Rift Valley University

Sendafa Campus

FINANCIAL MARKETS AND INSTITTIONS

BY: G/slassie Hailu

Sendafa, Ethiopia

2015 E.C (2023)

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 CHAPTER ONE
AN OVERVIEW OF FINANCIAL SYSTEM
Learning Objectives:
After completing this chapter, you will be able to:
 Define financial system.
 Distinguish the components of financial system;
 Explain the direct and indirect financing mechanism;
 Identify the properties of financial assets
 Lending and borrowing in the financial system
 Describe the role of financial institutions

Introduction
This module is designed to introduce you to the basic concepts of the financial systems; its
components, function and the role in socio-economic activities of nation. The first part of this
module chapter deals with the role of the financial system in the economy. Properties and roles of
the different types of financial assets that are created and traded in the financial system are also
discussed in the second part of this chapter. The third part of this chapter provides information

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regarding the role, classification and participants of financial markets in the financial system.
Finally, the last part discusses the lending and borrowing in the financial system.

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. Financial system is a system that aims at establishing and providing a
regular, smooth, effective and efficient linkage between depositors and investors. Therefore,
financial 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. 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.

1.1 Basic Components of Financial System

A financial system refers to a system which enables the transfer of money between investors and
borrowers. Financial system has five basic components. They are:
 Financial Institutions
 Financial Markets
 Financial Instruments (Assets or Securities)
 Financial Services

Figure 1: Five Basic Components of Financial System

1. Financial Institutions
Financial institutions facilitate smooth working of the financial system by making investors and
borrowers meet. They mobilize the savings of investors 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 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.

2. 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:
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  Assist in creation and allocation of credit and liquidity.
 Serve as intermediaries for mobilization of savings.
 Help achieve balanced economic growth.
 Offer financial convenience.
One more classification is possible: primary markets and secondary markets. A primary market
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.

3. 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.

4. 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
up to 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. Therefore, financial services
are considered as the 4th major component of the financial system.

5. 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.

The Role of the Financial System in The Economy

Therefore, whether simple or complex, all financial systems perform at least one basic function.
They move scarce funds from those who save and lend (surplus-budget units) to those who wish to
borrow and invest (deficit-budget units). The following are some roles played by financial system to
enhance the economic growth of a country.
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 1. Facilitate the flow of funds from the savers to the investors: The first goal is to facilitate the
flow of funds from the savers (those entities having a surplus of funds) to the investors (those
entities with a deficit of funds). In the process, money is exchanged for financial assets.
However, the transfer of funds from savers to borrowers can be accomplished in at least three
different ways. These are: - direct finance, semi-direct finance, and indirect finance. Most
financial systems have evolved gradually from direct finance toward indirect finance. Let see
them one by one as follows:
A) Direct Finance: Borrowers borrow funds directly from lenders in financial markets by selling
them securities (also called financial instruments). Borrowers and lenders meet each other and
exchange funds in return for financial assets. It is the simplest method of carrying financial
transactions. You engage in direct finance when you borrow money from a friend and give him
or her IOU (a promise to pay) or when you purchase stocks or bonds directly from the company
issuing them. We usually call the claims arising from direct finance primary securities because
they flow directly from the lender to the ultimate users of funds. That means the investors sell
their shares of stock or others directly to the general public in an Initial Public offerings (IPO).

Direct Finance

Borrower or Spenders
Funds Saver or Lenders
(Deficit budget units) (Surplus budget units)

Primary securities (stocks, bonds, notes,

Primary Secondary
Securities securities
Financial
intermediaries

Loanable funds Loanable funds

Indirect Finance
Figure 1: the flow of funds in the financial system (direct and indirect finance)
The principal lenders or savers are households, but business enterprises and the government
(particularly state and local government), as well as foreigners and their governments, sometimes
also find themselves with excess funds and so lend them out. The most important borrower- spenders
are business and the government (particularly the federal government) but households and foreigners
also borrow to finance their purchases of cars, furniture, and houses.
The following can be visible draw backs of this system:
i) Both borrower and lender must desire to exchange the same amount of funds at the same
time.
ii) The lender must be willing to accept the borrower’s IOUs (a promise to pay), which may be
quite risky, illiquid or slow to mature.

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 iii) There must be a coincidence of wants between surplus and deficit – budget units in terms of
the amount and form of a loan. Without that fundamentals coincidence, direct finance
breaks down.
iv) Both lender and borrower must frequently incur substantial information costs simply to find
each other.
v) The borrower may have to contact many lenders before finding the one surplus – budget
unit with just the right amount of funds and willingness to take on the borrower’s IOU.

B) Semi direct Finance: Early in the history of most financial systems, a new form of financial
transaction appears which we call semi direct finance.

Borrower-Spenders Primary Saver-Lenders

(Deficit Budget Securities
Primary
Security brokers and (Surplus Budget
Units)
dealers
Securities Units)
Proceeds of security
sales (less fees and Flow of funds
commission)

Figure 2: the flow of funds in the financial system (semi-direct finance)

Here, some individuals and business firms become securities brokers and dealers whose essential
function is to bring surplus and deficit budget units together – thereby reducing information costs.
Broker is an individual or institution that provides information concerning possible purchases and
sales of securities. Either a buyer or a seller of securities may contact a broker, whose job is simply
to bring buyers and sellers together. Dealer is also an individual or institution that serves as a middle
man between buyers and sellers, but the dealer actually acquires the seller’s securities in the hope of
marketing them at a more favorable price. Dealers take a position of risk because by purchasing
securities outright for their own portfolios, they are subject to risk of loss if those securities decline
in value.
C) Indirect Finance: The limitations of both direct and semi direct finance stimulated the
development of indirect finance carried out with the help of financial intermediaries. The process
of indirect finance using financial intermediaries (institutions), called financial intermediation, is
the primary route for channeling funds from lenders to borrowers, (see figure 1 above). Financial
intermediaries issue securities of their own or buy securities issued by corporations and then sell
those securities to investors. Examples of such securities include: checking and saving accounts,
health, life and accident insurance policies, retirement plan and shares in mutual fund.
1) They generally carry low risk of default.
2) The majority can be acquired in small denominations.
3) They are liquid (for most) and can be easily converted into cash with little risk of significant
loss for the purchaser.
2. Allowing economic agents to share risks:
 There are many risks that have very costs but low likelihood of occurring such as natural disasters,
early death, failure of a business and others. Risk averse (opposing something strongly) peoples
prefer to share these risks rather than bear them alone. The risk management function in the financial
system is exercised in different ways which is the most common on the insurance industries.
3. To generate liquidity:
There are two notions of liquidity concepts. These are:
a. The market liquidity of an asset (real or financial assets): It is the ease with which it may be
traded.
b. The funding liquidity: is the ability of an entity to come-up with cash on a short notice. For example,
firms holding cash on its balance sheet or a person/individual with cash in its wallet has a high degree
of funding liquidity.

1.2 Financial Assets

Asset is any possession that has value in an exchange. Assets are commonly known as anything with
a value that represent economic resources or ownership that can be converted into something of
value such as cash. Asset classified in to three as tangible, intangible and financial assets.
A. Tangible Assets (Physical Assets or Real Assets): Physical assets have a physical characteristics
or location such as buildings, equipment, inventories etc. Physical assets are tangible assets and
can be seen and touched, with a very identifiable physical presence. The value of tangible asset
depends on particular physical properties, example: buildings. That means their physical
condition is relevant for the determination of market value. Physical assets provide continuous
stream of services. Physical assets wear out or subject to depreciation. They usually experience a
reduction in value due to wear and tear of the asset through continuous use known as
depreciation, or may lose their value in becoming obsolete, or too old for use. Certain tangible
assets are also perishable, such as a container of apples, or flowers that need to be sold soon in
order to ensure that they do not perish and lose their value.
B. Intangible assets: Intangible asset represents legal claims to some future benefit. Their value
bears no relation to the form, physical or otherwise in which the claims are recorded. Example,
good will, patents, copyrights, royalties, etc.
C. Financial Assets: Financial assets represent a financial claim with a right to some cash. They
represent a claim against the income or wealth of a business firm, household, or unit of
government represented usually by a certificate of receipt or other legal document and usually
created by the lending of money (credit transactions). Simply, it is a claim on the issuer’s future
income or assets. Therefore, financial assets are intangible, meaning that they cannot be seen or
felt and may not have a physical presence except for the existence of a document that represents
the ownership interest held in the asset. It is important to note that the papers and certificates that
represent these financial assets do not have any intrinsic value (the paper held is only a document
certifying ownership and is of no value). The paper derives its value from the value of the asset
that is represented.

The Role of Financial Asset in the Financial System

Financial assets play a vital role in the economic performance of financial institutions and they have
two principal economic functions:
A) Mobilizing/transferring funds from those who have surplus of funds to deficit units who need to
invest in financial assets.
B) Redistributing unavoidable risk associated with the cash flow generated by tangible assets.
Properties of Financial Assets
Financial assets have certain properties which help to determine the intention of investors on
financial assets being traded in financial market. These specific properties distinguish them from
physical and intangible assets. Some of them are:
a) Moneyness: some of the financial assets are used as a medium of exchange to settle transactions
and they termed/serve as money. This characteristic is a clearly desirable one for investors in the
market.
b) Divisibility and denomination: divisibility relates to the minimum size in which a financial asset
can be liquidated and exchanged for money. It is the characteristic of an asset to be bought and
sold in small portions or fractions. Financial assets are easily divisible compared to physical
assets which are sold or bought in whole quantities. The smaller the size, the more the financial
asset is divisible. Financial assets have varying degree of divisibility depending on their
denomination.
c) Reversibility: is the cost of investing in financial securities and then getting out of it and back in
to cash again. This property also called round trip cost. Example, deposits at bank. A firm can
deposit currency in a bank and accept a deposit certificate that can be used to earn a rate of
return. When the need for currency arises, the bank deposit can be withdrawn in the form of
currency again and used as an exchange instrument to buy any other type of asset through which
productive activity can be carried on.
d) Term to maturity: is the length of the interval until the date when the instrument is scheduled to
make its final payment or the owner is entitled to demand liquidation.
e) Liquidity: it is the degree in which financial assets can easily be liquidated (sold) without a loss
in value. For this term, most scholars argued that there is no uniformly accepted definition, but
according to Professor James Tobin liquidity is defined in terms of “How much sellers stand to
lose if they wish to sell immediately as against engaging in a costly and time-consuming search.”
Any financial asset which takes more time to convert in to cash is termed as illiquid asset.
Example, pension funds. Whereas the less the time taken to convert in to cash is a liquid one.
Example, Deposits in banks.
f) Convertibility: is the ability of the financial assets to be convertible in to other financial assets.
Example, a corporate convertible bond is a bond that the bond holder can change in to equity
shares.
g) Currency: Most financial assets are denominated in one currency, such as US dollar or Yen, and
investors must choose them with that feature in mind.
h) Cash flow and return predictability: Are turn that an investor will realize by holding a financial
asset depends on the cash flow that is expected to be received. This includes dividend payments
on stocks and interest payments on debt instruments.
i) Complexity: some financial assets are complex in the sense that they are actually combinations
of two or more simpler assets. To find the true value of such an asset, one must decompose it in
to its component parts and price each component separately.
j) Tax status: Investors are more concerned with income after taxes than before taxes of financial
assets. All other properties of financial assets remain the same; taxable securities would have to
offer a higher before tax yields to investors than tax exempt securities to be preferred. But,
investors with in high tax brackets benefit most from tax-exempt securities. The yield/income
 after tax can be determined using the following formula: Yat = Ybt(1-T) where: Yat-yield after
tax, Ybt-yield before tax and T -Tax rate
Generally, the yield after tax depends on the existing Tax rates.

Financial Markets
Financial Market is a market in which financial assets (securities) such as stocks and bonds can be
bought and sold. Or it is a market in which funds are transferred or mobilized from people (surplus
units) having an excess of available funds to those people (deficit units) with a shortage of funds to
invest. As a market for financial claims, the main actors are households, business (including
financial institutions), and government units that purchase/sell financial asset. In short those
participants are broadly categorized in to surplus and deficit units.

The Role of Financial Markets in the Financial System

We have defined a financial market as a market for creation and exchange of financial assets. If you
buy or sell financial assets, you will participate in financial markets in some way or the other.
Financial markets play a pivotal role in allocating resources in an economy by performing following
important functions: Financial markets
 Facilitate price discovery,
 Provide liquidity to financial assets.
 Financial markets transfer risks:
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. 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:

(Current income receipts – Expenditures out of current income) = (Change in holdings of financial
assets - change in debt and equity outstanding)
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
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
It follows that for any given period of time (Example, 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
A net lender of funds (SBU) is really a net supplier of funds to the financial system. He/she
accomplish this function by purchasing financial assets, pay off debts or retiring equity (stock). In
contrast a net borrower of funds (DBU) is a net demander of funds from the financial system; selling
financial assets, issuing new debts or selling new stocks. The business and the government sectors of
the economy tend to be net borrowers (demanders) of funds (DBU); the household sector, composed
of all families and individuals, tend to be a net lender (supplier) of funds (SBU).

QUICK CHECK
1. Explain the financial system, its components and role in an economy
2. Discuss the types of financial institution?
3. List and discuss the types of financial institutions.

