The Financial Sector
Topic Twenty-Seven

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The Financial Sector

The financial sector can be defined as the interaction of lenders and borrowers in financial markets within a regulatory framework. Key in this interaction is lending and borrowing of financial capital or money. This lending and borrowing is usually achieved through financial intermediaries such as commercial banks, brokers and other financial institutions.  Some of the main functions of the financial sector are:

  • mobilization of savings - financial intermediaries allow individuals to save money in a secured place, which can then be lent to firms and individuals in society;
  • providing loans (risk management) - financial institutions manage risk by lending to a large number of borrowers. This means that the risk is spread among a large section of the system.  This risk is managed by charging a higher rate of interest on the funds lend over the interest paid on deposits;
  • expert advice -  many investors may lack knowledge about investing and so financial intermediaries perform the role of providing advice to investors regarding the most suitable investment instruments to invest in.
  • facilitating the exchange of goods and services - this exchange of goods and services is usually facilitated by these financial intermediaries performing the role of middlemen. For example, when a consumer wants to purchase a pair of shoes, they can do so with their bank’s debit card. 

Financial Institutions

Financial institutions provide services of financial intermediation between lenders and borrowers. The financial institutions of most economies include: the Central Bank, commercial banks, stock exchange, insurance companies, credit unions, mutual funds, development banks, building societies and investment trust companies.

Role of a Central Bank

A Central Bank plays a critical role in the growth and development of a country. The main functions of a central bank include:

  • Issuer of notes and coins – the Central Bank is the only issuer of notes and coins in a country. No other entity performs this role.  The reason why the Central Bank is usually the sole issuer of notes and coins is for there to be confidence in the notes and coins;
  • Banker’s bank - the Central Bank is the facilitator of loans to commercial banks;
  • Government’s bank - the Central Bank acts on behalf of the government for all financial transactions. Additionally, if the government needs loans the Central Bank facilitates this;
  • Management of the economy – the Central Bank usually assists the central government in managing the economy through monetary policy;
  • Lender of last resort - if commercial banks get into liquidity shortages meaning that they cannot honour their financial obligations, then the Central Bank is able to lend the commercial banks sufficient funds to avoid the bank running short of money.
  • Financial regulator – in many countries the Central Bank is the regulator or supervisor of the financial system. This financial regulator monitors and supervises the performance of banks in accordance with established laws, guidelines and industry polices and best practices. The purpose of financial regulation is to engender confidence and stability in the financial system. 

Commercial Banks

Like a central bank, commercial banks play a very vital role in the growth and development of a country.  The main functions of commercial banks are:

  • Mobilizing Saving for Capital Formation - commercial banks help in mobilizing savings through network of branch banking. They allow citizens to deposit their monies into the commercial banks and pay these depositors a rate of interest. These commercial banks then use these deposits to lend to businesses and individuals in society.  By lending these monies, the commercial banks charge borrowers a higher rate of interest than the rate of interest that they pay to depositors.  The difference between the interest rate that commercial banks charge borrowers and the interest rate they pay to depositors for the use of their money is the profit to the commercial banks.  Therefore, by taking deposits from individuals, commercial banks are mobilizing savings which they lend to others which contribute to capital formation.
  • Financing Industry - the commercial banks finance the industrial sector by providing short-term, medium-term and long-term loans to industry.
  • Financing Trade - commercial banks also help in financing both internal and external trade. The banks finance both exports and imports of goods and services of countries by providing foreign exchange facilities to importers and exporters of goods.
  • Financing Consumer Activities - people in less developed countries being poor and having low incomes do not possess sufficient financial resources to buy durable consumer goods. The commercial banks advance loans to these consumers for the purchase of such items.

Stock Exchange

Some of the important functions of stock exchange are as follows:

  • Mobilization of capital – by allowing investors to be able to buy shares of listed companies and being able to allow sellers of shares to sell their shares on the secondary market, a stock exchange assists in the mobilization of capital and the efficient allocation of such capital;
  • Economic indicator – changes in economic conditions are reflected in the share prices of companies listed on the stock exchange. The overall measure of the activities on the stock market is known as a stock or financial index. Changes in this index can serve to indicate where the economy is heading;
  • Pricing of securities – the stock market helps to determine the value of securities. This is accomplished through the forces of demand and supply.
  • Contributes to economic growth – because stock markets assist in the mobilization of capital, they can contribute to economic growth and development. Investors can raise financial capital through the stock market because it may be cheaper than debt financing which is by borrowing.  Through raising capital on the stock market which is termed equity financing, investors will be able to own a part of the company and owners will pay these investors dividends on their investments.  This contributes to economic growth and development.

Insurance Companies

Insurance is a method of transferring risk or pooling risk where people pay a fee (premium) to insure life and property.  Insurance involves pooling funds from many insured entities to pay for the losses that some may incur.

