Financial System Overview PDF

Chapter One: An overview of the financial System CHAPTER ONE AN OVERVIEW OF THE FINANCIAL SYSTEM Introduction The economic development of any country depends upon the existence of a well-organized financial system. It is the financial syste...

Chapter One: An overview of the financial System CHAPTER ONE AN OVERVIEW OF THE FINANCIAL SYSTEM Introduction The economic development of any country depends upon the existence of a well-organized financial system. It is the financial system which supplies the necessary financial inputs for the production of goods and services which in turn promotes the well-being and standard of living of the people of a country. Moreover, the financial system of an economy provides the means to collect money from the people who have it and distribute it to those who can use it best. Hence, the efficient allocation of economic resources is achieved by a financial system that allocates money to those people and for those purposes that will yield the greatest return. Furthermore, financial system consists of financial market, financial institutions, financial instruments, financial services and regulations. The impact of the financial system on the real economy is subtle and complex. Thus, the direct impact of financial institutions on the real economy is relatively minor. Nonetheless, the indirect impact of financial markets and institutions on economic performance is important. This chapter focuses on definition and components of financial system, their role in the economy, various types of financial assets, financial markets and their participants and lending and borrowing process in the system. Financial system and its components The financial system is the set of markets and intermediaries used by households, firms, and governments to implement their financial decisions. It includes the markets for stocks, bond s, and other securities, as well as financial intermediaries such as banks and insurance companies. Financial system is a system that aims at establishing and providing smooth, regular, efficient and effective linkage between (depositors) and investors (borrowers). The word “system” in the term “financial system” implies a set (group) of complex and closely connected or intermixed institutions, agents, practices, markets, transactions, claims, and liabilities within an economy. Financial system is a complex network of institutions, markets, and intermediaries that facilitate the flow of funds and capital within an economy. Furthermore, Financial system is a set of rules and regulations that allows acquisition and selling of financial assets between and among seekers of finance, suppliers of finance and those intermediating the transaction. Therefore, financial Financial markets & Institutions Compiled By: Alemayo S. (MSc) 1  Chapter One: An overview of the financial System system is the collection of markets, individuals, laws, polices, conventions, techniques and institutions through which bonds, stocks, and other securities are traded, interest rates are determined and financial services are provided and delivered. It plays a fundamental role in the allocation of resources and the efficient functioning of modern economies. The system is a necessary phenomenon for an economy for it facilitates creation and utilization of credit and financial assets. A financial system makes possible a more efficient transfer of funds by mitigating the information asymmetry problem between those with funds to invest and those needing funds. In addition to the lenders and the borrowers, the financial system has three components: (1) financial markets, where transactions take place; (2) financial intermediaries, who facilitate the transactions; and (3) regulators of financial activities, who try to make sure that everyone is playing fair. The end-users or participants of the system are households, business firms and government whose desire is to lend and to borrow. The purpose of the financial system is to transfer funds from Surplus Units (SSUs) to Deficit Units (DSUs) in the most efficient manner possible, either for investment in real assets or for consumption. The job of bringing DSUs and SSUs together can be done by; 1, Direct Financing: Direct transfers of money and securities occur when a fund seeking entity/business sells its stocks or bonds directly to savers, without going through any type of financial intermediary. The entity/business delivers its securities to savers, who in turn give the firm the money it needs. In direct financing, DSUs and SSUs exchange money and financial claims directly – DSUs issue financial claims on themselves and sell them for money to SSUs. The SSUs hold the financial claims in their portfolios as interest bearing assets. The financial claims are bought and sold in financial markets. 2, Indirect Financing or Intermediation Financing: They purchase direct claims with one set of characteristics (e.g., term to maturity, denomination) from DSUs and transform them into indirect claims with a different set of characteristics, which they sell to the SSU. This transformation process is called intermediation. Firms that specialize in intermediation are called financial intermediaries or financial institutions. Moreover, financial intermediaries issue securities of their own or buy securities issued by corporations and then sell those securities to investors. Financial markets & Institutions Compiled By: Alemayo S. (MSc) 2  Chapter One: An overview of the financial System The following diagram indicate financial system and its components, users or participants of financial system and also the transfer of funds between those seeking it and those suppliers. 