CHAPTER TWO
2. FINANCIAL INSTITUTIONS IN THE FINANCIAL SYSTEM
Learning Objectives:
After completing this chapter, you will be able to:
 Distinguish between depository and non-depositoryfinancial system.
 Explain the direct and indirect financing mechanism;
 Identify the properties of financial assets
 Describe the role of financial institutions
 Discus classification of Financial Institutions
 Identify the types of risks related with Financial industry

Financial Institutions and Capital Transfer

Business entities include nonfinancial and financial enterprises. Non-financial enterprises
manufacture products (e.g., cars, steel, and computers) and/or provide nonfinancial services (e.g.,
transportation, utilities, computer programming). Financial enterprises, more popularly referred to as
financial institutions, are those organizations, which are involved in providing various types of
financial services to their customers and are controlled and supervised by the rules and
regulations delineated by government authorities. Financial intermediaries are financial
institutions that engage in financial asset transformation. Financial institutions serve as
intermediaries by channeling the savings of individuals, business, and governments into loans and
investments. The primary suppliers of funds to financial institutions are individuals; the primary
demanders of funds are firms and governments. Generally, financial institutions provide
services related to one or more of the following:
a) Transforming financial assets acquired through the market and constituting them into a different,
and more widely preferable, type of asset—which becomes their liability. This is the function
performed by financial intermediaries, the most important type of financial institution.
b) Exchanging of financial assets on behalf of customers.
c) Exchanging of financial assets for their own accounts.
d) Assisting in the creation of financial assets for their customers, and then selling those
financial assets to other market participants.
e) Providing investment advice to other market participants.
f) Managing the portfolios of other market participants.
Financial institutions can be either private or public in nature. As a general rule what financial
intermediaries do is to create assets for savers and liabilities for borrowers which are more attractive
to each than would be the case if the parties have to deal with each other directly.

The Role of Financial Institutions

We have stressed that financial intermediaries play the basic role of transforming financial assets
that are less desirable for a large part of the public into other financial assets—their own liabilities—
which are more widely preferred by the public. This transformation involves at least one of four
economic functions:

 Providing a payment mechanism;

 Providing maturity intermediation;
 Reducing risk via diversification;
 Reducing the costs of contracting and information processing. Each function is described
below as follow:

Classification of Financial Institutions

Financial institutions are responsible for distributing financial resources in a planned way to the
potential users. There are a number of institutions that collect and provide funds for the necessary
sector or individual. Correspondingly, there are several institutions that act as the middleman and
join the deficit and surplus units. Investing money on behalf of the client is another variety of
functions of financial institutions. Basically, the services provided by the various types of financial
institutions may vary from one institution to another. Broadly speaking, financial institutions are
categorized in to two major parts, as follow: Depository financial institutions and Non-depository
financial institutions.

Depository Financial Institutions

Depository institutions are financial intermediaries that accept deposits from individuals and
institutions and make loans. These institutions include commercial banks and the so-called thrift
institutions (thrifts): savings and loan associations, mutual savings banks, and credit unions. The
primary functions of financial institutions of this nature are: Accepting Deposits; Providing
Commercial Loans; Providing Real Estate Loans; Providing Mortgage Loans; and Issuing Share
Certificates.
Depository institutions are popular financial institutions for the following reasons: They offer
deposit accounts, they provide loan facilities, they accept the risk on loans provided, they have more
expertise and they diversify their loans among numerous deficit units

A. Commercial Banks: These financial intermediaries raise funds primarily by issuing checkable
deposits (deposits on which checks can be written), savings deposits (deposits that are payable
on demand but do not allow their owner to write checks), and time deposits (deposits with fixed
terms to maturity). They then use these funds to make commercial, consumer, and mortgage
loans and to buy government securities and municipal bonds. They are the largest financial
intermediary and have the most diversified portfolios (collections) of assets.
B. Saving institutions:-These depository institutions include saving and loan associations and
mutual saving banks and they obtain funds primarily through savings deposits (often called
 shares) and time and checkable deposits. The basic motivation behind the creation of saving &
loans associations was provision of funds for financing the purchase of home. The collateral for
the loans would be the homes being financed. Saving and loans associations are either mutually
owned or have corporate stock ownership. Mutually owned means there is no stock outstanding,
so technically the depositors are the owners. To increase the ability of saving and loans
associations to expand the sources of funding available to bolster/strengthen their capital,
legislation facilitated the conversion of mutually-owned companies in to a corporate stock
ownership structure. To sum up, saving and loans associations offer deposit accounts to surplus
units and channel these deposits to deficit units and unlike commercial banks, they concentrated
on residential mortgage loans to the owners (shareholders) of the institutions. Saving banks are
institutions similar to, although much older than, saving and loans associations. They can be
either mutually owned in which case they are called mutual savings banks or stock holder owned.
Most savings banks are of the mutual form. While the total deposits at savings banks are less
than saving and loans associations, savings banks are typically larger institutions. Asset
structures of savings banks and saving and loans associations are similar. The principal source of
funds for savings banks is deposits.
C. Credit Unions:-Credit unions are the smallest and the newest of the depository institutions.
They are varying small co-operative lending institutions organized around a particular group and
owned by their members, member deposits are called shares. The distribution paid to members is
therefore in the form of dividends, not interest. Examples of credit unions can be union members,
employees of a particular firm. Credit unions are different from other depository institutions
because they: Are non- profit and restrict their funds to provide loans to their members only

2. Non-Depository institutions:-Non-depository financial institutions are intermediaries that

cannot accept deposits but do pool the payments in the form of premiums or contributions of
many people and either invest it or provide credit to others. Hence, non-depository institutions
form an important part of the economy. These non-depository institutions are sometimes referred
to as the shadow banking system, because they resemble banks as financial intermediaries, but
they cannot legally accept deposits. Consequently, their regulation is less stringent, which allows
some non-depository institutions, such as hedge funds, to take greater risks for a chance to earn
higher returns. These institutions receive the public's money because they offer other services
than just the payment of interest. They can spread the financial risk of individuals over a large
group, or provide investment services for greater returns or for a future income. The basic non-
depository financial institutions include insurance companies, pension funds, mutual funds,
finance companies, money market mutual funds, etc.
A. Insurance Companies:-The primary function of insurance companies is to compensate
individuals and corporations (policyholders) if perceived adverse event occur, in exchange for
premium paid to the insurer by policyholder. Insurance companies provide (sell) insurance
policies, which are legally binding contracts and promise to pay specified sum contingent on the
occurrence of future events, such as death or an automobile accident. Insurance companies are
risk bearers.
They accept or underwrite the risk for an insurance premium paid by the policyholder or owner of
the policy. Income of insurance companies is: Initial underwriting income (insurance premium)
Investment income that occur over time
Therefore, profit of insurance companies = (insurance premium + investment income) – (operating
expense + insurance payment or benefits).

Insurance companies can be classified in to life insurance and general (Property-causality)

insurance.
 Life insurance companies: Life insurance companies insure people against financial
insecurities following a death and sell annuities (annual income payments upon retirement).
They acquire funds from the premiums that people pay to keep their policies in force and use
them mainly to buy corporate bonds and mortgages. Because claim payments are more
predictable, life insurance companies invest mostly in long-term bonds, which pay a higher
yield, and some stocks.
 Property and Casualty Insurance: These companies insure policyholders against loss from
theft, fire, and accidents. They are very much like life insurance companies, receiving funds
through premiums for their policies, but they have a greater possibility of loss of funds if major
disasters occur. For this reason, they use their funds to buy more liquid assets than life insurance
companies.
B. Pension Funds:-Pension funds receive contributions from individuals and/or employers during
their employment to provide a retirement income for the individuals. Most pension funds are
provided by employers for employees. The employer may also pay part or all of the contribution,
but an employee must work a minimum number of years to be vested—qualified to receive the
benefits of the pension. Self-employed people can also set up a pension fund for themselves
through individual retirement accounts or other types of programs. While an individual has many
options to save for retirement, the main benefit of government-sanctioned pension plans is tax
savings. Pension plans allow either contributions or withdrawals that are tax-free. As a
consequence of the regular contributions and the tax savings, pension funds have enormous
amounts of money to invest. And because their payments are predictable, pension funds invest in
long-term bonds and stocks, with more emphasis on stocks for greater profits.
C. Mutual Funds:-A mutual fund (in US) or unit trust (in UK and India) raise funds from the
public and invests the funds in a variety of financial assets, mostly equity, both domestic and
overseas and also in liquid money and capital market.They are investment companies that pool
money from investors at large and offer to sell and buy back its shares on a continuous basis and
use the capital thus raised to invest in securities of different companies. Mutual funds possess
shares of several companies and receive dividends in lieu of them and the earnings are
distributed among the shareholders on a pro-rata basis. Mutual funds sell shares (units) to
investors and redeem outstanding shares on demand at their fair market value. Thus, they provide
opportunity of small investors to invest in a diversified portfolio of financial securities. Mutual
funds are also able to enjoy economies of scale by incurring lower transaction costs and
commission.

Advantage of Mutual Funds

i. Mobilizing small saving
 Direct participation in securities is not attractive to small investors because of some
requirements which are difficult for them.
 Mutual fund mobilizes funds by selling their own shares, known as units. These funds are
invested in shares of different institution, government securities, etc.
  To an investor, a unit in a mutual fund means ownership of a proportionate share of securities in
the portfolio of a mutual fund.
ii. Professional management
 Mutual funds employ professional experts who manage the investment portfolio efficiently and
profitably.
 Investors are relived of the emotional stress in buying and selling securities since Mutual fund
take care of this function.
 The professional managers act scientifically at the right time to buy and sell for their client, and
automatic reinvestment of dividends and capital gains, etc.
iii. Diversified investment/reduced risks
 Funds mobilized from investors are invested in various industries spread across the
country/globe.
 This is advantage to the small investors because they cannot afford to assess the profitability
and viability of different investment opportunities
 Mutual funds provide small investors the access to a reduced investment risk resulting from
diversification, economies of scale in transaction cost and professional financial management
iv. Better liquidity
 There is always a ready market for the mutual fund units- it is possible for the investors to
disinvest holdings any time during the year at the Net Asset Value (NAV)
 Securities held by the fund could be converted into cash at any time. Thus, mutual funds could
not face problem of liquidity to satisfy the redemption demand of unit holders.
v. Investment protection
 Mutual funds are legally regulated by guidelines and legislative provisions of regulatory
bodies (such as SEC in US, SEBI in India etc.)
vi. Low transaction cost (economy of scale)
 The cost of purchase and sale of mutual funds is relatively lower because of the large volume
of money being handled by MF in the capital market (economies of Scale)
 Brokerage fees, trading commission, etc., are lower
 This enhances the quantum of distributable income available for investors
vii. Economic Developments
 Mutual funds mobilize more savings and channel them to the more productive sectors of the
economy
 The efficient functioning of mutual funds contributes to an efficient financial system.
 This in turn paves ways for the efficient allocation of the financial resources of the country
which in turn contributes to the economic development.
The investors’ return in the mutual fund includes capital appreciation (capital gain from price
appreciation of the underlying assets), and the income generated by the assets of the fund.

Types of Mutual Funds

Mutual funds can be categorized in to two; open-ended mutual funds and closed-ended mutual funds

1. Open-ended Mutual Funds

Characteristics
• New investors can join the funds at any time.
• A fund (unit) is accepted and liquidated on a continuous basis by mutual fund manager
 • The fund manager buys and sells units constantly on demand by investors-it is always open
for the investors to sell or buy their share units.
• It provides an excellent liquidity facility to investors, although the units of such are not listed.
No intermediaries are required. There is a certainty in purchase price, which takes place in
accordance with the declared NAV.
• Investors in Mutual fund own a pro rata share of the overall portfolio, which is managed by
an investment manager of the fund who buys some securities and sells others.
• The value or price of each share of the portfolio is called net asset value (NAV).
• NAV equals the market value of the portfolio minus the liability of the mutual fund divided
by the number of shares owned by the mutual fund investors.
• NAV=
• The NAV is determined only once each day, at the close of the day. For example the NAV
for a stock of a mutual fund is determined from closing stock price for the day. Business
publications provide the NAV each day in their mutual fund.
• All new investments into the fund or withdrawal from the fund during a day are priced at the
closing NAV (investment after the end of the day) and a non-business day are priced at the
next day’s closing NAV)
• The total number of shares in the fund increases if more investments than withdrawals are
made during the day, and vice versa.
• The NAV of a mutual fund may increase or decrease due to an increase or decrease in the
price of the securities in the portfolio

