ECO 327 Financial Institutions

1. Fundamental Concepts
(i) Financial markets are markets in which funds are transferred from people who have an
excess of available funds also called surplus units, savers-lenders to people with deficit savings also
called deficit units, borrowers-spenders.
There are two methods by which funds are channeled from savers to borrowers, and together the
two represent the flow of funds in the financial system. The two methods are Direct financing
and indirect financing.
In direct financing, borrowers (businesses, government, households and foreigners) borrow
funds directly from lenders (households, businesses, governments and foreigners) in financial
markets by selling them securities also called financial instruments.
Financial instruments or securities such as stocks are claims on the borrower’s future income
or assets. Securities are assets for the person who buys them, but they are liabilities (IOUs or debts)
for the individual or firm that sells (issues) them. For example, if Nigerian Breweries needs to
borrow funds to pay for a new factory it might borrow the funds from savers by selling them a bond,
a debt security that promises to make payments periodically for a specified period.
In indirect financing, savers lend their funds to financial intermediaries also called financial
institutions, who then lend to borrowers directly or via financial markets.
Financial markets, such as bond and stock markets, are crucial to promoting greater economic
efficiency. By channeling funds from people who do not have a productive use for them to those who
do. Indeed, well-functioning financial markets are a key factor in producing high economic growth,
and poorly performing financial markets are one reason that many countries in the world remain
desperately poor. Activities in financial markets also have direct effects on personal wealth, the
behavior of businesses and consumers, and the cyclical performance of the economy.
Structure of Financial Markets
Financial markets are categorized according to their essential features. The categories are,
(1). Debt and Equity markets
(2) Primary and Secondary Markets
(3). Exchanges and Over- The- Counter (OTC) market
(4). Money Markets and Capital Markets
(1). Debt and Equity markets
Debt and equity markets are distinguished based on the type of instrument traded. Debt markets are
markets for trading in debt instruments, while equity markets are markets where equity stocks are
traded.
Equities are securities that are claims to share in the income and assets of a business and include
common stocks and preference stocks. Equity stocks are long term securities, and have no maturity
dates. While a debt is a contractual agreement by the borrower to pay the holder of the instrument
agreed interest and principal as at when due.
The debt market involves both money market debt instruments and bond (capital) market
instruments. The maturity of a debt instrument is the number of years (term) until that instrument’s
expiration date. Based on date of maturity, debt instruments with maturity less that one year are
called short term debt, an example is the 90 day Nigerian Treasury Bills (90-Day NTBs). Debt
securities with maturity greater than one year but less than 10 years are medium term debt, while
long term debts have maturity equal or above 10 years. Equity securities have no maturity date.
(2) Primary and Secondary Markets
Primary Markets are markets in which corporations raise funds through new issues of securities
(stocks or bonds). The new securities are sold to initial investors (suppliers of funds) in exchange for
funds (money) that the issuer (user of funds) needs.
Types of New Issues in Primary Markets
1. Initial public offerings (IPOs): A primary market sale may be a first-time issue by private
firm going public (i.e., listing on the stock exchange and therefore, allowing its equity, some of
which was held privately by managers and venture capital investors, to be publicly traded in stock
markets for the first time). These first-time issues are also referred to as initial public offerings
(IPOs). Firms find listing on the Nigerian stock exchange attractive for several reasons, including,
improved marketability of the firm’s stock (making it more valuable); publicity for the firm, which
could result in increased sales; and improved access to the financial markets, as firms find it easier to
bring new issues of listed stock to the market.
2. Seasoned Equity Offering (SEO): Alternatively, a primary market sale may be a seasoned
offering, in which the firm already has shares of the stock trading in the secondary markets.
In both cases, IPOs and SEOs, the issuer receives the proceeds of the sale and the primary market
investors receive the securities. Like the primary sales of corporate bond issues, corporate stocks
may initially be issued through either a public sale (where the stock issue is offered to the general
investing public) or a private placement (where stock is sold privately to a limited number of large
investors).
Secondary markets
Secondary markets where stocks, once issued, are traded—that is, bought and sold by investors. The
Nigerian Stock Exchange (NGX) is an example of a secondary market in stocks. When a transaction
occurs in a secondary stock market, funds are exchanged, usually with the help of a securities broker
or firm acting as an intermediary between the buyer and the seller of the stock. The original issuer of
the stock is not involved in this transfer of stock or funds.
The secondary markets serve two important functions: Liquidity and price determination.
Liquidity: Secondary markets make it easier and quicker to sell financial instruments to raise cash;
that is, they make the financial instruments more liquid.
Price Determination: secondary determine the price of the security that the issuing firm
sells in the primary market. Investors who buy securities in the primary market will pay the issuing
corporation no more than the price they think the secondary market will set for this security. The
higher the security’s price in the secondary market, the higher the price that the issuing firm will
receive for a new security in the primary market, and hence the greater the amount of financial
capital it can raise.
(3). Exchanges and Over- The- Counter (OTC) markets
Exchanges and Over- The- Counter (OTC) are two ways for organizing secondary markets. In the
exchange, for example, the Nigerian stock exchange, NGX, The FMDQ Exchange, buyers and
sellers of securities (or their agents or brokers) meet in one central location to conduct trades.
The over-the counter (OTC) market is the other method of organizing a secondary market.
Dealers at different locations who have an inventory of securities stand ready to buy and sell
securities “over the counter” to anyone who comes to them and is willing to accept their prices.
(4). Money Markets and Capital Markets
Money and capital markets are differentiated based on the maturity of the securities traded.
The money market is the market for trading in short term funds while the capital market is for trading
in long term funds.
Money market transactions do not take place in any one particular location or building. Instead,
traders usually arrange purchases and sales between participants over the phone and complete them
electronically. Because of this characteristic, money market securities usually have an active
secondary market.
Purpose of Money Market: The well-developed secondary market for money market instruments
makes the money market an ideal place for a firm or financial institution to “warehouse” surplus
funds until they are needed. Similarly, the money markets provide a low-cost source of funds to
firms, the government, and intermediaries that need a short-term infusion of funds. Most investors in
the money market who are temporarily warehousing funds are ordinarily not trying to earn unusually
high returns on their money market funds. Rather, they use the money market as an interim
investment that provides a higher return than holding cash or money in banks.

