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T TH HI I F FI IN NA AN NC CI IA AL L 8 8Y Y8 8T TI IM M I IN N T TH HI I I IC CO ON NO OM MY Y


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

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

2.0 THI ROLI OF THI FINANCIAL 8Y8TIM
Lets face it; we can never escape the reality that Life in abundance is probably one of the
greatest 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 would
eventually lead to true happiness. Even the astronomers at National Aeronautics and Space
Administration (NASA) look toward the heavens to try and find explanations that would
enhance our life on earth. The business world can almost be described with the same
philosophy 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 of
nothing, 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 with
numerous determinants playing a part in trying to supplement human life. The basic needs
in 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 borrow money - this is called demand for money. This phenomenon
happens where there is a shortage of money in the hands of those who want to
make use of it.
In the financial system funds flow from those who have surplus funds to those who have a
shortage of funds, either by direct, market-based financing or by indirect, bank-based
finance.

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Here we can draw comfort from the words of the former British Prime Minister William
Gladstone 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 organs
take their tone."
The Zambian Government, for instance, needs money for certain projects, while certain
private sector companies or individuals might have excess money to invest in profitable
investments. The price paid for money is interest paid on the amount borrowed, and the
interest 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, giving
them 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 erect
new 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 Limited
would seek to merge these different needs and demands of borrowers and lenders through
negotiation 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. These
instruments are called securities.

QIICK RIVIIW QII8TION8
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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2.1 THI ROLI OF FINANCIAL IN8TITITION8 IN ZAMBIA
According to the Bank of Zambia, the financial sector in Zambia has undergone two
notable phases in its development from the time of Zambias independence in 1964. Firstly,
during the early 1970s when the Governments nationalisation program had an important
impact upon the sector. Although commercial banks were not nationalised, all other major
financial institutions were nationalised and merged to form government owned institutions
such as the Zambia State Insurance Corporation (ZSIC) and the Zambia National Building
Society (ZNBS). Entry of non-bank financial institutions into the financial sector became
restrictive. However, Government established financial institutions such as the Development
Bank of Zambia (DBZ), the Local Authority Superannuation Fund (LASF) and the
Zambia Export and Import Bank, through appropriate Acts of Parliament.

The second phase of notable change in the financial sector in Zambia has been the
liberalisation of the sector, and the economy generally, since 1991. The financial system has
been liberalised following the Banking and Financial Services Act of 1994 and 2000 that
provides for regulation of the conduct of banking and financial services and safeguards for
investors and customers. The central bank is equipped with powers to deal with flouting of
prudential and regulatory requirements. Public confidence in the Zambia financial system
has grown, as it is seen to be robust and stable, with automated teller machines and
computerised 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 Development
Bank of Zambia (DBZ), Bureau de changes and leasing companies);
Insurance companies;
Pension funds; and
Capital markets.

2.1.1 Thc Bank of Zambia (BoZ)
The Banking environment in Zambia is controlled by the Central Bank - Bank of Zambia
whose 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 markets
include:
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 growth
perspective. Supervision is the guardian of financial stability, which in turn crucially
determines the capability of the financial system to allocate resources efficiently and absorb
liquidity shocks. Financial crises can have a deep and protracted impact on economic
growth, as illustrated by several episodes of financial instability that occurred in Zambia in
the last decade. The contribution of prudential supervision to economic growth proceeds
along two dimensions. From a preventive perspective, supervision has to ensure a
continuous 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 for
a swift and ordered resolution. The Bank of Zambia can only be effective in these two
respects if it is able to pay sufficient attention to systemic issues, namely the risk of
contagion effects. In order to address this issue in an effective way, the Bank should be able
to bridge the gap between information of a micro-prudential nature, namely information
on the safety and soundness of individual institutions, and macro-prudential analysis, which
encompasses all activities aimed at monitoring the exposure to systemic risk and at
identifying potential threats to financial stability arising from macroeconomic or financial
developments.
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 the
preservation 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 would
also be profitable from the perspective of another traditional central banking task, namely
the oversight of payment systems.
The major argument against a large involvement of the Bank of Zambia in supervision is the
alleged conflict of interest between monetary policy and prudential supervision. Many
people have argued that the institution in charge of monetary policy cannot be entrusted
with supervision, because the monetary policy stance would be "contaminated" by
supervisory issues, for instance the need to safeguard the liquidity of individual banks.
2.1.2 Commcrcial Banks

