Overview of Financial

System
Lecture 1
 Objectives
The objectives of this lesson are to:

• Define a financial System

• Identify the Components of the financial System
• Functions of a Financial system in an economy
 What is a financial System?
• A financial system is a network of financial institutions – such as insurance
companies, stock exchanges, and investment banks – that work together to
exchange and transfer capital from one place to another. Through the
financial system, investors receive capital to fund projects and receive a
return on their investments.
• A financial system could be defined at an international, regional or
organization level. The term “system” in “Financial System” indicates a
group of complex and closely linked institutions, agents, procedures,
markets, transactions, claims and liabilities within a economy
• Financial markets operate within a government regulatory framework that
filters the sort of transactions that can be conducted. Financial systems are
heavily regulated due to their influence and facilitation capabilities to
contribute to the growth of real assets.
 Components of the Financial System
The financial system is composed of many components depending on the level. From
a company’s perspective, its financial system includes procedures that follow its
financial activities. It would include aspects such as finances, accounting, revenue,
expenses, wages, and more.

From a regional standpoint, the financial system, as mentioned above, facilitates the
exchange of funds between borrowers and lenders. Players on a regional level would
include banks and other financial institutions such as clearinghouses.

On a global scale, the financial system includes the interactions between financial
institutions, investors, central banks, government authorities, the World Bank, and
more.
 Example of a Financial System
Example
• An example of one player within the financial system is the Bank of Botswana (BoB). The BoB
promotes economic and financial welfare for Botswana by cultivating a financial system
whereby banks, credit unions, financial markets, and other factors interact to ensure the
economic landscape continues to operate effectively for its citizens. The BoB achieves its
objectives through the following:
• Providing central bank services such as liquidity and credit facilities: The BoB sources liquid
funds to the financial system and is often known as the lender of last resort.
• Developing and implementing national policy: The federal government introduces legislation
to implement a new retail payments framework. The BoB would oversee the service with
operational and financial requirements, ensuring regulations are maintained.
• Oversees financial market infrastructures: The central bank conducts regulatory oversight and
acts as the resolution authority for financial market infrastructures. They include payments
systems and clearing and settlement systems.
Components of a Financial System
Financial Institutions
• Financial institutions facilitate smooth working of the financial system
by making investors and borrowers meet. They mobilize the savings of
investors either directly or indirectly via financial markets, by making
use of different financial instruments as well as in the process using
the services of numerous financial services providers.

• They could be categorized into Regulatory, Intermediaries, Non-

intermediaries and Others. They offer services to organizations
looking for advises on different problems including restructuring to
diversification strategies. They offer complete array of services to the
organizations who want to raise funds from the markets and take care
of financial assets for example deposits, securities, loans, etc.
Financial Markets
• A financial market is the place where financial assets are created or transferred. It can be broadly
categorized into money markets and capital markets. Money market handles short-term financial assets
(less than a year) whereas capital markets take care of those financial assets that have maturity period of
more than a year. The key functions are:
1. Assist in creation and allocation of credit and liquidity.
2. Serve as intermediaries for mobilization of savings.
3. Help achieve balanced economic growth.
4. Offer financial convenience.
• One more classification is possible: primary markets and secondary markets. Primary markets handles
new issue of securities in contrast secondary markets take care of securities that are presently available in
the stock market.
• Financial markets catch the attention of investors and make it possible for companies to finance their
operations and attain growth. Money markets make it possible for businesses to gain access to funds on a
short-term basis, while capital markets allow businesses to gain long-term funding to aid expansion.
Without financial markets, borrowers would have problems finding lenders. Intermediaries like banks
assist in this procedure. Banks take deposits from investors and lend money from this pool of deposited
money to people who need loan. Banks commonly provide money in the form of loans.
Financial Instruments
This is an important component of financial system. The products
which are traded in a financial market are financial assets, securities or
other type of financial instruments. There is a wide range of securities
in the markets since the needs of investors and credit seekers are
different. They indicate a claim on the settlement of principal down the
road or payment of a regular amount by means of interest or dividend.
Equity shares, debentures, bonds, etc are some examples.
Financial Services
• Financial services consist of services provided by Asset Management and Liability
Management Companies. They help to get the necessary funds and also make sure that
they are efficiently deployed. They assist to determine the financing combination and
extend their professional services upto the stage of servicing of lenders. They help with
borrowing, selling and purchasing securities, lending and investing, making and allowing
payments and settlements and taking care of risk exposures in financial markets. These
range from the leasing companies, mutual fund houses, merchant bankers, portfolio
managers, bill discounting and acceptance houses.