The capital market in Nigeria dates back to the colonial period, when the British government to
finance development infrastructure and long term capital projects issued the First Nigerian
Government Registered Stock 1956/1961 managed by the Accountant-General. The Regulation and
structure of the market advanced with the creation of the Lagos Stock Exchange (LSE) on
September 15, 1960 and in 1958, the LSE opened for business with Nineteen (19) securities made up
of Three (3) equities, Six (6) FGN bonds and Ten (10) industrial bonds. In 1977, the LSE was
changed to the Nigerian stock exchange (NSE). On April 1, 1978 the Security and Exchange
Commission ( The capital market regulatory commission ) was established.
The capital market has two major sub-divisions, the bond market and the equity market.
Bond markets are markets in which bonds are issued and traded, while Stock markets are markets
where corporate stocks or equity are traded. Bonds are used to assist in the transfer of funds from
individuals, corporations, and government units with excess funds (buyers/holders of bonds) to
corporations and government units in need of long-term debt funding (Issuers/sellers of bonds).
Stocks facilitate equity investment into firms and the transfer of equity investments between
investors.
(ii) Financial institutions: Financial institutions also called financial intermediaries are what
make financial markets work. They are the agents in financial markets that enable movement of
funds from people who save to people who have productive investment opportunities. FIs Include
banking financial intermediaries, and investment or non-bank financial intermediaries, all of which
are heavily regulated by the government. Banking Fis include commercial banks, savings and loan
associations, mutual savings banks, credit unions and Investment financial institutions include
investment banks, insurance companies, mutual funds, pension funds, and finance companies.
Why do financial institutions exist?
Three main reasons why financial institutions exists are as follows,
Different Requirements of Lenders and borrowers
Transaction Costs
Problems arising from information asymmetry.
(iii). Financial System
The financial system is complex, a mix of different types of private-sector financial institutions,
markets and instruments. The financial markets, institutions and instruments facilitate financial
intermediation. A direct lending, a process where a surplus unit makes a loan to the general
manager of Nigerian Breweries for example, is not the practice in modern financial systems. Rather,
the surplus unit would lend to Nigerian Breweries by purchasing a Nigerian Breweries security
issue in the financial market, or lend indirectly through financial intermediaries, that borrow funds
from people who have saved and in turn make loans to others. The financial system thus, plays a key
role in economic growth and development.

(iv) Why Study financial markets and Institutions?

Activities in financial markets have direct effects on individuals’ wealth, the behavior of businesses,
and the efficiency of our economy. Three financial markets deserve particular attention: the bond
market (where interest rates are determined), the stock market (which has a major effect on people’s
wealth and on firms’ investment decisions), and the foreign exchange market (because fluctuations in
the foreign exchange rate have major consequences for the Nigerian economy). Specifically,
1. Interest rates are determined in the bond market. How interest rates behave is an important
input in decision taking by individuals, households and businesses. Also, stock prices in the
stock market have a major effect on people’s wealth and on firms’ investment decisions, and
fluctuations in the foreign exchange rate in the foreign exchange market have major
consequences for the economy.
2. Also, monetary policy conducted by central banks affects interest rates, inflation, and
business cycles, (factors that have important impact on financial markets and institutions). we
need to understand how monetary policy is conducted by central banks in the Nigeria.
3. Banks and other financial institutions channel funds from people who might not put them to
productive use to people who can do so and thus play a crucial role in improving the
efficiency of the economy.
4. Understanding how financial institutions are managed is important because there will be
many times in your life, as an individual, an employee, or the owner of a business, when you
will interact with them.

Some Review Questions

1. Financial instruments are a means of direct financing, Explain

2. Distinguish between financial markets, financial institutions and instruments
3. Examine the structure of financial markets.
4. List and explain the reasons why financial institutions exists.