1.1The Role of financial system in the economy Financial system performs some vital functions to the economy, which tend to enhance the performance of the economy toward its growth and development. Such roles/functions include the following: Mobilizations of Savings An important function of a financial system is to mobilize savings and channelize them into productive activities i.e., they channel funds from those who have savings to those who have more productive use of them. The financial system should offer appropriate incentives to attract savings and make them available for more productive ventures. Thus, the financial system facilitates the transformation of savings into investment and consumption. The financial intermediaries have to play a dominant role in this activity i.e., they facilitate the flow of funds from saving-surplus agents with no profitable use of their funds to deficit-spending agents with profitable projects. Therefore, more goods and services can be produced (i.e., productivity will rise), increasing the world’s standard of living. When savings decline, investment and living standards begin to fall in those nations where savings are in short supply. Promotion of Liquidity Financial markets & Institutions Compiled By: Alemayo S. (MSc) 3  Chapter One: An overview of the financial System The most important function of a financial system is to provide money and monetary assets for the production of goods and services. There should not be any shortage of money for productive ventures. In financial language, the money and monetary assets are referred to as liquidity. Monetary assets are those assets which can be converted into cash or money easily without loss of value. All activities in a financial system are related to liquidity-either provision of liquidity or trading in liquidity. Payment Function The global financial system also provides a mechanism for making payments for purchases of goods and services. Certain financial assets-including currency, non-interests-bearing checking accounts (referred to as demand deposits), and interest-bearing checking accounts (referred to as negotiable order of withdrawal or NOW accounts) still serve as a popular medium of exchange in making payments all over the globe. Also high on the payments list plastic debit and credit cards issued by banks, credit unions, and retail stores. In the case of credit cards, the customer receives instant access to short-term credit when contracting for purchases of goods and services. If present trends continue, electronic means of payment, including computer terminals in homes, offices, and stores and digital cash (accessed by an encoded plastic card) will eventually replace checks and other pieces of paper as the principal means of paying in the future. Indeed, electronic means of payment are growing rapidly today while checks and other paper-based means of payment are declining in volume. Protection Function/ Risk Function The financial markets offer businesses, consumers, and government’s way to manage uncertainty and control risk against life, health, property, and income risks. These guarantees are accomplished through the sale of life, health insurance and property insurance policies. Policies marketed by life insurance companies indemnify a family against possible loss of income following the death of a loved one. Property casualty insurers protect their policyholders against an incredibly wide array of personal and property risks, ranging from ill health and storm demand to negligence on the highways. In addition to making possible the sale of insurance policies, the money and capital markets have been used by businesses and consumers to “self-insure” against risk; that is, holdings of wealth are built up as protection against future losses. The financial system permits individuals Financial markets & Institutions Compiled By: Alemayo S. (MSc) 4  Chapter One: An overview of the financial System and institutions to engage in both risk sharing and risk reduction. Risk sharing occurs when an individual or insurance transfers risk exposure to someone willing to accept that risk (such as an insurance company), while risk reduction usually takes place when we diversify our wealth across a wide variety of different assets so that our overall losses are likely to be more limited. Policy Function The financial system has been the principal channel through which government has carried out its policy of attempting to stabilize the economy and avoid inflation. By manipulating interest rates and the availability of credit, government can affect the borrowing and spending plans of the public, impacting the growth of jobs, production, and prices. Information Function A financial system makes available price-related information that helps coordinate decentralized decision-making in various sectors of the economy. This is a valuable function helping those who need to take economic and financial decisions. Financial markets disseminate information for enabling participants to develop an informed opinion about investment, disinvestment, reinvestment or holding a particular asset. Transfer Function A financial system provides a mechanism for the transfer of the resources across geographic boundaries. Reformatory Functions A financial system undertaking the functions of developing, introducing innovative financial assets/instruments services and practices and restructuring the existing assets, services etc. to cater the emerging needs of borrowers and investors (financial engineering and re-engineering). 