Insurers make money in two ways:

  • Underwriting – underwriting is the process by which insurers select the risks to insure and decide how much in premiums to charge for accepting those risks,
  • Investing – insurance companies invest portions of the premiums they collect from insured parties.

The role and function of insurance therefore includes:

  • Protection against losses which economic agents may experience – any losses which may occur including fire, vehicular accidents, health, etc are fully insured through a premium.
  • Providing liquidity in the economy- when claims made by insured agents are honoured by insurance companies, this provides cash for insured persons to cover their losses.

Credit Unions

A credit union is a member-owned financial cooperative, democratically controlled by its members. The role and function of credit unions include:

  • Promoting thrift - credit unions encourage its member to save by giving attractive dividends on shares.
  • Providing loans – members are given loans at competitive rates based on the number of shares they own in the credit union.
  • Supporting community development - credit unions assist in sponsoring local community events as well as enhancing the physical appearance of communities.

Mutual Funds

A mutual fund is a professionally-managed trust that pools the savings of many investors and invests them in securities like stocks, bonds and short-term money market instruments.  Investors in a mutual fund have a common financial goal and their money is invested in different asset classes in accordance with the fund’s investment objective. Investments in mutual funds entail comparatively small amounts, giving retail investors the advantage of having financial professionals control their money.  Mutual funds are considered safer because it is diversified where investors have the opportunity to invest in equity indirectly.  This is safer in that it is an indirect way of being involved in the equity market. ***

Debt Financing

Debt financing involves borrowing from investors through the sale of bonds either by the government or private businesses. The borrowers are the government and private businesses who sell the bonds and the lenders are the investors who purchase the bonds.  This may be short term, medium term or long term in duration and investors receive interest payments (coupon payments) on their investment at specific intervals over a period of time and the principal amount at maturity.

Advantages of Debt Financing

The following are some advantages of debt financing:

  1. Short term needs – debt finance can easily be secured on a short term bases. This make it very advantageous to the small business as finance of this type can easily be secured for short term business needs.
  2. No future lender claims – lenders has no direct claim on future earnings
  3. Claims of ownership -  because the lenders do not own parts of the business that  borrowed the money, they have no ownership claims.

Equity Financing

Equity financing involves borrowing by firms from the public through the sale of shares or stocks of a company to shareholders. As such, the purchasers of the shares are part owners of the company and receive dividends on their shares. Equity is the portion of the company's assets that belongs to the owners or stockholders.

Advantages of Equity Financing

The following are some advantages of equity financing:

  1. No repayment- the major advantage of taking the route of equity to raise funds for the business is that the company is not required or bound to repay the amount of money. The investor buys a portion of the company and gets the proportionate share of the profits or loss as dividends
  2. Immunity- since investors share profits and loss, equity financing protects the company during times of economic downturn and limits the promoter’s loss.
  3. Better corporate governance-the law requires publicly listed companies to maintain appropriate records and hold regular general director meetings, audit their accounts, and follow other standard practices. This increases the quality of corporate governance and instills professionalism.

Government Bonds

A government bond is an instrument used by governments to borrow money for a long term funds for the purpose of financing projects.  It is one of the most secured types of investments available as the likelihood that the government will not repay its debt is very low. During the life of the bond, the government pays interest to bondholders and the principal amount borrowed is returned either at the end of the period or over some specified period. 

Treasury Bills and Treasury Notes

Treasury bills and Treasury notes are marketable securities issued by governments to raise financial capital for a short term.  When investors purchase these, they are lending money to the government.  Treasury bills or T-Bills are short-term debt obligations issued with a term of one year or less. Because they are sold at a discount from face value, they do not pay interest before maturity. The interest is the difference between the purchase price and the price paid at maturity (face value) or the price of the bill if sold prior to maturity. Treasury notes, on the other hand, are securities that have a stated interest rate that is paid semi-annually until maturity. What makes T-bills and bonds different are the terms to maturity. T-bills are issued in periods of less than one year while bonds are long-term investments with terms of even more than 10 years.

Corporate bonds

A corporate bond is a bond issued by a corporation in order to raise financing.  Companies use the funds they raise from selling bonds for a variety of purposes, from building facilities to purchasing equipment to expanding their business. When investors purchase a corporate bond, they are lending money to the corporation that issued it. The corporation promises to return investors’ money which is the principal on a specified maturity date. Until that time, it also pays the investor a stated rate of interest, usually semiannually.

Municipal Bonds

Municipal bonds are debt obligations issued by the local government level of government.  The funds raised from the issuance of these bonds are used for the maintenance of roads, bridges, etc.     When investors purchase a municipal bond, they are lending money to a state or local government entity, which in turn promises to pay investors a specified amount of interest (usually paid semiannually) and return the principal to investors on a specific maturity date.

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