2. Closed-ended Fund
Characteristics
 The shares of a closed-end fund are similar to the shares of common stock of a corporation. The
new shares of a closed-end fund are initially issued by an underwriter for the fund and after the
new issue the number of shares remains constant.
 After the initial issue, no sale or purchase of shares are made by the fund company as in open-
end funds. Instead, the shares are traded on a secondary market, either in an exchange or in the
over-the-counter market.
 Since the number of shares available for purchase, at any moment in time, is fixed, the NAV of
the fund’s shares is determined by the underlying shares as well as by the demand for the
investment company’s shares themselves.
 When demand for the investment company’s shares is high, because the supply of shares in the
fund is fixed, the shares can be traded for more than the NAV of the securities held in the fund’s
assets portfolio. In this case the shares said to be trading at a premium; if demand is low, the
shares are sold for discount.
The main difference between an open-ended and a closed-ended mutual fund is; the number of
shares of an open-end fund varies because the fund sponsor sells new shares to investors and buys
existing shares from shareholders. By doing so the share price is always the NAV of the fund. In
contrast, closed-ended funds have a constant number of shares outstanding because the fund sponsor
does not redeem shares and sell new shares to investors except at the time of a new underwriting.
Thus, supply and demand in the market determines the price of the fund shares, which may be above
or below NAV, as previously discussed.
D. Finance Companies: Finance companies raise funds by selling commercial paper (a short-term
debt instrument) and by issuing stocks and bonds. They lend these funds to consumers, who
make purchases of such items as furniture, automobiles, and home improvements, and to small
businesses. Some finance companies are organized by a parent corporation to help sell its
product. For example, Ford Motor Credit Company makes loans to consumers who purchase
Ford automobiles.
E. Money Market Mutual Funds:-These relatively new financial institutions have the
characteristics of a mutual fund but also function to some extent as a depository institution
because they offer deposit-type accounts. Like most mutual funds, they sell shares to acquire
funds that are then used to buy money market instruments that are both safe and very liquid. The
interest on these assets is then paid out to the shareholders. A key feature of these funds is that
shareholders can write checks against the value of their shareholdings. In effect, shares in a
money market mutual fund function like checking account deposits that pay interest.
Risks in Financial Industry
One of the major objectives of a financial institution’s managers is to increase the financial
institution returns for its owners. Increased returns often come at the cost of increased risk, which
comes in many forms:
1. Credit Risk (Default Risk): the risk that promised cash flows from loans and securities held by
financial institutions may not be paid in Full. Therefore, financial institutions face credit risk or
default risk if their clients default on their loans and other obligations.
2. Liquidity Risk: the risk that a sudden and unexpected increase in liability withdrawals may
require a financial institution to liquidate assets in a very short period of time and at low
prices. They encounter liquidity risk as a result of excessive withdrawals of liabilities by
customers.
3. Interest Rate Risk: the risk incurred by financial institution when the maturities of its assets and
liabilities are mismatched and interest rates are volatile. Financial institutions face interest
rate risk when the maturities of their assets and liabilities are mismatched.
4. Market Risk: the risk incurred in trading assets and liabilities due to changes in interest rates,
exchange rates, and other asset prices. They incur market risk for their trading portfolios of
assets and liabilities if adverse movements in the prices of these assets or liabilities occur.
5. Off-Balance -Sheet Risk: the risk incurred by financial institution as the result of its activities
related to contingent assets and liabilities. Modern-day financial institutions also engage in
significant amount of off-balance-sheet activities, thereby exposing them to off-balance-sheet
risks —changing values of their contingent assets and liabilities.
6. Foreign Exchange Risk: the risk that exchange rate changes can affect the value of financial
institution’s assets and liabilities denominated in foreign currencies. If financial institutions
conduct foreign business, they are subject to foreign exchange risk.
7. Country or Sovereign Risk: Business dealings in foreign countries or with foreign companies
also subject financial institutions to sovereign risk. It is the risk that repayments by foreign
borrowers may be interrupted because of interference from foreign governments or other
political entities.
8. Technology Risk: the risk incurred by financial institution when its technological investments
do not produce anticipated cost savings.
9. Operational Risk: the risk that existing technology or support systems may malfunction, that
fraud may occur that impacts the financial institution’s activities, and/or external shocks such as
hurricanes and floods occur.
10. Insolvency Risk: the risk that financial institution may not have enough capital to offset a
sudden decline in the value of its assets relative to its liabilities. FIs face insolvency risk when
their overall equity capital is insufficient to withstand the losses that they incur as a result of such
risk exposures.
The effective management of these risks—including the interaction among them—determines
the ability of a modern financial institution to survive and prosper over the long run.

QUICK CHECK
1. Distinguish between depository and non-depository financial institutions and identify their category?
2. Explain the different market classifications
3. How money markets differ from capital market?

CHAPTER THREE
3. INTEREST RATE IN THE FINANCIAL SYSTEM
Learning Objectives:
After completing this chapter, you will be able to:
 Explain the functions of interest rate in the economy
 Distinguish different theory of Interest Rate
 The role of interest rate in the financial system
 Identify the real versus nominal interest Rates

Introduction
The money and capital markets are one of the vast pools of funds, depleted by the borrowing
activities of households, businesses and governments and replenished by the savings these sectors
supply to the financial system. Clearly, then, the acts of saving and lending, borrowing and investing
are intimately linked through the financial system. And one factor that significantly influences and
ties all of them together is the rate of interest. The rate of interest is the price a borrower must pay
to secure scarce loanable funds from a lender for an agreed-upon period. It is the price of credit. But
unlike other prices in the economy, the rate of interest is really a ratio of two quantities: the money
cost of borrowing divided by the amount of money actually borrowed, usually expressed as an
annual percentage basis. Interest rates are among the most closely watched variables in the economy.
Their movements are reported almost daily by the news media, because they directly affect our
everyday lives and have important consequences for the health of the economy. They affect personal
decisions such as whether to consume or save, whether to buy a house, and whether to purchase
bonds or put funds into a savings account. Interest rates also affect the economic decisions of
businesses and households, such as whether to use their funds to invest in new equipment for
factories or to save their money in a bank. Yield to maturity is the most accurate measure of interest
rates; the yield to maturity is what economists mean when they use the term interest rate. This
chapter discusses the theories of interest rates, term structure of interest rates, distinctions between
the real and nominal interest rates, and how the yield to maturity is determined.
Definition of Interest Rate
Interest rate can be defined as a rate of return paid by a borrower of funds to a lender of them, or a
price paid by a borrower for a service, the right to make use of funds for a specified period. Interest
rate is the price paid to borrow debt capital. In other words, it is the cost of Money. Or it is the
"rental" price of money. The rate of interest is the price the borrower must pay to scarce loanable
funds from a lender for an agreed up on period. Or it is the price of credit. Or interest is
compensation to the lender for forgoing other useful investments that could have been made with the
loaned asset. These forgone investments are known as the opportunity cost. One type of interest rate
is the yield on a bond. Interest rates send price signals to borrowers, lenders, savers, and investors.
For example, higher interest rates generally bring forth a greater volume of savings and stimulate the
lending of funds. Lower rates of interest, on the other hand, tend to dampen the flow of savings and
reduce lending activity. Higher interest rates tend to reduce the volume of borrowing and capital
investment, and lower rates stimulate borrowing and investment spending.
Functions of the Rate of Interest in the Economy
The rate of interest performs several important roles or functions in the economy:
 It helps guarantee that current savings will flow into investment to promote economic growth.
 It rations the available supply of credit, generally providing loanable funds to those investment
projects with the highest expected returns.
 It brings into balance the supply of money with the public‘s demand for money.
 It is also an important tool of government policy through its influence on the volume of saving
and investment.
The Theory of Interest Rate
The main focus of the Interest Theory is on the charged amount paid against borrowed money. There
are two economic theories explaining the level of real interest rates in an economy: The loanable
funds theory and liquidity preference theory.
1. The Loanable Funds Theory
This theory was formulated by the Swedish economist Knut Wicksell in the 1900s. According to
him, the level of interest rates is determined by the supply and demand of loanable funds available in
an economy’s credit market (i.e., the sector of the capital markets for long-term debt instruments).
This theory suggests that investment and savings in the economy determine the level of long-term
interest rates. Short-term interest rates, however, are determined by an economy’s financial and
monetary conditions.
The term ‘loanable fund’ simply refers to the sums of money offered for lending and demanded by
consumers and investors during a given period. The interest rate in the model is determined by the
interaction between potential borrowers and potential savers. According to the loanable funds theory
for the economy as a whole:
 Demand for loanable funds = net investment + net additions to liquid reserves
 Supply of loanable funds = net savings + increase in the money supply.
Given the importance of loanable funds and that the major suppliers of loanable funds are
commercial banks, the key role of this financial intermediary in the determination of interest rates is
vivid. The central bank is implementing specific monetary policy; therefore it influences the supply
of loanable funds from commercial banks and thereby changes the level of interest rates. As central
bank increases (decreases) the supply of credit available from commercial banks, it decreases
(increases) the level of interest rates. In an economy, there is a supply of loanable fund (i.e., credit)
in the capital market by households, business, and governments. The higher the level of interest
rates, the more such entities are willing to supply loan funds; the lower the level of interest, the less
they are willing to supply. These same entities demand loanable funds, demanding more when the
level of interest rates is low and less when interest rates are higher.
2. Liquidity Preference Theory
It was proposed by John Maynard Keynes back in 1936 which explain how interest rates are
determined based on the preferences of households to hold money balances rather than spending or
investing those funds. Saving and investment of market participants under economic uncertainty may
be much more influenced by expectations and by exogenous shocks than by underlying real forces. A
possible response of risk-averse savers is to vary the form in which they hold their financial wealth
depending on their expectations about asset prices. Since they are concerned about the risk of loss in
the value of assets, they are likely to vary the average liquidity of their portfolios.
Liquidity preference is preference for holding financial wealth in the form of short-term, highly
liquid assets rather than long-term illiquid assets, based principally on the fear that long-term assets
will lose capital value over time. Money balances can be held in the form of currency or checking
accounts, however it does earn a very low interest rate or no interest at all. A key element in the
theory is the motivation for individuals to hold money balance despite the loss of interest income.
Money is the most liquid of all financial assets and, of course, can easily be utilized to consume or to
invest. The quantity of money held by individuals depends on their level of income and,
consequently, for an economy the demand for money is directly related to an economy’s income.
There is a trade-off between holding money balance for purposes of maintaining liquidity and
investing or lending funds in less liquid debt instruments in order to earn a competitive market
interest rate. The difference in the interest rate that can be earned by investing in interest-bearing
debt instruments and money balances represents an opportunity cost for maintaining liquidity.The
lower the opportunity cost, the greater the demand for money balances; the higher the opportunity
cost, the lower the demand for money balance.
Measuring Interest Rates
Different debt instruments have very different streams of payment with very different timing. Thus
we first need to understand how we can compare the value of one kind of debt instrument with
another before we see how interest rates are measured. To do this, we make use of the concept of
present value. The concept of present value (or present discounted value) is based on the
commonsense notion that a birr paid to you one year from now is less valuable to you than a birr
paid to you today: This notion is true because you can deposit a birr in a savings account that earns
interest and have more than a birr in one year.
Let’s look at the simplest kind of debt instrument, which we will call a simple loan. In this loan, the
lender provides the borrower with an amount of funds (called the principal) that must be repaid to
the lender at the maturity date, along with an additional payment for the interest. For example, if you
made your friend, a simple loan of $100 for one year, you would require him/her to repay the
principal of $100 in one year’s time along with an additional payment for interest; say, $10. In the
case of a simple loan like this one, the interest payment divided by the amount of the loan is a
natural and sensible way to measure the interest rate. This measure of the so called simple interest
rate, i, is:
 $10
i   0.10 
10%
100
If you make this $100 loan for one year, two years, three years or for n years, you would have
1
$100 (1  0.10) 
$110
2
$100 (1  0.10) 
$121
$100 (1  0.10)3 
$133
FV PV (1
n
i)

The process of calculating the future value of dollars received today, as we have seen above, is
called compounding the present. The process of calculating today’s value of dollars received in the
future is called discounting the future. We can generalize this process by writing today’s (present)
value of $100 as PV, the future value of $133 as FV, and replacing 0.10 (the 10% interest rate) by i.
This leads to the following formula:
FV
PV  n
(1  i)
In terms of the timing of their payments, there are four basic types of credit market instruments.
1. A simple loan, which we have already discussed, in which the lender provides the borrower with
an amount of funds, which must be repaid to the lender at the maturity date along with an
additional payment for the interest. Many money market instruments are of this type: for
example, commercial loans to businesses.
2. A fixed-payment loan: (which is also called a fully amortized loan) in which the lender
provides the borrower with an amount of funds, which must be repaid by making the same
payment every period (such as a month), consisting of part of the principal and interest for a set
number of years. For example, if you borrowed $1,000,000, a fixed-payment loan might require
you to pay $126,000 every year for 25 years. Installment loans (such as auto loans) and
mortgages are frequently of the fixed-payment type.
3. A coupon bond pays the owner of the bond a fixed interest payment (coupon payment) every
year until the maturity date, when a specified final amount (face value or par value) is repaid.
The coupon payment is so named because the bond holder used to obtain payment by clipping a
coupon off the bond and sending it to the bond issuer, who then sent the payment to the holder.
Nowadays, it is no longer necessary to send in coupons to receive these payments. A coupon
bond with $1,000 face value, for example, might pay you a coupon payment of $100 per year for
ten years, and at the maturity date repays you the face value amount of $1,000 (The face value of
a bond is usually in $1,000 increments). A coupon bond is identified by three pieces of
information. First is the corporation or government agency that issues the bond. Second is the
maturity date of the bond. Third is the bond’s coupon rate, the dollar amount of the yearly
coupon payment expressed as a percentage of the face value of the bond. In our example, the
coupon bond has a yearly coupon payment of $100 and a face value of $1,000. The coupon rate
is then $100/$1,000 = 0.10, or 10%. Capital market instruments such as Government Treasury
 bonds and notes and corporate bonds are examples of coupon bonds.
4. A discount bond (also called a zero-coupon bond) is bought at a price below its face value (at a
discount), and the face value is repaid at the maturity date. Unlike a coupon bond, a discount
bond does not make any interest payments; it just pays off the face value. For example, a
discount bond with a face value of $1,000 might be bought for $900; in a year’s time the owner
 would be repaid the face value of $1,000.Treasury bills and long-term zero-coupon bonds are
examples of discount bonds.
These four types of instruments require payments at different times: Simple loans and discount
bonds make payment only at their maturity dates, whereas fixed-payment loans and coupon bonds
have payments periodically until maturity. How would you decide which of these instruments
provides you with more income? They all seem so different because they make payments at different
times. To solve this problem, we use the concept of present value, explained earlier, to provide us
with a procedure for measuring interest rates on these different types of instruments. Now, let us
look at how the yield to maturity/interest rate is calculated for the four types of credit market
instruments.
Simple Loan: Using the concept of present value, the yield to maturity on a simple loan is easy to
calculate. For the one-year loan we discussed, today’s value is $100, and the payments in one year’s
time would be $110 (the repayment of $100 plus the interest payment of $10). We can use this
information to solve for the yield to maturity, i, by recognizing that the present value of the future
payments must equal today’s value of a loan. Making today’s value of the loan ($100) equal to the
present value of the $110 payment in a year gives us:
110
$100 
(1  i)

Solving for i
110  100
i  0.10  10%
100
This calculation of the yield to maturity should look familiar, because it equals the interest payment
of $10 divided by the loan amount of $100; that is, the yield to maturity equals the simple interest
rate on the loan.

