LESSON ONE :
INSTITUTIONS
INTRODUCTION
TO
FINANCIAL
MARKETS
AND
Objectives
By the end of this lesson, you should be able to: Understand the nature of
financial systems Describe the usefulness of a financial system, the nature of
financial systems in Africa
1.0.
Nature of Financial system.
The financial system can also be defined as the collection of markets, institutions, laws,
regulations, and techniques through which financial instruments (bonds, stocks, and other
securities) are traded, interest rates are determined, and financial services are produced
and delivered around the world.
The financial system or the financial sector of any country (Bhole and Mahakund (2009)
consist of :

Specialized and non-specialized financial institutions

Organized and unorganized financial markets

Financial instruments and services which facilitate transfer of funds.

Procedures
and
practices
adopted
in
the
markets,
and
financial
interrelationship are also part of the system.
The structure of a financial system can as below :
FINANCIAL SYSTEM
FINANCIAL
INSTITUTIONS
FINANCIAL
MARKETS
0
FINANCIAL
INSTRUMENT
TS
FINANCIAL
SERVICE
Secondary
Primary
Regulatory
Intermediary
Nonintermediary
Short-term
Unorganised
d
Organised
Secondary
Primary
Money Market
Capital Market
Debt Market
medium long-term
Equity Market
Derivative Market
According to the structural approach, the financial system of an economy consists of
main components:
1) Financial markets; facilitate the flow of funds in order to finance investments by
corporations, governments and individuals
2) Financial intermediaries (institutions); are the key players in the financial markets as
they perform the function of intermediation and thus determine the flow of funds.
3) Financial regulators. Perform the role of monitoring and regulating the participants.
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4) Financial infrastructure is the set of institutions that enables effective operation of
financial intermediaries and financial markets, including such elements as payment
systems, credit information bureaus, and collateral registries.
5) Financial services
6) Financial instruments
Functions of a Financial System
Broad function of financial system can be put in three sets: (1) monetary function, (2)
capital allocation function and (3) controlling function. These functions can be expanded
into :
The following are the functions of a Financial System:
(i) Mobilise and allocate savings – linking the savers and investors to mobilise and
allocate the savings efficiently and effectively. [capital allocation function]
(ii) Monitor corporate performance – apart from selection of projects to be funded,
through an efficient financial system, the operators are motivated to monitor
the performance of the investment. [controlling function]
(iii)Provide payment and settlement systems – for exchange of gods and services and
transfer of economic resources through time and across geographic regions
and industries. The clearing and settlement mechanism of the stock markets is
done through depositories and clearing operations. [monetary function]
(iv) Optimum allocation and reduction of risk - by framing rules to reduce risk by
laying down the rules governing the operation of the system. This is also
achieved through holding of diversified portfolios.
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(v) Disseminate price-related information – which acts as an important tool for taking
economic and financial decisions and take an informed opinion about
investment, disinvestment, reinvestment or holding of any particular asset.
(vi) Offer portfolio adjustment facility – which includes services of providing quick,
cheap and reliable way of buying and selling a wide variety of financial assets.
Lower the cost of transactions – when operations are through and within the
(vii)
financial structure.
(viii)
Promote the process of financial deepening and broadening – through a wellfunctional financial system. Financial deepening refers to an increase of
financial assets as a percentage of GDP. Financial depth is an important
measure of financial system development as it measures the size of the
financial intermediary sector. Financial broadening refers to building an
increasing number of varieties of participants and instruments.
Key elements of a well-functioning Financial System
The basic elements of a well-functional financial system are:
i.
a strong legal and regulatory environment;
ii.
stable money;
iii.
sound public finances and public debt management;
iv.
a central bank;
v.
a sound banking system;
vi.
an information system; and
vii.
Well functioning securities market.
1.1.
Financial instruments and services
Financial system deal in financial services and claims or financial assets or securities
or financial instruments. Financial securities are classified as primary (direct) and
secondary (indirect). The primary securities are issued by the ultimate investors
directly to the ultimate savers such as shares and debentures, while the secondary
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securities are issued by the financial intermediaries to the ultimate savers such as
bank deposits, insurance, unit trust shares. The investment characteristics of financial
assets and financial products are the following :

