Chapter one: Overview of financial system

1Definition and Component of financial

system
Definition
• Financial system is a system that aims at
establishing and providing smooth, regular,
efficient and effective linkage between savers
(depositors) and investors (borrowers).
• It is a set of complex and closely connected
instructions, practices, agents and claims
related to the financial aspects of the
economy.
 Cont,d
• A financial system is a set of institutions, such as
banks, insurance companies, and stock
exchanges, that permit the exchange of funds.
Financial systems exist on firm, regional, and
global levels.

• Financial systems can be organized using market

principles, central planning, or a hybrid of both.
 The role of financial system in the economy
The following are the roles of financial system in the
economic development of a country.

1. Savings-investment relationship
• To attain economic development, a country needs more
investment and production. This can happen only when
there is a facility for savings. As, such savings are
channelized to productive resources in the form of
investment. Here, the role of financial institutions is
important, since they induce the public to save by
offering attractive interest rates. These savings are
channelized by lending to various business concerns
which are involved in production and distribution.
 Cont,d
2. Financial systems help in growth of capital
market
• Any business requires two types of capital
namely, fixed capital and working capital. Fixed
capital is used for investment in fixed assets,
like plant and machinery. While working capital
is used for the day-to-day running of business.
It is also used for purchase of raw materials
and converting them into finished products.
 Con,d
• Fixed capital is raised through capital market by
the issue of debentures and shares. Public and
other financial institutions invest in them in
order to get a good return with minimized risks.
• For working capital, we have money market,
where short-term loans could be raised by the
businessmen through the issue of various credit
instruments such as bills, promissory notes, etc.
 Cont,d
3. Government Securities market
• Financial system enables the state and central governments to
raise both short-term and long-term funds through the issue of
bills and bonds which carry attractive rates of interest along
with tax concessions.

• The budgetary gap is filled only with the help of government

securities market. Thus, the capital market, money market along
with foreign exchange market and government securities
market enable businessmen, industrialists as well as
governments to meet their credit requirements. In this way, the
development of the economy is ensured by the financial system.
 Con,d
4. Financial system helps in Infrastructure and
Growth
• Economic development of any country depends
on the infrastructure facility available in the
country. In the absence of key industries like coal,
power and oil, development of other industries
will be hampered. It is here that the
financial services play a crucial role by providing
funds for the growth of infrastructure industries.
 Cont,d
5. Financial system helps in development of Trade
• The financial system helps in the promotion of both
domestic and foreign trade.
• The financial institutions finance traders and the
financial market helps in discounting financial
instruments such as bills.
• Foreign trade is promoted due to per-shipment and
post-shipment finance by commercial banks. They
also issue Letter of Credit in favor of the importer.
 Cont,d
• Thus, the precious foreign exchange is earned
by the country because of the presence of
financial system. The best part of the financial
system is that the seller or the buyers do not
meet each other and the documents are
negotiated through the bank. In this manner,
the financial system not only helps the traders
but also various financial institutions.
 Cont,d
6. Employment Growth is boosted by financial system
• The presence of financial system will generate more
employment opportunities in the country.
• The money market which is a part of financial system
provides working capital to the businessmen and
manufacturers due to which production increases,
resulting in generating more employment opportunities.
• With competition picking up in various sectors, the
service sector such as sales, marketing, advertisement,
etc., also pick up, leading to more employment
opportunities
 Cont,d
• Various financial services such as leasing,
factoring, merchant banking, etc., will also
generate more employment.
• The growth of trade in the country also
induces employment opportunities.
Financing by Venture capital provides
additional opportunities for techno-based
industries and employment.
 Cont,d
7. Venture Capital
• The economic development of a country will be rapid
when more ventures are promoted which require
modern technology and venture capital.
• Venture capital cannot be provided by individual
companies as it involves more risks.
• It is only through financial system, more financial
institutions will contribute a part of their investable
funds for the promotion of new ventures. Thus,
financial system enables the creation of venture capital.
 Cont,d
8. Financial system ensures balanced growth
• Economic development requires a balanced growth
which means growth in all the sectors simultaneously.
• Primary sector, secondary sector and tertiary sector
require adequate funds for their growth.
• The financial system in the country will be geared up
by the authorities in such a way that the available
funds will be distributed to all the sectors in such a
manner, that there will be a balanced growth in
industries, agriculture and service sectors.
 Cont,d
9. Financial system helps in fiscal discipline and control of
economy

• It is through the financial system, that the government can

create a congenial business atmosphere so that neither too
much of inflation nor depression is experienced.
• The industries should be given suitable protection through
the financial system so that their credit requirements will
be met even during the difficult period.