1.2Financial Assets: Role and Properties 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. For every financial instrument there is a minimum of two parties. The party that has agreed to make future cash payments is called the Financial markets & Institutions Compiled By: Alemayo S. (MSc) 5  Chapter One: An overview of the financial System 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 Vs Financial Assets Real Assets A real asset is anything that generates a flow of goods or services over time. 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. This productive capacity is a function of the real assets of the economy. Real assets need not be tangible. Both physical and human assets together generate the entire spectrum of output produced and consumed by the society. Examples are land, building, knowledge, machines, inventions, business plans, goodwill, reputation, etc. Financial Assets A financial asset is a legal contract that gives its owner a claim to payments, usually generated by a real asset. Financial instruments are no more than sheets of paper. Their value is derived from the value of the underlying real assets. Examples include stocks, bonds, bank deposit, bank loans, options, futures, etc. Unlike real assets, financial assets do not represent a society’s wealth; do not contribute directly to the productive capacity of the economy instead they are claims to the income generated by real assets or claims on the income from the government. They are a means by which individuals hold their claims on real assets. Examples of financial assets ❖ A loan by Dashen Bank (investor) to an individual (issuer/borrower) to purchase a car ❖ A Treasury bond issued by National Bank of Ethiopia ❖ A bond issued by the government of Ethiopia (for the Grand Renaissance Dam) ❖ A bond issued by A.A City Municipal 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. Financial markets & Institutions Compiled By: Alemayo S. (MSc) 6  Chapter One: An overview of the financial System ❖ i.e., Your financial claim on a firm is an asset, but the firm's issuance of that claim is the firm's liability. ❖ Thus, when we aggregate overall balance sheets, financial assets will cancel out, leaving only the sum of real assets as the net wealth of the aggregate. ❑ 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. 1.2.1 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 denominated in currency units determined by the government, representing their value. Most financial assets are denominated in one currency such as US dollars. 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. 3. Convertibility: an important property of some financial asset is their convertibility in to other financial assets. In some cases, conversion takes place with one class of financial assets, as when a bond converted in to another bond. For example, with corporate convertible bond the bond holder can change in to equity shares. Some preferred stock may be convertible in to common stock. 4. Reversibility: refers to the cost of investing in financial asset and then getting out of it and back in to cash again. As result, reversibility is also referred to as turnaround cost or round - trip cost. It indicates the cost of buying an asset and then re-selling it. A financial asset a deposit at a bank is highly reversible because usually the investor incurs no charge for adding to or withdrawing from it. for financial assets traded in organize markets or with “market makers” the most relevant cost of round-trip cost is the so-called bid-ask spread, to which might be added commissions and the time and the cost, if any of delivering the asset. The bid ask spread consists of the difference between the price at which a market maker is willing to sell a Financial markets & Institutions Compiled By: Alemayo S. (MSc) 7  Chapter One: An overview of the financial System financial asset (i.e., the price it is asking) and at which a market maker is willing to buy the financial asset (i.e., the price it is bidding). For example, if a market maker is willing to sell some financial asset for $70.50 (the ask price) and buy it for $70.00 (the bid price), the bid ask spread is $0.50. The bid ask spread is referred to as offer spread. 5. Liquidity/Marketability: Financial assets are highly liquid and can be easily traded or exchanged for currency, providing flexibility to investors who may have immediate cash needs or expect 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 compared to real assets or tangible assets. Financial markets are typically characterized by extensive reporting and disclosure requirements, making information about financial assets more accessible. This transparency enables investors to make informed decisions based on available information about the asset's value, performance, and associated risks. 8. Complexity: some financial assets are complex in the sense that they combine two or more complex assets. 9. Tax status: an important feature of any financial asset is its tax status. Governmental codes for taxing the income from ownership or sale of financial assets vary widely. Tax rates differ from year to year, country to country, or from financial-to-financial asset, depending on the type of the issuer, the length of time the asset is held, the nature of the owner and so on. 1.2.2 Role of financial assets in financial system Financial assets serve two principal economic functions. First, financial assets transfer funds from those parties who have surplus funds to invest to those who need funds to invest in tangible assets. As their second function, they transfer funds in such a way as to redistribute the unavoidable risk associated with the cash flow generated by tangible assets among those seeking and those providing funds. However, the claims held by the final wealth holders generally differ from the liabilities issued by the final demanders of funds because of the activity of entities operating in Financial markets & Institutions Compiled By: Alemayo S. (MSc) 8  Chapter One: An overview of the financial System financial markets, called financial intermediaries, who seek to transform the final liabilities into different financial assets proffered by the public. 