chapter 2 - the financial system in the economy

8/13/2019 Chapter 2 - The Financial System in the Economy

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After studying this chapter, you should be able to display a good understanding of thefollowing:

The role of the financial system The role of financial institutions in Zambia Financial Instruments and markets Current situation in the Zambian financial system

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Lets face it; we can never escape the reality thatLife in abundanceis probably one of thegreatest desires of mankind. In business, people make every effort to administer their assets(and liabilities for that matter) to achieve maximum advantage, which they believe wouldeventually lead to true happiness. Even the astronomers at National Aeronautics and Space

Administration (NASA)look toward the heavens to try and find explanations that wouldenhance our life on earth. The business world can almost be described with the samephilosophy with which Arno A. Penzias, Novel prize winner in physics, described the

universe:

Astronomy leads us to a unique event, a universe which was created out ofnothing, and delicately balanced to provide exactly the conditions required to

support life.

The business environment in Zambia is such that it is also delicately balanced withnumerous determinants playing a part in trying to supplement human life. The basic needsin the financial environment may simply be stated as follows:

The need to invest excess money this is called money supply in elementary

economics, which you must have studied by now. The need to borrowmoney - this is called demand for money. This phenomenon

happens where there is a shortage of money in the hands of those who want tomake use of it.

In the financial system funds flow from those who have surplus funds to those who have ashortage of funds, either by direct, market-based financing or by indirect, bank-basedfinance.


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Here we can draw comfort from the words of the former British Prime Minister WilliamGladstone who expressed the importance of finance for the economy in 1858 as follows:

"Finance is, as it were, the stomach of the country, from which all the other organstake their tone."

The Zambian Government, for instance, needs money for certain projects, while certainprivate sector companies or individuals might have excess money to invest in profitableinvestments. The price paid for money is interest paid on the amount borrowed, and theinterest rate is thus the price mechanism used in financial markets.

To match different financial needs such as the need to borrow and the need to invest,intermediaries are mostly used, for example:

Where an institution wants to invest a certain sum of money, for a certain time, givingthem a certain yield

Another institution wants to borrow a certain amount of money for a period at the

lowest cost possible.

An example would be:

ZESCO Limited may need ZMK 100 million for a period of at least 10 years to erectnew power lines in Nchelenge District.

Barclays Bank has ZMK 50 million it wants to invest for 8 years Investrust Bank Plc has ZMK 50 million it wants to invest for 10 years.

An intermediary such as Intermarket Securities Limited, or Pangea/ EMI Securities Limitedwould seek to merge these different needs and demands of borrowers and lenders throughnegotiation and financial instruments. A certificate would be issued to the lender giving him

the right to the interest payments and the redemption amount at expiry of the loan. Theseinstruments are called securities.

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1. Explain why we have a financial system in the Zambian economy?

2. What do we call the price paid for borrowing money?


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OKN qeb olib lc cfk^k f i fkpqfqrqflkp fk w^j_f According to the Bank of Zambia, the financial sector in Zambia has undergone twonotable phases in its development from the time of Zambias independence in 1964. Firstly,during the early 1970s when the Governments nationalisation program had an importantimpact upon the sector. Although commercial banks were not nationalised, all other majorfinancial institutions were nationalised and merged to form government owned institutionssuch as the Zambia State Insurance Corporation (ZSIC) and the Zambia National BuildingSociety (ZNBS). Entry of non-bank financial institutions into the financial sector becamerestrictive. However, Government established financial institutions such as the DevelopmentBank of Zambia (DBZ), the Local Authority Superannuation Fund (LASF) and theZambia Export and Import Bank, through appropriate Acts of Parliament.

The second phase of notable change in the financial sector in Zambia has been theliberalisation of the sector, and the economy generally, since 1991. The financial system hasbeen liberalised following the Banking and Financial Services Act of 1994 and 2000 thatprovides for regulation of the conduct of banking and financial services and safeguards forinvestors and customers. The central bank is equipped with powers to deal with flouting ofprudential and regulatory requirements. Public confidence in the Zambia financial systemhas grown, as it is seen to be robust and stable, with automated teller machines andcomputerised services.

The financial sector has grown and now comprises the following key players:

The Bank of Zambia; Commercial banks; Non-bank financial institutions (comprising the three building societies, some micro

Finance institutions, the National Savings and Credit Bank (NSCB), the DevelopmentBank of Zambia (DBZ), Bureau de changes and leasing companies);

Insurance companies; Pension funds; and Capital markets.

