ADDIS ABABA UNIVERSITY COLLEGE OF BUSINESS AND ECONOMICS

FINANCIAL SYSTEM IN DEVELOPIN COUNTRIES (FE 608 ) INDIVIDUAL ASSIGNMENT

Name ID NO

TEMESGEN TESHALE GSR/9216/16

Submitted to: Dr, JEMBERU

Part I: Discussion Questions

1. Why does the Principal-Agent Problem make debt more attractive than equity to investors?

ANSWER: The Principal-Agent Problem is a situation where the interests of investors and management
may be in conflict. In such a scenario, equity investors may be more vulnerable to losses as they have
less control over the management of the company. Debt, however, offers a fixed rate of return and is
given priority in the company's capital structure. This makes debt a more attractive option for investors
as it provides greater security and less risk in terms of returns. Moreover, debt investors have legal
rights to receive their payment before equity investors in the event of bankruptcy or liquidation of the
company.

2. Explain the advantages and disadvantages of maintaining a large amount of bank capital.

ANSWER: Maintaining a large amount of bank capital has several advantages. Firstly, it enhances
financial stability by providing a buffer to absorb losses, reducing the risk of insolvency and promoting
overall stability in the financial system. Secondly, it improves the bank's ability to withstand economic
downturns, ensuring that it can continue lending and supporting economic activity. Lastly, it increases
confidence and credibility among investors, depositors, and regulators, leading to lower borrowing costs
and increased market confidence.

However, there are also disadvantages to maintaining a large amount of bank capital. It can reduce
profitability by limiting a bank's ability to generate profits through leverage and risk-taking. Additionally,
raising additional capital can be costly and dilute existing shareholders' ownership. Moreover, banks
with large capital buffers may become more cautious in extending credit, which could limit the
availability of loans to businesses and individuals.

3. What if investment banking activities are part commercial banks or vice versa? Explain

ANSWER: When investment banking activities are combined with commercial banking activities or vice
versa, there are advantages and disadvantages to consider. On the positive side, integrating these
activities can lead to cost efficiencies and cross-selling opportunities, benefiting from economies of scale
and scope. It also diversifies a bank's revenue streams and enhances its ability to cater to diverse client
needs.

However, there are also potential disadvantages. Combining investment banking and commercial
banking activities can create conflicts of interest and increase the risk of contagion. Investment banking
activities involve higher levels of risk and volatility compared to traditional commercial banking
activities. If a bank's investment banking activities suffer losses, it could have adverse effects on its
commercial banking operations, and vice versa.

4. Discuss nexus among pension, longevity and dependency ratio

ANSWER: The nexus among pension, longevity, and dependency ratio refers to the interconnection
between these factors and their impact on the sustainability of pension systems and the overall
economy.

As people live longer due to increased longevity, pension systems face challenges in providing income
security for retirees over an extended period. Longer life expectancy results in longer periods of pension
payments, putting strain on pension funds and governments responsible for funding them.

The dependency ratio, which compares the proportion of the population that is not working
(dependent) to those of working age, is also affected. As longevity increases and the elderly population
grows, the dependency ratio rises. This places a burden on the working-age population to support the
non-working population, including pensioners. These factors are interconnected, and their implications
need to be considered when designing sustainable pension systems and planning for the financial well-
being of retirees.

5. Explain the function of Basel Committee on Banking Supervision

ANSWER: The Basel Committee on Banking Supervision (BCBS) plays a crucial role in global banking
regulation and supervision. It develops and promotes international standards and guidelines for the
regulation, supervision, and risk management of banks. One of the main functions of the BCBS is to
develop and review international banking regulations known as the Basel Accords. These accords
provide a framework for banks to assess and manage various risks, including credit, market, and
operational risks. The committee aims to promote the implementation and adoption of these regulatory
standards by member countries, ensuring a level playing field and enhancing the stability of the global
banking system. The BCBS also facilitates the exchange of information and best practices among
member countries, fostering cooperation and coordination in supervisory matters. It conducts research
and analysis on emerging risks and trends in the banking sector, providing valuable insights to inform
policymaking and regulatory initiatives.

