CHAPTER ONE

AN OVERVIEW OF THE FINANCIAL SYSTEM

1.1) Introduction to the Financial System and Economy;
Financial system is the collection of markets, institutions, laws, regulations and techniques through which bonds,
stocks and other securities are traded, interest rates are determined and financial services are produced and
delivered. It is a set of complex and closely connected institutions, directives, agents, practices, markets,
transactions, claims and liabilities relating to financial aspects of an economy. It is the scheme which established
for the purpose of providing a standard/regular, smooth, effective and efficient linkage between surplus units
{lender} and deficit units {borrower} in the economy. It is a mechanism that allows people to easily buy and sell
financial assets (such as; stocks and bonds) in the financial markets.

Financial system is a system which provides a mechanism whereby an individual unit (which may be a household
or firm) that is a surplus spending unit (SSU) or surplus budget unit (SBU) may conveniently make funds available
to deficit budget unit (DBU) or deficit spending unit (DSU) who intends to spend more than their current income.
Thus, „surplus spending units (SSU) are those households and firm whose income exceeds their spending. That
means, SSUs spend towards consuming goods and services less than their current income and they have surplus
funds to buy investment goods which may be real or financial assets. While, deficit spending units (DSU)‟ are
those households and firms whose spending exceeds their income. Obviously, the DSUs have deficit and they need
to find means to finance their deficit.

The objective of all economic activity is to promote the well-being and standard of living of the people, which
depends on the income and distribution of income in terms of real goods and services in the economy. The
production of output, which is vital to the growth process in the economy, is a function of the many inputs used in
the productive process. These inputs are material inputs (in the form of physical materials, viz., raw materials,
plant, machinery, etc.), human inputs (in the form of labor and enterprise) and financial inputs (in the form of
capital, cash and credit). The easy availability of financial inputs promotes the growth process through proper
coordination between human and material inputs.
MATERIAL INPUTS HUMAN INPUTS FINANCIAL INPUTS

PRODUCTION OUTPUTS
The financial inputs emanate from the financial system, while real goods and services are part of the real system.
The interaction between the real system (goods and services) and the financial system (money and capital) is
necessary for the productive process. Trading in money and monetary assets constitute the activity in the
financial markets and are referred to as the financial system.
Finance – at the micro and macro levels;
Finance at micro level; finance is the study of the financial or monetary aspects of the production,
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 spending, borrowing, and lending decisions. It deals with the raising and using of money by
individuals, firms, governments, and foreign investors. In this context, finance deals with how
individuals manage money.
Finance at macro level; finance is concerned with how the financial system coordinates and
channels the flow of funds from lenders to borrowers and vice versa, and how new funds may be
created by financial intermediaries during the borrowing process. The production and sale of goods
and services within the economic system are intimately related to the deposits, stocks and bonds, and
other financial instruments that are bought and sold in the financial system.
Financial system is vital to a healthy economy. That is why the government regulates and supervises the operations
of a financial system. The aim of such regulations is to promote and ensure a smooth-running, efficient financial
system. By establishing and enforcing operating regulations for financial markets and institutions, Government (as
a regulator) tries to promote competition and efficiency while preserving the safety and soundness of the system.
Our expenditure is continuous and ongoing, while our income is received only periodically (usually monthly). This
lack of synchronization between the receipt of income and expenditures (one is periodical and the other is
persistent) calls for a better management of our resources, that money. Whatever we spend (out of earnings)
towards the purchase of goods and services for our personal and family use is called consumption spending.
Income that is not spent on consumption is called „saving‟. Such savings will either be invested in real assets or
investment goods (such as the house we buy or build), and in financial assets (such as bank deposits, stocks and
bonds, and money). The uses of saving can be easily understood by studying the following table;
1) Total Saving; (A) Household Saving (income not spent on consumption)
(B) Business Saving ( income not distributed to owners of the firm)
2) Household Saving (A) Investment in real assets
(B) Surplus funds available to be lent in the financial markets
3) Business Saving (A) Investment in new capital (plant, machinery & inventory)
(B) Surplus funds available to be lent in the financial markets
Generally, Total Saving = Household Saving + Business Saving
= Investment + Surplus Funds
1.2) The Features and Major Components of Financial System;
The following points are the major features of financial system. These are;
(1) Financial system creates an ideal linkage between depositors and investors. It encourages savings and
investment.
(2) Financial system promotes efficient allocation of financial resources for socially desirable and
economically productive purposes.
(3) Financial system influences both the quality and the pace/speed of economic development.
According to the structural approach, the financial system of an economy consists of four main components;
(1) financial markets; (2) financial instruments; (3) financial intermediaries (financial institutions); and (4)
financial regulators.

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According to the functional approach, financial markets facilitate the flow of funds in order to finance
investments of corporations, governments and individuals. Financial institutions are the key players in the
financial markets as they perform the function of intermediation and thus determine the flow of funds. Financial
instrument is an asset which is expected to provide future benefits in the form of a claim to future cash. The
financial regulators perform the role of monitoring and regulating the participants in the financial system. The
following figure presents a typical structure of financial system in the country;
Figure 1: The structure of financial system;
Financial System