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The Banking environment in Zambia is controlled by the Central Bank - Bank of Zambiawhose principle objectives include: -

Maintenance of monetary and financial system stability through the formulation and

implementation of appropriate monetary and supervisory policies Issuing of bank licenses, supervising and regulating the activities of banks and non-

bank financial institutions to promote safe, sound and efficient payment mechanisms; Acting as banker and fiscal agent to the Government; Supporting the efficient operation of the exchange systems; Acting as advisor to the Government on economic and monetary management


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Some of the monetary policies that have been implemented for the financial marketsinclude:

Statutory reserves ratio requirement of 12.5% on third party deposit liabilities Adhere to the requirement of 35% core liquid asset ratio on third party deposit

liabilities. To ensure that no more than 25% of regulatory capital is loaned out to any one or

group of related names. To maintain a foreign exchange open position of 15% of the regulatory capital.

In addition, the design of prudential regulation plays an important role from a growthperspective. Supervision is the guardian of financial stability, which in turn cruciallydetermines the capability of the financial system to allocate resources efficiently and absorbliquidity shocks. Financial crises can have a deep and protracted impact on economicgrowth, as illustrated by several episodes of financial instability that occurred in Zambia inthe last decade. The contribution of prudential supervision to economic growth proceedsalong two dimensions. From a preventive perspective, supervision has to ensure acontinuous and comprehensive monitoring of all the potential threats to financial stability.The role of supervision is also crucial after the emergence of a crisis, in order to provide fora swift and ordered resolution. The Bank of Zambia can only be effective in these tworespects if it is able to pay sufficient attention to systemic issues, namely the risk ofcontagion effects. In order to address this issue in an effective way, the Bank should be ableto bridge the gap between information of a micro-prudential nature, namely informationon the safety and soundness of individual institutions, and macro-prudential analysis, whichencompasses all activities aimed at monitoring the exposure to systemic risk and atidentifying potential threats to financial stability arising from macroeconomic or financialdevelopments.

This line of argument would support a large role for the Bank of Zambia in supervision,since it has traditionally played a large role in macro-prudential analysis and thepreservation of financial stability and it has acquired a strong expertise in this field.Furthermore, smooth access of the Bank of Zambia to micro-prudential information wouldalso be profitable from the perspective of another traditional central banking task, namelythe oversight of payment systems.

The major argument against a large involvement of the Bank of Zambia in supervision is thealleged conflict of interest between monetary policy and prudential supervision. Manypeople have argued that the institution in charge of monetary policy cannot be entrustedwith supervision, because the monetary policy stance would be "contaminated" bysupervisory issues, for instance the need to safeguard the liquidity of individual banks.

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Despite entry of new financial institutions after the liberalisation of the economy, theZambian financial system has remained relatively small. The state owned Zambia NationalCommercial Bank (ZNCB) and foreign owned banks dominate the financial sector.Commercial banks hold about 90 percent of financial system assets and foreign equityparticipation is significant, accounting for three quarters of the banking systemcapitalisation. The banking system is comprised of 13 commercial banks. There are five


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large banks (Barclays Bank, Standard Chartered Bank, City Bank, Stanbic Bank and ZambiaNational Commercial Bank) four of which are subsidiaries of multinational banks (SMBs). Interms of assets, Barclays is the largest bank followed by the Government bank, ZambiaNational Commercial Bank (ZNCB), which is in the process of being privatised.

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The insurance business is very small in Zambia and contributed 1.5 percent of GDP inpremiums in 2000. The insurance market is dominated by the Zambia State InsuranceCorporation (ZSIC). Since deregulation in 1992, a number of locally registered insurancecompanies have emerged such as Professional Insurance of Zambia, Madison Insurance andGoldman Insurance.

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The pension sector in Zambia comprises the National Pension Scheme Authority (NPSA),which is mandatory for all employees in the formal sector, and supplementary schemes,which are offered by private sector employers. There are over 200 of these independently

administered pension schemes, which include both defined benefit and definedcontributory plans. The supplementary pension schemes- at about K360 billion- have thelargest assets in the pensions sector, while the NAPSA represents over K 230 billion.

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1997 1998 1999 2000 2001

Chart 1: Net Assets of Pension Funds

Net assets

Arguably the most significant development in the pensions industry in the recent past hasbeen the enactment for the first time in Zambia of specific pensions legislation thePension Scheme Regulation Act 1996. The Act was passed to provide for the prudentialregulation and supervision of pension schemes; to provide for the appointment of theRegistrar of Pensions and Insurance; to provide for the Registrars powers and functions,and to provide for matters in connection with or incidental to the foregoing.


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There are four other types of non-bank financial institutions in Zambia. These are:

Institutions that accept deposits from the public, including the three building societies,some micro finance institutions, and the National Savings and Credit Bank(NSCB); Leasing companies; Thirty-seven bureaux de change; and The Development Bank of Zambia (DBZ), which previously financed itself from foreign

development banks.

Government owns three of the non-bank financial institutions namely, the DBZ, the ZNBSand the NSCB.

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Leasing companies undertake a diverse range of financial services including factoring andtrade finance, term lending, corporate finance advisory services, investment advisoryservices, corporate restructuring, treasury management as well as traditional leasingactivities. Leasing companies are financed largely through donor lines of credit, and theissuance of promissory notes or debentures to institutional investors, notably, the NAPSA.

