Section 4 – The Financial Sector

The Financial system- is a network of formal and informal, savers, investors and financial institutions that work together to transfer the money saved by people to investors.

Financial Intermediaries (middle-men) The Financial System The direct flow The Indirect flow Owners of excess money (SAVERS) Households, Businesses and Government Finance Markets People who need money to borrow Households, Businesses and government Financial Intermediaries (middle-men)

The financial sector- this refers only to the FORMAL yet complex network of markets, households, businesses, governments, laws and institutions interacting with one another.

The role of the financial sector The financial sector organizes the financial markets that operate within it. Savers lend money and investors and borrowers use this money. The reward that savers get is called their interest and this is also the money that people pay to borrow money. The financial sector ensures that people who are borrowing pay a rate that is profitable to lenders. The financial sector works to increase consumption and investment in the economy.

The Functions of the Financial Sector It must encourage savings. It must lend savings to investors and make a profit from it. Ensures that banks, insurance, stock markets and governments work in total harmony. Provides support for organizations so that they succeed. Provides short-term loans to firms so that they can cover their expenses. Liquidity deals with how well a firm’s revenue can cover its expenses.

The Informal Sector This refers to economic activities that are not officially regulated by government. These activities are not governed by the laws of the financial sector and government. These activities are not necessarily illegal. This causes the government to lose income in the form of taxes. For example: a family partnership.   Operations of the Informal sector It provides jobs and provides opportunities for people. Plays important role in reducing poverty especially in developing countries.

Characteristics/ Features of the Informal sector This sector may consist of two categories of people: People doing temporary jobs or multiple jobs or those engaged in subsistence farming. People engaged in illegal activities and who are trying to evade taxes.

Why is the Informal sector so prosperous? Because it is easy to enter it. Because it is unregulated and very competitive.

MONEY

The Development of money Human beings engage in economic activities to satisfy their basic needs. In earlier times people only provided enough for their own consumption and to satisfy their personal needs, this is called subsistence economy/living.

Barter As people began to produce more and more at times they realized they had a surplus/excess. This caused people to start trading with each other. Barter is direct exchange of goods and services without the use of money. For example: a cow may be swapped for some chickens.

Problems with the Barter system Double coincidence of wants – A person had to find someone who wanted what they had and who is also offering what they themselves want. For example: if I had a cow and want some chickens I would have to find someone who wants a cow and is offering me chickens at the same time. This extremely difficult at times. Divisibility of goods – some rates of exchange made it difficult for exchange to take place because the goods cannot be divided into smaller parts. For example: if a live donkey is worth 20 chickens and I came across a person who only has 10 chickens it would not be possible for trade to take place because a half donkey cannot be kept alive. Storage of wealth – It was impossible for certain goods to be kept for a long period of time as they would spoil. This means it would be extremely difficult to accumulate riches. Due to the above faults of the barter system, the development of money took place.

What is money? Money is any commodity that is widely accepted as a medium of exchange and can be used to pay for goods and bills. Money does not have to be in the form of notes and coins. In earlier times gold, silver, beads, shells, etc were used as money.

Qualities/Characteristics of Money In order for a commodity to be accepted as money it must have the following features: Acceptable- Must be easily recognized or fiat. This is also called legal tender. Durable – Money must be able to last a very long time. This means it should not wear out easily. Divisible – This means it should be easy for money to be broken down into smaller units. Portable – money should be very lightweight so it can be easily carried around.

Functions of Money A medium of exchange – Money makes the exchange of goods easier. This is the most important function of money. This function of money eliminates the problem of double coincidence of wants. A measure of value – Money can be used to state the prices of goods. In other words it helps to place a value on items. A store of value – This means money can be stored for use in the future. This could be used in the future for payments, etc. A standard of postponed payments – This means money can be spent before it is earned. For example: you may purchase something on credit and pay at a later date.

Money Supply The amount of money available to the general public makes up the money supply. This includes the total amount of notes + coins + bank deposits + deposits in other financial institutions that are circulating in the economy. Not all this money is available to the public at one time because regulations require that certain amount of money be held for a period of time in banks, etc

The role of the central bank and other financial institutions Commercial Banks Stock exchanges/markets Development Banks Insurance companies Mutual funds Building Societies Informal Credit institutions

The Central bank this is the government’s bank. The government uses this bank to implement its economic policies to benefit the entire country.

Functions: The central bank collects taxation on behalf of the government. It makes payment on behalf of the government and manages the national debt. It controls the money supply and also the interest rates. It is the only institution authorized to print money on behalf of the government. It is also a lender of last resort for the government and other banks. They lend money in order to prevent smaller banks from failing. It supervises the activity of commercial banks.

  Commercial Banks this is an institution that is engaged in day-to-day banking activities. These are owned by private shareholders and offers services to businesses and individuals. A commercial bank buys money in the form of savings and sells money by making loans out of the deposits. In order to make a profit the commercial bank will pay a lower rate of interest on deposits and collect a higher rate from borrowers.