Financial Financial Financial Financial

Markets Institutions Instruments Regulators

Financial markets are markets where financial instruments/financial assets are bought and sold. Financial
institutions are an intermediary who channels the funds‟ of surplus units into loans for deficit units, or investment.
Financial instruments is also called financial assets, are intangible assets, which are expected to provide future
benefits in the form of a claim to future cash. Financial regulation is an intervention made by an authorized body,
in most case central bank, to ensure the fair treatment of market participants. One of the key aims of financial
regulation is to ensure business disclosure of accurate information for investment decision making. When financial
market information is disclosed only to partial set of investors, those gained unlimited information may have major
advantages than other groups of investors those gained little information. Each of the components plays a specific
role in the economy. The financial system increases overall productivity for the economy and leads to raise living
standards, by channeling funds from savers to investors with good projects through financial intermediary.
1.3) The Role of Financial System in the Economy;
The financial system plays the key function in the economy by stimulating economic growth, influencing
economic performance of the actors, affecting economic welfare. This is achieved by financial infrastructure, in
which entities with funds allocate those funds to those who have potentially more productive ways to invest those
funds. The following are the role of the financial system in the economic development of a given nation.
(1) It helps to increase saving – investment relationship; to attain economic development, a country needs more
investment and production. This can happen only when there is a facility for savings. Savings are channelized
to productive resources in the form of investment. Financial system induces the public to save by offering
attractive interest rate and then the savings are channelized by lending to various business concerns which are
involved in production and distribution.
(2) Government securities market; financial system enables the state and central government to raise both short
term and long term funds through the issue of bills and bonds which carry attractive rate of interest along with
tax concession. The budgetary gap is filled only with help of government securities market. Thus, the capital
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 market, money market along with foreign exchange market and government securities market enables
businessmen, industries as well as government to meet their credit requirements. Those and other economic
development are ensured by the financial system.
(3) It helps in development of trade; the financial system helps in the promotion of both domestic and foreign
trade. The financial institution finance traders and the financial markets help in discounting financial
instruments. Foreign trade is promoted due to per –shipment and post-shipment finance by commercial banks.
They also issue letter of credit in favor of the importer. The precious foreign exchange is earned with in the
nation because of the presence of financial system. The best part of the financial system is that the sellers or
the buyers do not meet each and the documents are negotiated through the financial system or banks.
(4) Helps for boosting of employment growth; the presence of financial system will generate more employment
opportunities in the country. The money market which is part of financial system, provides working capital to
the businessmen and manufacturers due to this production increases, resulting in generating more employment
opportunities. With competition picking up in various sectors, the service sector such as sales, marketing,
advertisement etc. also pick up leading more employment opportunities.
(5) It ensured balanced growth; economic development requires a balanced growth which means growth in all
the sectors simultaneously. Primary sector, secondary sector and tertiary sector requires adequate funds for
their growth. The financial system in the country will be geared up by the authorities in such a way that the
available funds will be distributed to all sectors in such manner, there will be a balanced growth in industries,
agriculture and service sectors.
(6) It helps in fiscal discipline and control of economy; through the financial system, the government can create
a congenial business atmosphere so that neither too much of inflation nor depression is experienced. The
industries should be given suitable protection through the financial system so that their credit requirements will
be met even during the difficult period. The government on its part can raise adequate resources to meet its
financial commitment so that economic development is not hampered.
(7) It helps in balanced regional development; through the financial system, backward areas could be developed
by providing various concessions. This ensures a balanced development throughout the country and this will
mitigate political or any other kind of disturbances in the country. It will also check migration of rural
population towards towns and cities.
(8) It helps in attracting foreign capital; financial system promotes capital market. A dynamic capital market is
capable of attracting funds from both domestic and abroad. With more capital, investment will expand and this
speed up the economic development of a country.
(9) It promotes economic integration; financial system of different countries is capable of promoting economic
integration. This means that in all those countries, there will be common economic policies such as common
investment, trade, employment legislation, transport co-ordination etc.

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(10) It helps in uniform interest rates; financial system is capable of bringing a uniform interest rate throughout
the country by which there will be balanced movement of funds between centers which will ensures
availability of capital for all kinds of industries.

1.4) Financial Assets; Meaning, Characteristics, and Kinds;

1.4.1) Meaning of Financial Assets;
Financial asset is a claim against income or wealth of a business firm, household or government unit represented
usually by a certificate of receipt or other legal documents and usually created by the lending of money. For
instance, stocks, bonds, insurance policies, deposits held in commercial banks, credit unions and saving banks and
others. Financial assets, financial instruments or securities are intangible assets, that they represent legal claims to
some future benefits. The typical future benefit for financial assets is a claim to future cash. The value of tangible
asset depends on particular physical properties (example building), and intangible asset represent legal claims to
some future benefit, that their value bears no relation to the form, physical or otherwise in which the claims are
recorded.
1.4.2) Characteristics of Financial Assets;
(A) The general properties of financial assets;
(1) Do not provide a continuing stream of services to their owners as does physical assets.
(2) They promise future returns to their owners and serve as a store of value (purchasing power).
(3) They cannot be depreciated because they do not wear out like physical goods.
(4) The physical condition of financial assets is not relevant in determining their market value (price).
(5) Because financial assets are generally represented by a piece of paper (certificate or contract) or by
information stored on computer file, they have little or no value as commodity and their cost of transport
and storage low.
(B) Divisibility and Denomination; denomination is the dollar value of the amount that each unit of the asset
will pay at maturity. Divisibility relates to the minimum size in which a financial asset can be liquidated and
exchanged for money. Example, financial asset such as deposit is typically infinitely divisible (down to the
penny), but other financial assets have varying degree of divisibility depending on their denominations, which
is the dollar value of the amount that each unit of the asset will pay at maturity. Generally divisibility is
desirable for investors but not for borrowers.
(C) Reversibility (Round trip cost); it refers to the cost of investing in a financial assets and getting out of it and
back to cash again. A financial asset such as a deposit is obviously highly reversible because usually there is
no charge for adding to or withdrawing from it. Other transactions cost may be unavoidable but these are
small. Financial assets are highly reversible.
(D) Yield and Return; yield can be cash yield or non-cash yield. Cash yield of financial assets consists of all the
cash distributions that the financial asset will pay to its owners. This includes; (1) dividends as shares, and
(2) coupon payments on bonds. The total yield includes also non-cash payments such as stock dividends and