6. Explain the typical Ethiopian bank and non-bank financial institutions balance sheet

ANSWER:The balance sheet of a typical Ethiopian bank and non-bank financial institution consists of
various components.On the asset side, it includes cash and cash equivalents, representing the funds
held in the form of cash or highly liquid assets. Loans and advances are also included, which represent
the amount of money lent to borrowers, including both corporate and retail loans. Investments, such as
government securities and corporate bonds, are also part of the balance sheet. Additionally, property
and equipment, such as buildings and technology infrastructure, are listed as assets. Other assets, such
as receivables and intangible assets are also included. On the liability side, deposits are a significant
component, representing the funds held by the bank on behalf of its customers, including different
types of accounts such as demand deposits, savings accounts, and fixed deposits. Borrowings, which are
funds borrowed by the bank from other financial institutions or the central bank, are also listed as
liabilities. Other liabilities, such as payables, provisions, and accrued expenses, are accounted for as well.

Equity includes share capital, representing the capital contributed by shareholders, retained earnings,
which are the accumulated profits or losses that have been retained within the institution, and reserves,
which are funds set aside for specific purposes such as reserves for loan losses or general reserves. It's
important to note that the specific composition and structure of the balance sheet may vary among
individual Ethiopian banks and non-bank financial institutions, depending on their size, business model,
and regulatory requirements.
Part II: Term Paper

Outline of the paper

1. Introduction

1.1. Background

1.2. Purpose of the Paper

2. Peculiarities of the Financial System in Developing Countries

2.1. Overview of Developing Countries' Financial Systems

2.2. Key Characteristics and Peculiarities

2.2.1. Limited Access to Formal Financial Institutions

2.2.2. High Reliance on Informal Financial Mechanisms

2.2.3. Volatility and Instability in Financial Markets

2.2.4. Weak Regulatory Frameworks and Governance

2.2 5. Limited Financial Inclusion and Access to Credit

3. Basics of Islamic Finance and its Differences with Conventional Finance System

3.1. Introduction to Islamic Finance

3.2. Fundamental Principles of Islamic Finance

3.3. Key Differences between Islamic Finance and Conventional Finance

3.3 1. Prohibition of Interest (Riba)

3.3.2. Profit-and-Loss Sharing (Mudarabah and Musharakah)

3.3.3. Asset-Backed Financing (Ijarah and Murabaha)

3.3.4. Ethical and Social Considerations

3.3.5. Regulatory Framework and Supervision

4. Indigenous and Informal Financial Institutions in Developing Countries

 4.1. Definition and Scope of Indigenous and Informal Financial Institutions

4.2. Examples of Indigenous and Informal Financial Institutions

4.2 1. Rotating Savings and Credit Associations (ROSCAs)

4.2.2. Moneylenders and Pawnbrokers

4.2. 3. Informal Savings Groups and Microfinance Institutions

4.3. Practices and Functions of Indigenous and Informal Financial Institutions

4.3.1. Social Capital and Trust-Based Networks

4.3.2. Flexibility in Loan Terms and Collateral Requirements

4.3.3. Cultural Relevance and Customized Financial Services

5. Bank Concentration: Few in Number and Large in Size or Large in Number and Small in Size?

5.1. Introduction to Bank Concentration

5.2. Arguments for Few Large Banks

5.2.1. Economies of Scale and Scope

5.2.2. Enhanced Financial Stability and Risk Management

5.3. Arguments for Many Small Banks

5.3.1. Increased Competition and Innovation

5.3.2. Local Market Knowledge and Customer Focus

5.4. Case Studies and Empirical Evidence

5.5. Implications for Developing Countries

Conclusion

A. Summary of Key Findings

B. Implications for Policy and Future Research

REFERENCES

1. Introduction
 1.1. Background

The financial systems in developing countries exhibit unique characteristics and peculiarities that
distinguish them from those in developed economies. These peculiarities are shaped by various factors,
including economic development levels, institutional frameworks, cultural norms, and historical
contexts. Understanding the distinct features of financial systems in developing countries is crucial for
policymakers, researchers, and practitioners to design effective strategies for promoting financial
stability, economic growth, and poverty reduction.