Functions: It provides a safe place to store money. Can make payments on behalf of customers. Buys and sells shares on behalf of customers.

Stock exchanges/markets this is an institution that allows the purchase and sale of share by public companies. In most countries this is done by smaller agents known as stockbrokers who buy and sell on behalf of their clients. For example: JMMB and Mayberry Investments.

Functions: Allows public companies to raise new capital. Provides protection for investors as companies need to have a good reputation to be on the stock market. Allows public companies already on the stock market to raise additional capital.

A person’s ability to speculate is of great benefit in the stock market. This is done as investors try to forecast movements in the market. There are three types of speculators: Bulls, Bears and Stags

Bull this type of investor forecasts an increase in the price of shares. Therefore, he buys them when the price is low and sells them when the price is highest.

Bear This type of investor forecasts a decrease in the price of shares. Therefore he will sell the shares when the prices are high and buy again when price is lowest. Markets are classified either into ‘bull markets’ or bear markets.

Stag this is a short term investor who quickly enters the market, buys shares and resells them quickly to make a profit.

  Development Banks these banks grant assistance to all economies in areas such as agriculture, housing, transportation, etc. For example: The World Bank/International Bank for reconstruction and Development provides money to developing countries in the form of loans, etc. Its main focus is on reducing poverty and improving the standard of living.

Insurance companies Insurance is the transferring of a present risk facing a person to a group of persons who pool their money together. This is done because unexpected events occur and at times individuals may not be able to afford it.

Guiding principles: Insurable risks – risks are either insurable or non-insurable. Only risks that can be calculated will be insured by insurance companies. They must be able to estimate the chances of an event occurring. There must also be a lot of people who want to be insured from that risk so that the resources can be pooled. Pooling of risks – The amount of money people pay for insurance is called a premium. When each client pays their money it is used to cover the expenses of the unfortunate client who suffers loss. Indemnity- this requires that an individual be compensated for the amount they lost. Therefore you will only receive the exact amount that you lost. Proximate cause- this states that a claim will only be paid if the property is damaged only by the risk it was insured against. For example if your care is insured against motor vehicle accident and it gets washed away you would get no money.

Types of Insurance Life insurance – benefits in the event of death. Non-life insurance – Protection of other items such as motor vehicles, boats and cargo.

The roles of insurance: Encourages people to take risks and invest as they are covered. Encourage international trade as producers are able to recover losses in the event of an accident. Helps people cover expenses they would not be normally able to afford.

Mutual funds this is where many investors come together and combine their money and invest in shares/stocks. These funds are managed by professionals.

Building Societies these institutions lend long term loans to individuals. They mostly lend money for individuals to purchase homes. E.g. VMBS

Informal Credit institutions This is where persons in a community pool their funds in the form of Partner or meeting turns. People contribute a small amount of money and receive a much larger sum in their ‘partner draw’.

Types of Financial Markets Primary markets – these are used for the selling of new bond and shares to investors. New companies wanting to raise capital issue share on the primary market.   Secondary markets – this market allows people to sell ‘used’ items for cash. For example the sale of ‘used’ motor vehicles.

Types of Financial Instruments Financial instrument – is a certificate that shows that a debt has been brought into existence. These are also called securities and include: bills, bonds, stocks, certificates of deposit, etc. A Bill is an IOU (I owe you) for a short term loan. When this money is lent to the government it is called a treasury bill. A Bond is a contractual commitment of a borrower to pay interest to the lender for a fixed number of years. After this time is finished the lender is paid the FACE Value of the bond. The lender is known as the bondholder.

Treasury Bills, Notes and Bonds These are all loans lent to the government by private individuals. These are investments because the lender receives interest. The government must pay the face value when the loan matures.

Treasury bills These are short-term loans lent to the government. The interest rate on this instrument is not fixed by the government, banks bid and the government chooses the best rate. This money is part of the national debt. The government usually has up to 90days to repay.

Treasury notes these are medium term loans lent to the government. These are considered risk free as the government will most likely repay. Unlike the Treasury bill, the government has a fixed rate of interest on these notes. When the note matures, the government pays the face value. The government has between 1-10 years to repay.

Treasury bonds these are medium- long-term loans lent to the government. This money is part of the national debt. The government repays the full loan and the interest when the bond matures. The government usually has from 10-30 years to repay.

Other Instruments Corporate Bonds – these are long-term IOU’s issued by companies and is a claim against their assets. These earn a fixed rate of interest that must be paid whether or not the company is making a profit. These have a maturity date from 5-30 years. Municipal Bonds- these are long term debts owed by Local government. This money is usually borrowed to build roads, schools, etc. Equity Securities- Recall that equities are ordinary shares/common stock/equities securities in a company and are a claim on the company’s assets. These shares do not have a fixed rate of interest. When profits are high they may receive more dividends but if profits are low or if the company makes a loss they may receive no dividends.

Please study Section 3 and 4 for test next class.. End of Section 4 Please study Section 3 and 4 for test next class..