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 options to purchase additional stock, or the distribution of other securities. The yield can be computed gross
or net of taxes: in the latter case, the same instrument may have different yields for different investors. The
return is the sum of the yield and any capital gains or losses that may have been incurred during the period.
(E) Term to maturity; is the length of interval until the date when the instrument is scheduled to make its final
payment or the owner is entitled to demand liquidation. Instruments for which the creditor can ask for
repayment of any time such as checking accounts and many saving accounts are called demand instruments.
Maturity is an important characteristic of financial assets such as debt instruments that ranges from one day to
a few decades and other many instruments such as equities have no maturity –since they are a form of
perpetual instruments.
(F) Liquidity; there are features that affect liquidity of a financial assets;
(1) Types of the assets; for many financial assets, liquidity is determined by contractual arrangements;
ordinary deposits at a bank for instance are perfectly liquid because the bank has a contractual obligation
to convert them at par on demand. On the other hand, claims on pension funds may be regarded as
illiquid; these can be cashed only at retirement.
(2) Quantity of financial assets to be traded; small quantities may be quite liquid; a large lot may run into
illiquid problems.
(3) Market conditions; refers to market thickness or market thinness. Thinness always has the effect of
increasing the round trip cost, even of a liquid financial asset. But beyond some point it becomes an
obstacle to the formation of a market and has direct effect on the illiquidity of the financial asset. Costs
are small for thick markets (with a lot of buying/selling) but larger for thin markets. A '' thin market'' is
one which has few trades on a regular or continuous basis.
(G) Predictability or risk; the value of the financial asset depends on the cash flow expected and on the interest
rate used to discount this cash flow. This is the basic property of financial asset, in that it is a major
determinant of their values. Assuming investors are risk averse, the riskiness of an asset can be equated with
the uncertainty or unpredictability of its returns.
1.4.3) Different Kinds of Financial Assets;
Although there are thousands of different financial assets, they generally fall into the following categories;
(1) Money; is a financial asset that is generally accepted in payments for goods and services. Example, checking
account, reserve currency. It is the legal currency of any country, ETB in Ethiopia, USD in America, etc.
The Functions/Services performed by Money;
1) It serves as a standard of value for all goods and services.
2) It serves as a medium of exchange. It is usually the only financial asset which virtually every
business, household, and government will accept in payment for goods and services.
3) It serves as a store of value – a reserve of future purchasing power. Purchasing power can be
stored in currency or in checking account until the time is right to buy.
4) It functions as the only perfectly liquid asset in the financial system. (An asset is considered to
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 be liquid, if it possesses three characteristics: price stability, ready marketability, and
reversibility).
The Importance of Money as a Financial Asset;
1) Acceptability of money for all transactions (legal tender).
2) Negotiability (it can be converted for any other financial asset or real asset).
3) Measure of wealth (it serves as a measure of one‟s wealth) Non-perishability (even stored for
long time, it does not perish – may be there could be value fluctuations due to market conditions).
(2) Equities (also known as stocks); more common are stocks, represent ownership shares in a business firm.
Further sub-divided in to common stock and preferred stock. They provide claims of varying or residual
dollar amount. Such as claims against firm‟s profit and against proceed from sale of assets.
(3) Debt securities; they provide claims of fixed dollar amount. Include such as bonds, notes, and account
payables. Legally these financial assets entitle their holders to individuals, business firms or government
units. Usually fixed in amount of claims and time of maturity, and depends on the terms of indentures
(contract) accompanying most debt securities, may be backup by the pledge of specific assets as collateral.
Financial analysts usually divide debt securities in to further categories; (1) negotiable or marketable, which
can be easily transferred from holder to holder as a marketable securities, example, treasury bonds and
corporate notes; (2) non- negotiable, which cannot be legally transferred to another party, example, pass
book savings, savings bonds.
(4) Derivative Securities; are those whose formation is dependent on the original securities. They have a market
value that is tied to or influenced by the value or return on a financial asset. Examples include futures
contracts, options, and swaps.
1.4.4) The Real Assets Versus Financial Assets;
Financial assets have some contrasting features with real assets. Some of the differences are;
(1) Material wealth of the society is determined by the productive capacity of its economy –the goods and services
that can provide to its members. This productive capacity is the function of the real assets of the economy-land
building, equipment and machine, knowledge, workers etc. nevertheless, financial assets such as stocks and
bonds do not directly contribute to the productive capacity of the economy. Shares of stock are no more than
sheets of papers. They do not represent society‟s wealth.
(2) Real assets appear only on the left side (asset side) of the balance sheet. The financial assets appear always on
both sides of the balance sheet.
(3) Financial assets are created and destroyed in the ordinary course of business, example, when loans are paid off
both the financial asset and financial liability cease to exist. In contrast, real assets are destroyed only by
accident or wear out over time.
(4) Real assets are income – generating assets, whereas financial assets define the allocation of income or wealth
among investors. Individuals can choose either consuming their endowments of wealth today or investing for
the future. When they invest for the future they may choose to hold financial assets, the money a firm relieves
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 when it issues securities (sell them to investors) is used to purchase real assets. Ultimately then, the returns of
financial assets comes from the income produced by the real assets that are financed by the issuance of
securities.
(5) The physical condition of financial assets is not relevant in determining their market value (price). A stock
certificate is not more or less valuable. Whereas, physical conditions (size, quality quantity) are so much
important while determining value of real assets.
1.5) Financial Markets; Meaning, Role, Classifications, and Participants;
1.5.1) Meaning of Financial Markets;
Financial markets are markets in which funds are transferred from people who have a surplus of available funds
to people who have a shortage of available funds. They are forums in which suppliers of funds and demanders of
funds can transact business directly. It is where the loans and investments of institutions are made without the
direct knowledge of the suppliers of funds (savers). They are important means of channeling funds from those who
have excess funds (savers, lenders) to those who have a financial shortage (borrowers).
1.5.2) The Functions of Financial Markets;
The following are the functions of financial markets;
(1) Enhancing income; financial markets allow lenders earn interest /dividend on their surplus invested funds,
thus contributing to the enhancement of the individual & the national income
(2) Transfer of resources; financial markets facilitate the transfer of real economic resources from lenders to
ultimate borrowers.
(3) Productive usage; financial markets allow for the productive use of the funds borrowed, thus enhancing the
income & the gross national production.
(4) Capital formations; financial markets provide a channel through which new savings flow to aid capital
formation of a country.
(5) Price determination; financial markets allow for the determination of the price of the traded financial asset
through the interaction of buyers & sellers, that through demand and supply. The interactions of buyers and
sellers in a financial market determine the price of the traded assets; or equivalently, the required
return on a financial asset is determined. The inducement for firms to acquire funds depends on the required
return that investors demand, and it is this feature of financial markets that signals how the funds in the
economy should be allocated among financial assets. This is called the price discovery process.
(6) Provide a mechanism for investor to sell a financial asset; because of this feature, it is said that a financial
market offers liquidity, an attractive feature when circumstances either force or motivate an investor to sell. In
the absence of liquidity, the owner will be forced to hold a debt instrument until it matures and an equity
instrument until the company is either voluntarily or involuntarily liquidated. While all financial markets
provide some form of liquidity, the degree of liquidity is one of the factors that characterize different markets.
(7) It reduces the search and information costs of transacting; search costs represent explicit costs, such as the
money spent to advertise the desire to sell or purchase a financial asset, and implicit costs, such as the value of
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 time spent in locating counterparty. The presence of some form of organized financial market reduces costs.
Information costs are those entailed with assessing the investment merits of financial assets that is the amount
and the likelihood of the cash flow expected to be generated. In an efficient market, prices reflect the aggregate
information collected by all market participants.
1.5.3) Classification of Financial Markets in the Financial System;
There are many ways to classify financial markets.
(1) Based on type financial claims (equity and debt); the financial claims traded in a financial market may
be either for a fixed dollar amount or for a residual amount. The financial assets traded under a fixed dollar
amount are referred to as debt instruments. The financial market where debt instruments (bonds, treasury
bills, commercial papers others) are traded is known as debt markets. Financial assets traded under the
residual amount are referred as equity instruments. The financial market where equity instruments (stocks)
are traded is referred to as equity market.
(2) Based on maturity of the security (money and capital); financial market for short –term financial assets,
which mature with in less than one year such as treasury bills, commercial papers, certificate of deposits is
called money market. Financial markets for long –term financial assets with the maturity of more than
one year is referred to as capital markets. Based on this classification part of debt instruments can be part
of money market and capital market depending on their maturity. But all equity instruments are generally
as capital markets because of their perpetuity.
(3) Based on whether the financial claims are newly issued or seasonal (origin); the financial market for
newly issued financial assets is called primary market. Markets used for exchanging financial claims
previously issued called secondary market or the market for seasonal instruments.
(4) Based on organizational structure; (1) auction market - all financial assets are traded in the centralized
trading facility through bidding; (2) over- the- counter market - markets that do not operate in a specific
fixed location- rather transactions occur via telephone, wire transfers, computer trading. This type of
market allows a number of dealers (seller and buyer of financial instruments) without any restriction.
1.5.4) Participants of the Financial Market;
The principal participants in the financial market are as follows:
(1) Banks; largest provider of funds to business houses and corporate through accepting deposits. Banks are
the major participant in the financial market.
(2) Insurance companies; issue contracts to individuals or firms with a promise to refund them in future in
case of any event and thereby invest these funds in debt, equities, properties, etc.
(3) Finance companies; engages in short to medium term financing for businesses by collecting funds by
issuing debentures and borrowing from general public.
(4) Merchant Banks; funded by short term borrowings; lend mainly to corporations for foreign currency and
commercial bills financing.

