So What Is a Financial System?

Before we talk about the financial system, let us talk about money and its origins in Nigeria.

Money has not always been what we now know as money. Different things have served as money over the years, including salt, corn, and rice. In pre-colonial Nigeria, cowries were used as money. Precious metals like gold and silver served as money before the paper money that we all know.

Have you ever thought about what makes money, money?

For anything to be considered money, it must be accepted by everyone as money. Money must also be scarce. If everyone had money, then no one would desire it, and it would no longer be money.

What do you need money for?

Money is used to get other things you do not have. Hence, money is referred to as a medium of exchange. Before money existed, you could only get what you want by exchanging a possession of your own for it. This system of exchange was called barter. You exchanged your yam for someone else's cassava. If you could not find someone with cassava who wanted your yam, then you could not get cassava. Money simplified things by making it possible for you to sell your yam to whoever wanted a yam, and then use the money to buy cassava.

Money is also used as a unit of measurement. Everything you buy is measured in terms of money. A hundred-naira food item is expected to be smaller than a five-hundred-naira food item. A woman who has a million naira in a bank account is considered richer than a woman with just a hundred thousand naira.

Money is also used to store value. You can save a hundred thousand naira in a bank now, and spend it in a year's time. Provided there is no increase in the prices of goods and services (referred to as inflation in economics), your hundred thousand naira will buy almost the same quantity of items one year from now as it would today.

With money, you can buy an item today and pay later. You can buy a phone today for twenty thousand naira and pay in six months' time. This is possible because of the use of money as a store of value.

The financial system exists because of money. So what is the financial system?

The financial system is the process that allows the exchange of money between those who have money and those who do not. Those who have money are called savers or investors in a financial system. Those who do not have money are referred to as borrowers or issuers. Exchange of money in the financial system is done through financial institutions like commercial banks or lenders, investment banks, asset managers, finance houses, and stock exchanges, among others.

Money moves around the financial system from a point of excess or surplus to a point of lack or deficit. So in the financial system, money moves from people and companies that have more money to people and companies that do not have enough money.

Savers or investors supply money to the financial system. Issuers or borrowers demand money from the financial system. Financial institutions act as intermediaries, linking those who have excess money (the supply side) with those who do not (the demand side), in a place called the financial market.

A financial system thus serves these main purposes:

• provides a way for individuals and organisations to pay for goods and services

• ensures money retains value over time

• provides a way for people, organisations, and government to reduce the risk of holding money and also to make some additional money from their investments

• provides a platform for the most efficient use of scarce resources

• provides a way for value to be measured through a pricing system.

Test Your Knowledge

1. What are those on the supply side of the financial system called?

2. What are those on the demand side of the financial system called?

Activity

Find out all the denominations of money in Nigeria. Discuss which denominations are no longer widely accepted by Nigerians and why.

This Is the Financial Market

The financial market is like your local market. The major difference is that in your local market, you only buy items that you can see and touch, like tomatoes or yams. In the financial market, you buy things that you cannot see and touch, like bonds and stocks. These are called financial assets.

As evidence that you own a financial asset in the financial market, you are often given a piece of paper or other form of documentation. For example, when you buy the shares of a company, you are often given a share certificate or an electronic receipt as evidence of your shareholding.

The financial market is where those who lack money meet those who have excess money. People who need money from the financial market include entrepreneurs who are about to start a business, existing businesses, institutions, and governments. Those who have excess money in a financial system include individuals like you and me; institutions; firms set up primarily to invest in other companies, like private equity firms; and even the investment arms of governments.

A financial market is said to be efficient when it provides liquidity. Liquidity is how easily or quickly those who own financial assets can sell them, and how easily and quickly those who want to buy financial assets can find them to buy. If it is easy to buy and sell financial assets, then the financial market is liquid.