Despite entry of new financial institutions after the liberalisation of the economy, the
Zambian financial system has remained relatively small. The state owned Zambia National
Commercial Bank (ZNCB) and foreign owned banks dominate the financial sector.
Commercial banks hold about 90 percent of financial system assets and foreign equity
participation is significant, accounting for three quarters of the banking system
capitalisation. 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 Zambia
National Commercial Bank) four of which are subsidiaries of multinational banks (SMBs). In
terms of assets, Barclays is the largest bank followed by the Government bank, Zambia
National Commercial Bank (ZNCB), which is in the process of being privatised.

2.1.3 Insurancc Companics

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

2.1.4 Pcnsion Funds

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 defined
contributory plans. The supplementary pension schemes- at about K360 billion- have the
largest assets in the pensions sector, while the NAPSA represents over K 230 billion.

161
214
266
326
465
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50
100
150
200
250
300
350
400
450
500
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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 has
been the enactment for the first time in Zambia of specific pensions legislation the
Pension Scheme Regulation Act 1996. The Act was passed to provide for the prudential
regulation and supervision of pension schemes; to provide for the appointment of the
Registrar 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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2.1.5 Non - Bank Financial Institutions

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 ZNBS
and the NSCB.

2.1.6 Lcasing Companics

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

2.1. Micro Financc Institutions

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

2.2 INTIRNATIONAL FINANCIAL IN8TITITION8
International Financial Institutions (IFIs) refers to those financial institutions and regulators
that act on the international level, as opposed to those that act on a national or regional
level. The main players include the World Bank, International Monetary Fund (IMF) and the
European Union. Ideally, international financial institutions should help integrate human
rights into the global economy by promoting the creation of national institutions to enforce
rights and insisting on progressive improvement in respect for rights as part of loan
packages. However, their frequent failure to play this role has made both the World Bank
and the International Monetary Fund the focus of much of the protest against globalization.
These protests are understandable because, until recently, these institutions pursued a
conception of economic development that was largely insensitive to human rights. For
years, Nobel Prize economist Amartya Sen and others have demonstrated that abuse of
human rights impedes economic development - that unaccountable governments are more
likely to indulge corruption or misguided economic projects and less likely to distribute the
benefits of development to those most in need. Yet the World Bank and the IMF insisted
that human rights were a purely "political" matter outside their economic mandates.
Because of the influence of these institutions, governments and private investors often
followed suit. The funds they plowed into authoritarian governments were frequently

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wasted or misspent, while debts piled up that now thwart successor governments' efforts
to lift their people from poverty.
Many of these problems remain today. But the World Bank in particular has begun to
change this sorry legacy. The bank's efforts to combat corruption, reduce poverty, and
promote good governance and the rule of law have led it, in some countries, to show
greater sensitivity to human rights. Yet much of this attention is ad hoc. Additional progress
is needed to institutionalize human rights as an essential foundation of the bank's
development work if the bank is to help enforce human rights in the global economy.
The bank's approach to Zambia, illustrate some of the positive steps it took in 2000 to
address human rights issues:
The donors conference convened in Zambia in July was the first in Africa to be wholly
transparent. All deliberations were open to independent human rights activists and
other representatives of civil society, and the human rights performance of the
government was freely discussed as an integral part of development plans; and
In fighting corruption, the World Bank has also begun to pay more attention to human
rights-related concerns. It has promoted greater transparency in bank projects and
encouraged civil society to scrutinize these transactions. But it could still do more to
support whistle-blowers, journalists, and nongovernmental monitors who are arrested
or abused for exposing corruption. It should also do more to promote the basic legal
and judicial reform needed to achieve access to justice for all.
2.3.1 THI WORLD BANK