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 (5) Companies; the surplus funds generated from business operations are majorly invested in money market
instruments, commercial bills and stocks of other companies.
(6) Mutual funds; acquire funds mainly from the general public and invest them in money market,
commercial bills and shares. Mutual fund is also principle participant in financial market.
(7) Government; authorized dealers basically look after the demand-supply operations in financial market.
Also works to fill in the gap between the demand and supply of funds.
1.6) Lending and Borrowing in the Financial System;
Business firms, households and government play a wide variety of roles in modern financial systems. It is quite
common for an individual or institution to be a lender of funds in one period and borrower in the next, or to do
both simultaneously like financial intermediaries such as banks, insurance companies, which operates on both side
of financial markets, borrowing funds from customers by issuing attractive financial claims and simultaneously
making loans available to other customers.
Note that; each business firm, household or unit of government active in the financial system must conform to the
following identity;
Current revenue –expenditures out of current revenue = change in
holding FAs-change in debt& equity outstanding
Where; R= current revenue FA = change in holding financial assets
E = expenditure out of current revenue D = change in debt& equity outstanding
If our current expenditure (E) exceeds our current revenue (R), we usually make up the difference by;
(1) Reducing our holdings of financial assets (- FA); example, by drawing money out of saving account.
(2) Issuing debt or stock (+ D) or, (3) Using some combination of both.
If our receipts (R) in the current period are larger than current expenditures (E), we can;
(1) Build up our holdings of our financial assets (+ FA); example, placing money in saving account,
purchasing new shares of stock or debt.
(2) Pay off some outstanding debt or retire stock previously issued by our business firm(- D) or
(3) Do some combination of both.
It follows that for any given period of time (day, week, month, and year) the individual economic unit must fall
into one of the three groups;
1) Deficit budget unit (DBU) or net borrower of funds = E>R and so D> FA
2) Surplus budget unit (SBU) or net lender of funds = R>E and thus FA > D
3) Balance budget unit (BBU) = R=E and thus FA = D
Note that; a net lender of funds is really a net supplier of funds to the financial system. It accomplishes this
function by purchasing financial assets, paying off debt, or retiring equity (stocks). In contrast, a net borrower of
funds is a net demander of funds from the financial system, selling financial assets, issuing new stock or debt. The
government and the business sector of the economy tend to be net borrowers while the household sector composed
of all families and individuals tend to be net lender (supplier) of funds.

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 CHAPTER TWO
FINANCIAL INSTITUTIONS IN THE FINANCIAL SYSTEM
2.1) Introduction to Financial Institution and Capital Transfer;
A financial institution is an institution that provides financial services for its clients or members. It is an
institution that collects money and puts it into assets such as stocks, bonds, bank deposits, or loans. Financial
institutions are those firms that provide financial services to SSUs and DSUs. Financial institutions are business
organizations that provide savings and financing opportunities. They are business organizations that act as
mobilizes and depositories of savings and as purveyors of credit or finance. They differ from non-financial
(industrial and commercial) business organizations in respect of their wares, that while the former deals in
financial assets such as deposits, loans, securities, financial services and so on, the latter deal in real assets such as
machinery, equipment, real estate and so on. They are the key players in the financial markets as they perform the
function of intermediation and thus determine the flow of funds. Financial institutions serve as intermediaries by
channeling the savings of individuals, business, and governments into loans and investments. The primary
suppliers of funds to financial institutions are individuals; and the primary demanders of funds are firms and
governments. They are major players in the financial marketplace, which have huge financial assets under their
control. They often serve as the main source of funds for businesses and individuals.