• The government on its part can raise adequate resources to

meet its financial commitments so that economic
development is not hampered.
 Cont,d

10. Financial system’s role in balanced regional

development
• Through the financial system, backward areas
could be developed by providing various
concessions or sop. This ensures a balanced
development throughout the country and this
will mitigate political or any other kind of
disturbances in the country.
• It will also check migration of rural population
towards towns and cities.
 Cont,d
11. Role of financial system in attracting foreign
capital
• Financial system promotes capital market. A
dynamic capital market is capable of attracting
funds both from domestic and abroad. With
more capital, investment will expand and this
will speed up the economic development of a
country
 Cont,d
12. Financial system’s role in Economic Integration
• Financial systems of different countries are capable of
promoting economic integration.

• This means that in all those countries, there will be

common economic policies, such as common investment,
trade, commerce, commercial law, employment
legislation, old age pension, transport co-ordination, etc.

• We have a standing example of European Common

Market which has gone to the extent of creating a
common currency, representing several countries in
Western Europe.
 Cont,d
13. Political stability
• The political conditions in all the countries
with a developed financial system will be
stable. Unstable political environment will not
only affect their financial system but also their
economic development.
 Cont,d
14. Financial system helps in Uniform interest
rates
• The financial system is capable of bringing an
uniform interest rate throughout the country
by which there will be balanced movement of
funds between centers which will ensure
availability of capital for all kinds of industries.
 Cont,d
15. Financial system role in Electronic development:
• Due to the development of technology and the
introduction of computers in the financial system,
the transactions have increased multiple bringing in
changes for the all round development of the
country.

• The promotion of World Trade Organization (WTO)

has further improved international trade and the
financial system in all its member countries.
 Financial Assets
• In any financial transaction, there should be a creation
or transfer of financial asset. Hence, the basic product
of any financial system is the financial asset. Financial
assets are intangible assets where typically the future
benefits come in the form of a claim to future cash.

• Another term used for a financial asset is a financial

instrument. Certain types of financial instruments are
referred to as securities and generally include stocks
and bonds.
 Cont,d
• For every financial instrument there is a
minimum of two parties.
• The party that has agreed to make future cash
payments is called the issuer; and
• The party that owns the financial instrument
and therefore the right to receive the
payments made by the issuer is referred to as
the investor
 Real Assets

o A real asset is anything that generates a flow of goods

or services over time.
o The material wealth of a society is determined
ultimately by the productive capacity of its economy.
i.e. the goods and services that can be provided to its
members.
o This productive capacity is a function of the real assets
of the economy. Real assets need not be tangible.
o Both physical and human assets together generate the entire
spectrum of output produced and consumed by the society.
o Examples are land, building, knowledge, machines, inventions,
business plans, goodwill, reputation, etc
Distinction between real assets and financial assets

Real assets are income-generating assets,

whereas financial assets are the allocation of
income or wealth among investors.

