CHAPTER ONE

AN OVERVIEW OF FINANCIAL SYSTEM

Definition of Financial System
 Financial system is a set of complex and closely connected institutions, directives, agents, practices,
markets, transactions, claims and liabilities relating to financial aspects of an economy.
 Financial system is the scheme which established for the purpose of providing a standard/regular,
smooth, effective and efficient linkage between surplus units {lender} and deficit units {borrower} in
the economy.
 Financial system is a mechanism that allows people to easily buy & sell financial assets (such as; stocks
and bonds) in the financial markets.
According to the structural approach, the financial system of an economy consists of four main
components:
1) financial markets;
2) financial instruments;
3) financial intermediaries (financial institutions); and
4) financial regulators
According to the functional approach, financial markets facilitate the flow of funds in order to finance
investments of corporations, governments and individuals. Financial institutions are the key players in the
financial markets as they perform the function of intermediation and thus determine the flow of funds.
Financial instrument is an asset which is expected to provide future benefits in the form of a claim to future
cash. The financial regulators perform the role of monitoring and regulating the participants in the financial
system. The following figure presents a typical structure of financial system in the country:

Financial System

Financial Financial Financial Financial

Markets Institutions Instruments Regulators

Figure 1: The structure of financial system

Financial market is a market where financial instruments/financial assets are bought and sold.
Financial institutions are an intermediary who channels the funds’ of surplus units into loans for deficit
units, or investment.
Financial instruments is also called financial assets, are intangible assets, which are expected to
provide future benefits in the form of a claim to future cash.
Financial regulation is an intervention made by an authorized body, in most case central bank, to ensure
the fair treatment of market participants. One of the key aims of financial regulation is to ensure business
disclosure of accurate information for investment decision making. When fin.mkt information is
disclosed only to partial set of investors, those gained unlimited information may have major
advantages than other groups of investors those gained little information.

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Each of the components plays a specific role in the economy. By channeling funds from savers to investors
with good projects through financial intermediary, the financial system increases overall productivity for the
economy and leads to a rise in living standards.
The financial system plays the key function in the economy by stimulating economic growth, influencing
economic performance of the actors, affecting economic welfare. This is achieved by financial
infrastructure, in which entities with funds allocate those funds to those who have potentially more
productive ways to invest those funds. A financial system makes it possible a more efficient transfer of
funds. As one party of the transaction may possess superior information than the other party, it can lead to the
information asymmetry problem and inefficient allocation of financial resources. By overcoming the
information asymmetry problem the financial system facilitates balance between those with funds to invest
and those needing funds.
Features of Financial System
 Financial system creates an ideal linkage between depositors and investors. It encourages savings
and investment.
 Financial system promotes efficient allocation of financial resources for socially desirable and
economically productive purposes.
 Financial system influences both the quality and the pace/speed of economic development.
Major Components of Financial System
A. Financial Market
Financial markets are forums in which suppliers of funds and demanders of funds can transact business
directly. It is where the loans and investments of institutions are made without the direct knowledge of the
suppliers of funds (savers), suppliers in the financial markets know where their funds are being lent or
invested. They are important means of channeling funds from those who have excess funds (savers, lenders)
to those who have a financial shortage (borrowers).
Functions of financial markets
1. Enhancing income: financial markets allow lenders earn interest /dividend on their surplus invested
funds, thus contributing to the enhancement of the individual & the national income
2. Transfer of resources: Financial markets facilitate the transfer of real economic resources from
lenders to ultimate borrowers.
3. Productive usage: Financial markets allow for the productive use of the funds borrowed, thus
enhancing the income & the gross national production.
4. Capital formations: financial markets provide a channel through which new savings flow to aid
capital formation of a country.
5. Price determination: financial markets allow for the determination of the price of the traded financial
asset through the interaction of buyers & sellers, i.e., through demand & supply.
To sum up, financial markets facilitates:
 The raising of capital (in the capital market)
 International trade (in the currency market)
 The transfer of risk ( in the derivative market),
 They facilitate buying and selling of financial claims, assets, services, and securities.
 In financial markets funds or savings are transferred from surplus units to deficit units and are used
to match those who want capital with those who have it.
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Different financial markets serve different types of customers or different parts of the economic sector.
Financial markets also vary depending on the maturity of the securities being traded and the types of assets
used to back the securities. Financial markets can be classified based on different ways. For these reasons it
is often useful to classify markets along the following dimensions:
On the basis of financial claim (stock market vs. debt market), maturity period (money market vs. capital
market), origin (primary market vs. secondary market), time of delivery (future/forward market vs. Spot
market), structure (over-the-counter vs. auction market), and the like. {Note: the detail discussions of this
section will be presented in third chapter of this course}.
B. Financial Institutions
In economies, where financial institutions are less developed, direct fund transfers among individuals are
more common. However, businesses in developed economies, doing a direct transfer of funds are more
difficult, and they find it more efficient to join the services of one or more financial institutions when they
want to raise capital or invest their surplus funds.
Financial intermediaries are an institution who channels the funds’ of surplus units {lenders} into loans for
deficit units {borrowers}. They also provides various types of financial functions to the economy {such as;
liquidity, redistribution of various risks, etc}. Financial institutions differ from non-financial business
organizations(such as; manufacturing companies) in respect of their products; i.e. the former deals in
financial assets such as bonds, equity, loans securities and so on, while the latter deal in real assets such as
machinery, equipment, real estate and so on.
Financial intermediary is a special financial entity, which performs the function of efficient allocation of
funds, when there are conditions that make it difficult for lenders or investors of funds to deal directly with
borrowers of funds in financial markets. Financial intermediaries/ institutions includes: commercial banks,
savings & credit associations, microfinance institutions, credit unions, insurance companies, regulated
investment companies, investment banks, and pension funds. On the basis of their primary functions, these
financial institutions are broadly divided into three major categories, namely; depository institutions, Non-
depository institutions, and investment intermediaries. {Note: Detail discussions of this section will be
presented in chapter 2}
On the basis of their formality, financial institutions also classified as formal financial institutions, semi-
formal financial institutions and informal financial institutions.
C. Financial Instruments/Assets
An asset is any resource that is expected to provide future benefits, and thus possesses economic value.
Assets are divided into two categories: tangible assets with physical properties and intangible assets. An
intangible asset represents a legal claim to some future economic benefits. The value of an intangible asset
bears no relation to the form, physical or otherwise, in which the claims are recorded.
Financial assets, often called financial instruments, are intangible assets, which are expected to provide
future benefits in the form of a claim to future cash. Some financial instruments are called securities and
generally include stocks and bonds. Financial security or financial assets is simply a legal claims to a future
cash flows.
Financial instruments are documents that have a monetary value or evidence a legal enforceable (binding)
agreement between two or more parties regarding a right to payment of money. Financial instruments are
often called financial securities, financial assets, or financial claims.