The most important financial institutions are the financial intermediaries. Financial intermediaries are those
financial institutions (such as banks) which borrow from SSU for the purpose of lending to DSU. Thus, the
financial intermediaries serve as a connecting link between SSU and DSU. This activity of SSU lending their
surplus funds through financial intermediaries to DSU to meet their deficit is called „indirect finance‟. For
example, Mr. K/Mariam may choose to park his surplus funds in Commercial Bank of Ethiopia at Aksum and the
CBE may use these funds to lend to one its business custom. The activity of SSUs lending their funds directly to
DSUs is called „direct finance‟. Some financial institutions accept customers‟ savings deposits and lend this
money to other customers or to firms. In fact, many firms rely heavily on loans from institutions for their financial
support. The key suppliers of funds to financial institutions and the key demanders of funds from financial
institutions are individuals, businesses, and governments. Governments maintain deposits of temporarily idle
funds, certain tax payments, and social security payments in commercial banks. They do not borrow funds directly
from financial institutions, although by selling their debt securities to various institutions, governments indirectly
borrow from them. The government, like business firms, is typically a net demander of funds. It typically borrows
more than it saves.
2.2) Financial Intermediaries; Meaning, Nature and Roles;
2.2.1) Meaning of Financial Intermediaries;
A financial intermediary is a financial institution that connects surplus and deficit agents. The classic example of
a financial intermediary is a bank that consolidates deposits and uses the funds to transform them into loans. The

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purpose of financial intermediaries is to connect borrowers to savers. Financial intermediaries perform the vital
role of bringing together those economic agents with surplus funds who want to lend, with those with a shortage of
funds who want to borrow. In doing this, they offer the major benefits of maturity and risk transformation. It is
possible for this to be done by direct contact between the ultimate borrowers, but there are major cost
disadvantages of direct finance.
A financial intermediary is one which intermediates funds transfer between the SSU and DSU, by creating
secondary securities. The financial intermediaries obtain the funds from the SSU and offer their own securities
(such as deposit certificates, insurance contracts, pension contracts, which are commonly known as secondary
securities) as financial claims to the SSU. Then, they provide the funds to the DSUs (in the form of advances) and
accept the securities issued by DSUs (such as stocks and shares, bonds and debentures, treasury bills, which are
widely known as primary securities) as financial claims on the DSUs. Thus they carry out „financial
intermediation‟.
A financial intermediary is a firm or an institution that acts an intermediary between a provider of service and the
consumer. It is the institution or individual that is in between two or more parties in a financial context. In
theoretical terms, a financial intermediary channels savings into investments. Financial intermediaries exist for
profit in the financial system and sometimes there is a need to regulate the activities of the same. There are
financial institutions which do not act as financial intermediaries. They are financial institutions which facilitates
funds transfers from SSUs to DSUs without creating securities on their own. They simply act as conduit (medium)
pipe between the SSUs and DSUs.
Note that; thus, all financial intermediaries are financial institutions, but not all financial institutions are financial
intermediaries. The following list is an example for financial intermediaries; (which means they are financial
institutions also);
(1) Commercial Banks, (2) Saving Banks,
(3) Saving and Loan Associations, (4) Credit Unions,
(5) Insurance Companies (Life and Property), and (6) Pension Funds.
The following are examples for financial institutions which are not financial intermediaries;
(1) Security Dealers (2) Security Brokers (3) Investment Bankers
2.2.2) The Nature of Financial Intermediation;
Funds rose through intermediation are the most important sources of external financing for business firms.
Financial intermediaries exist for the following main reasons;
(a) Different requirement of lenders and (b) Transaction costs; (c) Problems arising out of
borrowers, and information asymmetries.
(A) Different requirements of lenders and borrowers; firms borrowing funds to finance investment will tend to
repay the borrowing amount over the expected life of the investment. In addition, the claims issued by firms
will have relatively high default risk reflecting the nature of business investment. In contrast, lenders will
generally looking to hold assets which are relatively liquid and low risk. To reconcile the conflicting
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 requirement (interest) of lenders and borrowers a financial intermediary will hold the long- term, high risk
claims of borrowers and finance this by issuing liabilities called deposits which are highly liquid and have
low risk of default.
(B) Transaction cost; the presence of transaction cost makes very difficult for a potential lender to find
appropriate borrower. There are four main types of transaction costs;
(1) Search cost; both lender and borrower will incur costs of searching for finding
information about a suitable counter party.
(2) Verification cost; lenders must verify the accuracy of the information provided by
the borrower.
(3) Monitoring cost; once a loan is created, the lender must monitor the activities of the
borrower, in particular to identify if a payment is missed.
(4) Enforcement cost; the lender will need to ensure enforcement of the terms of
contract or recovery of the debt in the event of default.
(C) Asymmetric information; it refers to the situation where one party has more information than the other party
about the transaction. Example, purchase /sale of second hand car, in this case, the seller has more information
about the condition of the car than the buyer. This likely makes the buyer reluctant to purchase the car unless
he/she can obtain more information, perhaps from mechanics inspection. In the case of financial transactions,
the borrower will have more information about the potential returns and risk the investment project for which
funds are being borrowed compared to the lender. The existence of asymmetric information creates problems
for the lender both before the loan is made at the verification and after, at the monitoring /enforcement stages.
Problems may be created by the asymmetric information when the lender is selecting a potential
borrower, that;
(1) Adverse selection; can occur a borrower who likely to default may be selected; and
(2) Moral hazard; this is a problem that occurs after loan is made. The borrower might be engaged
in activities that are undesirable (immoral) from the lender point of view. To overcome the
problems of high risk, high transaction cost and other problems related with asymmetric
information lenders and borrowers require financial intermediaries.
2.2.3) Role of Financial Intermediaries;
Intermediation means acting as a joint path for two parties that are usually lenders and borrowers. Financial
intermediaries involve more than just bringing two parties together. They create assets for savers and liabilities for
borrowers which are more attractive to each other. Financial intermediaries play a number of special roles, and
help solve a number of special problems, in the process of indirect finance.
(1) Intermediaries transform assets; for example Company “A” wants to deposit some portion of funds for less
than a year; and company “B” wishes to borrow some amount of funds which can be repaid after two years. In
the absence of financial intermediaries (commercial banks), the two companies cannot attain their wants
because the borrower‟s and the lender‟s length of time sought could not agree. The borrowers want to issue
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 claims which might be different from those sought by the lenders. In the existence of financial intermediaries,
they can transform long-term high risk assets in to short- term low risk by giving the borrower a loan for the
time sought and the lender deposited a financial asset for the desired investment horizon. Therefore, financial
intermediaries can satisfy both the borrowers and lenders at the time by transforming the maturity and liquidity
of financial assets.
(2) Intermediaries reduce transaction costs; financial intermediaries are able to reduce transaction costs
substantially because they have; (1) developed expertise; and (2) large size enables them to take advantages
economies of scale other than individual lender /borrower.
(3) Intermediaries reduce the problems arising out of asymmetric information; the lenders face two problems
related with asymmetric information; (1) adverse selection of borrowers; and (2) moral hazard. But, the
problem of moral hazard can be reduced by introducing restrictive covenants in to loan contracts.
Intermediaries are more capable to reduce the adverse selection problem because; (1) they develop expertise
information production that enables them to select good risk; and (2) they have access to information from
customers transaction accounts held with the bank.
2.3) The Functions of Financial Institutions;
Financial institutions serve as intermediaries by channeling the savings of individuals, business, and governments
into loans and investments. The most important function of financial institutions is to assist in the transfer of funds
from surplus agents to deficit agents. Thus, in assisting this process, a financial intermediary undertakes several
economic roles.
(1) Provision of payment mechanism; financial intermediaries, especially commercial banks, facilitate the
payments of funds by non-cash measures such as; cheques, credit cards, electronic transfer, letter of credit etc.
An effective payment system is essential to the health of a modern economy among domestic agents and
between domestic and foreign agents.
(2) Maturity transformation role; surplus agents typically wish to have their surplus funds redeemable at short
notice, and deficit agents (investors) wish to borrow funds over long term horizon. Thus, financial
intermediaries such as commercial banks, accepts investors fund on a short term basis and channel these funds
to long-term borrowers. The process of converting short term liabilities (deposits) into long-term assets (loan)
is known as maturity transformations.
(3) Risk diversification role; surplus agents needs complete protection for their capital. On the other hand,
borrowers need capital to finance in risky investment projects. Thus, the demands of these two agents
contradict each other. If a surplus agent lends directly to a deficit agent, this would leave them heavily exposed
to the risk of default by the deficit agent. Financial intermediaries can play an important part in transforming
the low risk requirement of savers into meeting the risk finance requirement of firms {borrowers}. Thus, a
financial intermediaries that receives funds from many surplus agents can pool these funds lend to a large
number of deficit agents (diversification). Financial intermediaries mitigate several types of risk. First, bank
take deposits from many people and make thousands of loans with these deposits. Thus, each depositor faces
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 only a small amount of the risk associated with loans that would go default. No one depositor losses all these
assets when a bank loan goes unpaid. Banks also provide a low-cost way for depositors to diversify their
investments. Mutual fund companies of small investors a way to purchase a diversified portfolio of several
different stocks.
(4) Liquidity role; liquidity refers to the ease with which an asset can be converted into cash. Surplus agents
would not be willing to hold the financial assets (bonds or shares) unless they have the ability to sell them at
short notice at fair market place. Thus, deposit taking institutions are therefore able to ensure liquidity
provision without maintaining large balances in relation to total deposits.
(5) Reduction of contracting, search and information costs role; the cost of acquiring and processing the
information about the borrower (known as information processing costs) must be considered when you lend
money. The cost of loan contracts is referred to as contracting cost. In addition cost of contracting, the ability,
and cost of enforcing the terms of loan agreements should also be considered by lenders. Most surplus agents
lack the time, skill and resources to find and analysis prospective deficit agents and draw up and enforce the
necessary legal contracts. Financial institutions such as banks, provides cost effective intermediations;
financial intermediations benefits from considerable economies of scale, because they are looking for many
prospective investment opportunities, they can devote resources to recruiting and training high quality staff to
assist in the process of finding suitable deficit agents. They draw up more standardized contract or they can
recruit legal counsel as part of professional staff to write contract involving more complex transactions. The
two potential credit cost necessarily incurred by the lenders (surplus agent) and which is eliminated by
financial intermediations is cost of analyzing credit worthiness of borrowers and cost of developing contract
(stationary, witness per-diem, etc.).
2.4) Classifications of Financial Institutions;
Financial institutions act as a channel through which scattered savings are collected and then invested in business
firms. These institutions can broadly be divided in to three categories, namely;
(1) Depository institutions, (2) Non-depository institutions, and (3) Investment intermediaries.
2.4.1) Depository Financial Institutions;
These are financial intermediaries that accept deposits from individuals and institutions and then, make loans.
These institutions include commercial banks, savings and loan associations, and credit unions. They are unique
from the other intermediaries in that they are directly engaged in accepting deposit and channeling it to others.
(1) Commercial banks; serve a variety of savers and borrowers. Historically, commercial banks were the major
institutions that handled checking accounts and through which the central bank expanded or contracted the
money supply. Today, however, several other institutions also provide checking services and significantly
influence the money supply. Conversely, commercial banks are providing an ever-widening range of services,
including stock brokerage services, agency services and so on.