• The financial services sector offers a number of professional services like credit rating,
venture capital financing, mutual funds, merchant banking, depository services, book
building, etc. Financial institutions and financial markets help in the working of the
financial system by means of financial instruments. To be able to carry out the jobs given,
they need several services of financial nature.
Money

Money is understood to be anything that is accepted for payment of

products and services or for the repayment of debt. It is a medium of
exchange and acts as a store of value.
Function of the financial System - Saving

• Both individuals and companies alike set aside money in the present
to have more to spend in the future. Individuals typically save during
their working years so they can withdraw money later on to fund their
retirement. Corporations may save money collected from customers
to repay suppliers or lenders, purchase new equipment, or to acquire
other companies. Money can be saved in a broad range of investment
vehicles: from low-risk treasury bills to higher risk corporate bonds
and stocks. Investors that put money into riskier investments expect
to be compensated with higher returns.
Function of the financial System -Borrowing
• In contrast to saving, borrowing involves receiving money in the present
that will be repaid in the future. People can borrow money through secured
loans, like most car loans and mortgages for example, where the lender can
sell the asset posted as collateral in the event that the borrower defaults.
On the other hand, student loans or credit card debt is typically unsecured.
Since there is no collateral to be recovered if the borrower fails to pay,
lenders will typically charge a higher interest rate on unsecured loans to
compensate for the greater downside risk. Companies oftentimes utilize
both debt and equity to fund current and future investments.Finally,
governments also borrow money to finance current spending by issuing
bills, notes, and loans that will be repaid with future taxes or revenue
earned by government projects.
Function of the financial System -Raising Equity Capital

• Companies use investment banks to assist in raising equity capital,

where investors trade cash for a share of ownership in the company.
While equities don’t promise investors a fixed payment in the future,
investors expect payments in the form of future dividends or capital
gains. Analysts help investors accurately value company shares while
regulatory reporting requirements and accounting standards aim to
ensure that investors are not misled by a company’s financial
statements.
Function of the financial System -Managing Risks

• In order to manage risks, investors use forward contracts, futures

contracts, options contracts, insurance contracts, and other
derivatives. These contracts serve to offset the effect of adverse price
movements in assets that a party may need to buy or sell in the
future. For example, an airline may enter into a forward contract to
buy jet fuel at a certain price on some fixed date in the future,
hedging the risk of rising prices. The party on the other side of the
trade may be the fuel supplier, hedging the risk of falling prices. While
their risks are opposite, both parties achieve their purposes with a
single transaction.
Function of the financial System -Exchanging Assets for
Immediate Delivery (Spot Market Trading)

• People and companies use the spot market to trade a currency to

acquire other currencies or commodities, which will be delivered
immediately when the transaction takes place.
Function of the financial System -Information-Motivated Trading

• While both investors and information-motivated traders ultimately try to buy low and sell
high, information-motivated traders are different in that they expect to earn excess
returns from their informational advantage in addition to the normal returns traditional
investors earn for the risk of holding an asset over time. Information-motivated traders
believe the information they have allows them to buy undervalued companies and sell
overvalued companies, expecting to profit when the share prices more accurately reflect
the intrinsic value of the companies.
• Active investment managers all take part in information-motivated trading to beat their
benchmark or the return earned by “buy and hold” investors taking similar risks. In theory,
active managers can gain an information edge over other market participants by hiring
skilled professionals and conducting thorough research on potential investments.
Investors are also information-motivated traders when they allocate funds with the
expectation of earning conditional returns greater than the unconditional returns they
would earn in the same asset class.
Function of the financial System -Determining Appropriate Rates of
Return

• Since savers are on the opposite end of transactions with borrowers

and equity sellers, the rate of return must be set at the point where
both parties are satisfied. The cost of moving money through time, or
the equilibrium interest rate, is the rate at which aggregate supply for
funds through savings equals aggregate demand. Savers won’t supply
capital if too low of a rate is offered, and borrowers won’t demand
capital if too high of a rate is offered. To determine the rate of return,
the equilibrium interest rate must be adjusted depending on the risk
characteristics, terms, and liquidity of the security.
Function of the financial System -Efficient Capital Allocation

• Efficient capital allocation allows the market’s scarce capital to be

allocated to only the most productive investments. A market is
efficient when market participants have access to accurate
information. When investors are thorough in their analysis of
available information, they improve the efficiency of the market by
simply acting in their own best interests. Well-informed investors will
not make a loan to someone with poor credit without being
appropriately compensated with a higher rate of return, nor will they
invest in projects unless the value of future cash flows exceeds the
cost.
The link between the financial system and the
economy
• The financial system is the blood system of the economy. It is essential for
the health of the economy as it allows the savings of the population to go
to various projects and investments. When it performs these functions well,
the economy thrives. When it doesn’t, the economy stagnates or, worse,
goes into a crisis. What is the benefit of having a financial system and when
do things go bad?
• Financial markets help to efficiently direct the flow of savings and
investment in the economy in ways that facilitate the accumulation of
capital and the production of goods and services. The combination of well-
developed financial markets and institutions, as well as a diverse array of
financial products and instruments, suits the needs of borrowers and
lenders and therefore the overall economy.
Any questions?