability to be converted into other financial assets
 Cont.….
 Currency
 are denominated in a certain currency
 Cash flow and return predictability
 return on a financial asset depends on the cash flow
expected to be received
 Complexity
 some financial assets may be combinations of two or
simpler assets
 Tax status
 financial assets have different tax status
 Financial Market
 A financial market is a market in which financial assets
(securities) such as stocks and bonds can be exchanged.
 Facilitate the flow of funds from those who have excess fund
(surplus units/investors) to those who need fund (deficit
units/borrowers).
 Function of Financial Markets

Reading
Assignment
 Classification of Financial Market
 There are different ways of classifying financial markets.
1. By the type of financial claim traded
 Debt vs Equity Market

2. By the maturity of claims

 Money market vs Capital Market

3. Based on whether the claims represent new issues or

outstanding issues such as:
 Primary vs Secondary Market

4. By the timing of delivery such as;

 Cash/spot market vs Forward/futures Market

5. By the nature of its organizational structure such as:

 An exchange traded market vs an Over the
Counter Market
 Debt vs Equity Market
 Debt Market
 a financial market for fixed claims (debt instruments)
Debt market instruments
 the most common method of getting fund
 a contractual agreement by the borrower to pay the
holder of the instrument fixed amount of money at
regular intervals (I + P) until a specified date, when a
final payment is made.
Classifications of debt market instruments
 Short-term- matures < a year
 Intermediate-term- matures between 1 & 10 years
 Long-term- matures ≤ 10 years
 Money Market vs Capital Market
 Equity Market
 a financial market for residual claims (equity
instruments)
Equity market instruments
 are claims to share in the net income and net assets of a
business
 make periodic payments (dividends) to their holders and
are considered long-term securities because they have no
maturity date
 Money Market vs Capital Market
 Money markets
 are markets that facilitate the flow of short-term capital
 only short-term debt instruments (matures < a year) are
traded
Characteristics of money market securities
• Liquid
• Low expected return
• Low degree of risk
• Example: Treasury bills, certificate of deposits
 Cont.….
 Capital market
 are markets that facilitate the flow of long-term capital
 Longer-term debt (maturity of ≥ 1 year) and equity
securities are traded.
Characteristics of capital market securities
• have a higher expected return and more risk than money
market securities.
• Example: Bonds (Municipal Bonds, Corporate Bonds) and
mortgages, Stocks (Commons Stocks, Preferred Stocks).
 Primary Market vs Secondary Market
 Primary market
 a financial market in which new issues of a security, such
as a bond or a stock, are sold to initial buyers
 enable organizations to raise new finance, by issuing new
shares or new bonds.
Classification of primary market
1. Public Market Issuance- sold to the general public through
underwriting of securities in investment banks and auctions
2. Private Placement Market- sold to selected individual
investors
 Cont.….
 Secondary Market
 a financial market that enable investors to buy and sell
existing securities to each other
 no new capital is raised and the issuer of the security
does not benefit directly from the sale
 trading takes place among investors through stock
brokers.
 E.G. NYSE (18.5 trillion. Apple, Facebook, Google, etc),
NASDAQ (7.5 trillion. eBay, Microsoft, Craft, etc.), Japan
Exchange Group (4.5 trillion), Shanghai Stock Exchange (3.9
trillion), LSE (3.6 Trillion)
Secondary markets serve two important functions
1. they make the financial instruments more liquid
2. they determine the price of the security that the issuing firm
sells in the primary market.
Exchange Traded Market vs Over The Counter Market
 Secondary markets may be organized on exchanges or
may consist of over the counter (OTC) transactions
 Exchange Traded Market
 buyers and sellers of securities meet in one central
location, the exchange, to conduct trades
 only listed financial instruments are traded
 E.g. NSE, LSE, ECEM, etc.
 Over-the-Counter Markets
 where transactions do not involve buying and selling
through an exchange, but customers negotiate
individual transactions, usually with a financial
intermediary such as a bank.
 a market where unlisted financial instruments are
traded
 Market players/market participants
INDIVIDUALS INDIVIDUALS

Financial Intermediaries
(e.g. housing/consumer (as savers and
goods finance) investors)

FIRMS FIRMS
(share capital; loans) (with long-term funds
to invest)

GOVERNMENTS GOVERNMENTS
(budget deficit) (budget surplus)
 Financial Intermediaries/Institutions
 Financial intermediaries
 financial institutions through which savers can indirectly
provide funds to borrowers
 link lenders (fund surplus units) with borrowers (fund
deficit units), by obtaining deposits from lenders and then
relending them to borrowers
 play an important role in the financial system because
they
• reduce transaction costs (due to economies of scale),
• allow risk sharing (through portfolio investment), and
• solve problems created by asymmetric information
(adverse selection and moral hazard)
 Cont.….
 Types of Financial Intermediaries
 Depository institutions (Banks)
• Commercial banks
• Savings and loan associations and mutual savings banks
• Credit unions
 Contractual savings institutions
• Life insurance companies
• Fire and casualty insurance companies
• Pension funds (private)
• State and local government retirement funds
 Investment intermediaries
• Finance companies
• Mutual funds
• Money market mutual funds
 Regulation of the Financial System
 Governments regulate financial markets and financial
intermediaries for two main reasons:
1. To increase the information available to investors and
2. To ensure the soundness of the financial system
 Regulations include
 requiring disclosure of information to the public,
 restrictions on who can set up a financial intermediary,
 restrictions on the assets financial intermediaries can hold,
 the provision of deposit insurance,
 limits on competition, and
 restrictions on interest rates.
The end
Individual Assignment
How a financial system affects economic
development of a country?

One to two pages

Deadline: Next week