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 (2) Savings and credit associations (S&Ls); traditionally served individual savers and residential and
commercial mortgage borrowers, taking the funds of many small savers and then lending this money to home
buyers and other types of borrowers.
(3) Credit unions; are cooperative associations whose members are supposed to have a common bond, such as
being employees of the same firm. Members‟ savings are loaned only to other members, generally for auto
purchases, home improvement loans, and home mortgages. Credit unions are often the cheapest source of
funds available to individual borrowers.
2.4.2) Non-Depository Financial Institutions;
These are financial intermediaries that acquire funds at periodic intervals on a contractual basis. Their main
purpose is giving different financial services (sharing of loss and pension services). But, they are also important
financial intermediaries because they raise huge fund which they channel to investors in different ways. The major
types of non-depository financial institutions are, (1) insurance companies, and (2) pension funds.
(1) Insurance companies; provide (sell and service) insurance policies, which are legally binding contracts.
Insurance company is a company that offers insurance policies to the public. The primary functions of
insurance company is to compensate the individual and companies (policy holders) if perceived adverse event
occur, in exchange for premium paid to the insurer (insurance company) by policy holder. It provides social
security and promotes individual welfare. Insurance companies promises to pay specified sum contingent on
the occurrence of future unforeseen events, such as death, or an automobile accidents. They distribute or
spreading risks to a number of individuals. They function as risk bearers. They accept or underwrite the risk
for an insurance premium paid by the policy maker or owner of the policy.
(2) Pension funds; after people retire from their employment, most people can expect to receive some form of
pension. This comes in one of three forms; (a) a flat-rate pension paid by the state to everyone above a
certain age; (b) an occupational pension provided from a fund to which the employer and employee have
contributed; and (c) a personal pension paid from a fund to which the individual has made contributions. As
we shall see, only the second and third forms strictly involve financial intermediation. This is because the first
of these operates on „pay as you go‟ principles, while payments under the latter are made from an accumulated
fund of savings. A pension fund is a fund that is established for the eventual payment of retirement benefits.
The entities that establish pension plans, called the plan sponsors, are; (1) private business entities acting for
their employees; (2) federal, state & local entities on behalf of their employees; and (3) unions on behalf of
their employee. There are two types of pension funds. These are;
(1) Unfunded pension schemes; schemes where payments to pensioners are financed by simultaneous
contributions from those in work. Such schemes are often called “pay as you go” or PAYG schemes.
(2) Funded pension schemes; this scheme is where payments to pensioners are made out of the income
earned by a fund of savings which has been built up in earlier years by (usually regular) savings
contributions. The two types of funded scheme are; defined benefit plan, and defined contribution plan.