The World Bank is a public international
financial institution created at the end of World
War II whose mission is to provide loans and
credits to developing countries for projects that
alleviate poverty and promote social and
economic development. The Banks lending to
governments is done through the International
Bank for Reconstruction and Development
(IBRD) and the International Development
Association (IDA). IBRD loans are made with
favorable interest rates and rather long
repayment schedules. IDA credits are extended
to the poorest of the poor countries (defined
largely in terms of per capita income) at no interest, with very relaxed loan repayment
schedules. The IBRD and IDA also provide loans and guarantees in support of private sector
projects. However, the majority of Bank financing for private sector operations is done
through the International Finance Corporation (IFC) and the Multilateral International
Guarantee Agency (MIGA).
t _~ e~ n~ t~ a`

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Thus, the World Bank Group consists of IBRD, IDA, IFC and MIGA. In general IBRD and IDA
make 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 and
procedures. The IFC and MIGA have recently adopted their own policies and procedures. At
this time, only IBRD and IDA are subject to the jurisdiction of the Inspection Panel. For the
past 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 CAO
is an important step toward greater accountability in the private sector side of the World
Bank Group operations. It was designed in part to address the concerns of the local
communities who are adversely affected by IFC and MIGA-supported projects and to advise
senior management. The CAO reports directly to the President of the Bank.
The World Bank Group is owned and governed by national governments, which become
members by contributing to its capital stock. To join IBRD, countries must first be members
of the International Monetary Fund (IMF). The amount of shares and voting power each
member is allocated reflects its quota in the IMF. There are 181 member governments of
IBRD 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 more
economically powerful countries control a greater percentage of the vote. For instance, the
United States as the largest shareholder controls approximately 17% of the vote. The Board
must approve all projects financed by the Bank that are proposed by the Bank
Management. The President of the Bank is appointed by the Board, and also serves as
Chairman of the Board.
2.3.2 THI INTIRNATIONAL MONITARY FIND
The IMF describes itself as an organization of 184 countries, working to foster global
monetary cooperation, secure financial stability, facilitate international trade, promote high
employment and sustainable economic growth, and reduce poverty. With the exception of
North Korea, Cuba, Liechtenstein, Andorra, Monaco, Tuvalu and Nauru, all UN member
states 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, countries
started attempting to defend their economies by increasing restrictions on imports. To
conserve dwindling reserves of gold and foreign exchange, some countries curtailed foreign
imports, some devalued their currencies, and some introduced complicated restrictions on
foreign exchange accounts held by their citizens. These measures were arguably detrimental
to the countries themselves as the theory of Ricardian comparative advantage states that
everyone 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 distributional
concerns are taken into account, there are always industries that lose out even as others
benefit.
As World War II came to a close, the leading allied countries considered various plans to
restore order to international monetary relations, and at the Breton Woods conference the
IMF emerged. The founding members drafted a charter (or Articles of Agreement) of an
international 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 the
stability of exchange rates.
The IMF came into existence in December 1945, when the first 29 countries signed its
Articles of Agreement. The statutory purposes of the IMF today are the same as when they
were 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 integration
into the capitalist system has added substantially to the growth of the system. Within the
capitalist system, the benefits of growth have not flowed equally to all, either within or
among nations, but most capitalist countries have seen recent increases in prosperity that
contrast 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 of
international economic policies that have encouraged the growth of international trade and
helped smooth the economic cycle of boom and bust.
The Fund has been criticised for the conditionality of its support, which is usually given only
if the recipient country promises to implement IMF-approved economic reforms.
Unfortunately, the IMF has often approved one size fits all policies that, not much later,
turned out to be inappropriate. It has also been accused of creating moral hazard, in effect
encouraging governments (and firms, banks and other investors) to behave recklessly by
giving 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 their
money, 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 IMF
to be abolished, as the absence of its safety net would encourage more prudent behaviour
all round. More sympathetic folk argued that the IMF should evolve into a global lender of
last resort.
2.3.3 THI IIROPIAN INION