Fixed-Payment Loan:Recall that this type of loan has the same payment every period throughout
the life of the loan. On a fixed-rate mortgage, for example, the borrower makes the same payment to
the bank every month until the maturity date, when the loan will be completely paid off. To calculate
the yield to maturity for a fixed-payment loan, we follow the same strategy we used for the simple
loan—we equate today’s value of the loan with its present value. Because the fixed-payment loan
involves more than one payment, the present value of the fixed-payment loan is calculated as the
sum of the present values of all payments
Example: Consider a loan of $1000 with fixed annual payments of $126 for the next 25 years.
Making today’s value of the loan ($1,000) equal to the sum of the present values of all the yearly
payments gives us:
FP FP FP FP
1000  1
   .........  n
(1  i) (1 2
 i) (1
3
 i) (1  i)
1000  126  .........  126n (1
(1     i)
1 126 126
i)
(1  i) (1  i)
2 3

For a fixed payment loan amount, the fixed yearly payment and the number of years until maturity
are known quantities, and only the yield to maturity is not. So, solve for i.
  1 
1  (1  )i  n  1  (1  i) n 
PV  FP  FP  
 i   i 
 

1  (1  i)25 
1000  $126 i  12%
 i 
Where, PV is Present value; FP is fixed payment; i is yield to maturity and n is years to
maturity day.

Coupon Bond- To calculate the yield to maturity for a coupon bond, follow the same strategy for the
fixed payment loan; equate today’s value of the bond with its present value. It is calculated as the
sum of the present values of all the coupon payments plus the present value of the final payment of
the face value of the bond.

C C C C FV
Pb 1    .........  n  n
 (1  i) (1 2
 i) (1
3
 i) (1  i) (1  i)

Where, P = Price of coupon bond

b
C = yearly coupon payment
FV = Face value of the bond
n= Years to maturity date
General formula:
 1 
n 1 
1  (1  i)  FV  (1  i) n  FV
Pb  C   n Pb  C  
 i  (1  i)  i  (1  i)
n

 
Example: What is the price of a 10% coupon bond with a face value of $1000, a 10% yield to
maturity, and eight years to maturity?
Solution: Annual coupon (C) = 10% 1000 = 100
 1 
1  8 
(1  0.1) 1000
P b 100  8  $1000
 0.10  (1  0.10)

 

Three interesting facts:
1. When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate. In
other words, when the coupon rate is equal to the yield to maturity, the price of the bond will be
equal to its par value
2. If the yield to maturity is greater than the coupon rate, the bond will be priced below its face
value. A bond selling below par value is termed as a discount bond. For instance if the market
interest rate in the above example rises to 12.25%, the bond will sell for $889.20.
3. If the yield to maturity is less than the coupon rate, the bond is priced above its par value; hence
a bond selling above par value is called as a premium bond. Assume the market interest rate falls
to 6% in the above example, the price of the bond will be $1249.40
Generally, the price of a coupon bond and the yield to maturity are negatively related; that is, as the
yield to maturity rises, the price of the bond falls. If the yield to maturity falls, the price of the bond
rises. To explain why the bond price declines when the interest rate rises is that a higher interest rate
implies that the future coupon payments and final payment are worthless when discounted back to
the present; hence the price of the bond must be lower.
Discount Bond: the yield to maturity calculation for a discount bond is similar to that of the simple
loan.
Example: If a $1000 face value, 1 year maturity bond is currently selling at $900, what will be its
yield to maturity?
FV  Pd
i Where; FV = Face Value of the bond and Pd = current price of the discount bond
Pd
1000  900
i   0.111 
11.1%
900

Real versus Nominal Interest Rates

So far in our discussion of interest rates, we have ignored the effects of inflation on the cost of
borrowing. What we have up to now been calling the interest rate makes no allowance for inflation,
and it is more precisely referred to as the nominal interest rate, which is distinguished from the
real interest rate, the interest rate that is adjusted by subtracting expected changes in the price level
(inflation) so that it more accurately reflects the true cost of borrowing. The real interest rate is
more accurately defined by the Fisher equation, named for Irving Fisher, one of the great monetary
economists of the twentieth century. The Fisher equation states that the nominal interest rate i equals
the real interest rate ir plus the expected rate of inflation
i  ir e

Rearranging terms, we find that the real interest rate equals the nominal interest rate minus the
expected inflation rate:
ir  i   e

Risk and Term Structure of Interest Rates

Risk Structure of Interest Rates
The risk structure of interest rates (the relationship among interest rates on bonds with same
maturities) is explained by three factors: default risk, liquidity, and income tax consideration
1. Default Risk: One attribute of a bond that influences its interest rate is its default risk which
occurs when the issuer of the bond is unable or unwilling to make interest payments when
promised or pay off its face value when the bond matures. As the bonds default risk increases,
the risk premium on that bond (the difference between its interest rate and the interest rate on a
default free treasury bond) rises.
2. Liquidity: Another attribute of a bond that influences its interest rate is its liquidity. A liquid
asset is one that can be quickly and cheaply converted in to cash if the need arises. The more
liquid an asset is the more desirable it is. Government treasury bonds are the most liquid of all
long term bonds because they are so widely traded that they are the easiest to sell and the cost of
selling them is low. Corporate bonds are not as such liquid because fewer for any one
 corporation are traded; thus it can be costly to sell these bonds in an emergency because it may
be hard to find buyers quickly.
3. Income tax consideration: if a bond has a favorable tax treatment as do municipal bond, whose
interest payments are exempt from federal income taxes, its interest rate will be lower.
Term Structure of Interest Rates
We have seen how risk, liquidity, and tax considerations (collectively embedded in the risk structure
of interest rates) can influence interest rates. Another factor that influences the interest rate on a
bond is its term to maturity. Bonds with identical risk, liquidity and tax characteristics may have
different interest rates because the time remaining to maturity is different. The relationship between
the yields on comparable securities but different maturities is called the term structure of interest
rates. The primary focus here is the Treasury market. The graph which depicts the relationships
between the interest rates payable on bonds with different lengths of time to maturity is called the
yield curve. That is, it shows the term structure of interest rates. The focus on the Treasury yield
curve functions is due mainly because of its role as a benchmark for setting yields in many other
sectors of the debt market. However, a Treasury yield curve based on observed yields on the
Treasury market is an unsatisfactory measure of the relation between required yield and maturity.
The key reason is that securities with the same maturity may actually provide different yields.
Hence, it is necessary to develop more accurate and reliable estimates of the Treasury yield curve. It
is important to estimate the theoretical interest rate that the Treasury would have to pay assuming
that the security it issued is a zero-coupon security. If the term structure is plotted at a given point in
time, based on the yield to maturity, or the spot rate, at successive maturities against maturity, one of
the three shapes of the yield curve would be observed. The type of yield curve, when the yield
increases with maturity, is referred to as an upward-sloping yield curve or a positively sloped yield
curve. A distinction is made for upward sloping yield curves based on the steepness of the yield
curve. The steepness of the yield curve is typically measured in terms of the maturity spread between
the long-term and short-term yields. A downward-sloping or inverted yield curve is the one, where
yields in general decline as maturity increases. A variant of the flat yield is the one in which the
yield on short-term and long-term Treasuries are similar. But the yield on intermediate-term
Treasuries are much lower than, for example, the six-month and 30-year yields. Such a yield curve is
referred to as a humped yield curve.