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 (A) Defined benefit plan; in defined benefit plan, the plan sponsor agrees to make specified dollar payment to
qualifying employees at retirement (and some payments to beneficiaries in case of death before
retirement). The retirement payments are determined by a formula that usually takes in to account the
length of service of the employee and the earning of the employee. The pension obligations are effectively
the debt obligation of the plan sponsor, who assumes the risk of having insufficient funds in the plan to
satisfy the contractual payments that must be made to retired employees. Thus, unlike a defined
contribution plan, in a defined benefit plan, all the investment risks are born by the plan sponsor.
(B) Defined contribution plans; in a defined contribution plan, the plan sponsor is responsible only for
making specified contribution in to the plan on behalf of qualifying participants. The amount contributed is
either a percentage of the employee's salary or a percentage of profit. The payment that will be made to
qualifying participants up on retirement will depend on the growth of the plan assets, that is, payment is
determined by the investment performance of the asset in which the pension fund is invested. The plan
sponsor gives the participants various options as to the investment vehicles in which they may invest.
Therefore, in a defined contribution plan the employee bears all the investment risks.
2.4.3) Investment Companies;
These are financial intermediaries that sell share to the public and invest the proceeds in a diversified portfolio of
securities. Each share that they sell represents a proportionate interest in the portfolio of securities owned by the
investment company. This group of financial intermediaries includes investment banks and mutual funds which are
involved in the purchase and sale of different securities such as bonds and stocks. Their primary function is to help
individuals/firms to buy and issue/sell the securities. They advise investors about their portfolio choice and pricing
of different securities. They also serve as security traders by arranging traders among borrowers and lenders.
Besides, they acquire funds by issuing and selling different securities and use the funds so raised to purchase
diversified portfolio of securities. The two types of investment companies are mutual funds and investment
banking;
(1) Mutual Funds; mutual funds (in US) or unit trust (in UK and India) raise funds from the public and invest the
fund in a variety of financial assets. Mutual funds are investment companies that pool money from investors at
large and offer to sell and buy back its shares on a continuous basis and use the capital raised to invest in
securities of different companies. Mutual funds possess shares of several companies and receive dividends in
lieu of them and the earnings are distributed among the units/shares holders. Mutual funds sell shares (units) to
investors and redeem outstanding shares on demand at their fair market value. Thus, they provide opportunity
of small investors to invest in a diversified portfolio of financial securities. They also enjoy economies of scale
by incurring lower transactions costs and commissions. Mutual fund is a trust that pools the savings of a
number of investors who share a common financial goal. This pool of money is invested in accordance with a
stated objective. The joint ownership of the fund is thus “Mutual”, i.e. the fund belongs to all investors. The
money collected is then invested in financial market instruments on different securities; such as shares,
debentures and other securities. The income earned through these investments and the capital appreciations

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 realized are shared by its unit holders in proportion the number of units owned by them. Thus, a mutual fund is
the most suitable investment for the common man as it offers an opportunity to invest in a diversified,
professionally managed basket of securities at a relatively low cost. A Mutual Fund is an investment tool that
allows small investors access to a well-diversified portfolio of equities, bonds and other securities. Each
shareholder participates in the gain or loss of the fund. Units are issued and can be redeemed as needed. The
fund‟s Net Asset value (NAV) is determined each day.
Investments in securities are spread across a wide cross-section of industries and sectors and thus the risk is
reduced. Diversification reduces the risk because all stocks may not move in the same direction in the same
proportion at the same time. Mutual fund issues units to the investors in accordance with quantum of money
invested by them. Investors of mutual funds are known as unit holders.
The Different Types of Mutual Funds;
Based on their structure; Based on their investment objectives;
(1) Open- Ended Mutual (1) Equity funds; these funds invest in equities and equity
Funds, and related instruments.
(2) Close-Ended Mutual (2) Debt funds; they invest only in debt instruments.
Funds. (3) Balanced funds; they invest on both equity and debt
instruments.
(A) Open-End Funds; are mutual funds those continually stands ready to sell new shares to the public and to
redeem its outstanding shares on demand at a price equal to an appropriate share of the value of its portfolio,
which is computed daily at the close of the market. Investors can buy and sell the units from the fund, at any
point of time. A mutual fund's share price is based on its net asset value (NAV) per shares.
Formula to Compute NAV;

For Example; assume that a mutual fund with 10 million shares outstanding has a portfolio with a market value of
Birr 215 million and liabilities of Birr 15 million. What would be the NAV per share?

(B) Closed-end fund; in contrast to open-end mutual funds, closed-end funds sell shares like any other
corporation and usually do not redeem their shares. These funds raise money from investors only once.
Therefore, after the offer period, fresh investments cannot be made into the fund. Units/shares of close-end
funds sell on either an organized exchange. Investors who wish to purchase closed-end funds must pay a
brokerage commission at the time of purchase and again at the time of sale. Redemption of units can be made
during specified intervals. Therefore, such funds have relatively low liquidity. The price of the share is
determined by supply and demand, so the price can fall below or rise above the NAV per shares. Thus, shares
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 selling below NAV are said to be trading at discount, and shares selling above NAV are said to be trading at
premium.
Difference between Open-Ended and Close-Ended Mutual Funds;
2) The number of shares of an open-ended fund varies because the fund sponsor sells new shares
to investors and buys existing shares from shareholders. By doing so the share price is always
the NAV of the fund.
3) In contrast, closed-end fund have a constant number of shares outstanding because the fund
sponsor does not redeem shares and sells new shares to investors, except at the time of new a
underwriting.
The following are some of the benefit associated with mutual funds;
(1) Mobilizing small saving; direct participations in securities is not attractive to small investors because
of some requirements which is difficult for them. Mutual fund mobilize funds by selling their own
shares, known as units, this funds are invested in shares of different institutions (private and public
institutions).
(2) Professional Management; mutual funds employ professional experts who manage the investment
portfolio efficiently and profitability. Thus, investors are relieved from the emotional stress in buying
and selling securities since mutual funds take care of this functions. The professional managers act
scientifically with; (1) the right timing to buy and sell for their clients, and (2) automatic
reinvestment of dividends and capital gains….etc.
(3) Diversified Investment/Reduced Risk; funds mobilized from investors are invested in various
industries spread across the country/globe. This is advantage to the small investors, because they
cannot afford to assess the profitability and viability of different investment opportunities. Mutual
funds provide small investors the access to a reduced investment risk resulting from diversifications,
economies of scale in transactions cost and professional financial management.
(4) Better Liquidity; there is always a ready market for the mutual funds units -it is possible for the
investors to divest holding at any time during the year at the Net Asset Value (NAV). Securities held
by the fund could be converted into cash at any time.
(5) Investment Protections; mutual funds are legally regulated by guidelines and legislative provisions
of regulatory bodies.
(6) Low Transactions Cost (Economy of Scale); the cost of purchase and sell of mutual funds is
relatively lower because of the large volume of money being handled by mutual funds in the capital
market. Brokerage fees, trading commissions, etc. are lower. This enhances the quantum of
distributable income available for investors.
(7) Economic Development; mutual funds mobilize more savings and channel them to the most
productive sector of the economy. The efficient functioning of mutual funds contributes to an
efficient financial system. It creates ways for the efficient allocations of the financial resources of the