In today's globalized economy, the financial systems of developing countries play a crucial role in their
economic growth and stability. These countries face unique challenges and opportunities as they strive
to establish robust financial systems that can support their development objectives. Understanding the
characteristics and performance of these financial systems is essential for policymakers, researchers,
and investors to make informed decisions and promote sustainable economic growth.

1.2. Purpose of the Paper

This paper aims to explore the peculiarities of financial systems in developing countries and provide
insights into four key areas. Firstly, it will examine the basics of Islamic finance and its differences
compared to conventional finance systems. Islamic finance, rooted in principles derived from Islamic law
(Shariah), operates on the basis of ethical and socially responsible practices. Secondly, it will delve into
the practices of indigenous and informal financial institutions in developing countries, which often serve
as vital sources of financial services for individuals and communities. Thirdly, it will analyze the debate
surrounding bank concentration, exploring the arguments for having a few large banks versus many
small banks. Lastly, the paper will discuss the implications of these factors for developing countries and
suggest potential policy implications. And also the paper is to conduct a comparative analysis of financial
systems in developing countries. By examining the similarities and differences among these systems, we
aim to identify key factors that contribute to their effectiveness, resilience, and inclusiveness. This
analysis will provide valuable insights into the specific challenges faced by developing countries and
shed light on potential strategies for enhancing their financial systems.

2. Peculiarities of the Financial System in Developing Countries

2.1. Overview of Developing Countries' Financial Systems

Developing countries' financial systems differ from those in advanced economies in terms of their
structure, regulations, and level of development. These systems are often characterized by a mix of
formal and informal financial mechanisms and face unique challenges that require tailored approaches.
While there is significant heterogeneity among developing countries, certain key characteristics and
peculiarities can be identified.

2.2. Key Characteristics and Peculiarities

 2.2.1. Limited Access to Formal Financial Institutions

One of the prominent features of financial systems in developing countries is the limited access to
formal financial institutions, such as commercial banks. Many individuals and small businesses,
particularly those in rural areas and low-income segments, have little or no access to formal banking
services. This lack of access restricts their ability to save, invest, and access credit, hindering economic
growth and poverty reduction.

2.2.2. High Reliance on Informal Financial Mechanisms

In the absence of formal financial institutions, developing countries often rely heavily on informal
financial mechanisms. These include community-based savings groups, moneylenders, and non-bank
financial intermediaries. Informal mechanisms can provide limited access to credit but are often
associated with high interest rates, lack of transparency, and limited consumer protection. Additionally,
informal mechanisms may not effectively mobilize savings or provide avenues for long-term investment

2.2.3. Volatility and Instability in Financial Markets

Financial markets in developing countries are often marked by higher volatility and instability compared
to their counterparts in advanced economies. Factors such as weak institutional frameworks,
inadequate risk management practices, and limited market liquidity contribute to increased market
volatility. Fluctuations in exchange rates, interest rates, and commodity prices can have a significant
impact on the stability of financial systems in these countries.

2.2.4. Weak Regulatory Frameworks and Governance

Developing countries frequently face challenges in establishing robust regulatory frameworks and
effective governance structures for their financial systems. Weak regulatory oversight, inadequate
enforcement mechanisms, and corruption can undermine the stability and integrity of financial markets.
Strengthening regulatory capacity, enhancing transparency, and promoting good governance are crucial
for developing countries to build resilient financial systems

2.2 5. Limited Financial Inclusion and Access to Credit

Financial inclusion, defined as the access and usage of formal financial services by individuals and
businesses, remains a major challenge in developing countries. Limited access to credit is a significant
impediment to entrepreneurial activities and economic growth. Factors contributing to limited financial
inclusion include high transaction costs, lack of collateral, inadequate credit information, and
asymmetric information between lenders and borrowers. Efforts to promote financial inclusion and
expand access to credit are essential for fostering inclusive economic development.

Developing countries face unique challenges and opportunities in developing their financial systems.
Understanding these peculiarities is crucial for designing effective policies and interventions to promote
inclusive financial development. By addressing the limitations and harnessing the potential of their
financial systems, developing countries can create an enabling environment for sustainable economic
growth and poverty reduction.