Liquidity

Marketability

Reversibility

Transferability

Lower transaction costs
There are two Financial Systems prevalent in the world today:
(a)
Bank Dominated Financial System – Stage I – In undeveloped countries
(b)
Market Dominated Financial System – Stage III – In developed countries.
In between the two, there is a second stage which is a transitory stage between Stage I
and III. This stage is often found in developing countries like ours who are in the process
of transition from Bank Dominated to Market Dominated Financial System.
When the equity market is fully evolved, industrialists raise finance from the market.
However, in case the market is not fully developed, govt facilitates easy finance for
industrial development through banks.
Market Dominated Financial System is prevalent in US and UK. Such system is possible
only in countries where Debt and Equity market has fully evolved. Therefore, Financial
System in countries like Germany and Japan, which otherwise are well developed, have
still got Bank Dominated System.
1.2.
Importance of a Well Functioning Financial System
In a well-functioning financial system, financial contracts, markets and intermediaries act
to reduce the costs of acquiring information, enforcing contracts, and making
transactions. Financial instruments and institutions, in turn, influence the allocation of
financial resources within an economy in favor of the more efficient use of capital. Thus,
a developed financial system is better equipped than an underdeveloped one to perform
the following functions:
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• Producing information and allocating capital. Financial intermediaries can
reduce the costs associated with acquiring information, which leads to more
efficient capital allocation;
• Monitoring firms and exerting corporate governance. The extent to which
capital providers can monitor capital users has implications in terms of the use of
resources. For example, if capital providers can monitor firms effectively and
ensure that management is committed to maximizing firm value, firms will make
better use of their resources;
• Trading, diversification, and risk mitigation. Financial institutions and
instruments can diversify, mitigate and distribute agents’ risks over time. The
financial system facilitates separating, distributing, trading, hedging, diversifying,
pooling and reducing risks.
• Mobilizing and pooling savings. Mobilizing and allocating capital is a costly
process due to (i) transaction costs related to collecting savings from many
individuals and (ii) mitigating informational asymmetries between savers and
those seeking capital; and,
• Easing exchange of goods and services. Financial systems that reduce transaction
costs can lead to greater specialization, technological innovation, access to
finance, and growth.
1.3 The Negative Impact of Small Financial Systems in Africa
As well as being associated with lower economic growth, small size is also an obstacle to
the development of financial systems. Financial services in small systems tend to be more
limited in scope, more expensive, and of poorer quality than services in larger systems. In
Sub-Saharan Africa, many countries’ financial systems and financial institutions are
amongst the smallest in the world. Only South Africa and Nigeria have financial systems
with total assets of more than US$10 billion . Only ten countries’ financial systems have
assets of between US$2 and US$10 billion, and the remaining countries’ systems have
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assets of less than US$2 billion, which is the equivalent of a moderately sized bank
branch in many developed countries. The impact of small size on financial markets
can be summarized as:
• Fewer participants and are consequently less competitive. Small financial
systems tend to have fewer participants and are consequently less competitive.
This leads to higher financial product pricing, less access to finance, and lower
levels of innovation than in larger financial systems;
• Inefficiency. Small financial systems are less efficient because economies of scale
are often absent. Research has found scale economies for banking, securities
markets and payment systems. For instance, modern banks, insurance companies,
pension funds, payments systems, and securities markets all use computer-based
technology that is scale dependent for cost-effective operation. Even in their
smallest configurations, the capacity of these technologies often far exceeds the
processing needs of institutions in small financial systems;
• Inadequate services. Small financial systems are more likely to be incomplete.
Since minimum scale economies may preclude the provision of some financial
services, customers may be unable to purchase some of the products and services
they need e.g development of the derivative market;
• Small financial systems are less able to diversify their investment and
operational risks. The smaller range of products, clients and geography in small
markets make financial services firms inherently less stable than firms in larger
markets;
• The regulatory infrastructure of small financial systems tends to be of higher
cost and lower quality than in large systems. Financial supervision and
regulation is prone to high set-up costs and faces human capital constraints; and,
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• Auxiliary components of financial infrastructure are often absent from small
systems. For example, credit information services may not exist in small markets
because they are unable to secure the economies of scale required for cost
effective operation and the legal infrastructure may lack the skills and capacity to
meet the needs of modern financial services.
1.4. Financial System and Economic Development
The role of financial system in an economic development can be illustrated using the
flow indicated below :