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 country which in turn contributes to the economic development. Diversions of resources from
consumptions into saving and investment.
(2) Investment Banking Firms; investment bank is a financial institution engaged in securities business.
Investment banking firms perform activities related to the issuing of new securities and the
arrangement of financial transactions. Investment banking, or I-banking, as it is often called, is the
term used to describe the business of raising capital for companies and advising them on financing
and merger alternatives. Investment banking includes a wide variety of activities, including
underwriting, selling, and trading securities, providing financial advisory services, and managing
assets. Investment banks cater to a diverse group of stakeholders – companies, governments, non-
profit institutions, and individuals – and help them raise funds on the capital market. They perform
the following major functions for their customers;
(1) Serve as intermediaries for clients, manage investment portfolios & lend & invest banks‟ assets.

(2) Provide an advice service on mergers, acquisitions, and other financial transactions, to help
companies become more competitive.

(3) Research and develop opinions on securities, markets, and economies; maintenance of large
databases that allows them to produce research reports on economies, markets, companies, stocks,
and bonds.

(4) Issue, buy, sell, and trade stocks and bonds; they help companies and governments raise
capital by issuing different types of securities such as, equity, debt, private placements,
commercial paper, medium-term notes

Figure; How Financial institutions Provide Finance to Firms;

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Investment banks once contrasted sharply with commercial banks, where people mainly deposited their
money and sought commercial and retail loans. Thus, in recent years, though, the two types of structures
have become increasingly similar; commercial banks now offer more investment banking services as they
attempt to corner the market by presenting themselves as one-stop shops. They mainly involve in primary
markets, the market in which new issues are sold and bought for the first time. Furthermore, classification
of financial institutions can be made as follow based on their legal formality;
(1) Formal, (2) Semiformal, and (3) Informal financial institutions;
(1) Formal financial institutions; are those that are subject not only to general laws and regulations, but
also to specific regulations and supervisions. Their operations are under a direct supervision of
central bank. It includes; (1) development banks (both private and public); (2) commercial banks
(both public and private); (3) saving banks; and (4) non- bank financial intermediaries (insurance
companies, investment companies, etc.).
(2) Semi-formal institutions; are those that are formal in the sense of being registered entities subject to
all relevant laws, including the commercial laws, but informal insofar as they are, with few
exceptions, not under the bank regulations and supervisions; (1) free to set their own interest rate;
and (2) unlike banks, free from minimum capital requirement. The semi-formal institutions includes
; (1) credit unions; (2) multipurpose cooperatives; and (3) self-help associations (such as idir).
(3) Informal financial providers (generally not referred to as institutions); are those to which neither
special bank law, nor general commercial law applies, and whose operations are also so informal that
disputes arising from contract with them often cannot be settled by recourse to the legal system. The
informal fund provider consists of; (1) individual money lenders; (2) traders, land lords; (3) rotating
and saving credit associations {like equb in Ethiopia}; and (4) families and friends.
2.5) Risks in the Financial Industry;
Risk can be referred to like the chances of having an unexpected or negative outcome. Any action or
activity that leads to loss of any type can be termed as risk. There are different types of risks that a firm
might face and needs to overcome. Widely, risks can be classified into three types that business risk,
non-business risk, and financial risk;
(1) Business Risk; these types of risks are taken by business enterprises themselves in order to maximize
shareholder value and profits. For example, Companies undertake high-cost risks in marketing to
launch a new product in order to gain higher sales.
(2) Non- Business Risk; these types of risks are not under the control of firms. Risks that arise out of
political and economic imbalances can be termed as non-business risk.

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(3) Financial Risk; financial risk as the term suggests is the risk that involves financial loss to firms.
Financial risk generally arises due to instability and losses in the financial market caused by
movements in stock prices, currencies, interest rates and more.
Financial risk is one of the high-priority risk types for every business. Financial risk is caused due to
market movements and market movements can include a host of factors. Based on this, financial risk can
be classified into various types such as market risk, credit risk, liquidity risk, operational risk, and legal
risk, as it has been presented as follow;

(1) Market Risk; arises due to the movement in prices of financial instrument. Market risk can be
classified as directional risk and non-directional risk. Directional risk is caused due to movement in
stock price, interest rates and more. Non-Directional risk, on the other hand, can be volatility risks.
(2) Credit Risk; arises when one fails to fulfill their obligations towards their counterparties. Credit risk
can be classified into sovereign risk and settlement risk. Sovereign risk usually arises due to difficult
foreign exchange policies. Settlement risk, on the other hand, arises when one party makes the
payment while the other party fails to fulfill the obligations.
(3) Liquidity Risk; arises out of an inability to execute transactions. Liquidity risk can be classified
into asset liquidity risk and funding liquidity risk. Asset liquidity risk arises either due to
insufficient buyers or insufficient sellers against sell orders and buys orders respectively.
(4) Operational Risk; arises out of operational failures such as mismanagement or technical failures.
Operational risk can be classified into fraud risk and model risk. Fraud risk arises due to the lack of
controls and Model risk arises due to incorrect model application.
(5) Legal Risk; arises out of legal constraints such as lawsuits. Whenever a company needs to face
financial loses out of legal proceedings, it is a legal risk.

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