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Financial instruments are assets that represent the transfer of fund from one party to another. They are traded
in financial markets. When a firm wants to raise a fund it may issue a financial instrument and sell. The
buyer will pay money to the seller of the financial instrument and will in turn get the instrument with a
promise and he/she will get him/her money back with some positive return in the future.
Financial instruments are written legal obligation of a transfer of something of value from one party to
another party at some future time under certain conditions.
Any transaction related to financial instrument includes at least two parties:
i) the party that has agreed to make future cash payments and is called the issuer;
ii) the party that owns the financial instrument, and therefore the right to receive the payments made by
the issuer, is called the holder/investor.
Functions of Financial Assets
Financial assets provide the following two key economic functions.
 Transfer of Funds: financial assets allow the transfer of funds from those entities, who have surplus
funds to invest to those who need funds to invest in tangible assets;
 Redistribute the Unavoidable Risk: they redistribute the unavoidable risk related to cash
generation among deficit and surplus economic units.
Types of Financial Instruments
Broadly speaking, there are two wide-ranging distinct types of financial instruments: debt claim and equity
claims.
Debt claim is claim in which the holder (investor) obtain the predetermined cash claims at maturity date and
a rate of interest charged are often be fixed. On the contrary, with equity claim the holder (investor) are
entitled an ownership right of the future earning and also entitled a residual claim in the form of dividends,
such as common stock. Many financial instruments are a mixture of debt and equity such as preference share.
Some types of financial instruments are discussed below:
I) Bond: Bonds are instruments that represent long-term contract under which a borrower agrees to make
payment of interest and principal, on specific dates, to the holders of the bond. Bonds are classified into two
main types: corporate bonds and government bonds.
 Government bonds: are the bonds that have been issued by the government to finance budget deficit.
 Corporate bonds: as the name implies, it is issued by corporations/companies to finance capital assets.
II) Treasury Bills: are shot-term debt instruments issued by governments to finance budget deficits. The
issuers pay a predetermined amount at maturity and have not interest payment, but they effectively pay
interest by initially selling at a discount, that is, at a price lower than the face value at the maturity.
Features of TB
1. Issuer: it is issued by the government for raisings short-term funds for bridging temporary gaps
between revenue and expenditure.
2. Liquidity: it enjoys high degree of liquidity
3. Monetary Mgt: TBs serve as an important tool of monetary management used by the central bank of
the country t
4. o influence liquidity in to the economy.
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III) Bank Loans: These are loans to consumers and businesses made by banks. Loans are an asset for the bank
{creditor}
IV) Certificates of Deposit: Are certificates or books issued by banks certifying that the holder has
deposited some money in the bank. Fixed deposits are good examples.
V) Commercial paper: Commercial paper is a debt instrument which is issued by well known, high
creditworthy corporations for raising short term financial resources from money market.
Characteristics of CP
 They are unsecured debts of corporate.
 They are issued in the form of promissory notes.
 They are redeemable at par to the holder at maturity, i.e., they are issued at discount to face value.
 They are issued by top rated corporate (credit worthy companies) .
 The marketability of the CPs is influenced by the rates prevailing in the call money market & the
foreign exchange market, i.e., attractive rates in call money market affects the demand of CPs.
VI) Certificate of Deposits (CD): CD is a financial document showing that a person or organization has a
specified sum on deposit at a bank, usually for a specific period, at special interest rate.
Features of CD
 Negotiable instrument: CDs are negotiable time deposit certificate issued by commercial banks
/financial institution at discount.
 Maturity: They have a specified maturity date. The maturity period of CDs ranges from 15 days to
one year.
VII) Repurchase Agreement (Repo or RP): is an agreement involving the sale of securities by one party
to another with a promise to repurchase the securities at a specified price and on a specific date in the future.
Individuals or firms with temporary idle or excess capital buy short term securities. (eg. T-bills) from their
banks in order to earn small return until the money is needed, the bank then agrees to repurchase the T- bills
in the future at a higher price.
VII) Shares/Stocks: are equity claims on the net income and assets of a corporation. They are issued by
corporate firms to raise fund. The buyers of stock become owners of the company. Typically there are two
class of stock; common stock and preferred stock.
i. Common Stock:
 It entitles the investor to receive dividends distributed by a company.
 Investors have a claim to a pro rata share of the net assets value of a company in case of liquidation.
 Common stock can also be known as residual claim. i.e., it obligates the issuer of the financial
assets to pay the holder an amount based on earnings, if any, after holder of debt instruments have
been paid.
Advantages and disadvantages of Common Shares
Equity capital is the most important long term source of financing. It offers the following advantage.
1. Permanent Capital: Since ordinary shares are not redeemable, the company has no liability for cash
out flow associated with its redemption.

