The Five Parts of the Financial System
1. Money: Anything generally accepted as a means of payment or medium of exchange. It’s useful because you can exchange goods or services with it, either now or later (non-perishable, store of wealth. Contrast with, say, fish).
2. Financial Instruments: A written legal obligations of one party to transfer
something of value to another party at some future date under certain conditions. These obligations usually transfer resources from savers to investors. Examples: Stocks, bonds, insurance policies.
3. Financial Markets: Places or networks where financial instruments are sold quickly and cheaply Examples: New York Stock Exchange, Chicago Board of Trade and Nairobi Stock exchange.
4. Financial Institutions: Firms that provide savers and borrowers with access to financial instruments and financial markets. Among other services, they allow individuals to earn a decent return on their money while at the
same time avoiding risk. Exs.: banks, insurance companies, mutual funds, brokerage houses
5. Regulators: Government entity which monitors the state of the economy and conducts monetary policy. Example: central Bank of Kenya.
Flow of funds in a Financial system;-
Financial system ensure flow of funds through two mechanisms;-
i) Direct finance
ii) Indirect finance
Direct finance: – Borrowers borrow directly from lenders in financial markets by selling to them securities (financial instruments) shares, bonds, debentures Financial markets are critical for producing an efficient allocation of capital
which contribute to higher production Indirect finance: – Ensures movement of funds from lenders to borrows
through financial intermediaries.
Financial intermediaries
These are Financial institution (such as a bank, credit union, finance company, insurance company, stock exchange, brokerage company) which acts as the ‘middleman’ between those who want to lend and those who want
to borrow.
Importance of financial intermediaries
a) Reduction of transaction cost
They reduce transaction cost by taking advantage of economies of scale and expertise’s (skills in financial management). They ensure flow of funds from borrows to lenders at low cost.
They provide customers with services hence making it easier for customers to conduct transaction i.e. commercial bank facilities transactions in any
given economy
b)Risk sharing
Uncertainly due to variation in the returns of investment Financial intermediary through a process known as risk sharing ensure return in investment and also ensure diversification of portfolio.
The process of risk sharing ensures that there is low risk on investors’ assets.
This process of risk sharing is sometimes known as assets transformation. This is because risky assets are transformed into safer assets for investors.
c) Information Asymmetry
Financial intermediaries in any given economy ensures that investors have information that enables them to make accurate decisions, however there can be cases of individuals and firm having more information than other.
This is known as information asymmetry
Lack of adequate information created by information asymmetry causes two
problems in financial systems
1. Adverse selection
Problem created by asymmetric information before a transaction occurs, which makes potential borrows not to pay back the loan hence increasing credit risk. This makes lenders avoid lending even to credit worth customers.
Adverse selection makes the financial market to be inefficient
2 Moral hazard
It’s the problem created by information asymmetry after the transaction has occurred. Moral hazard in financial market is the risk that the borrower may engage in activities in order to avoid paying back the loan i.e. selling the
collateral.
