The Financial System PDF

**The Financial System.** ▪ Financial System refers to the network of frameworks, structures, institutions and players that facilitate financial transactions in an economy. **It Encompasses:** ▪ Financial markets. ▪ Financial institutions. ▪ Economic agents/players. ▪ Legal/Regulatory framewor...

**The Financial System.** ▪ Financial System refers to the network of frameworks, structures, institutions and players that facilitate financial transactions in an economy. **It Encompasses:** ▪ Financial markets. ▪ Financial institutions. ▪ Economic agents/players. ▪ Legal/Regulatory framework. ▪ Systems/Platforms that facilitate transactions to be executed. **Regulation of the Financial System** ▪ The financial system is among the most heavily regulated sectors of the economy world over. ▪ This a very crucial to the economic health of a country because money is the lifeblood of an economy. ▪ Government regulates financial markets for two main reasons: ▪ to increase the information available to investors; and, ▪ to ensure the safety and soundness of the financial system. **Increasing Information Available to Investors** ▪ Asymmetric information in financial markets means that investors may be subject to adverse selection and moral hazard problems that may hinder the efficient operation of financial markets. ▪ Risky firms/ outright crooks may sell securities to unwary investors, and the resulting adverse selection problem may keep investors out of financial markets. ▪ Furthermore, the borrower may have incentives to engage in risky activities or to commit outright fraud. Moral hazard Moral hazard is a term used to describe how a person or an organization tends to indulge in risky undertakings by knowing they are protected against the consequences. The risk-taking party has minimal responsibility towards the loss and its cost, which instigates them to do so. A moral hazard can occur due to: The incentive or motivation to take risks Lack of information Desire to earn commission or profits **Adverse selection** Adverse selection occurs when one party in a negotiation has relevant information the other party lacks. The asymmetry of information often leads to poor decisions, e.g., doing more business with less profitable or riskier market segments. ▪ The presence of this moral hazard problem may keep investors away ▪ Government regulation can reduce adverse selection and moral hazard from financial markets and enhance the efficiency of the markets by increasing the amount of information available to investors. **Functions of financial Markets** ▪ Price Determination: The prices at which the financial instruments trade in the financial market are determined by the market forces, i.e., demand and supply. ▪ Financial market provides the vehicle by which the prices are set for both financial assets which are issued newly and for the existing stock of the financial assets. ▪ Funds Mobilization: The financial market helps in the mobilization of the investors\' savings. ▪ Liquidity: Investors can sell their securities readily and convert them into cash in the financial market, thereby providing liquidity. ▪ Risk sharing: With the help of the financial market, the risk is transferred from the person who undertakes the investments to those who provide the funds for making those investments. **Functions of financial Markets** ▪ Easy Access: Financial market platform provides the potential buyer and seller easily, which helps them save their time and money in finding the potential buyer and seller. ▪ Reduction in Transaction Costs and Provision of the Information: Financial ▪ Capital Formation: Financial markets provide the channel through which market helps provide every type of information to the traders without the requirement of spending any money by them. the new investors\' savings flow in the country, which aids in the country\'s capital formation. **Flow of funds in a financial system** ▪ The principal lender-savers are households, but firms and government maybe involved when they have excess funds. ▪ Borrower-spenders are businesses and the government, but households might participate when in need. ▪ Funds flow from lender-savers to borrower-spenders via two routes. ▪ In direct finance, borrowers borrow funds directly from lenders in financial markets by selling them securities (also called financial instruments). ▪ These are claims on the borrower's future income or assets. **Type of financial Markets** Money and Capital markets: ▪ Primary and secondary markets ▪ Debt and Equity Markets. ▪ Exchanges and Over-the-Counter Markets. ▪ Internationalization of Financial Markets. **Money Markets** ▪ Consist of short term highly marketable debt securities. ▪ Most instruments here trade in large denominations and beyond the reach of individual investors e.g. ▪ Treasury bills: Most marketable of all money market instruments. ▪ Certificates of deposit: Time deposit with a bank. Interest and principal ▪ Commercial paper: short term unsecured debt notes issued by large and is paid to depositor at maturity. ▪ Eurocurrency: Foreign currency deposits made with local banks e.g., Eurodollar deposit ( dollar deposit in Zambia). ▪ Bankers' acceptance: An order to a bank by a bank's customer to pay a sum of money at a future date (like postdated cheque). **Capital Markets** ▪ Consist of debt instruments and equity securities (Source of long-term finance) e.g. ▪ Treasury (government) bonds: issued by government when borrowing from the public. ▪ Eurobond: Bond issued in foreign currency. ▪ Corporate Bond: issued by private firms and public limited firms when borrowing from the public. ▪ Can be unsecured (debentures), secured, callable or convertible bonds. **Primary and Secondary markets.** ▪ Primary Market: o Market for 'new' funds i.e., where first time issuance of financial securities takes place. o Applies to both money markets and capital markets. ▪ Secondary market: Market for subsequent trading in existing securities. o Liquidity market. o Supports the operations of primary markets. **Financial intermediation** ▪ Intermediation: o Process of engaging in a financial transaction with the help of an intermediary e.g., a bank or dealer. o An intermediary facilitates exchange of assets, capital, and risk. ▪ Disintermediation: o By passing the intermediary when participating in a financial transaction (not involving an intermediary). **Main functions of intermediaries** ▪ Bringing together savers and borrowers (supply liquidity) ▪ Risk pooling --risk reduction. ▪ Repacking finance ▪ Maturity transformation ▪ Efficient allocation of information. ▪ Provides clearing houses that settle trades. **Financial assets.** ▪Financial assets (shares, bonds, derivatives) : ▪Are claims on income derived from the use of real assets. ▪May also have an ownership claim on real assets. ▪Are created and destroyed in the ordinary course of business. ▪Their value depends on the value of the underlying real assets. ▪Do not directly contribute to productive capacity of an economy. ▪ Fixed income securities (debt securities): ▪ Short term debt securities (money market instruments e.g. treasury bills , certificates of deposit, commercial paper). ▪ Long term securities (capital market instruments e.g. treasury and corporate bonds). ▪ Can be issued by corporation or government to raise debt finance. ▪ Provide periodic income payments at predetermined fixed interest rate. **Equity securities:** ▪ Represents an ownership stake in a business. ▪ Its value increases/decreases with the performance of the firm and its real assets. ▪ Is riskier than debt securities. ▪ Have a residual claim on the income and assets of a business. ▪ Equity securities (preference shares): ▪ Has both equity features and debt features. ▪ Debt features of preference shares: dividend is fixed and payable before equity dividend. ▪ Equity feature of preference shares: non-payment of dividend cannot lead to a possibility of bankruptcy. ▪ Can be issued as cumulative, non-cumulative, participating or convertible preference shares. ▪Derivative instruments (Forwards, options, futures etc.): ▪Derive their value from the performance of other securities whether real assets or financial assets. ▪Derivatives have no value of their own. ▪Help to hedge risk or transfer them to other parties. ▪Can be used in highly speculative positions. ▪Require sound financial knowledge to mitigate risk and earn good returns