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 2. Borrowing base: Lenders generally lend in proportion to the company's equity capital. By issuing
ordinary shares, the company increases its financial capabilities because it can borrow additional
funds. Thus, the amount of equity capital increases the borrowing limit of a company.
3. Dividend Payment Discretion: A company is not legally obliged to pay dividend. In times of
financial difficulties, it can reduce or suspend payment of dividend. Thus, it can avoid cash outflow
associated with ordinary share.
Common stock has the following limitation:
1. Cost: Equity capitals have a higher cost at least for two reasons;
a. Dividends are not tax deductible as an interest payment.
b. Flotation costs on ordinary shares are higher than those on debt.
2. Risk: Equity shares are riskier from investors' point of view as there is uncertainty regarding dividend
and capital gains. Therefore, the equity holders require a relatively higher rate of return.
3. Earnings dilution: The issue of new ordinary shares dilute the existing shareholders' earning per
share if the profit is not increase in equal proportion with the increase in number of ordinary shares.
4. Ownership dilution: The issuance of new ordinary shares may dilute the ownership and control of
the existing shareholders. That means the issuance of ordinary shares can change the ownership.
ii. Preference Shares
A preference share is often considered to be a hybrid security since it has many features of both ordinary
shares and debentures. It is similar with ordinary share in:
1. The non- payment of dividend does not force the company to insolvency.
2. Dividends are not deductible for tax purpose.
3. In some cases, it has no fixed maturity date.
It is similar with debenture (bond) in:
1. Dividend rate is fixed.
2. Preference shareholders have claims on income and assets prior to ordinary shareholders.
3. They do not share in the residual earnings.
4. They do not have voting rights.
Features of preference share:
1. Claims on income and assets: Preference shares are a senior security as compared to ordinary shares.
It has prior claim on the company's income in the event of distribution dividend and prior claim on
assets in case of liquidation.
2. Fixed dividend: The amount of preference dividend is fixed. That is, it will be equal to the dividend
rate multiplied by the par value.
3. Cumulative dividend: Preference shares are requiring that all past unpaid preference dividend be paid
before any ordinary dividends are paid. This feature is a protective device for preference
shareholders.
Advantages and disadvantages of Preference shares
Preference shares have the following advantages:
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 1. Risk less leverage advantage: Preference share provides financial leverage advantages since
preference dividend is a fixed obligation. This advantage occurs without a series risk of default. The
non-payment of preference dividend does not force the company into insolvency.
2. Dividend postponability: Since preference shares can postpone payment of dividend, it provides
some financial flexibility to the company.
3. Fixed dividend: The preference dividend payments are restricted to the stated amount. Shareholders
do not participate in excess profit as do the ordinary shareholders.
4. Limited voting rights: Preference shareholders do not have voting rights except in case of dividend
arrears exist.
Preference shares have the following limitations:
1. Commitment to pay dividend: Preference dividend can not be omitted, they have to be paid because
of their cumulative nature.
2. Non-deductibility of dividend: Preference dividend is not tax deductible. Thus, it is costlier than
debenture.

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