YTM A: Upward slopping YTM B: Downward slopping

YTM C: Flat YTM D: Humped

Theories of term structure of interest rates
There are several major economic theories that explain the observed shapes of the yield
curve: Expectations theory, Liquidity premium theory and Market segmentation
theory
1. Expectations theory:-The pure expectations theory assumes that investors are indifferent
between investing for a long period on the one hand and investing for a shorter period with a
view to reinvesting the principal plus interest on the other hand. For example an investor would
have no preference between making a 12-month deposit and making a 6-month deposit with a
view to reinvesting the proceeds for a further six months so long as the expected interest
receipts are the same. This is equivalent to saying that the pure expectations theory assumes
that investors treat alternative maturities as perfect substitutes for one another. The pure
expectations theory assumes that investors are risk-neutral. A risk-neutral investor is not
concerned about the possibility that interest rate expectations will prove to be incorrect, so long
as potential favorable deviations from expectations are as likely as unfavorable ones. Risk is not
regarded negatively.
However, most investors are risk-averse, i.e. they are prepared to forgo some investment return in
order to achieve greater certainty about return and value of their investments. As a result of risk-
aversion, investors may not be indifferent between alternative maturities. Attitudes to risk may
generate preferences for either short or long maturities. If such is the case, the term structure of
interest rates (the yield curve) would reflect risk premiums.
If an investment is close to maturity, there is little risk of capital loss arising from interest rate
changes. A bond with a distant maturity (long duration) would suffer considerable capital loss in the
event of a large rise in interest rates. The risk of such losses is known as capital risk.
To compensate for the risk that capital loss might be realized on long-term investments, investors
may require a risk premium on such investments. A risk premium is an addition to the interest or
yield to compensate investors for accepting risk. This results in an upward slope to a yield curve.
This tendency towards an upward slope is likely to be reinforced by the preference of many
borrowers to borrow for long periods (rather than borrowing for a succession of short periods).
Some investors may prefer long maturity investments because they provide greater certainty of
income flows. This uncertainty is income risk. If investors have a preference for predictability of
interest receipts, they may require a higher rate of interest on short term investments to compensate
for income risk. This would tend to cause the yield curve to be inverted (downward sloping).
The effects on the slope of the yield curve from factors such as capital risk and income risk are in
addition to the effect of expectations of future short-term interest rates. If money market participants
expect short-term interest rates to rise, the yield curve would tend to be upward sloping. If the effect
of capital risk were greater than the effect of income risk, the upward slope would be steeper. If
market expectations were that short-term interest rates would fall in the future, the yield curve would
tend to be downward sloping. A dominance of capital-risk aversion over income-risk aversion would
render the downward slope less steep (or possibly turn a downward slope into an upward slope).
2. Liquidity premium theory:-Some investors may prefer to own shorter rather than longer term
securities because a shorter maturity represents greater liquidity. In such case they will be willing
to hold long term securities only if compensated with a premium for the lower degree of
liquidity. Though long-term securities may be liquidated prior to maturity, their prices are more
 sensitive to interest rate movements. Short-term securities are usually considered to be more
liquid because they are more likely to be converted to cash without a loss in value. Thus there is
a liquidity premium for less liquid securities which changes over time. The impact of liquidity
premium on interest rates is explained by liquidity premium theory.
3. Market segmentation theory:-According to the market segmentation theory, interest rates for
different maturities are determined independently of one another. The interest rate for short
maturities is determined by the supply of and demand for short-term funds. Long-term interest
rates are those that equate the sums that investors wish to lend long term with the amounts that
borrowers are seeking on a long-term basis. According to market segmentation theory, investors
and borrowers do not consider their short-term investments or borrowings as substitutes for
long-term ones. This lack of substitutability keeps interest rates of differing maturities
independent of one another. If investors or borrowers considered alternative maturities as
substitutes, they may switch between maturities. However, if investors and borrowers switch
between maturities in response to interest rate changes, interest rates for different maturities
would no longer be independent of each other. An interest rate change for one maturity would
affect demand and supply, and hence interest rates, for other maturities.
 CHAPTER FOUR
4. THE FINANCIAL MARKETS IN THE FINANCIAL SYSTEM
Learning Objectives:
After completing this chapter, you will be able to:
 Identify the classification, organization and structure of financial markets
 Describe the role of financial institutions
 Discus classification of financial institutions
 Identify the types of risks related with financial industry
Introduction
A Market is an institutional mechanism where supply and demand will meet to exchange goods and
services. Market is a place or event at which people gather in order to buy and sell things in order to
trade. In modern economies, households provide labor, management skills, and natural resources to
business firms and governments in return for income in the form of wages, rents and dividends.
Consequently, one can see that markets are used to carry out the task of allocating resources which
are scarce relative to the demand of the society. Along with many different functions, the financial
system fulfills its various roles mainly through markets where financial claims and financial services
are traded (though in some least-developed economies Government dictation and even barter are
used). These markets may be viewed as channels which move a vast flow of loanable funds that are
continually being drawn upon by demanders of funds and continually being replenished by suppliers
of funds.
The Organization of Markets
Broadly speaking, markets can be classified in to factor markets, product market and financial
markets.
a) Factor markets: - are markets where consuming units sell their labor, management skill, and
other resources to those producing units offering the highest prices, i.e. this market allocates
factors of production (Land, labor and capital – and distribute incomes in the form of wages,
rental income and so on to the owners of productive resources).
b) Product markets: - are markets where consuming units use most of their income from the
factor markets to purchase goods and services i.e. this market includes the trading of all
goods and services that the economy produces at a particular point in time.
c) Financial markets: - are markets where funds are transferred from people who have an
excess of available funds to people who have a shortage. Financial markets such as the
bond and stock markets are important in channeling funds from people who do not have a
productive use for them to those who do.
Classification and Structure of Financial Markets
Primary and Secondary Markets
1. Primary Market:-It is a financial market in which new issues of a security such as a bond or
stock are sold to initial buyers by the corporation or government agency borrowing the funds.
New securities are issued by firms in the primary market, and purchased by investors.
The primary markets for securities are not well known to the public because the selling of
securities to the 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 under writing securities: It guarantees a price for a corporation’s securities
and then sells them to the public. Therefore, the sale of new securities to the general public is
referred to as a public offering and the first offering of stock is called an initial public offering.
The sale of new securities to one investor or a group of investors (institutional investors) is
referred to as a private placement.
2. Secondary Market:-Secondary market is a financial market in which securities that have been
 previously issued (and are thus second handed) can be resold. If investors desire to sell the
securities that they previously purchased, they use the secondary market. 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 corporation that issued the security acquires no new funds. A
corporation acquires new funds only when its securities are first sold in the primary market.
Nonetheless, secondary market serves two important functions:
 They make it easier to sell these financial instruments to raise cash; that is, they make the
financial instruments more liquid.
 They determine the price of the security that the issuing firm sells in the primary market.
Exchanges and Over-the–Counter Markets
1. Organized Exchanges (Auction) Markets: -An auction market is some form of centralized
facility (or clearing house) by which buyers and sellers, through their commissioned agents
(brokers), execute trades in an open and competitive bidding process. The "centralized facility" is
not necessarily a place where buyers and sellers physically meet. Rather, it is any institution that
provides buyers and sellers with a centralized access to the bidding process. All of the needed
information about offers to buy (bid prices) and offers to sell (asked prices) is centralized in one
location which is readily accessible to all would-be buyers and sellers, e.g., through a computer
network. 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. Experimental economists have
devoted a tremendous amount of attention in recent years to auction markets.
2. Over-the-counter (OTC) markets:-An over-the-counter market has no centralized mechanism
or facility for trading. 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. 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. Many well-
known common stocks are traded over-the-counter through NASDAQ (National Association of
Securities Dealers' Automated Quotation System)
3. Debt and Equity Market
1. Debt Market:-This is a financial market where debt instruments such as bonds or mortgages
are traded. These instruments are contractual agreements by the borrower to pay the holder of
the instruments fixed dollar amounts at regular intervals (interest and principal payments) until
the specified date (the maturity date). The maturity of a debt instrument is the time term to the
instrument’s expiration date. A debt instrument is short-term if its maturity is less than a year
and long term if its maturity is ten years of longer. Debt instruments with a maturity between
one and ten years are said to be intermediate term.
2. Equity Market:-It is a financial market where equity securities, such as common stock, which
are claims to share in the net income (income after expenses and taxes) and the assets of a
business, are traded. Equities usually make payments (dividends) to their holders and are
considered long-term securities because they have no maturity date.The main disadvantage of
owning a corporation’s equities rather than its debt is that an equity holder is a residual
claimant; i.e. 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 the benefit because their dollar payments are fixed.
4. Money and Capital Markets
1. The Money Market:-The money market is a financial market in which only short term debt
instruments (maturity of less than one year) are traded. Securities with short-term maturities (1
year or less) are called money market securities, while securities with longer-term maturities are
called capital market securities. Money market securities, which are discussed in detail latter,
have the following characteristics.
 They are usually sold in large denominations
 They have low default risk
 They have smaller fluctuation in prices than long-term securities, making them safer
investments
 Widely traded than long-term securities and so more liquid.
Money market transactions do not take place in any one particular location or building. Instead,
traders usually arrange purchases and sales between participants over the phone and complete them
electronically. Because of this characteristic, money market securities usually have an active
secondary market. This means that after the security has been sold initially, it is relatively easy to
find buyers who will purchase it in the future. An active secondary market makes the money market
securities very flexible instruments to use to fill short term financial needs. Another characteristic of
the money markets is that they are whole-markets. This means that most transactions are very large.
The size of this transaction prevents most individual investors from participating directly in the
money markets. Instead, dealers and brokers, operating in the trading rooms of large banks and
brokerage houses, bring customers together.
2. The Capital Market:-Capital market is a financial market for debt and equity instruments with
maturities of greater than one year. They have far wider price fluctuations than money market
instruments and are considered to be fairly risky investments. Firms that issue capital securities
and the investors who buy them have very different motivations than those who operate in the
money markets. Firms and individuals use the money markets primarily to warehouse funds for
short period of time until a more important need or a more productive use for the funds arises. To
the contrary, firms and individuals use the capital markets for long term investments.
Capital market trading occurs in either the primary market or the secondary market. The primary
market is where new issues of stocks and bonds are exchanged. Investment funds, corporations, and
individual investors can all purchase securities offered in the primary market. A primary market
transaction is the one where the issuer of securities actually receives the proceeds of the sale. When
firms sell securities for the very first time, the issue is called Initial Public Offering (IPO).
Subsequent sales of a firm’s new stocks or bonds to the public are simply primary market
transactions.
The capital markets have well-developed secondary markets. A secondary market is where the sale
of previously issued securities takes place, and it is important because most investors plan to sell
long-term bonds and stocks before maturity. Secondary market for capital market instruments may
take place either in an organized exchanges market or in an over the counter market.
Capital Markets can be classified in to two broad categories; the bond market and the equity (stock)
markets.

i. The Bond Market:-The bond market is composed of longer-term borrowing debt

instruments than those that trade in the money market. These instruments are some times said
to comprise the fixed income capital market, because most of them promise either a fixed
 stream of income or stream of income that is determined according to a specified formula. In
practice, these formulas result in a flow of income that far from fixed. Therefore the term
“fixed income” is probably not fully appropriate. It is simpler and more straightforward to
call these securities either debt instruments or bonds.
A bond is a security that is issued in connection with a borrowing arrangement. The borrower issues
(sells) a bond to the lender for some amount of cash; the bond is in essence the “IOU” of the
borrower. The arrangement obligates the issuer to make specified payments to the bond holder on
specified dates. A typical bond obligates the issuer to make semiannual payment of interest called,
coupon payments, to the bond holder for the life of the bond. These are called coupon payments
because, in pre computer days, most bonds had coupons that investors would clip off and present to
the issuer of the bond to claim the interest payment. When the bond matures, the issuer repays the
debt by paying the bond’s par value (or its face value). The coupon rate of the bond determines the
interest payment: The annual payment equals the coupon rate times the bond’s par value. The
coupon rate, maturity date, and par value of the bond are part of the bond indenture, which is the
contract between the issuer and the bond holder. Types of Bonds are Long term bonds traded in
the capital markets include government (Treasury) bonds, corporate bonds, municipal bonds,
and foreign bonds.