The European Union (EU) is an inter- governmental and
supra national union of 25 member states. The European
Union was established under that name in 1992 by the
Treaty on European Union (the Maastricht Treaty).
However, many aspects of the Union existed before that
date through a series of predecessor relationships, dating
back to 1951.
The European Investment Bank (EIB), the financing institution of the European Union, was
created by the Treaty of Rome. The members of the EIB are the Member States of the
European Union, who have all subscribed to the Bank's capital.
The EIB enjoys its own legal personality and financial autonomy within the Community
system. The EIB's mission is to further the objectives of the European Union by providing
long-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 of
economic integration and greater economic and social cohesion.
As an institution of the Union, the EIB continuously adapts its activity to
developments 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.
2.4 FINANCIAL IN8TRIMINT8 AND MARKIT8
2.4.1 FINANCIAL IN8TRIMINT8
Financial instruments can be thought of as easily tradeable packages of capital, each having
their own unique characteristics and structure. The wide array of financial instruments in
today's marketplace allows for the efficient flow of capital amongst the world's investors. In
other words, financial instruments package financial capital in readily tradeable forms - they
do not exist outside the context of the financial markets. Their diversity of forms mirrors the
diversity of risk that they manage.
Financial instruments can be categorised according to whether they are cash instruments or
derivatives of 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 lender
have to agree on a transfer.
Derivative instruments can be divided into exchange traded derivatives and over the
counter derivatives.
Alternatively they can be categorised by 'asset class' depending on whether they are equity
based (reflecting ownership of the issuing entity) or debt based (reflecting a loan the
investor has made to the issuing entity). If it is debt, it can be further categorised into short
term (less than one year) or long term. Foreign Exchange instruments and transactions are
neither 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 CLASS
Securities Other cash
Exchange traded
derivatives
OTC derivatives
Debt (Long
Term)
>1 year
Bonds Loans
Bond futures
Options on bond
futures
Interest rate swaps
Interest rate caps
and floors
Interest rate
options
Exotic instruments
Debt (Short
Term)
<=1 year
Bills, e.g. T-
Bills
Commercial
paper
Deposits
Certificates of
deposit
Short term interest
rate futures
Forward rate
agreements
Equity Stock N/A
Stock options
Equity futures
Stock options
Exotic instruments
Foreign
Exchange
N/A
Spot foreign
exchange
Currency futures
Foreign exchange
options
Outright forwards
Foreign exchange
swaps
Currency swaps
Note:
Some instruments defy categorisation into the above matrix, for example
repurchase agreements.

2.4.2 FINANCIAL MARKIT8
People have different needs, and in trying to fulfill these needs, opposite needs are
matched. Where needs are matched on a large scale, markets for those needs develop.
Market forces are thus:
The supply of an item or service where there is
A demand for that item or service.

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Trading of that item or service is created through a price mechanism. The price is based on
the value of the item or service to the traders (buyers and sellers), depending on certain
market 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 goods
traded are not necessarily physical goods. Trading might take place over the telephone, and
goods traded might be knowledge, etc. Goods traded in markets are traded through a price
mechanism which expresses the interaction of demand for and supply of these goods as a
value. So, for instance, the trading of apples uses the price mechanism of a monetary
amount, for example K1, 500 per apple.
Zambias financial markets are thin and largely short term, in part reflecting prolonged
periods of high inflation, and volatility in interest rates. The inter-bank market is
concentrated in the overnight maturity. The primary market for government securities has
been 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 been
attributed 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 small
number of large exporters and foreign aid. The BoZ has discontinued auctions of foreign
exchange at the dealing window on 23 July 2002 and introduced the inter-bank foreign
exchange 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. For
instance, suppose the Zambia Electricity Supply Corporation (ZESCO) forecasts an increase in the
demand for electricity in the North-Western province following recent increased mining activities
and investments, and the company decides to build a new power plant. It almost certainly will not
have the K40 BILLION or so necessary to pay for the plant, thus ZESCO will have to raise this
capital in the financial market. Institutions wanting to borrow or raise funds are brought together
with those having surplus funds in the financial markets.
These serve as intermediaries by channeling the savings of individuals, businesses, and
governments into loans or investments. Many financial institutions directly or indirectly pay interest
on 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 deposits
and lend this money to other customers or to firms; others invest customers' savings in earning
assets such as real estate or shares and bonds.