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The micro finance industry is relatively new in Zambia and serves a very small percentage ofthe population.

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International Financial Institutions (IFIs) refers to those financial institutions and regulatorsthat act on the international level, as opposed to those that act on a national or regionallevel. The main players include the World Bank, International Monetary Fund (IMF) and theEuropean Union. Ideally, international financial institutions should help integrate humanrights into the global economy by promoting the creation of national institutions to enforcerights and insisting on progressive improvement in respect for rights as part of loanpackages. However, their frequent failure to play this role has made both the World Bankand the International Monetary Fund the focus of much of the protest against globalization.

These protests are understandable because, until recently, these institutions pursued aconception of economic development that was largely insensitive to human rights. For

years, Nobel Prize economist Amartya Senand others have demonstrated that abuse ofhuman rights impedes economic development - that unaccountable governments are morelikely to indulge corruption or misguided economic projects and less likely to distribute thebenefits of development to those most in need. Yet the World Bank and the IMF insistedthat human rights were a purely "political" matter outside their economic mandates.Because of the influence of these institutions, governments and private investors oftenfollowed suit. The funds they plowed into authoritarian governments were frequently


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Thus, the World Bank Group consists of IBRD, IDA, IFC and MIGA. In general IBRD and IDAmake loans for public sector projects, and IFC and MIGA promote private sector investment.IBRD and IDA share the same staff, and must meet the World Banks policies andprocedures. The IFC and MIGA have recently adopted their own policies and procedures. Atthis time, only IBRD and IDA are subject to the jurisdiction of the Inspection Panel. For thepast several years, there have been negotiations and commitments to extend the Inspection

Panel to IFC and MIGA. In the meantime, however, a Compliance Advisor/Ombudsman(CAO) function for IFC and MIGA was created and began operation in July 1999. The CAOis an important step toward greater accountability in the private sector side of the WorldBank Group operations. It was designed in part to address the concerns of the localcommunities who are adversely affected by IFC and MIGA-supported projects and to advisesenior management. The CAO reports directly to the President of the Bank.

The World Bank Group is owned and governed by national governments, which becomemembers by contributing to its capital stock. To join IBRD, countries must first be membersof the International Monetary Fund (IMF). The amount of shares and voting power eachmember is allocated reflects its quota in the IMF. There are 181 member governments ofIBRD and 160 members of IDA. These countries are represented by a Board of Executive

Directors, which has 24 members. Voting power is determined by shares, so the moreeconomically powerful countries control a greater percentage of the vote. For instance, theUnited States as the largest shareholder controls approximately 17% of the vote. The Boardmust approve all projects financed by the Bank that are proposed by the BankManagement. The President of the Bank is appointed by the Board, and also serves asChairman of the Board.

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The IMF describes itself as an organization of 184 countries, working to foster globalmonetary cooperation, secure financial stability, facilitate international trade, promote highemployment and sustainable economic growth, and reduce poverty. With the exception ofNorth Korea, Cuba, Liechtenstein, Andorra, Monaco, Tuvalu and Nauru, all UN memberstates either participate directly in the IMF or are represented by other member states.

In the 1930s, as economic activity in the major industrial countries dwindled, countriesstarted attempting to defend their economies by increasing restrictions on imports. Toconserve dwindling reserves of gold and foreign exchange, some countries curtailed foreignimports, some devalued their currencies, and some introduced complicated restrictions onforeign exchange accounts held by their citizens. These measures were arguably detrimentalto the countries themselves as the theory of Ricardian comparative advantage states thateveryone gains from trade without restrictions. It is noteworthy to mention that, although

the "size of the pie" is enhanced according to this theory of free trade, when distributionalconcerns are taken into account, there are always industries that lose out even as othersbenefit.

As World War II came to a close, the leading allied countries considered various plans torestore order to international monetary relations, and at the Breton Woods conference theIMF emerged. The founding members drafted a charter (or Articles of Agreement) of aninternational institution to oversee the international monetary system and to promote both


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the elimination of exchange restrictions relating to trade in goods and services, and thestability of exchange rates.

The IMF came into existence in December 1945, when the first 29 countries signed itsArticles of Agreement. The statutory purposes of the IMF today are the same as when theywere formulated in 1944. From the end of World War II until the late-1970s, the capitalist

world experienced unprecedented growth in real incomes. Since then, Chinas integrationinto the capitalist system has added substantially to the growth of the system. Within thecapitalist system, the benefits of growth have not flowed equally to all, either within oramong nations, but most capitalist countries have seen recent increases in prosperity thatcontrast starkly with the conditions within capitalist countries during the interwar period.The lack of a recurring global depression is likely due to improvements in the conduct ofinternational economic policies that have encouraged the growth of international trade andhelped smooth the economic cycle of boom and bust.