ii. The Stock Market/Equities Market

Equities represent ownership shares in a corporation. Each share of common stock entitles its owners
to one vote on any matters of corporate governance put in to a vote at the corporation’s annual
meetings and to a share in the financial benefits of ownership. Investors can earn a return from
a stock in one of two ways; the yield or capital gains.
 Yield is the income the investor receives while owning an investment.
 Capital gains are increases in the value of the investment itself, and are often not available to the
owner until the investment is sold.
Types of Stock/Equity: There are two most important forms of equity investments; these are the
common stock /ordinary shares (in America) and preferred stock/ preference shares (in British
terminologies).
A. Common Stock/ Ordinary shares
Common stock, as an investment has the following basic characteristic features:
Residual claim means stockholders are the last in line of all those who have a claim on the assets and
income of the corporation. In a liquidation of the firm’s assets, the shareholders have claim to what
is left after paying all other claimants, such as tax authorities, employees, suppliers, bondholders,
and other creditors. In a going concern, shareholders have claim to the part of operating income left
after interest and taxes have been paid. Management either can pay this residual as cash dividends to
shareholders or reinvest it in the business to increase the value of the shares.
B. Preferred Stock/ Preference Shares
Preferred stock has features similar to both equity and debt. Like a bond, it promises to pay to the
holder a fixed stream of income each year. In this sense, preferred stock is similar to an infinite-
maturity bond, that is, perpetuity. It also resembles a bond in that it does not give the holder voting
power regarding the firm’s management.
However, preferred stock is an equity investment. The firm retains discretion to make the dividend
payments to the preferred stock holders: It has no contractual obligation to pay those dividends.
Instead, preferred dividends are usually cumulative: that is, unpaid dividends cumulate and must be
paid in full before any dividends may be paid to holders of common stock. In contrast, the firm does
not have a contractual obligation to make timely interest payments on the debt. Failure to make these
payments sets off corporate bankruptcy proceedings. Preferred stock also differs from bonds in terms
of its tax treatments for the firm. Because preferred stock payments are treated as dividends rather
than as interest on debt, they are not tax-deductible expenses for the firm.
Even though preferred stock ranks after bonds in terms of the priority of its claim to the assets of the
firm in the event of corporate bankruptcy, preferred stock often sells at lower yields than corporate
bonds. Presumably this reflects the value of the dividend exclusion, because the higher risk of
preferred stock would tend to result in higher yields than those offered by bonds.
Corporations issue preferred stock in variations similar to those of corporate bonds. Preferred stock
can be callable the issuing firm, in which case it is said to be redeemable It also can be convertible in
to common stock at some specified conversion ratio.
5. The Derivatives Market
Firms are exposed to several risks in the ordinary course of operations and when borrowing funds.
For some risks, management can obtain protection from an insurance company. For example,
management can insure a plant against destruction by fire by obtaining a fire insurance policy from a
property and casualty insurance company. There are capital market products available to
management to protect against certain risks that are not insurable by an insurance company. Such
risks include risks associated with a rise in the price of commodity purchased as an input, a decline
in a commodity price of a product the firm sells, a rise in the cost of borrowing funds, and an adverse
exchange rate movement. The instruments that can be used to provide such protection are called
derivative instruments. The term derivatives refers to a large number of financial instruments, the
value of which is based on, or derived from, the prices of securities, commodities, money or other
external variables. These instruments include futures contracts, forward contracts, option contracts,
and swap agreements.
1. Futures Contract:-A futures contract is an agreement between a buyer/seller and an established
exchange or its clearinghouse in which the buyer/seller agrees to take/make delivery of
something at a specified price at the end of a designated future date. The thing that the two
parties agree either to take or make the delivery is referred to as the underlying for the
contract or simply the underlying. The price at which the parties agree to transact in the future
is called the futures price and the designated date at which the parties must transact is
called the settlement date or delivery date. The basic economic function of futures markets is to
provide an opportunity for market participants to hedge against the risk of adverse price
movements. Futures contracts involving the trading of traditional agricultural commodities (such
as grain and livestock), imported foodstuffs (such as coffee, cocoa, and sugar), or industrial
commodities are known as commodity futures. Futures contracts based on a financial
instrument or a financial index are known as financial futures. Financial futures include stock
index futures, interest rate futures, and currency futures.
2. Forward Contracts:-A forward contract, just like a futures contract, is an agreement for the
future delivery of the underlying at a specified price at the end of a designated period of time.
Difference between futures and forward contracts
 Futures contracts are standardized agreements as to the delivery date, quantity, and quality of
the deliverable, and are traded on organized exchanges. Whereas a forward contract is
usually non-standardized (that is, the terms of each contract are negotiated individually
between buyer and seller), has no clearinghouse, and secondary markets are often nonexistent
or extremely thin.
 Unlike a futures contract, which is an exchange-traded product, a forward contract is an over-
the-counter instrument.
 The parties in a forward contract are exposed to credit risk because either party may default
on the obligation. The risk that the counterparty may default is referred to as counterparty
risk. Counterparty risk is minimal in the case of futures contracts because the clearinghouse
 associated with the exchange guarantees the other side of the transaction.
 Futures contracts are not intended to be settled by delivery. In contrast, forward contracts, are
intended for delivery.
 Futures contracts are marked to market at the end of each trading day. Consequently, futures
contracts are subject to interim cash flows as additional margin may be required in the case
of adverse price movements, or as cash is withdrawn in the case of favorable price
movements. A forward contract may or may not be marked to market, depending on the
wishes of the two parties. For a forward contract that is not marked to market, there are no
interim cash flow effects because no additional margin is required.
 Other than these differences, most of what we say about futures contracts applies equally to
forward contracts.
3. Options:- An option is a contract in which the writer of the option grants the buyer of the option
the right, but not the obligation, to purchase from or sell to the writer an asset at a specified price
within a specified period of time (or at a specified date). The writer, also referred to as the seller,
grants this right to the buyer in exchange for a certain sum of money, which is called the option
price or option premium. The price at which the asset may be bought or sold is called the
exercise price or strike price. The date after which an option is void is called the expiration
date. As with a futures contract, the asset that the buyer has the right to buy and the seller is
obligated to sell is referred to as the underlying. When an option grants the buyer the right to
purchase the underlying from the writer (seller), it is referred to as a call option, or call. When
the option buyer has the right to sell the underlying to the writer, the option is called a put
option, or put.
Options, like other financial instruments, may be traded either on an organized exchange or in the
over-the-counter (OTC) market. The advantages of an exchange-traded option include;
 The exercise price and expiration date of the contract are standardized.
 As in the case of futures contracts, the direct link between buyer and seller is severed after the
order is executed because of the interchangeability of exchange-traded options.
 The clearinghouse associated with the exchange where the option trades performs the same
function in the options market that it does in the futures market.
 Finally, the transactions costs are lower for exchange-traded options than for OTC options.
4. Swaps: -In addition to forwards, futures, and options, financial institutions use one other
important financial derivative to manage risk. Swaps are financial contracts that obligate two
parties (counter parties) to the contract to exchange (swap) a set of payments (not assets) it owns
for another set of payments owned by another party. The amount of the payments exchanged is
based on some predetermined principal, called the notional principal amount or simply notional
amount. The amount each counterparty pays to the other is the agreed-upon periodic rate times
the notional amount. The only amounts that are exchanged between the parties are the agreed-
upon payments, not the notional amount. A swap is an over-the-counter contract. Hence, the
counterparties to a swap are exposed to counterparty-risk. The most widely used types of swaps
include interest rate swaps, currency swaps, and commodity swaps.
6. Foreign Exchange Market
A Foreign exchange market is a market in which currencies are bought and sold. It is to be
distinguished from a financial market where currencies are borrowed and lent. The foreign exchange
market provides the physical and institutional structure through which the money of one country is
exchanged for that of another country, the rate of exchange between currencies is determined, and
foreign exchange transactions are physically completed. A foreign exchange transaction is an
agreement between a buyer and a seller that a given amount of one currency is to be delivered at a
specified rate for some other currency.
Functions of the Foreign Exchange Market
The foreign exchange market is the mechanism by which a person of firm transfers purchasing
power from one country to another, obtains or provides credit for international trade transactions,
and minimizes exposure to foreign exchange risk.
1. Transfer of Purchasing Power: Transfer of purchasing power is necessary because
international transactions normally involve parties in countries with different national
currencies. Each party usually wants to deal in its own currency, but the transaction can be
invoiced in only one currency.
2. Provision of Credit: Because the movement of goods between countries takes time, inventory
in transit must be financed.
3. Minimizing Foreign Exchange Risk: The foreign exchange market provides "hedging"
facilities for transferring foreign exchange risk to someone else.
 CHAPTER FIVE
5. REGULATION OF FINANCIAL MARKETS AND INSTITUTIONS
Learning Objectives:
After completing this chapter, you will be able to:
 Identify the purpose and nature of financial system regulation
 Discuss on the form and the principle of regulations
 Discuss on the arguments for and against financial system regulations
The Purpose and Nature of Financial System Regulation
A good financial system with a well-functioning competitive market as well as a well-supporting
financial institution is an essential ingredient for sustainable economic growth. Developing sound
financial markets requires the establishment of public confidence in the institutions that constitute
the finance sector. Confidence can only be maintained if these institutions deliver services as
promised. Thus, one of the duties of governmental authorities is to preserve the long term stability of
the financial system and reliability of its components. Governments could do by using different
procedures and regulations. Regulation of financial markets rests on the tenet (principle) that it
serves the interest of the public by protecting investors and guarding against systemic risk. With
regard to investor protection, regulations maintain that their oversight is justified on the grounds that
investors are uninformed and unskilled.
The initial focus, and still the central element, of regulatory system are to solve the problem of the
uninformed investor through company disclosure and transparency of trading markets. Most people
agree that disclosure provides the information needed to make rational decisions. But regulation
today goes far beyond disclosure requirements, because a growing number of stakeholders are
presumed to be unskilled and incapable of making informed decisions. For example, because of
asymmetric information in financial markets, that means investors may be subject to adverse
selection and moral hazard problems that may hinder the efficient operation of financial markets.
Risky firms or outright crooks may be the most eager to sell securities to unwary investors, and the
resulting adverse selection problem may keep investors out of financial markets. Furthermore, once
an investor has bought a security, thereby lending money to a firm, the borrower may have
incentives to engage in risky activities or to commit outright fraud. The presence of this moral
hazard problem may also keep investors away from financial markets. Government regulation
reduce adverse selection and moral hazard problems in financial markets and increase their
efficiency by increasing the amount of information available to investors.
The other basis for financial regulation is concern about systemic risk. Systemic risk arises if the
failure of one financial institution causes a run on other institutions and precipitates system-wide
failure. Regulation is said to be required because individual institutions do not adequately take
account of the external costs they impose on the financial system when they fail. But almost every
aspect of financial markets, if not daily living itself, involves systemic risk. One of the most complex
issues facing governments is identifying the appropriate level and form of intervention.
In similar ways, ensuring the soundness of financial system is the other reason for the necessity of
the rules and procedures. Uncertain and confusing information can also lead to widespread collapse
of financial intermediaries, referred to as a financial panic. Because providers of funds to financial
intermediaries may not be able to assess whether the institutions holding their funds are sound, if
they have doubts about the overall health of financial intermediaries, they may want to pull their
funds out of both sound and unsound institutions.
Regulatory efficiency is a significant factor in the overall performance of the economy. Inefficiency
ultimately imposes costs on the community through higher taxes and charges, poor service,
uncompetitive pricing or slower economic growth. The possible outcome is a financial panic that
produces large losses for the public and causes serious damage to the economy. Therefore, the
financial system is regulated to increase the information available to investors, to ensure the
soundness of the financial system and improve control of monetary policy.
The Form of Regulation
To protect the public and the economy from financial panics, the governments are implementing a
number of regulations. These regulations are taking the form of restrictions on entry; disclosure
regulation, restrictions of financial institutions, deposit insurance, financial activities regulation, limits
on competition, and restrictions on interest rates.
a) Restrictions on Entry:-Governments endorse very tight regulations governing who is allowed
to set up a financial intermediary. Individuals or groups that want to establish a financial
intermediary, such as a bank or an insurance company, must obtain a charter from the state or the
federal government.
b) Disclosure Regulation:-There are stringent reporting requirements for financial intermediaries.
Their bookkeeping must follow certain strict principles, their books are subject to periodic
inspection, and they must make certain information available to the public.
c) Regulation of financial institutions:-It is also called regulations on assets and activities. There
are restrictions on what financial intermediaries are allowed to do and what assets they can hold.
Before you put your funds into a bank or some other such institution, you would want to know
that your funds are safe and that the bank or other financial intermediary will be able to meet its
obligations to you. One way of doing this is to restrict the financial intermediary from engaging
in certain risky activities. For example some countries legislation separates commercial banking
from the securities industry so that banks could not engage in risky ventures associated with this
industry. Another way is to restrict financial intermediaries from holding certain risky assets, or
at least from holding a greater quantity of these risky assets than is prudent. For example,
commercial banks and other depository institutions are not allowed to hold common stock
because stock prices experience substantial fluctuations. However, insurance companies are
allowed to hold common stock, but their holdings cannot exceed a certain fraction of their total
assets.
d) Financial activity regulation:-These are rules about traders of securities and trading on
financial markets. Probably the best example of this type of regulation is rules prohibiting the
trading of a security by those who, because of their privileged position in a corporation, know
more about the issuer’s economic prospects than the general investing public. Such individuals
are referred to as insiders and include, yet are not limited to, corporate managers and members of
the board of directors. Trading by insiders (referred to as insider trading) is another problem
posed by asymmetric information.
e) Deposit Insurance: -The government can insure people’s deposits so that they do not suffer any
financial loss if the financial intermediary that holds these deposits fails. All commercial and
mutual savings banks, with a few minor exceptions, are required to enter deposit insurance,
which is used to pay off depositors in the case of a bank’s failure.
f) Limits on Competition:-Politicians have often declared that unbridled (uncontrolled) competition
among financial intermediaries promotes failures that will harm the public. Although the
evidence that competition does this is extremely weak, it has not stopped the state and federal
governments from imposing many restrictive regulations.
g) Restrictions on Interest Rates:-Competition has also been inhibited by regulations that impose
restrictions on interest rates that can be paid on deposits and loans.