Real assets appear only on the asset side of

the balance sheet, whereas financial assets
appear on both sides of balance sheets.
• i.e. Your financial claim on a firm is an asset, but
the firm's issuance of that claim is the firm's
liability.
 Cont,d
Financial assets are created and destroyed in
the ordinary course of doing business. For
example, when a loan is paid off, both the
creditor's claim (a financial asset) and the
debtor's obligation (a financial liability) cease
to exist.
• Whereas real assets are destroyed only by
accident or by wearing out over time.
 Role and Properties of Financial Assets
• The following are the properties of Financial Assets, which
distinguish them from Physical and Intangible Assets:
1. Currency:
• Financial Assets are exchange documents with an attached
value. Their values are dominated in currency units determined
by the government of an economy.
2. Divisibility
• Financial Instruments are divisible into smaller units. The total
value is represented in terms of divisions that can be handled
in a trade. The divisibility characteristic of Financial Assets
enables all players, small or big, to participate in the market.
 Cont,d
3. Convertibility
• Financial Assets are convertible into any other type of
asset. This characteristic of convertibility gives flexibility
to financial instruments. Financial Instruments need not
necessary be converted into another form of Financial
Asset; they can also be converted into Physical/Tangible
and Intangible Assets.
4. Reversibility
• This implies that a financial instrument can be exchanged
for any other asset and logically, the so formed asset
may be transferred back into the original financial
instrument.
 Cont,d
5. Liquidity /Marketability/
• The financial asset can be exchanged for currency with another
market participant who does not have immediate cash need, but
expects future benefits.
6. Cash Flow
• The holding of the financial instrument results in a stream of cash
flows that are the benefits accruing to the holder of the financial
instrument. However, a financial instrument by itself does not
create a cash flow.
7. Information Availability
• In many cases, information concerning financial assets is more
readily available than for real assets
 Financial Markets

• A financial market is a market where financial instruments

are exchanged. The more popular term used for the
exchanging of financial instruments is that they are
“traded.” They are markets where people buy and sell
financial instruments like stocks, bonds and future
contracts.
Financial markets provide the following three major
economic functions:
 Price discovery
 Liquidity
 Reduced transaction costs
 Price discovery

• Price discovery means that the interactions of

buyers and sellers in a financial market
determine the price of the traded asset.
• Equivalently, they determine the required
return that participants in a financial market
demand in order to buy a financial instrument.
 Liquidity

• Financial markets provide a forum for

investors to sell a financial instrument and is
said to offer investors “liquidity”. This is an
appealing to sell a financial instrument.
• All financial markets provide some form of
liquidity. However, the degree of liquidity is
one of the factors that characterize different
financial markets.
 Reduces the cost of transacting
• Transacting cost can be classified into two types:
search costs and information costs.
• Search costs in turn fall into two categories: explicit
costs and implicit costs.
• Explicit costs include expenses that may be needed
to advertise one’s intention to sell or purchase a
financial instrument;
• implicit costs include the value of time spent in
locating counterparty to the transaction.
 Cont,d
• The presence of some form of organized
financial market reduces search costs.

• Information costs are costs associated with

assessing a financial instrument’s investment
attribute. In a price efficient market, prices
reflect the aggregate information collected by
all market participants.
 Classification of Financial Markets and their roles

•There are five ways that one can classify

financial markets: (1) nature of the claim, (2)
•maturity of the claims, (3) new versus
seasoned claims, (4) cash versus derivative
instruments, and (5) organizational structure of
the market.
 Debt and Equity Markets

• The claims traded in a financial market may be either for

a fixed dollar amount or a residual amount and financial
markets can be classified according to the nature of the
claim.
• As explained earlier, the former financial assets are
referred to as debt instruments, and the financial market
in which such instruments are traded is referred to as the
debt market.
• The latter financial assets are called equity instruments
and the financial market where such instruments are
traded is referred to as the equity market or stock market.
 Cont,d
• Preferred stock represents an equity claim that
entitles the investor to receive a fixed dollar
amount. Consequently, preferred stock has in
common characteristics of instruments classified
as part of the debt market and the equity
market. Generally, debt instruments and preferred
stock are classified as part of the fixed income
market.
 Cont,d
• A firm or an individual can obtain funds in a
financial market, in two ways. These are
I. By issuing a debt instrument, such as a bond
or a mortgage
II. raising funds is by issuing equities, such
as common stock and preferred stock
•The main disadvantage of owning a corporation's equities
rather than its debt is that an equity holder is a residual
claimant; that is, the corporation must pay all its debt holders
before it pays its equity holders.
• The advantage of holding equities is that equity holders
benefit directly from any increases in the corporation‘s
profitability or asset value because equities confer
ownership rights on the equity holders. Debt holders do not
share in this benefit because their dollar payments are fixed.
 2. Money and Capital Markets

o A second way to classify financial markets is by the maturity of the

claims. For example, a financial market for short-term financial assets is
called the money market, and the one for longer maturity financial assets
is called the capital market.
o The traditional cutoff between short term and long term is one year. That is, a
financial asset with a maturity of one year or less is considered short term and
therefore part of the money market.
o A financial asset with a maturity of more than one year is part of the capital
market.
o Thus, the debt market can be divided into debt instruments that are part of the
money market, and those that are part of the capital market, depending on the
number of years to maturity.
 Cont,d
o Another way of distinguishing between markets is on
the basis of the maturity of the securities traded in
each market.
o The money market is a financial market in which
only short-term instruments (maturity of one year or
less one year) are traded; the capital market is the
market in which longer-term debt (maturity of more
than one year) and equity Instruments are traded.
o Money Market facilitates short term debt
financing and capital.
 Cont,d
 Money market securities are usually more widely traded
than longer-term securities and so tend to be more liquid.