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

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and allocates credit across space and time. It provides not only payment services, but also
enables firms and households to cope with economic uncertainties by hedging, pooling,
sharing and pricing risks. An efficient financial sector reduces the cost and risk of producing
and trading goods and services and thus makes an important contribution to raising the
standard of living.
Efficient financial markets require an infrastructure of laws, conventions and regulation.
Most of all, an efficient financial system requires confidence. Confidence encourages
investors to allocate their savings through financial markets and institutions rather than to
buy non-productive assets as a store of value. Such confidence can be fostered by
appropriate regulation of institutions and markets to ensure users of financial services that
they will receive fair treatment. The challenge is to foster a static and dynamically efficient
financial system while maintaining sufficient regulatory oversight to promote confidence in
the safety and soundness of the financial system. Financial institutions actively participate in
the financial markets as both suppliers and users of funds.
Thc Moncy Markct
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 some
individuals, businesses, governments, and financial institutions have temporarily idle funds that
they wish to put to some interest-earning use. Most money market transactions are made in
marketable securities - short-term debt instruments. By definition, the duration of
transactions is up to one year.
Thc Capital Markct
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. The
backbone of the capital market is formed by various securities exchanges that provide a
forum for bond and share transactions.
Both market and bank-based financial systems have their own comparative advantages. For
some industries at certain times of their development, market-based financing is
advantageous. For example, financing through stock markets is optimal for industries where
there are continuous technological advances and where there is little consensus on how
firms should be managed. The stock market checks whether the manager's view of the
firm's production is a sensible one. For other industries, bank-based financing is preferable.
This holds in particular for industries which face strong information asymmetries. Financing
through financial intermediaries is an effective solution to adverse selection and moral
hazard problems that exist between lenders and borrowers. Banks in particular have
developed expertise to distinguish between good and bad borrowers. Economies that have
both well-developed banking sectors and capital markets thus have an advantage.
Furthermore, in times of crisis in either system, the other system can perform the function
of the famous spare wheel.


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Raising Capital on thc Lusaka 8tock Ichangc

The financial system is also particularly important in reallocating capital and thus providing
the basis for the continuous restructuring of the economy that is needed to support
growth. In countries with a highly developed financial system, a greater share of investment
is allocated to relatively fast growing sectors. When we look back more than one century
ago, 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 of
innovative firms. Today's young innovative high-technology firms will be the main drivers of
future 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 the
competitiveness of an economy today given the strongly increased international
competition, rapid technological progress and the increased role of innovation for growth
performance.
In recent years, "new markets", for stocks of young and growing companies, have become
a growing market segment. Equity financing is particularly advantageous for these
companies 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 to
the risk profile of these firms, and the greater exposure to a negative result in a loan
contract.

0
2,000,000
4,000,000
6,000,000
8,000,000
10,000,000
12,000,000
14,000,000
16,000,000
18,000,000
1999 2000 2000 2001 2001 2002 2002 2003 2003 2004

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Thc Functions of Financial Markcts
Financial markets serve six basic functions. These functions are briefly listed below:
Borrowing and Lending: Financial markets permit the transfer of funds
(purchasing power) from one agent to another for either investment or
consumption purposes.
Price Determination: Financial markets provide vehicles by which prices are set
both for newly issued financial assets and for the existing stock of financial assets.
Information Aggregation and Coordination: Financial markets act as collectors
and aggregators of information about financial asset values and the flow of funds
from lenders to borrowers.
Risk Sharing: Financial markets allow a transfer of risk from those who undertake
investments to those who provide funds for those investments.
Liquidity: Financial markets provide the holders of financial assets with a chance to
resell or liquidate these assets.
Efficiency: Financial markets reduce transaction costs and information costs.
In attempting to characterize the way financial markets operate, one must consider both
the various types of financial institutions that participate in such markets and the various
ways in which these markets are structured.
Who arc thc Major Playcrs in Financial Markcts:
By definition, financial institutions are institutions that participate in financial markets, i.e.,
in the creation and/or exchange of financial assets. At present in Zambia the major players
in the financial markets are:
LuSE All Share Index (LASI)
100.00
300.00
500.00
700.00
900.00
1,100.00
1,300.00
Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06