Two key requirements of financial markets are;

• Pricing: A financial market provides information about the prices of all financial assets traded in the market. This information is not a secret; it is known to everyone in the financial market. Price is a good indicator of value of a financial asset in the financial market.

• Fairness: A financial market must not only be fair but must also be seen to be fair. Every person trying to buy and sell financial assets in the financial market should be given equal treatment. All participants must be given equal opportunity to buy or sell an asset at the price known to everyone.

It is a crime in the financial market to take advantage of information that is not known to everyone and benefit from such information. This crime is called "insider trading," and people have been jailed because of it.

Test Your Knowledge

1. What is bought in the financial market?

2. What is the difference between a financial market and your local market?

Activity

Have a class discussion on the importance of price and how it is determined.

The Twin Daughters of the Financial Market

The financial market has two sides: the money market and the capital market. The difference between these markets is the length of time that lenders are willing to lend and borrowers can keep the borrowed money.

The Money Market

The money market is the short end of the financial market. It is called short end because money can only be borrowed or lent for short periods of time.

In the money market, investors can only borrow money for short periods of time — usually from one month to twelve months. In this market, the most important player is the Central Bank of Nigeria (CBN), with the commercial banks and related financial institutions like finance houses, discount houses, and microfinance banks also playing a role.

A well-functioning money market performs several functions.

• It ensures that those who need short-term loans are able to get them easily, while those who want to make short-term investments can also do so easily.

• It sets the price, also referred to as the interest rate, for borrowing for the short term. This price should not be excessive, or else it will discourage those who need money from accessing it.

• The Central Bank should be able to intervene in the money market easily by either selling or buying treasury bills in a way that controls the amount of money in the economy.

The Capital Market

In the capital market, money can be borrowed or invested for medium to long periods of time, ranging from about twelve months to forever. The players in this market include investment or merchant banks, issuing houses, stockbrokers, pension funds, insurance firms, and mortgage banks, among others. In, Nigeria, the Securities and Exchange Commission (SEC) is the main regulator in this market, ensuring that everyone plays by the same rules and regulations.

A well-functioning capital market fulfils these purposes:

1. It provides a platform that links medium- to long-term investors with entrepreneurs or businesses looking for medium- to long-term funds.

2. It provides sufficient information about investment opportunities, options, and their prices to all investors.

3. The market is fair, transparent, and competitive for all investors.

Test Your Knowledge

1. What are the two sides of the financial market?

2. What is the difference between these two sides of the market?

Activity

Invite a bank manager and stock broker to discuss the money and capital markets with the class.

The bank manager should discuss the importance of liquidity in the money market. The stock broker should discuss why a capital market must be seen to be fair, transparent, and competitive.

Revealed: All the Players in the Financial System

There are four main participants or players in a financial market. These are:

* savers and investors

* borrowers and issuers

* a financial institution

* a regulator.

Savers and Investors

Savers and investors operate at the surplus end or supply side of the financial market. They can be individuals like you and me, institutions like private equity or investment firms, or even governments with excess money. Investors or savers are willing to invest or save now in order to earn higher returns at some future date.

Savers participate in the financial market when they approach a bank to save some part of the money they have, on the promise that they will be paid an interest rate on the money deposited.

Investors, on the other hand, buy financial assets like stocks or bonds. Investors who buy shares expect to be paid dividends, while investors who buy bonds are paid a stated interest rate, usually called a coupon.

When savers or investors deposit money in a bank or buy stocks or bonds in the capital market, they are participating in the financial market as suppliers of funds.

Savers and investors are promised a certain higher amount of money at a future date. The promise of this return must be attractive enough to make them give up the option of spending their money immediately.

The promised return should be high enough to compensate for the expected inflation – the rise of prices of goods and services over time &8211; for the period during which the saver or investor is deprived of his or her funds.

The promised return to savers and investors must also compensate for the time value of money. The time value of money explains why a naira today is more valuable than a naira earned tomorrow: the naira earned today can be invested today to start earning interest or return, while tomorrow's naira can only be invested tomorrow. For a naira today to be more valuable than a naira tomorrow, the naira today must start to earn interest today.