The Fund has been criticised for the conditionality of its support, which is usually given onlyif the recipient country promises to implement IMF-approved economic reforms.Unfortunately, the IMF has often approved one size fits allpolicies that, not much later,turned out to be inappropriate. It has also been accused of creating moral hazard, in effectencouraging governments (and firms, banks and other investors) to behave recklessly bygiving them reason to expect that if things go badly the IMF will organise a bail-out. Indeed,some financiers have described an investment in a financially shaky country as a moral-hazard play because they were so confident that the IMF would ensure the safety of theirmoney, one way or another. Following the economic crisis in Asia during the late 1990s,and again after the crisis in Argentina, some policymakers argued (to no avail) for the IMFto be abolished, as the absence of its safety net would encourage more prudent behaviourall round. More sympathetic folk argued that the IMF should evolve into a global lender oflast resort.

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The European Union(EU) is an inter- governmental andsupra national union of 25 member states. The EuropeanUnion was established under that name in 1992 by theTreaty on European Union (the Maastricht Treaty).However, many aspects of the Union existed before thatdate through a series of predecessor relationships, datingback to 1951.

The European Investment Bank (EIB), the financing institution of the European Union, wascreated by the Treaty of Rome. The members of the EIB are the Member States of theEuropean Union, who have all subscribed to the Bank's capital.

The EIB enjoys its own legal personality and financial autonomy within the Communitysystem. The EIB's mission is to further the objectives of the European Union by providinglong-term finance for specific capital projects in keeping with strict banking practice.


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It thereby contributes towards building a closer-knit Europe, particularly in terms ofeconomic integration and greater economic and social cohesion.

As an institution of the Union, the EIB continuously adapts its activity todevelopments in Community policies.

As a Bank, it works in close collaboration with the banking community both when

borrowing on the capital markets and when financing capital projects. The EIB grants loans mainly from the proceeds of its borrowings, which, together with

"own funds" (paid-in capital and reserves), constitute its "own resources". Outside the European Union, EIB financing operations are conducted principally from

the Bank's own resources but also, under mandate, from Union or Member States'budgetary resources.

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Financial instruments can be thought of as easily tradeable packages of capital, each havingtheir own unique characteristics and structure. The wide array of financial instruments intoday's marketplace allows for the efficient flow of capital amongst the world's investors. Inother words, financial instruments package financial capital in readily tradeable forms - theydo not exist outside the context of the financial markets. Their diversity of forms mirrors thediversity of risk that they manage.

Financial instruments can be categorised according to whether they are cashinstruments orderivativesof other instruments.

Cash instruments can be divided into securities, which are readily transferable, and

other cash instruments such as loans and deposits, where both borrower and lenderhave to agree on a transfer.

Derivative instruments can be divided into exchange traded derivatives and over thecounter derivatives.

Alternatively they can be categorised by 'asset class' depending on whether they are equitybased (reflecting ownership of the issuing entity) or debt based (reflecting a loan theinvestor has made to the issuing entity). If it is debt, it can be further categorised into shortterm (less than one year) or long term. Foreign Exchange instruments and transactions areneither debt nor equity based and belong in their own category.

Combining the above methods for categorisation, the main instruments can be organized

into a matrix as follows:


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Financial Instruments Matrix

INSTRUMENT TYPE

ASSET CLASSSecurities Other cash

Exchange tradedderivatives

OTC derivatives

Debt (LongTerm)

>1 yearBonds Loans

Bond futuresOptions on bondfutures

Interest rate swapsInterest rate capsand floorsInterest rateoptionsExotic instruments

Debt (ShortTerm)


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Trading of that item or service is created through a price mechanism. The price is based onthe value of the item or service to the traders (buyers and sellers), depending on certainmarket factors. There are different markets in a system, such as

The services market The products market The financial markets.

A market is not necessarily a physical and geographically identifiable place, and goodstraded are not necessarily physical goods. Trading might take place over the telephone, andgoods traded might be knowledge, etc. Goods traded in markets are traded through a pricemechanism which expresses the interaction of demand for and supply of these goods as avalue. So, for instance, the trading of apples uses the price mechanism of a monetaryamount, for example K1, 500 per apple.

Zambias financial markets are thin and largely short term, in part reflecting prolongedperiods of high inflation, and volatility in interest rates. The inter-bank market isconcentrated in the overnight maturity. The primary market for government securities hasbeen growing rapidly but the secondary market is very small, as banks hold bills to maturity.Interest rate volatility in the inter-bank market has remained quite high. This has beenattributed to sharp swings in flows of cash between the government and the private sector.

The foreign exchange market is characterized by the concentration of supply in a smallnumber of large exporters and foreign aid. The BoZ has discontinued auctions of foreignexchange at the dealing window on 23 July 2002 and introduced the inter-bank foreignexchange market. This ensures that the exchange rate reflects conditions in the market.