1.3 Financial markets: role, classfications and participants A financial market is a market where financial assets are exchanged (traded). 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 or financial market is a market in which financial assets (securities) such as stocks and bonds can be purchased or sold. Funds are transferred in financial markets when one party purchases financial assets previously held by another party. Financial markets transfer funds from those who have excess funds to those who need funds. Those participants with receive more money than they spend are referred to as surplus units (investors). Those participants who spend more money than they receive are referred to as deficit units (borrowers). Many deficit units such as firms and government agencies access funds from financial markets by issuing securities, which represent a claim on the issuer. Debt securities represent debt (also called credit, or borrowed funds) incurred by the issuer. Deficit units that issue the debt securities are borrowers. The surplus units that purchase debt securities are creditors, and they receive interest on a periodic basis (such as every six months). Debt securities have a maturity date, at which time the surplus units can redeem the securities in order to receive the principal (face value) from the deficit units that issued them. Equity securities (also called stocks) represent equity or ownership in the firm. Some businesses prefer to issue equity securities rather than debt securities when they need funds but might not be financially capable of making the periodic interest payments required for debt securities. Financial markets provide the following three major economic functions: 1. Price discovery: 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. Because the motivation for those seeking funds depends on the required return that investors demand, it is the functions of financial markets that signals how the funds available from those who want to lend or invest funds will be allocated among those needing funds and raise those funds by issuing financial instruments. Financial markets & Institutions Compiled By: Alemayo S. (MSc) 9  Chapter One: An overview of the financial System 2. Liquidity: Financial markets provide a mechanism for an investor to sell a financial asset. Because of this feature, it is said that a financial market offers liquidity, an attractive feature when circumstances either force or motivate an investor to sell. If there were not liquidity, the owner would be forced to hold a debt instrument until it matures and an equity instrument until the company is either voluntarily or involuntarily liquidated. While all financial markets provide some form of liquidity, the degree of liquidity is one of the factors that characterize different markets. 3. It reduces the cost of transacting. There are two costs associated with transacting search costs and information costs. Search cost represent explicit costs, such as money spent to advertise one’s intention to sell or purchase a financial asset, and implicit costs such as the value time spent in locating a counter party. The presence of some form of organized market reduces search costs. Information costs are costs associated with assessing the investment merits of a financial asset, the amount and the likelihood of cash flow expected to be generated. In an efficient market, prices reflect the aggregate information collected by all market participants. 1.3.1 Classifications of financial markets 1. By the type of financial claim: a) Debt Market: - The debt market is the financial market for fixed claims (debt instruments) and 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. Debt market classification based on time period ✓ Short-term: If its maturity is less than a year ✓ Intermediate-term: if its maturity is between one and ten years ✓ Long-term: if its maturity is ten years or longer b) Equity market: - The equity market is the financial market for residual claims (equity 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. Financial markets & Institutions Compiled By: Alemayo S. (MSc) 10  Chapter One: An overview of the financial System ✓ Owning stock means that you own a portion of the firm and thus have the right to vote on issues important to the firm and to elect its directors. 2. By the maturity of claims a) Money market: - The market for short term financial claims is referred to as the money market, and only short-term debt instruments (generally those with original maturity of less than one year) are traded. Money market Short-term securities have smaller fluctuations in prices than long-term securities, making them safer investments. As a result, corporations and banks actively use the money market to earn interest on surplus funds that they expect to have only temporarily Money Market- for short-term funds (less than a year) I. Organized (Banks) II. Unorganized (money lenders) b) Capital market: - The market for long term financial claims is called the capital market. Longer term debt (generally those with original maturity of one year or greater) and equity instruments are traded. 