 In addition short-term securities have smaller fluctuations

in prices than long-term securities, making them safer
investments.
 As a result, corporations and banks actively use this market to
earn interest surplus funds that they expect to have only
temporarily.
 Cont,d
o Capital market securities such as stocks and long-term bonds
are often held by financial intermediaries such as
insurance companies and pension funds, which have little
uncertainty about the amount of funds they will have-
available in the future.
 Primary and Secondary Markets
 Because equity instruments are generally perpetual, a third
way to classify financial markets is by whether the financial
claims are newly issued. When an issuer sells a new financial
asset to the public, it is said to ―issue‖ the financial asset.
 The market for newly issued financial assets such as stock and
bond is called the primary market. After a certain period of time,
the financial asset is bought and sold (i.e., exchanged or
traded) among investors.
 The market where this activity takes place is referred to as
the secondary market.
 Cont,d

• The primary markets for securities are not well

known to the public because the selling of
securities to initial buyers takes place behind
closed doors.
• An important financial institution that assists in the
initial sale of securities in the primary market is the
investment bank. It does this by underwriting
securities: It guarantees a price for a corporation’s
securities and then sells them to the public.
•
 Cont,d
• Securities brokers and dealers are crucial to a
well-functioning secondary market.
• Brokers are agents of investors who match
buyers with sellers of securities;
• dealers link buyers and sellers by buying and
selling securities at stated prices
 Cont,d

• When an individual buys a security in the

secondary market, the person who has sold the
security receives money in exchange for
the security, but the organization that issued
the security acquires no new funds.
• The organization acquires new funds only
when its securities are first sold in the
primary market
 Cont,d
o Nonetheless secondary markets serve two important
functions.

I. They make it easier to sell these financial instruments to

raise cash; that is, they make the financial instruments
more liquid. The increased liquidity of these
instruments then makes them more desirable and thus
easier for the issuing firm to sell in the primary market.
II. They determine the price of the security that the issuing
firm sells in the primary market.
 Cont,d

• The firms that buy securities in the primary market will

pay the issuing corporation no more than the price that
they think the secondary market will set for this
security.
• The higher the security's price in the secondary market, the
higher will be the price that the issuing firm will receive for
a new security in the primary market and hence the greater
 Organizational structure of secondary market

I. organize exchanges, where buyers and sellers of securities (or

their agents or brokers) meet in one central location to conduct
trades.
II. Over-The-Counter (OTC) market, in which dealers at different
locations who have an inventory of securities stand ready to
buy and sell securities "over the counter" to anyone who
comes to them and is willing to accept their prices.
• Because over-the-counter dealers are in computer contact and know
the prices set by one another, the OTC market is very competitive
and not very different from a market with an organized exchange.
 Derivative Markets

 Some financial assets are contracts that either

obligate the investor to buy or sell another
financial asset or grant the investor the choice to
buy or sell another financial asset. Such contracts
derive their value from the price of the financial
asset that may be bought or sold..
 Cont,d
• These contracts are called derivative instruments and
the markets in which they trade are referred to as
derivative markets. The array of derivative
instruments includes options contracts, futures
contracts, forward contracts, swap agreements, and
cap and floor agreements
 Auction Markets and Over-The- Counter Markets

o Although the existence of a financial market is not a necessary

condition for the creation and exchange of a financial asset, in
most economies financial assets are created and subsequently
traded in some type of organized financial market structure.
o A financial market can be classified by its organizational structure.
These organizational structures can be classified as auction
markets, over-the-counter markets, Organized Exchanges, and
Intermediation financial markets. We describe each type below.
 Cont,d
•These structures take four basic forms:

I. Auction markets: conducted through brokers;

II. Over-the-counter (OTC) markets: conducted through

dealers;

III.Organized Exchanges

IV.Intermediation financial markets: conducted through

financial intermediaries;
 Cont,d
• Financial markets taking the first three
forms are generally referred to as securities
markets. Some financial markets combine
features from more than one of these
categories, so the categories constitute only
rough guidelines.
 Auction Markets:

• An auction market is typically a public market in the

sense that it open to all agents who wish to
participate.
• Auction markets can either be call markets --
such as art auctions -- for which bid and asked
prices are all posted at one time, or
• continuous markets -- such as stock exchanges and
real estate markets -- for which bid and asked prices
can be posted at any time the market is open and
exchanges take place on a continual basis.
•Auction markets depend on participation for any
one type of asset not being too "thin." The costs of
collecting information about any one type of asset are
sunk costs independent of the volume of trading in
that asset. Consequently, auction markets depend on
volume to spread these costs over a wide number of
participants
 Over-the-Counter Markets:

o An over-the-counter market has no centralized mechanism or

facility for trading.
o Instead, the market is a public market consisting of a
number of dealers spread across a region, a country, or
indeed the world, who make the market in some type of
asset.
o That is, the dealers themselves post bid and asked prices for this
asset and then stand ready to buy or sell units of this asset
with anyone who chooses to trade at these posted prices.
•The dealers provide customers more flexibility in trading than
brokers, because dealers can offset imbalances in the demand
and supply of assets by trading out of their own accounts
 Organized Exchanges

•Specifically, organized exchanges permit buyers and sellers

to trade with each other in a centralized location, like an
auction. However, securities are traded on the floor of the
exchange with the help of specialist traders who
combine broker and dealer functions. The specialists
broker trades but also stand ready to buy and sell
stocks from personal inventories if buy and sell orders do
not match up.
 Intermediation Financial Markets:

•An intermediation financial market is a financial market in which

financial intermediaries help transfer funds from savers to
borrowers by issuing certain types of financial assets to savers
and receiving other types of financial assets from borrowers. The
financial assets issued to savers are claims against the financial
intermediaries, hence liabilities of the financial intermediaries,
whereas the financial assets received from borrowers are claims
against the borrowers, hence assets of the financial
intermediaries.
 Cont,d
•By definition, financial institutions are institutions that
participate in financial markets, i.e., in the creation
and/or exchange of financial assets.
•At present in the United States, financial institutions can
be roughly classified into the following four categories:
•brokers;

•dealers;

•investment bankers; and

• financial intermediaries.
 Brokers:

o A broker is a commissioned agent of a buyer (or

seller) who facilitates trade by locating a seller (or
buyer) to complete the desired transaction.
o A broker does not take a position in the assets he or she
trades -- that is, the broker does not maintain inventories in
these assets.
o The profits of brokers are determined by the commissions
they charge to the users of their services (the buyers, the
sellers, or both).
 Dealers:

•Like brokers, dealers facilitate trade by matching buyers

with sellers of assets; they do not engage in asset
transformation.
•Unlike brokers, however, a dealer can and does "take
positions" (i.e., maintain inventories) in the assets he or she
trades that permit the dealer to sell out of inventory rather
than always having to locate sellers to match every offer to
buy. Also, unlike brokers, dealers do not receive sales
commissions.
 Cont,d

•Rather, dealers make profits by buying assets at

relatively low prices and reselling them at
relatively high prices (buy low - sell high). The price
at which a dealer offers to sell an asset (the "asked
price") minus the price at which a dealer offers to
buy an asset (the "bid price") is called the bid-
ask spread and represents the dealer's profit
margin on the asset exchange.
 Cont,d

•Investment Banks:

•An investment bank assists in the initial sale of newly

issued securities (i.e., in IPOs = Initial Public Offerings)
by engaging in a number of different activities:
•Advice: Advising corporations on whether they should
issue bonds or stock, and, for bond issues, on the
particular types of payment schedules these
securities should offer;
 Cont,d