Business firms, as well as individuals and government wings, often need to raise funds. Forinstance, suppose the Zambia Electricity Supply Corporation (ZESCO) forecasts an increase in thedemand for electricity in the North-Western province following recent increased mining activitiesand investments, and the company decides to build a new power plant. It almost certainly will nothave the K40 BILLION or so necessary to pay for the plant, thus ZESCO will have to raise thiscapital in the financial market. Institutions wanting to borrow or raise funds are brought togetherwith those having surplus funds in the financial markets.

These serve as intermediaries by channeling the savings of individuals, businesses, andgovernments into loans or investments. Many financial institutions directly or indirectly pay intereston deposited funds; others provide services for a fee (for example, checking accounts for which

customers pay service charges). Some financial institutions accept customer's savings depositsand lend this money to other customers or to firms; others invest customers' savings in earningassets such as real estate or shares and bonds.

What distinguishes financial institutions from other firms is the relatively small share of realassets on their balance sheets. Thus, the direct impact of financial institutions on the realeconomy is relatively minor. The indirect impact of financial markets and institutions oneconomic performance is extraordinarily important. The financial sector mobilizes savings


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The financial system is also particularly important in reallocating capital and thus providingthe basis for the continuous restructuring of the economy that is needed to supportgrowth. In countries with a highly developed financial system, a greater share of investmentis allocated to relatively fast growing sectors. When we look back more than one centuryago, during the Industrial Revolution, we see that England's financial system did a better

job in identifying and funding profitable ventures than other countries in the mid-1800s.This helped England enjoy comparatively greater economic success.

Nowadays, the lack of a well-developed stock market would be a particularly serious

disadvantage for any economy. Equity is essential for the emergence and growth ofinnovative firms. Today's young innovative high-technology firms will be the main drivers offuture structural change essential for maintaining a country's long-term growth potential.The contribution of financial markets in this area is a necessity for maintaining thecompetitiveness of an economy today given the strongly increased internationalcompetition, rapid technological progress and the increased role of innovation for growthperformance.

In recent years, "new markets", for stocks of young and growing companies, have becomea growing market segment. Equity financing is particularly advantageous for thesecompanies and their investors given the uncertainties of the economic return. As the term"shares" suggests, with equity financing you get your share of the outcome, whether it is

positive or negative. Banks, on the other hand, may be reluctant to provide loans owing tothe risk profile of these firms, and the greater exposure to a negative result in a loancontract.

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1999 2000 2000 2001 2001 2002 2002 2003 2003 2004


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_WA brokeris a commissioned agent of a buyer (or seller) who facilitates trade by locating aseller (or buyer) to complete the desired transaction. A broker does not take a position inthe assets he or she trades - that is, the broker does not maintain inventories in theseassets. The profits of brokers are determined by the commissions they charge to the usersof their services (either the buyers, the sellers, or both). Examples of brokers include realestate brokers and stock brokers.

a~WLike brokers, dealers facilitate trade by matching buyers with sellers of assets; they do notengage in asset transformation. Unlike brokers, however, a dealer can and does "takepositions" (i.e., maintain inventories) in the assets he or she trades that permit the dealer tosell out of inventory rather than always having to locate sellers to match every offer to buy.

Also, unlike brokers, dealers do not receive sales commissions. Rather, dealers make profitsby buying assets at relatively low prices and reselling them at relatively high prices (buy low- sell high). The price at which a dealer offers to sell an asset (the "asked price") minus theprice at which a dealer offers to buy an asset (the "bid price") is called the bid-ask spreadand represents the dealer's profit margin on the asset exchange. Real-world examples ofdealers include car dealers, dealers in GRZ bonds, and stock dealers.

f _~An investment bank assists in the initial sale of newly issued securities by engaging in anumber of different activities:

Advice: Advising corporations on whether they should issue bonds or stock, and, forbond issues, on the particular types of payment schedules these securities shouldoffer;

Underwriting: Guaranteeing corporations a price on the securities they offer, eitherindividually or by having several different investment banks form a syndicate tounderwrite the issue jointly;

Sales Assistance: Assisting in the sale of these securities to the public.

c~~ f~WUnlike brokers, dealers, and investment banks, financial intermediaries are financialinstitutions that engage in financial asset transformation. That is, financial intermediariespurchase one kind of financial asset from borrowers -- generally some kind of long-termloan contract whose terms are adapted to the specific circumstances of the borrower (e.g.,a mortgage) - and sell a different kind of financial asset to savers, generally some kind ofrelatively liquid claim against the financial intermediary (e.g., a deposit account). In addition,unlike brokers and dealers, financial intermediaries typically hold financial assets as part ofan investment portfolio rather than as an inventory for resale. In addition to making profitson their investment portfolios, financial intermediaries make profits by charging relativelyhigh interest rates to borrowers and paying relatively low interest rates to savers.