The Principles of Regulation

The main principle of the regulation of the financial markets and institutions includes: Competitive
neutrality; cost effectiveness; accountability; flexibility; and transparency
 i. Competitive Neutrality:-The regulatory burden applying to a particular financial commitment or
promise should apply equally to all who make such commitments, as per the competitive
neutrality principle. It requires further that there would be:Minimal barriers to entry and exit
from markets and products;No undue restrictions on institutions or the products they offer;
andMarkets open to the widest possible range of participants.
ii. Cost Effectiveness:-Regulation can be made totally effective by simply prohibiting all actions
potentially incompatible with the regulatory objective. But, by inhibiting productive activities
along with the anti-social, such an approach is likely to be highly inefficient. Cost effectiveness
is one of the most difficult issues for regulatory cultures to come to terms with. Any form of
regulation involves a natural tension between effectiveness and efficiency. Yet the underlying
legislative framework must be effective, by fostering compliance through enforcement in cases
where participants do not abide by the rules. In general, a cost-effective regulatory system may
require:
 an allocation of functions among regulatory bodies which minimizes overlaps, duplication and
conflicts;
 an explicit mandate for regulatory bodies to balance efficiency and effectiveness;
 the allocation of regulatory costs to those enjoying the benefits; and
 a presumption in favor of minimal regulation unless a higher level of intervention is justified.
iii. Accountability:-The regulatory structure must be accountable to its stakeholders and subject to
regular reviews of its efficiency and effectiveness. In addition, regulatory agencies should
operate independently of sectional interests and with appropriately skilled staff.
iv. Flexibility:-The regulatory framework must have the flexibility to cope up with changing
institutional and product structures without losing its effectiveness.
v. Transparency:-Transparency of regulation requires that all guarantees be made explicit and
that all purchasers and providers of financial products be fully aware of their rights and
responsibilities. It should be a top priority of an effective financial regulatory structure that
financial promises (both public and private) to be understood. If there is a general perception that
a particular group of financial institutions cannot fail because they have the authorization of
government, there is a great danger that perception will become a reality.
Arguments for and Against Financial System
Regulations
The financial system is among the most heavily regulated sectors of most economies.
The
government regulates financial markets for different reasons. But, there are different views as to the
need and extent of Government intervention in financial markets. Some argue that free and
competitive markets can produce an efficient allocation of resources and provide a strong foundation
for economic growth and development. Others emphasize that Governments could play in
maintaining a healthy economic and social environment in which enterprises and their customers can
interact with confidence. Since deferent scholars have contradictory stands for or against the
regulations it is better to examine about some reasons that have led to the present regulatory
environment. Some of the views for or against financial market regulations include: Regulation for
Financial Safety; Systemic Stability; Information Asymmetry; Regulatory Assurance; and
Regulation for Social Purposes.
i. Regulation for Financial Safety: Many regulations in the financial institutions’ sector spring
from the ability of some financial institutions to create money in the form of credit cards,
checkable deposits, and other accounts that can be used to make payments for purchase of
goods and services. Such creation of money is closely associated with inflation which should be
managed by the government. Financial regulation arises from the risks attaching to
 financial promises. While in some other industries safety regulation aims to eliminate risk
almost entirely (for example, to eliminate health risks in food preparation), this is not an
appropriate aim for most areas of the financial activities. One of the vital economic functions of
the financial institutions is to manage, allocate and price risk. However, there are some areas of
the financial activities where government intervention is aimed at eliminate reducing risk. One
of the most difficult tasks facing those charged with designing financial market
regulations is that of defining the aims and boundaries of regulation for financial safety. In
essence, the task is to decide which financial promises have characteristics that warrant much
higher levels of safety than would otherwise be provided by markets (even when they are
subject to effective conduct, disclosure and competition regulation). As a general principle,
financial safety regulation will be required where promises are judged to be very difficult to
honor and assess, and produce highly adverse consequences if breached. Promises which
rank highly on these characteristics are referred to as having a high ‘intensity’. The higher
the intensity of a promise, the stronger the case for regulation to reduce the likelihood of
breach.
ii. Systemic Stability: The first case for regulation to prevent systemic instability arises because
certain financial promises have an inherent capacity to transmit instability to the real
economy,
inducing undesired effects on output, employment and price inflation. The more sophisticated
the economy, the greater its dependence on financial promises and the greater its vulnerability
to failure of the financial system. The most potent source of systemic risk is financial contagion.
This occurs when financial distress in one market or institution is communicated to others and,
eventually, engulfs the entire system. The position of banks as the main providers of payments
services adds to risk that bank failure might disrupt the integrity of the payments system and
precipitate a wider economic crisis.
iii. Information Asymmetry: The second case for regulation relates to the need to address
information asymmetry. In a market economy, consumers are assumed, for the most part, to the
best judges of their own interests. In such cases, disclosure requirements play an important role
in assisting consumers to make informed judgments. However, disclosure is not always
sufficient. For many financial products, consumers lack (and cannot efficiently obtain) the
knowledge, experience or judgment required to make disclosure, no matter how high quality or
comprehensive, cannot overcome market failure. In these cases, it may be desirable to substitute
the opinion of a third party for that of consumers themselves. In effect, the third party is
expected to behave paternalistically, looking out for the best interests of consumers when they
are considered incapable of doing so alone. To some extent, such third parties can be supplied
by markets (such as the role played by self-regulatory associations). However, for many years
the practice in all countries has been for government prudential regulators to take on much of
this role.
iv. Regulation for Social Purposes: A further case for regulation is sometimes made on the grounds
that financial institutions have ‘community service obligations’ to provide subsidies to some
customer groups. For example, financial institutions are urged to deliver certain services free of
charge or at a price below the cost of provision. This is the least persuasive case for
intervention. Financial institutions, like other business corporations, are designed to produce
wealth, not to redistribute it. This is not to say that their creation of wealth should ignore the
claims of social and moral propriety. But it is another thing entirely to require financial
institutions to undertake social responsibilities for which they are not designed or well suited.
Obliging financial institutions to subsidies some activities compromises their efficiency and is
unlikely to prove sustainable in a competitive market.
QUICK CHECK
1. Distinguish between the purpose and nature of financial system regulation
2. Discuss on the form and the principle ofregulations
3. Discuss on the arguments for and against financial system regulations
CHAPTER SIX
6. OVERVIEW OF ETHIOPIAN FINANCIAL SYSTE
Learning Objectives:
After completing this chapter, you will be able to:
 Define financial system and its feature
 Discusson the components of financial system in Ethiopia
 The regulation of financial markets & institutions in Ethiopia
Financial Markets and Institutions in Ethiopia
The financial sector in Ethiopia consists of formal, semiformal and informal institutions. The formal
financial system is a regulated sector which comprises of financial institutions such as banks, insurance
companies and microfinance institutions. The saving and credit cooperative are considered as semi-formal
financial institutions, which are not regulated and supervised by National Bank of Ethiopia (NBE). The
informal financial sector in the country consists of unregistered traditional institutions such as Iqub
(Rotating Savings and Credit Associations) Idir (Death Benefit Association) and money lenders. Ethiopian
financial system is known with non-existence of formal capital market to act enactment stage; where long-
term Equity and Debt are traded. The Treasury-bill market is the main financial market in Ethiopia in
which 28 and 98 days government Treasury-bill are offered for auction to the general public. However, the
participants are mostly existing commercial banks. There is also inter-banks money market in which the
existing commercial banks are taking part and foreign exchange market also functional in Ethiopia. The
commodity market in which few major agricultural products are formally traded is the phenomenon of the
Ethiopian financial system.
Financial Sector Developments
The Formal Sector
The major formal financial institutions operating in Ethiopia are banks, insurance companies and
microfinance institutions. In the formal financial sector of Ethiopia, banks take the dominant position
financing the economy.
a. The Banking System
The agreement that was reached in 1905 between Emperor Minilik-II and R.MaGillivray, representative of
the British owned National Bank of Egypt marked the introduction of modern banking in Ethiopia.
Following the agreement, the first bank called Bank of Abyssinia was inaugurated in Feb. 16, 1906 by the
Emperor. The Bank was totally managed by the Egyptian National Bank. By 1931 Bank of Abyssinia was
legally replaced by Bank of Ethiopia shortly after Emperor Haile Selassie came into power. The National
Bank of Ethiopia with more power and duties started its operation in January 1964. Following the
incorporation as a share company on December 16, 1963 per proclamation No. 207/1955 of October 1963,
Commercial Bank of Ethiopia took over the commercial banking activities of the former State Bank of
Ethiopia. It started operation on January 1, 1964 with a capital of Eth. Birr 20 million. There were two
other banks in operation namely Banco di Roma S.C and Banco di Napoli S.C. that later reapplied for
license according to the new proclamation each having a paid up capital of Eth. Birr 2 million.
Following the declaration of socialism in 1974 the government extended its control over the whole
economy and nationalized all large corporations. The Commercial Bank of Ethiopia commenced its
operation with a capital of Birr 65 million. The Savings and Mortgage Corporation S.C and Imperial
Saving and Home Ownership Public Association were also merged to form the Housing and Saving Bank
with working capital of Birr 6.0 million and all rights, privileges, assets and liabilities were transferred by
proclamation No. 60, 1975 to the new bank.

Following the change of government in 1991, financial sector reform took place and the subsequent
measures taken to liberalize and reorient the economy towards a system of economy based on commercial
considerations, the financial market was deregulated. A Monetary and Banking Proclamation number
84/94 was issued out to effect the deregulation and liberalization of the financial sector, and a number of
private banks and insurance companies were established following the proclamation. The National Bank
of Ethiopia as a judicial entity separated from the government and outlined its main functions. Directives
issued in subsequent years further deepen the liberalization mainly including the gradual liberalizations of
the interest rate, foreign exchange determination, and money market operation. Monetary and Banking
proclamation No. 83/1994 and the Licensing and Supervision of Banking Business No.84/1994 laid down
the legal basis for investment in the banking sector consequently, after the proclamation private banks
started operation.
Banks currently; according to the report 2022/23, the number of banks in Ethiopia reached 30, of
which 28 were private and 2 state owned. These banks have opened 563 new bank branches during
the review quarter, thereby increasing the total number of bank branches to 9,507. As a result, the
ratio of population to bank branch stood at 11,062.0. Of the total bank branches, 32.6 percent were
located in Addis Ababa. About 97 percent of the new bank branches were opened by private banks.
State owned banks accounted for 22.7 percent of the total bank branches while private banks took
77.3 percent share.
Meanwhile, total capital of the banking system reached Birr 210.1 billion of which private banks
accounted for 57.6 percent and state owned banks (Commercial Bank of Ethiopia and Development
Bank of Ethiopia) 42.4 percent. The banking sector disbursed Birr 129.3 billion in new loans during
the review quarter, signifying 98.1 percent annual growth. Of the total new loans disbursed,the share
of state owned banks was 16.9 percent and that of private banks 83.1 percent. Sector wise, international trade
was the largest beneficiary of the total fresh loans accounting for 33.3 percent followed by domestic trade
(18.1 percent), consumer and staff loans (13.7 percent), manufacturing (13 percent), building and construction
(9.7 percent), agriculture (7.8 percent) and transport & communication (6 percent).

In the meantime, the banking system collected Birr 91.8 billion in loans, showing a 12.4 percent
annual growth. Of the total loan collection, 58.5 percent was collected by private banks and 41.5
percent by state owned banks. Total outstanding credit of the banking system (including corporate
bond) increased to Birr 1.6 trillion depicting 27.1 percent year-on-year growth. About 99.6 percent
of the total outstanding credit of private banks was claims on cooperatives and private enterprises.
Insurance Sector
b. Insurance Companies and Other Financial Institutions
On the other hand, modern forms of insurance service, which were introduced in Ethiopia by Europeans,
trace their origin as far back as 1905 when the Bank of Abyssinia began to transact fire and marine
insurance as an agent of a foreign insurance company.
Before liberalization the command economy including political instability had been the stumbling
block for the growth of the financial sector in Ethiopia. The 1990’s ushered in economic
liberalization that led to the revival of private sector participation in the financial sector. This has led
to the formation of a number of private insurance companies. According to the National Bank of
Ethiopia (2016) there were 17 insurance companies with a total of 221 branches operating in the
country. In terms of ownership, all insurance companies except the Ethiopian Insurance Corporation
(EIC), are privately owned. Private insurance companies accounted for 69.5 percent of the total
capital, while the remaining share was taken up by the single public owned enterprise, the Ethiopian
Insurance Corporation. Of the total insurance branches, 50.7 percent are concentrated in Addis
Ababa. Private insurance companies owned 81.4 percent of the total branches.
Currently the most recent report of NBE 2022/23 indicates the number of insurance companies
remained at 18, of which 17 were private and 1 state owned. Their branches increased to 703 from
648 a year ago. Of the total branches, about 55.8 percent were located in Addis Ababa. Likewise,
total capital of insurance companies rose to Birr 14.0 billion from 11.6 billion last year, of which
private insurance companies accounted for 73.8 percent.
Microfinance Institutions
The emergence of Microfinance institution is a recent phenomenon in Ethiopia compared to other
developing countries. The first microfinance service in Ethiopia was introduced as an experiment in 1994,
when the Relief Society of Tigray (REST) attempted to rehabilitate drought and war affected people
through the rural credit scheme. It was inspired by other countries’ experiences and adapted to the
conditions of the Tigrayregion (northern part of Ethiopia). In the second half of the 1990s, as a result of its
success, the microfinance service was gradually replicated in other regions (Berhanu and Thomas, 2000).
Similar to microfinance approaches in many other parts of the world, MFIs in Ethiopia focus on group-
based lending and promote compulsory and voluntary savings. They use joint liability, social pressure, and
compulsory savings as alternatives to conventional forms of collateral (SIDA, 2003). These institutions
provide financial service, mainly credit and saving and, in some cases, loan insurance. The objectives of
MFIs are quite similar across organizations. Almost all MFIs in the country have poverty alleviation as an
objective. They focus on reducing poverty and vulnerability of poor households by increasing agricultural
productivity and incomes, diversifying off farm sources of income, and building household assets. They
seek to achieve these objectives by expanding access to financial services through large and sustainable
microfinance institutions.
The Ethiopian microfinance industry has undergone tremendous growth and development in a very short
period of time (Micro Ned, 2007, Amaha2009), As of 2009, the 29 MFIs licensed by the National Bank of
Ethiopia succeeded in reaching more than 2.3 million clients and delivered about 7 billion Birr in loans.
They also mobilized about 3.8 billion Birr of savings. In the same year, the sector has a total asset Birr
10.2 billion and total capital of Birr 2.9 billion. Despite the notable achievements, the operating MFIs
reach less than 20% of the total microfinance demand in the country (AEMFI, 2010). Turning to market
concentration, the three largest MFIs, namely Amhara, Oromia and Dedebit Credit and Savings
institutions accounted for 67.1 percent of the total capital, 81.4 percent of the savings, 74.0 percent of the
credit and 76.2 percent of the total assets of MFIs.
During the review quarter, the number of Micro Finance Institutions (MFIs) reached 43 which
jointly mobilized about Birr 21.8 billion in saving deposit, showing 13.4 percent annual growth.
Total outstanding credit of these institutions increased 25.9 percent and reached Birr 31.1 billion,
highlighting the growing role of MFIs in providing access to financial services, poverty reduction
and wealth creation among low income groups of the society as well as micro and small-scale
enterprises both in rural and urban areas. Their total asset also grew by 27.6 percent and stood at Birr
47.3 billion.