All interest rate and investment conditions being equal, tomorrow's naira cannot earn as much return as today's naira. For example, if someone promises to give you N100 today, and another person promises you N100 a year from today, which is more valuable?

If you take the N100 today and save it in a bank at 5 per cent interest rate, it will be worth N105 in a year's time. But if the person gives you N100 a year from today, you will have lost that N5 of interest you could have earned.

Borrowers and Issuers

Borrowers and issuers operate on the deficit or demand side of the financial market. They are like the buyers in your local market. They buy money from the financial market.

Example of borrowers are individuals looking to borrow money to meet personal needs, entrepreneurs looking to borrow money to create their businesses, or companies looking to borrow money to run or expand their businesses.

Issuers are mainly companies, institutions, and governments that come to the capital market to borrow money by issuing bonds and debentures, or to raise money by issuing shares.

An investor who buys a company's shares becomes a part owner of the company and will be paid dividends and also benefit from capital gains, that is, an increase in the share price of company, if the company's operations are profitable. But sometimes companies are not profitable. This will result in a drop in the company's share price and a loss for the investor or holder of that company's shares. An investor who buys a company's bond becomes a lender to the company. A bond holder cannot claim to own part of the company. He or she will earn interest, which will be stated on the bonds bought.

Companies, institutions, and governments all can issue bonds when they want to borrow money from the capital market. In Nigeria, bond holders are paid interest every six months by the bond issuer, in June and December. The interest rate to be paid, called the coupon, is stated at the time of bond issuance, or sometimes determined during the bond issuance process.

Most bonds are paid back over a period of time, such as five years. If the bond is issued for five years, then at the end of the fifth year, the bondholder will be paid the interest and the principal, which is the initial amount invested in the bond. Bonds can be issued for any length of time – five, seven, ten, twenty, or thirty years, and even in perpetuity.

Investors in shares, on the other hand, are paid cash dividends once a year, usually at the end of the company's financial year. Some companies also issue bonus shares. Bonus shares are extra shares given for free to existing shareholders, based on the number of shares they already own in the company.

Financial Institutions

Financial institutions are the middlemen or intermediaries in the financial market. They facilitate all the transactions that take place in the financial system. They are the link between the surplus and deficit ends of the financial system. Financial intermediaries link savers to borrowers and investors to issuers. Without financial institutions, it would be very difficult for the supply side of the financial system to deal with the demand side, unless they engaged in trade by barter, as was done before the advent of money.

Examples of financial institutions in the Nigerian financial system are commercial banks, merchant banks, mortgage banks, insurance companies, pension funds, issuing houses, investment companies, stockbroking firms, and finance houses.

Regulators

The regulator in the financial market is like the referee on the football field. The regulator ensures that everyone in the financial market plays according to established rules. That way, the financial market works the way it should.

The regulator is the impartial umpire, intervening in the financial system to ensure that all players carry out their functions according to laid-down regulations and in line with the terms of their licenses.

The regulator ensures that the lenders and the borrowers in the financial system operate legally. The borrower must ultimately repay money to the lender according to the agreed interest or dividends.

Examples of regulators in the Nigerian financial system are the Central Bank of Nigeria (CBN), the Securities and Exchange Commission (SEC), the Nigerian Insurance Commission (NAICOM), the Pension Commission (PENCOM), and the Nigeria Deposit Insurance Corporation (NDIC).

Test Your Knowledge

1. What is a coupon?

2. An investor who buys a company's shares is rewarded with what?

3. Name examples of regulators in the financial system.

Activity

Invite an official from any of the regulatory bodies mentioned above to come and discuss his or her role in the financial system.

Divided the class into groups and engage in a debate about which of the players in the financial market is the most important. Each group marshals points to support its position. The teacher can decide which group put forward the best argument