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Types of financial intermediaries include: Depository Institutions(commercial banks, savingsand loan associations, mutual savings banks, credit unions); Contractual Savings Institutions(life insurance companies, fire and casualty insurance companies, pension funds,government retirement funds); and Investment Intermediaries (finance companies, stockand bond mutual funds, money market mutual funds).

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The costs of collecting and aggregating information determine, to a large extent, the typesof financial market structures that emerge. These structures take four basic forms:

Auction marketsconducted through brokers;

Over-the-counter (OTC) marketsconducted through dealers;

Organized Exchanges, such as the Lusaka Stock Exchange, which combine auction and OTCmarket features. Specifically, organized exchanges permit buyers and sellers to trade with

each other in a centralized location, like an auction. However, securities are traded on thefloor of the exchange with the help of specialist traderswho combine broker and dealerfunctions. The specialists broker trades but also stand ready to buy and sell stocks frompersonal inventories if buy and sell orders do not match up.

Intermediation financial marketsconducted through financial intermediaries;

Financial markets taking the first three forms are generally referred to assecurities markets.Some financial markets combine features from more than one of these categories, so thecategories constitute only rough guidelines.

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An auction marketis some form of centralized facility (or clearing house) by which buyersand sellers, through their commissioned agents (brokers), execute trades in an open andcompetitive bidding process. The "centralized facility" is not necessarily a place wherebuyers and sellers physically meet. Rather, it is any institution that provides buyers andsellers with a centralized access to the bidding process. All of the needed information aboutoffers to buy (bid prices) and offers to sell (asked prices) is centralized in one location whichis readily accessible to all would-be buyers and sellers, e.g., through a computer network.No private exchanges between individual buyers and sellers are made outside of thecentralized facility.

An auction market is typically a public market in the sense that it is open to all agents whowish to participate. Auction markets can either be call markets- such as art auctions - forwhich bid and asked prices are all posted at one time, or continuous markets - such asstock exchanges and real estate markets - for which bid and asked prices can be posted atany time the market is open and exchanges take place on a continual basis. Experimentaleconomists have devoted a tremendous amount of attention in recent years to auctionmarkets.


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Many auction markets trade in relatively homogeneous assets (e.g. treasury bills to cutdown on information costs. Alternatively, some auction markets (e.g., in second-hand

jewelry, furniture, paintings etc.) allow would-be buyers to inspect the goods to be soldprior to the opening of the actual bidding process. This inspection can take the form of awarehouse tour, a catalog issued with pictures and descriptions of items to be sold, or (intelevised auctions) a time during which assets are simply displayed one by one to viewers

prior to bidding.

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An over-the-counter markethas no centralized mechanism or facility for trading. Instead,the market is a public market consisting of a number of dealers spread across a region, acountry, or indeed the world, who make the market in some type of asset. That is, thedealers themselves post bid and asked prices for this asset and then stand ready to buy orsell units of this asset with anyone who chooses to trade at these posted prices. The dealersprovide customers more flexibility in trading than brokers, because dealers can offsetimbalances in the demand and supply of assets by trading out of their own accounts.

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An intermediation financial market is a financial market in which financial intermediarieshelp transfer funds from savers to borrowers by issuing certain types of financial assets tosavers and receiving other types of financial assets from borrowers. The financial assetsissued to savers are claims against the financial intermediaries, hence liabilities of thefinancial intermediaries, whereas the financial assets received from borrowers are claimsagainst the borrowers, hence assets of the financial intermediaries.

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The enactment of the Banking and Financial Services Act, Securities Act, the PensionScheme Regulations Act and the Insurance Act and related legislation have resulted indistinct and separate regulatory responsibilities for the banking, securities, pensions andinsurance sectors. The main regulatory organs that have emerged in the financial sector are:

Bank of Zambia; Securities and Exchange Commission; Pensions and Insurance Authority; Zambia Competition Commission; and Patents and Companies Registration Office.

There exist a number of overlaps and areas of conflict in the regulatory environment of

financial services in Zambia leaving room for regulatory arbitrage and bureaucratictendencies to creep in. Technological improvements and globalisation have resulted in theemergence of complex financial structures which have blurred the traditional productboundaries among the banking, securities and insurance sectors as products and financialservice activities are becoming more integrated.