Regulations of Insurance sector in Ethiopia

In 1905, the insurance business like any undertaking was classified as trade and was administered by the
provisions of the commercial code. This was the only legislation in force in respect of insurance except
the maritime code of Ethiopia that was issued to govern the operations of maritime business and the
related marine insurance. The minimum paid-up capital required to establish an insurance company was as
little as 12,500 Ethiopian Birr as stipulated in the commercial code. There was no restriction on foreign
insurers.
The first remarkable event that the Ethiopian insurance market witnessed was the promulgation of
proclamation No. 281/1970. This proclamation was issued to provide for the control & regulation of
insurance business in Ethiopia. It is peculiar in that created an Insurance Council and an Insurance
Controller’s Office.
The law required an insurer to a domestic company whose share capital (fully subscribed) to be not less
than Ethiopian Birr 400,000 for a general insurance business and Ethiopian Birr 600,000 in the case of
long-term insurance business and Ethiopian Birr 1,000,000 to do both long-term & general insurance
business. Non-Ethiopian nationals were not barred /excluded from participating in insurance-business.
However, the proclamation defined domestic company as a share company having its head office in
Ethiopia and in the case of a company transacting a general insurance business at least 51% and in the
case of a company transacting life insurance business, at least 30% of the paid-up capital must be held by
Ethiopian nationals or national companies.
Four years after the enactment of the proclamation, the military government that came to power in 1974
put an end to all private entrepreneurship. Then all insurance companies operating were nationalized and
from January 1, 1975 onwards the government took over the ownership and control of these companies &
merged them into a single unit called Ethiopian Insurance Corporation. In the years following
nationalization, Ethiopian Insurance Corporation became the sole operator.
Following the change in the political environment in 1991, the proclamation for the licensing and
supervision of insurance business heralded the beginning of a new era. Immediately after the enactment of
the proclamation private insurance companies began to flourish.
Current regulations of Insurance sector in Ethiopia
It is of interest to note that the first regulations governing insurance were enacted to protect insurers
against fraudulent action on the part of the insured. It is only because of the appearance of compulsory
insurance and the increasing level of complexity of insurance contracts, that legislators concern
themselves with protecting interests of the insurance consumers.
The contractual relationship between the insured and the insurer reveals a potential imbalance. In other
words the insured pays his consideration (premium payment) at the very beginning of the contract. But
before the insurer is called to perform his part, time may change the security profile of the insurer. In view
of the economic importance of insurance, this has led Government Authorities to enact regulations that
should guarantee the long term viability of insurers.
Regulating the insurance industry does not seem a question of choice for Ethiopia-rather a must to do.
Some individuals who are participating in this industry believe that Ethiopian insurance companies are
working at the capital of other country’s insurance capital which requires legal protection. Besides,
because the attitude, awareness of the public and information flow about insurance activities is at a lower
level there is not any better than developing the trust/confidence of the people on insurance companies
through regulating their activities.
In our country proclamation 86/1994 is proclaimed to provide for the licensing and supervision of
insurance business. For the purpose of this chapter (your instructor) have summarized the basic
regulations in to the following categories:

1. Regulation related to Licensing:-Historically, fixed capital requirements have been specified in

most countries insurance statues to ensure that applicants seeking licenses to conduct insurance
business have sufficient capital to support their operational activities. In accordance with Article 4 of
 proclamation 86/1994 the minimum paid up capital requirement for nonlife and life
insurance business in Ethiopia is Birr 3,000,000 and Birr 4,000,000 respectively. For composite
insurers (undertaking both life and non-life) the requirement is Birr 7,000,000. In accordance with
Article 6, application for the grant of a license shall be accompanied by Memorandum and Articles
of Association, insurance policy founds and such other particulars as may be prescribed by
directive to be issued by the National Bank.
2. Regulation related to reserves and solvency:-Some reserves are specified and compulsory
by law: i.e., statutory deposit and various technical provisions. According to Article 4 of
proclamation
86/199
4:
a. Every insurer shall, in respect of each main class of insurance business he carries on
in Ethiopia, deposit and keep deposited with the bank, an amount equal to fifteen percent
(15%) his paid up capital in cash or government securities.
b. The deposit specified in sub-article (1) above shall be held to credit of the insurer provided
that the aforesaid deposit or any there of shall not be withdrawn except with the written
permission of the N. Bank: nor shall such deposit be used as a pledge or security against any
loan or overdraft.
The law also requires 10% of annual net profit to be deposited into a legal reserve account. Insurers
can also make additional reserves as prudent underwriting practice dictated them. All these
legally and practically required reserves are aimed at ensuring the financial strength of an insurer in
discharging its financial commitments.
To be solvent an insurance company’s total admitted assets have to exceed its total admitted
liabilities by a certain specified margin in line with the statutory requirement on force. According
to the definition of Article 20 of proclamation No. 86/1994, An insurer carrying on general
insurance business shall be deemed in solved if the value of the insurer’s assets does not exceed the
amount of his liabilities by whichever is the greater of: (a) The amount of the statutory deposit (i.e.
15% of the paid up capital), or 15% of the net premium written by the insurer in his last preceding
financial year.
c. Disclosure Regulation:-As per Article 18 of the proclamation, the balance sheet, profit and
loss account and revenue account of every insurer shall be audited annually by an auditor. A
copy of every report of the auditor shall be sent to the Bank not later than ninety (90) days after
the end of its financial year. In addition according to Directive No SIB/17/98, each insurer shall
submit to the supervision department of the National Bank of Ethiopia separate quarterly reports for
general and long-term insurance business within twenty days after the end of each quarter.
d. Prohibitions or Restrictions :-Usually large funds remain under the custody of insurers
and invested to produce additional returns. Under competitive pressure this additional income may
enable the insurer to charge lower rates than would be usual, and make the insurers, products
attractive here by improving its overall profitability. The management of these funds is thus very
important both to insurers and insured and may also play a significant role in the national
economy. Appropriate regulations to channel these funds so as to target developmental areas of the
economy may contribute to the overall economic development of the country. Hence the National
Bank of Ethiopia (NBE) Issued Directive No. SIB25/2004 which Limits on investment of insurance
funds as follows:
i. General Insurance
 Funds
The General Insurance funds of an insurance company can be invested in Treasury Bills and bank
deposits
not less than 65% of admitted assets; provided, however, that aggregate bank deposits (checking,
savings and time deposits) held with any one bank shall not exceed 25% of total admitted assets; In
investment in
company shares not exceeding 15% of total admitted assets; In real estate not exceeding 10% of total
admitted assets; and 10% of admitted assets in investments of the insurance company’s choice.
ii. Long-term Insurance Funds
The Long-term Insurance funds of an insurance company can be invested in Treasury Bills/Bonds and
bank deposits not less than, in aggregate, 50% of total admitted assets; provided, however, that aggregated
deposits (checking, savings and time deposits) held with any one bank shall not exceed 25% of total
admitted assets; Investments in company shares not exceeding 15% of total admitted assets; Investments
in real estate not exceeding 25% of total admitted assets; and 10% of total admitted assets in investments
of the insurance company’s choice.
In addition, Article 29 sub article 1 of the proclamation sets Restriction on loans, Advances, etc, by an
insurer. That is Unless provided otherwise by regulations and directives issued hereunder, no insurer shall
grant any loan, advance, financial guarantee or other credit facility either on hypothecation of property or
on personal security or otherwise, except loans on life policies issued by him within their surrender value,
to any shareholder of the insurer or to any director manager, actuary, auditor or officer working for the
insurer or to any insurance auxiliary or to any other person connected with the said persons.
Other regulations
 Re-Insurance:
In Ethiopia, reinsurance contracts are subject to supervision by NBE. The bank may give advice
and information about re-insurers but the task of monitoring (screening) the security of re-insurers
falls principally upon ceding companies, since it is up to them to choose their re-insurers.
 Amalgamation:
Article 40 requires that no insurer shall amalgamate with or takeover the insurance business of
another insurer except with the prior approval of the NBE.
Certification of Soundness of Terms of Insurance Business: According to Article 36:
1. The National Bank shall ensure that the terms of insurance policies safeguard the rights of policy-
holders, under the laws of Ethiopia.
2. At any time, the NBE may take any modifications to insure that premium rates, advantages, terms
and conditions offered are workable and sound.
Current regulations of Banking sector in Ethiopia
Banks control the payment system and government monetary policy is implemented through the banking
system. The huge mobilized funds from within and outside the country can be utilized in the economic
development through the banking system. Because of this and other special roles that these institutions
play in the financial system, they are highly regulated in Ethiopia-as it is true in other countries. The
general reasoning behind regulating Banks is almost the same as what we have tried to discuss for
insurance. Below are some of the basic regulations applicable to banks in Ethiopia.
According to proclamation No.84/1994, banking business shall mean any business that consists of:-
 Receiving funds from the public, through accepting deposits of money payable upon demand or in
a fixed period or by notice or any similar operation involving the sale of shares, certificates, notes,
or other securities.
 Using the funds received in whole or in part, for the account and at the risk of the person
undertaking the banking business and Buying and selling of gold and silver bullion and foreign
exchange.
1. Licensing Banks
  License for doing banking business is issued by the national Bank of Ethiopia if application is in
line with the provision of proclamation 84/1994 Article 3,4 and 5.
 According to Article 4 (sub article 2) the proclamation foreign national shall not undertake
banking business in Ethiopia.
2. Maintenance of Required Capital and Reserve requirement
As per the revised directive of SBB/No. 24/99 the minimum paid-up capital to obtain a banking business
license is birr 75,000,000. Because banks expand their activities every existing bank shall at all times
maintain minimum unimpaired capital of seventy five million birr to commensurate with the volume of
their business to withstand adverse effects, which shall be fully paid in cash and deposited in bank in the
name and to the account of the bank.
According to article 13(1) of the proclamation 84/1994, and directive 27/99, at the end of each fiscal year,
every bank shall maintain a legal reserve of not less than 25% (twenty five percent) of its net profit.
One of the important monetary policy instruments and prudential regulation tools is reserve requirement.
In this regard, according to article 16 of proclamation 84/1994 and directive No. SBB/37/2004 banks
carrying on business in Ethiopia shall maintain with the NBE a reserve account 5% (though now it is
increased to 15%) of all birr and foreign currency deposit liabilities held in the form of current, saving and
time deposits (this requirement is increased (changed) to 10% now).
3. Disclosure Requirement (Audit, Information, Inspection and Examination)
Article 18, 19 and 20 with their various directives of Proclamation 84/1994 are proclaimed in relation to
disclosure requirements. Accordingly, every bank shall appoint an independent auditor to report to the
shareholders of the bank upon the annual balance sheet and profit and loss statement, whether they exhibit
a true and fair statement of the Bank’s affair and the copy of the report shall be sent to the NBE not later
than 90 days after the end of financial year. Each bank shall send to NBE the duly signed Balance Sheet
every month within 20 days from the month from the closing of each financial year. In addition the NBE
may periodically or at any time, without prior notice make or cause an on-site inspection to be made of
any bank whether the inspected or examined bank has failed to comply with applicable laws or regulations
or with the terms and conditions of the license to carry on banking business in Ethiopia.
4. Limitation of the activities of Banks
The activities of banks are regulated by the government. According to proclamation No.84/1994, article
27 (1&2) without the prior written approval of the NBE, No person may acquire either directly or
indirectly in a bank a voting right exceeding 20% (Twenty percent) of the total capital. No bank shall
enter into any arrangement or agreement for the sale or disposal by amalgamation or effect restructuring,
dispose of the whole or any part of its property whether in or out of Ethiopia and other activities not given
by the provision of proclamation no 83/1994.
The overall open foreign currency position of each bank at the close of business day shall not exceed 15%
(fifteen percent) of its total capital.
To add one more activity limiting regulation of banks directive No. SBB/30/2002 states that the aggregate
sum of loans extended or permitted to be outstanding directly or indirectly to one related party and related
parties at any one time shall not exceed 15% (fifteen percent) and 35% (thirty five percent) respectively of
the total capital of the bank. The aggregate loan or extension of credit by a bank to any one borrower,
either a natural person or business organization at no time shall exceed 25% (twenty five percent) of the
total capital of the bank. Besides, Banks shall not extend loans to related parties on preferential terms with
respect to conditions, interest rates and repayment periods other than the terms and conditions normally
applied to other borrowers.
Penalties for Non-Performance
Because the fundamentals of these proclamations are to safeguard the whole economy and achieve
sustained economic growth through fostering monetary stability and sound financial system, not
to comply with it and/or with the directives would result in a consequence. As it is clearly indicated in
proclamation No. 86/2994, article 41/&7 and directive No. 27/2004, penalties could range from fine
in Birr and imprisonment up to cancellation of licenses.

The Regulation of Financial Markets & Institutions in

Ethiopia
According to a conventional view on the positive role of finance for growth, a good financial system
with
a well-functioning competitive market as well as a wee-supporting financial institution is an essential
ingredient for sustainable economic growth.
Developing sound Financial Markets requires the establishment of public confidence in the
institutions that constitute the Finance Sector. Confidence can only be maintained if these institutions
deliver services as promised. Thus one of the duties of Governmental Authorities is to preserve the long
term stability of the financial system and reliability of its components. Governments could do this using
different procedures and regulations.
Regulation of financial markets rests on the tenet that it serves the interest of the public by
protecting investors and guarding against systemic risk. With to investor protection, regulations maintain
that their oversight is justified on the grounds that investors are uninformed and unskilled. The initial
focus, and still the central element, of regulatory system is to solve the problem of the uninformed
investor through company disclosure and transparency of trading markets. Most people agree that
disclosure provides the information needed to make rational decisions. But regulation today goes far
beyond disclosure requirements, because a growing number of stakeholders are presumed to be unskilled
and incapable of making informed decisions.
The other basis for financial regulation is concern about systematic risk. Systemic risk arises if the failure
of one financial institution causes a run on other institutions and precipitates system-wide failure.
Regulation is said to be required because individual institutions do not adequately take account of the
external costs they impose on the financial system when they fail. But almost every aspect of financial
markets, if not daily living itself, involves systemic risk.
One of the most complex issues facing governments is identifying the appropriate level and form of
intervention. Regulatory efficiency is a significant factor in the overall performance of the economy.
Inefficiency ultimately imposes costs on the community through higher taxes and charges, poor service,
uncompetitive pricing or slower economic growth. Clearly there must be limits on the applicability of
this rational for regulation.
This chapter of the module considers the purposes and rational behind regulating financial market in
general. It looks in to the major and basic active regulations of Banking and Insurance operations in our
country. Besides, it sets out the different views for determining whether, where and how financial market
regulation should be applied.