3. Basics of Islamic Finance and its Differences with Conventional Finance System

3.1. Introduction to Islamic Finance

Islamic finance is a financial system that operates in accordance with the principles and rules of Islamic
law, also known as Shariah. It is based on ethical and moral principles that aim to promote economic
and social justice while adhering to Islamic teachings. Islamic finance encompasses a wide range of
financial products and services that comply with Shariah principles, providing an alternative to
conventional finance.

3.2. Fundamental Principles of Islamic Finance

The principles of Islamic finance are derived from the Quran (the holy book of Islam) and the Hadith (the
teachings and practices of the Prophet Muhammad). The fundamental principles include:

1. Prohibition of Interest (Riba): Islamic finance prohibits the charging or receiving of interest,
considering it exploitative and unjust. Instead, it promotes the concept of profit and risk-sharing
between parties involved in financial transactions.

2. Prohibition of Uncertainty or Speculation (Gharar): Islamic finance discourages transactions that

involve excessive uncertainty, ambiguity, or speculation. Contracts should have clear terms and
conditions, and risks should be shared transparently between parties.

3. Prohibition of Investing in Prohibited Activities (Haram): Islamic finance prohibits investments in

activities that are considered unethical or contrary to Islamic principles. This includes industries such as
alcohol, gambling, tobacco, and pork.

4. Ethical and Social Considerations: Islamic finance encourages ethical behavior, fairness, and
transparency in financial transactions. It promotes the well-being of society and discourages exploitative
practices.

3.3. Key Differences between Islamic Finance and Conventional Finance

3.3 1. Prohibition of Interest (Riba)

The most significant difference between Islamic finance and conventional finance is the prohibition of
interest (riba) in Islamic finance. In conventional finance, interest is a fundamental component of
lending and borrowing activities. Islamic finance, on the other hand, promotes profit and loss sharing
and prohibits the charging or receiving of interest.
 3.3.2. Profit-and-Loss Sharing (Mudarabah and Musharakah)

Islamic finance emphasizes profit and loss sharing between the provider of funds (investor) and the user
of funds (entrepreneur). This principle encourages a more equitable distribution of risks and rewards.
Mudarabah refers to a partnership where one party provides capital, and the other party provides
expertise. Musharakah refers to a joint venture partnership where both parties contribute capital and
share profits and losses.

3.3.3. Asset-Backed Financing (Ijarah and Murabaha)

Islamic finance promotes asset-backed financing rather than purely debt-based financing. Ijarah is a
leasing arrangement where the financial institution owns the asset and leases it to the customer for an
agreed period. Murabaha is a cost-plus-profit arrangement where the financial institution purchases an
asset and sells it to the customer at a higher price with deferred payments.

3.3.4. Ethical and Social Considerations

Islamic finance integrates ethical and social considerations into its operations. Investments in sectors
such as alcohol, gambling, tobacco, and pork are prohibited. Additionally, Islamic finance encourages
investments in socially responsible sectors that promote societal well-being, such as healthcare,
education, and renewable energy.

3.3.5. Regulatory Framework and Supervision

Islamic finance requires a specific regulatory framework and supervisory bodies to ensure compliance
with Shariah principles. Regulatory bodies, such as central banks or financial authorities, oversee the
operations of Islamic financial institutions and ensure adherence to Shariah principles. This includes
establishing Shariah boards composed of Islamic scholars who provide guidance and oversight.

These key differences between Islamic finance and conventional finance reflect the unique approach
and principles of Islamic finance. Islamic finance aims to create a more equitable and socially responsible
financial system while aligning with the teachings of Islam.

4. Indigenous and Informal Financial Institutions in Developing Countries

4.1. Definition and Scope of Indigenous and Informal Financial Institutions

Indigenous and informal financial institutions refer to financial systems and mechanisms that exist
outside the formal banking sector in developing countries. These institutions are deeply rooted in local
customs, traditions, and social networks. They cater to the financial needs of communities, particularly
those in underserved or remote areas, where formal financial institutions have limited reach.