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. Capital Market- for long-term funds i. Primary Issues Market ii. Stock Market iii. Bond Market 3. Based on whether the claims represent new issues or outstanding issues: a) Primary Market: - Is a financial market in which new issues of a security are sold to initial buyers by the corporation or government agency borrowing the funds. Investment bank (underwrites) new securities: it guarantees a price for corporation’s securities and then sells them to the public. c) Secondary market:- is a financial market in which securities that have been previously issued can be resold. Ex- The NSE & ASE, BSE, LSE and National Association of Securities Dealers’ Automated Quotation System (NASDAQ). Other examples are foreign exchange markets, Financial markets & Institutions Compiled By: Alemayo S. (MSc) 11  Chapter One: An overview of the financial System forward markets, futures markets, and options markets. Brokers match buyers with sellers of securities; Dealers link buyers and sellers by buying and selling securities at stated prices Secondary markets serve two important functions. i. The increased liquidity of these instruments then makes them more desirable and thus easier for issuing firm to sell in the primary market. ii. Determine the price for primary equities. 4. By the timing of delivery; a) Cash or Spot market: A cash or spot market is the market for the immediate purchase and sale of a financial instrument. b) Forward or future market: - A forward or futures market is one where the delivery occurs at a pre-determined time in the future (Derivative market). 5. By the nature of its organizational structure: a) Exchange Traded market: - An exchange traded market is characterized by a centralized organization with standardized procedures. b) Over the counter market: - An over-the-counter market is a decentralized market with customized procedures. Secondary markets can be organized in two ways One is to organize exchanges, where buyers and sellers of securities (or their agents or brokers) meet in the central location to conduct trades. Examples: The New York and American stock exchanges for stocks, the Chicago Board of Trade for Commodities (wheat, corn, silver, and other raw materials), Nikkei and Ethiopian Commodities Exchange are examples of organized exchanges. The other method is to have OTC market, in which dealers at different locations who have an inventory of securities stand ready to buy and sell securities “over the counter” Because over-the- counter sellers 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. Many common stocks are traded over-the-counter, although the largest corporations usually have their shares traded at organized stock exchanges such as the New York Stock Exchange. The U.S. government bond market, with a larger trading volume than the New York Stock Exchange, is set up as an over-the-counter market. Other over-the-counter markets include those that trade other types of Financial markets & Institutions Compiled By: Alemayo S. (MSc) 12  Chapter One: An overview of the financial System financial instruments such as negotiable certificates of deposit, federal funds, banker’s acceptances, and foreign exchange. 1.3.2 Financial market participants Participants in the national and global financial markets that issue and purchase financial claims include Household, Business entities (corporations & partnership), National governments, National government agencies, State and local government, and Supranational (such as WB, the European investment bank, the ADB) Regulators of financial market. 1.4 Lending and borrowing in the financial system Business firms, households and government play a wide variety of roles in modern financial systems. It is quite common for an individual or institution to be a lender of funds in one period and borrower in the next, or to do both simultaneously like financial intermediaries such as banks, insurance companies etc. which operates on both side of financial markets, borrowing funds from customers by issuing attractive financial claims and simultaneously making loans available to other customers. NB: Each business firm, household or unit of government active in the financial system must conform to the following identity. 𝑹 − 𝑬 = ∆𝑭𝑨 − ∆𝑫 (Current revenue – Expenditures out of current revenue) = (Change in holding financial assets - change in debt & equity outstanding). If our current expenditure (E) exceeds our current revenue (R), we usually make up the difference by, 1. Reducing our holdings of financial assets (-FA). Eg by drawing money out of saving account. 2. Issuing debt or stock(+D) or 3. Using some combination of both. Financial markets & Institutions Compiled By: Alemayo S. (MSc) 13  Chapter One: An overview of the financial System If our receipts (R) in the current period are larger than current expenditures (E), we can 1. Build up our holdings of our financial assets (+FA).Eg placing money in saving account, purchasing new shares of stock or debt. 2. Pay off some outstanding debt or retire stock previously issued by our business firm(-D) or 3. Do some combination of both. It follows that for any given period of time (day, week, month, and year) the individual economic unit must fall into one of the three groups. 1. Deficit budget unit (DBU) or net borrower of funds = E>R and so D>FA 2. Surplus budget unit (SBU) or net lender of funds = R>E and thus FA > D 3. Balance budget unit (BBU) = R=E and thus FA = D N.B A net lender of funds is really a net supplier of funds to the financial system. It accomplishes this function by purchasing financial assets, paying off debt, or retiring equity (stocks). In contrast, a net borrower of funds is a net demander of funds from the financial system, selling financial assets, issuing new stock or debt. The government and the business sector of the economy tend to be net borrowers while the household sector composed of all families and individuals tend to be net lender (supplier) of funds. Financial markets & Institutions Compiled By: Alemayo S. (MSc) 14