Financial System & Microfinance Textbook Overview

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CHAPTER ONE
AN OVERVIEW OF FINANCIAL SYSTEM
1.1 INTRODUCTION
Finance plays a key role in the part of economic and business activities of the country.
Systematic and efficient flow of finance is needed to efficient and effective management of the
business concern. Arrangement of finance to required business concern, should be properly
maintained and channelised through regulated institutions and markets. In Cameroon, with the
effect of the new economic policy, emerging needs of financial institution and markets should be
looked after. The world financial system has developed constantly and successfully to infuse the
new blood to the economic development of the nation. Hence, the economic growth and
development is purely based on the regulated and well established financial system of the
country.
 Financial system provides a transmission mechanism between saver-lenders and
borrower-spenders.
 Savers benefit—earn interest
 Investors benefit—access to money otherwise not available
 Economy benefits—efficient means of bringing savers and borrowers together
1.2 The origin of financial system
Ancient Babylonians began their relatively complex counting system around 3,000 B.C. About
one thousand years later, they had developed banking activities sufficiently complex to require
written standards of practice. Medieval European banking, the predecessor to modern financial

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activities, began in Italy, and centered on individual families, like the Medicis, and individual
cities like Florence, Venice and Genoa. As financial historian Fernand Braudel has described in
great detail, once a counting system exists, financial transactions occur. The financial apparatus
for that system, at first transitory and local (town markets and fairs), stabilizes and spreads
outward. The longer time-frame and wider reach of these financial transactions begin to require
systemic organization. Then came the creation of banks, financial markets, insurance companies,
and other components of a financial system. What then do these financial systems do?
1.3 WHAT IS A FINANCIAL SYSTEM?
In finance, the financial system is the system that allows the transfer of money between savers
(/and investors) and borrowers. It can operate on a global, regional or firm specific level..
According to Gurusamy”s opinion in his book titled, Financial Services and Systems has
described it as comprising "a set of complex and closely interconnected financial institutions,
markets, instruments, services, practices, and transactions."
In strict terms, financial system consists of financial markets and financial institutions. In a
broader view, financial assets and instruments, economic agents (individuals, households, and
firms), governments and central banks are also parts of the financial system. There are two types
of financial systems: bank based and market based financial system, in a bank based financial
systems, banks play a crucial rule in the allocation of loanable funds while in the market based
financial system, there is reliance on the financial markets on the allocation of loanable funds.
However, Allen and Gale in their book titled Comparing Financial Systems define a financial
system by their very peculiar functions:
"Financial systems are crucial to the allocation of resources in a modern economy. They channel
household savings to the corporate sector and allocate investment funds among firms; they allow
intertemporal smoothing of consumption by households and expenditures by firms; and they
enable households and firms to share risks. These functions are common to the financial systems
of most developed economies. Yet the form of these financial systems varies widely." Financial
systems depend on the countries viewpoint on freedom of trade. Some countries i.e. The Soviet
Union had socialist financial systems because they value centralized organized state funded
trading rather than freedom of trade by everyone. Allen and Gale went further by looking at the
purpose of a financial system and wrote that:
The purpose of a financial system is to channel funds from agen t s with s ur- pluses to
agen t s with deficits. They brought forward t wo approaches to analyzing the process that
takes place in a financial system.
1. The fi r s t is to consider how a g e n t s interact through fin anci al markets.
2. The second looks at the operation of financial i n t e r medi a r ies such as banks and
insurance companies.

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Looking at the definition of Allen and Gale it would be worthwhile defining who agents of a
financial system are. Economic agents are any individuals, institutions or groups of institutions
that play a part in any economic circuit through their rational actions and decisions.
1.4 Six major functions of the financial system
– Providing payment services
– Matching savers and investors
– Generating/distributing information
– Allocating credit efficiently
– Pricing, pooling, and trading risks
– Increasing asset liquidity
The role of the financial system to the economy
.1. Providing payment services: It is inconvenient, inefficient, and risky to carry around enough
cash to pay for purchased goods and services. Financial institutions provide an efficient
alternative. The most obvious examples are personal and commercial checking and check-
clearing and credit and debit card services; each are growing in importance, in the modern
sectors at least, of even low-income countries.
2. Matching savers and investors. Although many people save, such as for retirement, and many
have investment projects, such as building a factory or expanding the inventory carried by a
family micro enterprise, it would be only by the wildest of coincidences that each investor saved
exactly as much as needed to finance a given project. Therefore, it is important that savers and
investors somehow meet and agree on terms for loans or other forms of finance. This can occur
without financial institutions; even in highly developed markets, many new entrepreneurs obtain
a significant fraction of their initial funds from family and friends. However, the presence of
banks, and later venture capitalists or stock markets, can greatly facilitate matching in an
efficient manner. Small savers simply deposit their savings and let the bank decide where to
invest them.
3. Generating and distributing information. One does not always think of it this way, but from a
society wide viewpoint, one of the most important functions of the financial system is to generate
and distribute information. Stock and bond prices in the daily newspapers of developing
countries (and increasingly on the Internet as well) are a familiar example; these prices represent
the average judgment of thousands, if not millions, of investors, based on the information they
have available about these and all other investments. Banks also collect information about the
firms that borrow from them; the resulting information is one of the most important components
of the "capital" of a bank, although it is often unrecognized as such. In these regards, it has been
said that financial markets represent the "brain" of the economic system.

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4. Allocating credit efficiently. Channeling investment funds to uses yielding the highest rate of
return allows increases in specialization and the division of labor, which have been recognized
since the time of Adam Smith as a key to the wealth of nations.
5. Pricing, pooling, and trading risks. Insurance markets provide protection against risk, but so
does the diversification possible in stock markets or in banks' loan syndications.
6. Increasing asset liquidity. Some investments are very long-lived; in some cases - a
hydroelectric plant, for example - such investments may last a century or more. Sooner or later,
investors in such plants are likely to want to sell them. In some cases, it can be quite difficult to
find a buyer at the time one wishes to sell - at retirement, for instance. Financial development
increases liquidity by making it easier to sell, for example, on the stock market or to a syndicate
of banks or insurance companies.
Both technological and financial innovations have driven modern economic growth. Both were
necessary conditions for the Industrial Revolution as steam and water power required large
investments facilitated by innovations in banking, finance, and insurance. Both are necessary for
developing countries as they continue their struggle for economic development. But the effective
functioning of the financial system requires, in turn, the precondition of macroeconomic
stability.
1.5 COMPONENTS OF A FINANCIAL SYSTEM
Financial system is the basic concept for the industrial development of the nation. Financial
system provides adequate and smooth flow of finance to the needed parts. Cameroon financial
system consists of the four important components such as:
• Financial Institutions
• Financial Markets
• Financial Instruments
• Financial Services.
Financial system implies a set of complex and closely connected or intermixed institutions, agent
practices, markets, transactions, claims and liabilities in the economy.
The financial system is concerned about the money, loan and finance. These three parts are very
closely interrelated with each other and depend on each parts.

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Financial System
Financial
Institutions
Financial
Markets
Financial
Services
Financial
Instruments
Fig.6.5
Financial System