4.2. Examples of Indigenous and Informal Financial Institutions

4.2 1. Rotating Savings and Credit Associations (ROSCAs)

 ROSCAs, also known as "tontines" or "chit funds," are informal financial institutions where a group of
individuals pool their savings and contribute a fixed amount regularly. The accumulated funds are then
disbursed to each member on a rotational basis. ROSCAs provide access to credit and savings for
community members, particularly those who may not qualify for formal bank loans.

4.2.2. Moneylenders and Pawnbrokers

Moneylenders are individuals or small businesses that provide loans to borrowers, often at high-interest
rates. They play a significant role in meeting the credit needs of individuals and small businesses who
lack access to formal financial institutions. Pawnbrokers accept personal assets, such as jewelry or
electronics, as collateral for short-term loans.

4.2. 3. Informal Savings Groups and Microfinance Institutions

Informal savings groups, also known as "susu" or "hui," are community-based financial arrangements
where members contribute a fixed amount regularly. The accumulated savings are then available for
members to borrow from when needed. Microfinance institutions (MFIs) are semi-formal or informal
financial institutions that provide small loans, savings facilities, and other financial services to low-
income individuals and microenterprises.

4.3. Practices and Functions of Indigenous and Informal Financial Institutions

4.3.1. Social Capital and Trust-Based Networks.

Indigenous and informal financial institutions often rely on social capital and trust-based relationships
within communities. Members of these institutions share common social ties, cultural norms, and
mutual obligations, which build trust among participants. This trust mitigates the need for formal
collateral and facilitates lending and borrowing activities.

4.3.2. Flexibility in Loan Terms and Collateral Requirements

Indigenous and informal financial institutions typically offer more flexible loan terms compared to
formal institutions. They consider the borrower's character, reputation, and social standing rather than
relying solely on financial indicators. Collateral requirements may be less stringent or replaced by social
guarantees, reducing barriers to accessing credit for individuals who lack formal collateral.

4.3.3. Cultural Relevance and Customized Financial Services

Indigenous and informal financial institutions often tailor their services to meet the specific needs and
cultural practices of their communities. For example, they may align loan repayment schedules with
agricultural cycles or cultural festivals. These institutions also offer financial products and services that
are more attuned to the livelihoods and economic activities of local communities, such as agricultural
loans or livestock financing.

Indigenous and informal financial institutions play a vital role in providing financial services to
underserved populations in developing countries. While they serve as important sources of credit and
savings, they also face challenges related to limited scale, lack of regulation, and potential exploitation.
Recognizing the strengths and limitations of these institutions can inform efforts to integrate them into
the formal financial system and promote financial inclusion in developing countries.

5. Bank Concentration: Few in Number and Large in Size or Large in Number and Small in Size?

5.1. Introduction to Bank Concentration

Bank concentration refers to the distribution and structure of banks within a financial system. It raises
the question of whether it is preferable to have a few large banks or many small banks. The debate
surrounding bank concentration centers on the trade-offs between economies of scale, financial
stability, competition, innovation, and customer focus.

5.2. Arguments for Few Large Banks

5.2.1. Economies of Scale and Scope

Advocates for a few large banks argue that they can benefit from economies of scale and scope. Large
banks can spread their fixed costs over a larger asset base, potentially leading to cost efficiencies. They
can also offer a broader range of products and services, benefiting from diversification and cross-selling
opportunities.

5.2.2. Enhanced Financial Stability and Risk Management

Large banks may have stronger risk management capabilities and greater financial resources to
withstand shocks. They can handle large transactions, have access to sophisticated risk management
tools, and benefit from diversification across regions and sectors. This can contribute to enhanced
financial stability in the system.

5.3. Arguments for Many Small Banks

5.3.1. Increased Competition and Innovation

Supporters of many small banks argue that a competitive banking sector fosters innovation, efficiency,
and responsiveness to customer needs. Increased competition can drive banks to differentiate
themselves through product innovation, improved services, and lower costs, ultimately benefiting
consumers.