Economic Development
Savings and investment or
capital formation
Surplus spending economic
units
Deficit spending economic
units
Income minus (consumption
+own investment)
Income minus (consumption
+own investment
Surplus or Savings
Deficit or Negative Saving
Financial system
The economic development greatly depends on the rate of capital formation. Capital
formation depends on whether finance is made available in time, in adequate quantities
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and on favourable terms i.e a good financial system. The importance of finance and
finance system in economic development can be understood by discussing the theories of
the impact of financial development on saving and investment . These are :
1.5. Growth of Financial systems: Financial Repression and financial Deepening
Financial repression may be defined as a state where, due to either formal (Government)
or informal controls, there exist barriers to the development of free securities markets in
the economic sense. Following Goldsmith (1969), Shaw (1973), Fry (1982) and Fischer
(1989) one may conclude that the key characteristics of financial repression include:
- Existence of controls on interest rates (normally maintained at fixed statutory levels
by the Government) which may result in negative real interest rates in the economy.
- Government and other institutional barriers to the entry and development of
financial institutions and instruments. This is evidenced by very strict rules for joining
stock exchanges or registering financial institutions. These maintain such institutions at
the bare minimum and give the existing ones no incentive to innovate new financial
instruments
- Formally targeting savings and investments into specified areas of the economy
thereby stifling capital available to other high growth innovative projects. In developing
countries this is observed by requiring specific deposit/liquidity ratios, investment in
treasury bills and demanding fixed percentage investment in certain sectors e.g.
agriculture [Fry (1982)]. This has the effect of directing investment funds to inefficient
investments.
The consequence is to slow down the rate of economic growth and bring down the rate of
innovation in the securities market.
- The existence of parallel informal markets of money lenders who can advance funds
on a short term basis at very high-levels of interest rates. These markets will not be able
to satisfy the demand for funds since they are, by their risky nature, unable to attract any
significant deposits from savers.
Solutions of Financial repression
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Financial repression can be dealt with by systematic change of policies to move towards
financial deepening. Financial deepening means the accumulation of financial assets at a
pace, faster than accumulation of non-financial wealth [Shaw (1973, p.vii)]. The policies
adopted which encourage the growth of financial institutions and instruments are:
- Removing the institutionalised barriers of entry into the financial markets. This,
for example, calls for more liberal policies on entry into organised markets and the
floating of financial institutions. The removal of barriers may call for initial statutory
legislation and the synchronising of monetary and fiscal policies [IFC
(1984), Fischer (1989)].
- Action on existing interest rate policies. The presumption in financial repression that
fixed interest rates may be desirable to move the economy towards higher levels of
investment is not well founded [Kitchen (1986,
p.80-83)]. This is due to the banking sector sometimes being the only organised financial
market. The Government in such a case has no other access to ready borrowing other than
the banking system thereby stifling funds available to other borrowers. Financial
deepening calls for the liberalization of interest rates so that an equilibrium can be
reached between savings and investment.
It is not clear how the market may react to liberal policies on interest rates. It is
nevertheless expected that the rates of interest will adjust themselves to match yield on
other financial assets such as shares and also match expected returns on retained earnings.
The economic power of financial intermediation will be in full play.
Removing institutional targeting of savings and investments. This means that markets
would be free to exercise discretion on where to seek savings and where to direct
investments. One hypothesised effect of such a policy change is that it will be possible
for markets to make funds available for highly innovative projects which will play a
major role in economic development.
Key terms in financial markets :
Diversification : diversification means the existence or the development of a very wide
variety of financial institutions, markets, instruments, services and practices in the
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financial system. It refers to the opportunities for investors to purchase a large mix or
portfolio of varieties of financial system.
Disintermediation : it refers to the phenomenon of a decline in the share of financial
intermediaries in the economy because of investors seek direct finance in the open
market.
Disintermediation refers to the withdrawal of funds from a financial intermediary by
the ultimate lenders (savers) and the lending of those funds directly to the ultimate
borrowers.
Securitization: is used in financial literature in two senses
First, it means faster growth of direct (primary) financial markets and financial
instruments. In other words, it refers to the growing ability and practices of firms to tap
into the bond, commercial paper and equity market directly. Secondly it refers to the
process through which the existing assets of the lending institutions are sold or removed
from the balance sheet through their funding by other investors.
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