•Underwriting: Guaranteeing corporations a

price on the securities they offer, either
individually or by having several different
investment banks form a syndicate to
underwrite the issue jointly;
•Sales Assistance: Assisting in the sale of these
securities to the public.
 Financial Intermediaries:
• Unlike brokers, dealers, and investment banks,
financial intermediaries are financial institutions
that engage in financial asset transformation.
• That is, financial intermediaries purchase one kind
of financial asset from borrowers - generally some
kind of long-term loan contract whose terms are
adapted to the specific circumstances of the
borrower (e.g., a mortgage) - and sell a different
kind of financial asset to savers, generally some
kind of relatively liquid claim against the financial
intermediary (e.g., a deposit account).
 Cont,d

• In addition, unlike brokers and dealers, financial

intermediaries typically hold financial assets as part
of an investment portfolio rather than as an inventory
for resale.
• In addition to making profits on their investment
portfolios, financial intermediaries make profits by
charging relatively high interest rates to borrowers
and paying relatively low interest rates to savers.
 Cont,d

• Types of financial intermediaries include:

Depository Institutions (commercial banks,
savings and loan associations, mutual savings banks,
credit unions);
• Contractual Savings Institutions (life insurance
companies, fire and casualty insurance companies,
pension funds, government retirement funds); and
• Investment Intermediaries (finance companies,
stock and bond mutual funds, money market mutual
funds
 Financial Instruments

• Financial instruments are promissory notes that

represent the transfer of fund from one party to
another. They are also termed as financial assets or
securities.
• They are traded in financial markets. When a firm
wants to raise a fund it may issue a financial
instrument and sell.
• Example
 Cont,d

•Treasury Bills: are shot term debt instruments

issued by governments to finance budget deficits.
•They 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 set amount at the maturity.
 Cont,d
•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.

• Mortgages: are loans to households or firms to

purchase housing, land or other fixed assets where
the asset itself serves as collateral for the loans.
 Cont,d

•Bonds: are instruments that represent loan

and may be issued by firms or governments.
They pay interest unlike treasury bills.
•Bank Loans: These are loans to consumers and
businesses made by banks.
•In the case of consumers they are given for the
purchase of consumer durables like house.
 Cont,d
• Certificates of Deposit: Are certificates or books
issued by banks certifying that the holder has
deposited some money in the bank. Saving deposits
are good examples.
•Cheques: Are papers issued by banks and given
to depository who have checking accounts at the
banks. They allow the holder to make transactions by
writing them.
 Lending and Borrowing in the Financial System

• Business firms, households and governments play a wide

variety of roles in modern financial system. It is quite
common for an individual/institution to be a lender of
funds in one period and a borrower in the other, or
to do both simultaneously.
• Indeed financial intermediaries, such as banks and
insurance agencies operate on both sides of the financial
market; borrowing funds from customers by issuing
attractive financial claims and simultaneously making
loan available to other customers.
 Cont,d
•Economists John Gurley and Edward Shaw (1960) point out
that each business firm, household or a governmental unit
active in the financial system must conform to the following
identity:

• R – E = ΔFA – ΔD
•Where: R: Current income receipts

• E: Expenditures out of current income

• ΔFA: Change in holdings of financial assets

• ΔD: change in debt and equity outstanding
 Cont,d

•If current expenditure (E) exceeds current income

receipts (R), the difference will be made up by:

• 1) Reducing our holdings of financial assets

(-ΔFA), for example by drawing money out
of a saving account

• 2) Issuing debt or stock (+ΔD) or

• 3) Using some combination of both

 Cont,d

•On the other hand, if current income receipts (R) in the

current period are larger than current expenditure (E),

• 1) Build up our holdings of financial assets

(+ΔFA) for example, by placing money in a saving
account or buying a few shares of stock

• 2) Pay off some outstanding debt or retire stock

previously issued by the business firm (-ΔD) or

• 3) Do some combination of both of these steps

 Cont,d

• It follows that for any given period of time (eg. Day, week, month or
year), the individual economic unit must fall in to one of the following three
groups

• Deficit Budget Unit (DBU) - net borrower of funds: E>R; and so ΔD>ΔFA

• Surplus Budget Unit (SBU) - net lender of funds: E<R; and so ΔD<ΔFA

• Balanced Budget Unit (BBU) – neither net borrower nor net lender: E=R;
and so ΔD=ΔFA
END OF CHAPTER ONE