5.3.2. Local Market Knowledge and Customer Focus

Small banks, particularly community banks, are often deeply embedded in local markets. They possess
local market knowledge and have closer relationships with customers, allowing for personalized services
and tailored financial solutions. This local focus can contribute to better customer satisfaction and
support for local economic development.

5.4. Case Studies and Empirical Evidence

The impact of bank concentration on economic performance is context-specific, and empirical

evidence yields mixed results. Different countries have experienced varying degrees of success with both
concentrated and fragmented banking systems. Factors such as the regulatory environment, market
structure, and institutional framework play crucial roles in determining the outcomes

5.5. Implications for Developing Countries

Developing countries face unique challenges when considering bank concentration. Factors such as
financial stability, access to finance, competition, and the development of local markets should be
carefully evaluated. Developing countries often prioritize financial inclusion and access to credit, which
may be better served by a diverse set of financial institutions, including small banks, microfinance
institutions, and non-bank financial intermediaries.

It is important for developing countries to strike a balance between the benefits of scale and stability
offered by large banks and the advantages of competition, innovation, and local market knowledge
provided by small banks. A well-regulated and supervised banking sector that promotes healthy
competition, fosters innovation, and ensures financial stability is vital for sustainable economic
development.

Ultimately, the optimal structure of a country's banking sector depends on its unique circumstances and
policy objectives. A comprehensive assessment of the trade-offs and a thorough understanding of the
country's financial system are necessary to determine the most appropriate approach to bank
concentration.

Conclusion

A. Summary of Key Findings

In this discussion, we explored various topics related to finance, including the basics of Islamic finance
and its differences from conventional finance. We also examined indigenous and informal financial
institutions in developing countries, discussing their definition, examples, practices, and functions.
Finally, we delved into the debate surrounding bank concentration, considering arguments for few
large banks and many small banks, along with case studies and empirical evidence.

Key findings include:

- Islamic finance operates based on ethical and moral principles, prohibiting interest and
promoting profit and risk-sharing.

- Indigenous and informal financial institutions play a crucial role in providing financial services
to underserved populations, leveraging social capital and trust-based networks.
 - Bank concentration debates highlight the trade-offs between economies of scale, financial
stability, competition, innovation, and customer focus, with no one-size-fits-all solution.

B. Implications for Policy and Future Research

1. Policy Implications:

- Governments and regulators should create a supportive regulatory framework for Islamic finance,
enabling its growth while ensuring compliance with Shariah principles.

- Policymakers should recognize the importance of indigenous and informal financial institutions,
taking steps to integrate them into the formal financial system while ensuring consumer protection
and regulatory oversight.

- Bank concentration policies should carefully consider the specific needs of the country, aiming
for a balanced approach that promotes financial stability, competition, innovation, and financial
inclusion.

2. Future Research Directions:

- Further research is needed to explore the impact of Islamic finance on economic development,
financial stability, and social welfare, both within Islamic countries and across different financial
systems.

- Continued study of indigenous and informal financial institutions is necessary to understand their
dynamics, evaluate their impacts, and develop strategies to enhance their effectiveness and
sustainability.

- Additional research on bank concentration should focus on identifying the optimal structure
and size of banking systems in different contexts, considering the implications for economic
performance, financial stability, and access to finance.

Overall, the topics discussed in this exploration provide a foundation for further investigation and
policymaking in the realms of Islamic finance, indigenous and informal financial institutions, and bank
concentration. By understanding these areas, policymakers and researchers can contribute to the
development of more inclusive, sustainable, and resilient financial systems worldwide.
REFERENCES

 Frank J. Fabozzi, Franco P. Modigliani, and Frank J. Jones, Prentice Hall, 4th Edition, (2010),
Foundations of Financial Markets and Institutions.

• Frederic S. Mishkin, The Economics of Money, Banking and Financial Markets, 12th edition, 2019,
Pearson Education Limited.

• Glen Arnold (2011) Modern Financial Markets, Financial Times and Prentice-Ha. • Howells, P., and K.
Bain (2007), Financial Markets and Institutions, 5th ed. Financial Times/ Prentice Hall.

 LECTURE NOTES