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A National Committee (the Financial Sector Development Committee (FSDC)) to develop aFinancial Sector Development Pan was constituted in October 2002 following weaknessesnoted in the financial sector. The FSDC's role has been to identify and analyse the factorsthat have led to the current state of the financial system and make recommendations on

the nature of institutional, legal and regulatory arrangements that will ensure theattainment of the Bank of Zambia (BoZ) vision of a robust and effectively functioningfinancial sector. The FSDP process is being led by the BoZ with the involvement, through theFSDC, of key stakeholders including the Pensions and Insurance Authority, the Securitiesand Exchange Commission, National Pension Scheme Authority, Bankers Association ofZambia, Ministry of Finance and National Planning, IMF and the World Bank.

t~ w~~ c~~ pConcerned with the limited contribution of the financial sector to economic development,the Government devised and formulated policy mechanisms for addressing the identifiedobstacles within the framework of the Poverty Reduction Strategy Paper (PRSP) whose

implementation started in 2002. In line with the PRSP framework, the World Bank and theInternational Monetary Fund undertook an assessment of the financial system through theFinancial Sector Assessment Programme (FSAP) which identified the following weaknessesin the Zambian financial sector:

Financial intermediation is lowand the existing highly segmented financial systemplays a limited role in the economy. The ratio of private sector credit to GDP in 2001was one of the lowest in Sub- Saharan Africa at 6% whilst that of public sectorcredit, at 14%, was one of the highest.Access to financial services is very limited forlow-income consumers while there are a handful of micro finance institutions thatare expected to fill in the gap in the provision of financial services.

Public financial institutions that were established to provide various financial servicesto the majority of the people in the country are insolvent, and therefore ineffective,or have closed down. Examples include ZNBS (mortgages); LIMA Bank and Co-operative Bank (agriculture lending), EXIM Bank (export and import finance), DBZ(long term finance) and NSCB (banking services for the rural populace).

The financial system is dominated by commercial banks, which are expected to caterfor all the credit needs of the economy. As such, there is a financial intermediarygap in the formal financial sector.

Net interest margin and the ratio of fee income to average assets in banks areamong the highest in Africa. The operating costs of commercial banks are high byinternational standards, especially given moderate lending and depository services.

This makes the provision of financial services unaffordable. In addition, commercialbanks are increasingly relying on income from treasury bills and foreign exchangeoperations. This makes them vulnerable to adverse changes in the financial marketsand could threaten their long-term solvency.

Banks are highly exposed to an array of potential risks specific to structuralweaknesses of the economy such as the dependence on the copper sector, non-


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performance of public sector borrowings and adverse movements in interest andexchange rates.

There are no formal structures for a financial safety net in Zambia, thereby leavingthe public exposed to suffer losses every time there is a bank failure, although anexplicit pay out of K500,000 is in place through Act No. 28 of 1995 and the

establishment of a deposit insurance scheme is under consideration forimplementation.

Despite compliance to most international standards, problems still exist in thesupervisory process, such as low minimum capital requirements, lack ofindependence from the Government, non-implementation of consolidatedsupervision, and lack of adequate procedures for the orderly liquidation of banksand other financial institutions.

Several weaknesses in the regulation and supervision of contractual savings exist.Specifically the Insurance Act does not adequately provide for effective prudentialregulations, the Securities and Exchange Commission and the Pensions andInsurance Authority are under-funded and lack requisite supervisory skills to

effectively carry out their duties. Further, NAPSA is not supervised by anindependent regulatory body.

There exists weak responsiveness of the labour market to the skill and knowledgeneeds of the financial sector;

There are limited resources to train supervisory staff. While market activities of somebanks and non-bank financial institutions are becoming more complex in line withdevelopments in the international financial systems, the supervisory skills gapcontinues to lag behind.

Poor credit culture. The credit rating of customers who default in liquidated or

existing banks is not affected by their previous record.

The government has multiple and potentially conflicting roles in the financial sector.It is the regulator, supervisor, owner of several large financial institutions, the mainborrower from the financial system, client and major depositor and user of financialservices. These roles create problems of lack of transparency and potential conflictof interest.

Administrative weaknesses in the payment system cause delays and inefficiencies inthe process of remitting tax revenue to BoZ, thereby creating some float in thefinancial system.

While certain improvements have been registered in primary market activity forgovernment securities, secondary market activity remains extremely low. Thecommercial banks holding of securities to maturity has stifled secondary marketactivity.

Fiscal and monetary policy implementation are not well coordinated, such thatliquidity shocks that emanate from unanticipated Government spending are not


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sufficiently smoothened out, causing volatility in the inter-bank money market. Acomplicating factor in BoZs liquidity management is the uncertainty in thegovernments financing operations. The difficulty in reliably projectingGovernments cash flow and absorbing liquidity through open market operations(OMO) and Treasury bills auctions hamper BoZs control of liquidity. Theseunanticipated upsurges in liquidity are the primary cause of volatility in the inter-

bank money market interest rates.

Direct instruments of monetary policy implementation, such as statutory reserveratios, are still prominent in Zambias monetary framework. The relatively highstatutory reserve ratios tend to raise the cost of funds for banks. The final incidenceof this cost is often passed over by the banks to the public by offering lower depositand or higher lending rates.

The financing of persistent fiscal deficits has created distortions in the financialmarkets. Government borrowing through issuance of government securities tofinance large fiscal deficit has significantly reduced the amount of loanable funds in

the financial sector and contributed to the high cost of credit and the subsequentcrowding-out of private investment. Furthermore, Government borrowing from theBoZ, to supplement deficit financing has often left BoZ with a daunting task ofkeeping the growth of money supply within the desired realm.

Despite having a potentially unsustainable stock of domestic debt, there is nodeliberate programme in place to manage this debt stock. With a domestic debt toGDP ratio of 9.8% in 2002, Zambia had one of the highest debt ratios in Sub-Saharan Africa.

In light of the above, the FSDP had been prepared in order to address the weaknessesidentified above and to provide for a systematic and coherent approach for the realisation

of the vision for the financial system.

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1. What would happen to the standard of living in Zambia if people lost faith in the safetyof our financial institutions? And why?

2. Suppose you feel that the economy is just entering a recession. Your firm must raisecapital immediately, and debt will be used. Should you borrow on a long term basis or shortterm basis?


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1. Define each of the following terms:

Money market; capital market.

Primary market; secondary market

Financial intermediary

2. What are financial intermediaries and what economic functions do they perform?

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This is created by a financial relationship between suppliers and users of short-term funds(funds with maturities of one year or less). The money market exists because someindividuals, businesses, governments, and financial institutions have temporarily idle funds thatthey wish to put to some interest-earning use.

q `~~ j~The capital market is a market that enables suppliers and users of long-term funds to make

long-term transactions. Included are securities issues of business and government. Thebackbone of the capital market is formed by various securities exchanges that provide aforum for bond and share transactions.

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Is that part of the capital market that deals with the issuance of new securities. Companies,governments or public sector institutions can obtain funding through the sale of a newstock or bond issue. This is typically done through a syndicate of securities dealers. Theprocess of selling new issues to investors is called underwriting. In the case of a new stockissue, this sale is called an initial public offering (IPO). Dealers earn a commission that is builtinto the price of the security offering, though it can be found in the prospectus.

p~ j~In the secondary market, the trading of shares is between investors. This trading usuallytakes place through a Stock Exchange, such as the Lusaka Stock Exchange (LuSe).


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The secondary market is the financial market for trading of securities that have alreadybeen issued in an initial private or public offering. Alternatively,secondary marketcan referto the market for any kind of used goods. The market that exists in a new security just afterthe new issue is often referred to as the aftermarket. Once a newly issued stock is listedon a stock exchange, investors and speculators can easily trade on the exchange, as marketmakers provide bids and offers in the new stock.

In the secondary market, securities are sold by and transferred from one investor orspeculator to another. It is therefore important that the secondary market be highly liquidand transparent. Before electronic means of communications, the only way to create thisliquidity was for investors and speculators to meet at a fixed place regularly. This is howstock exchanges originated.

Secondary markets are vital to an efficient and modern capital market. Fundamentally,secondary markets mesh the investor's preference for liquidity (i.e., the investor's desire notto tie up his or her money for a long period of time, in case the investor needs it to dealwith unforeseen circumstances) with the capital user's preference to be able to use thecapital for an extended period of time. For example, a traditional loan allows the borrowerto pay back the loan, with interest, over a certain period. For the length of that period oftime, the bulk of the lender's investment is inaccessible to the lender, even in cases ofemergencies. Likewise, in an emergency, a partner in a traditional partnership is only beable to access his or her original investment if he or she finds another investor willing to buyout his or her interest in the partnership. With a securitized loan or equity interest (such asbonds) or tradable stocks), the investor can relatively easily sell his or her interest in theinvestment, particularly if the loan or ownership equity has been broken into relatively smallparts. This selling and buying of small parts of a larger loan or ownership interest in aventure is called secondary market trading.

Under traditional lending and partnership arrangements, investors may be less likely to put

their money into long-term investments, and more likely to charge a higher interest rates(or demand a greater share of the profits) if they do. With secondary markets, however,investors know that they can recoup some of their investment quickly, if their owncircumstances change.

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The term financial intermediary may refer to an institution, firm or individual whoperforms intermediation between two or more parties in a financial context. Typically thefirst party is a provider of a product or service and the second party is a consumer orcustomer. A financial institution, such as a commercial bank or savings and loanassociation, which accepts deposits from the public and makes loans to those needing

credit is a typical case in question. By acting as a middleman between cash surplus units inthe economy (savers) and deficit spending units (borrowers), a financial intermediary makesit possible for borrowers to tap into the vast pool of wealth in government insured deposits-accounting for more than half the financial assets held by all financial service companies-inbanks and other depository financial institutions.


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The movement of capital from surplus units through financial institutions to deficit unitsseeking bank credit is an indirect form of financing known as intermediation-consumers arenet suppliers of funds, whereas business and government are net borrowers. A bank givesits depositors a claim against itself, meaning that the depositor has recourse against thebank (and, if the bank fails, the deposit insurance fund protecting insured deposits), but hasno claim against the borrower who takes out a bank loan.

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chapter 2 - the financial system in the economy

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