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Brokcrs:
A broker is a commissioned agent of a buyer (or seller) who facilitates trade by locating a
seller (or buyer) to complete the desired transaction. A broker does not take a position in
the assets he or she trades - that is, the broker does not maintain inventories in these
assets. The profits of brokers are determined by the commissions they charge to the users
of their services (either the buyers, the sellers, or both). Examples of brokers include real
estate brokers and stock brokers.
Dcalcrs:
Like brokers, dealers facilitate trade by matching buyers with sellers of assets; they do not
engage in asset transformation. Unlike brokers, however, a dealer can and does "take
positions" (i.e., maintain inventories) in the assets he or she trades that permit the dealer to
sell 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 profits
by 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 the
price at which a dealer offers to buy an asset (the "bid price") is called the bid-ask spread
and represents the dealer's profit margin on the asset exchange. Real-world examples of
dealers include car dealers, dealers in GRZ bonds, and stock dealers.
Invcstmcnt Banks
An investment bank assists in the initial sale of newly issued securities by engaging in a
number of different activities:
Advice: Advising corporations on whether they should issue bonds or stock, and, for
bond issues, on the particular types of payment schedules these securities should
offer;
Underwriting: Guaranteeing corporations a price on the securities they offer, either
individually or by having several different investment banks form a syndicate to
underwrite the issue jointly;
Sales Assistance: Assisting in the sale of these securities to the public.
Financial Intcrmcdiarics:
Unlike brokers, dealers, and investment banks, financial intermediaries are financial
institutions that engage in financial asset transformation. That is, financial intermediaries
purchase one kind of financial asset from borrowers -- generally some kind of long-term
loan 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 of
relatively 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 of
an investment portfolio rather than as an inventory for resale. In addition to making profits
on their investment portfolios, financial intermediaries make profits by charging relatively
high 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, savings
and 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, stock
and bond mutual funds, money market mutual funds).
What Typcs of Financial Markct 8tructurcs Iist:
The costs of collecting and aggregating information determine, to a large extent, the types
of financial market structures that emerge. These structures take four basic forms:
Auction markets conducted through brokers;
Over-the-counter (OTC) markets conducted through dealers;
Organized Exchanges, such as the Lusaka Stock Exchange, which combine auction and OTC
market 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 the
floor of the exchange with the help of specialist traders who combine broker and dealer
functions. The specialists broker trades but also stand ready to buy and sell stocks from
personal inventories if buy and sell orders do not match up.
Intermediation financial markets conducted through financial intermediaries;
Financial markets taking the first three forms are generally referred to as securities markets.
Some financial markets combine features from more than one of these categories, so the
categories constitute only rough guidelines.
Auction Markcts:
An auction market is some form of centralized facility (or clearing house) by which buyers
and sellers, through their commissioned agents (brokers), execute trades in an open and
competitive bidding process. The "centralized facility" is not necessarily a place where
buyers and sellers physically meet. Rather, it is any institution that provides buyers and
sellers with a centralized access to the bidding process. All of the needed information about
offers to buy (bid prices) and offers to sell (asked prices) is centralized in one location which
is 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 the
centralized facility.
An auction market is typically a public market in the sense that it is open to all agents who
wish to participate. Auction markets can either be call markets - such as art auctions - for
which bid and asked prices are all posted at one time, or continuous markets - such as
stock exchanges and real estate markets - for which bid and asked prices can be posted at
any time the market is open and exchanges take place on a continual basis. Experimental
economists have devoted a tremendous amount of attention in recent years to auction
markets.

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Many auction markets trade in relatively homogeneous assets (e.g. treasury bills to cut
down 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 sold
prior to the opening of the actual bidding process. This inspection can take the form of a
warehouse tour, a catalog issued with pictures and descriptions of items to be sold, or (in
televised auctions) a time during which assets are simply displayed one by one to viewers
prior to bidding.
Ovcr-thc-Countcr Markcts:
An over-the-counter market has no centralized mechanism or facility for trading. Instead,
the market is a public market consisting of a number of dealers spread across a region, a
country, or indeed the world, who make the market in some type of asset. That is, the
dealers themselves post bid and asked prices for this asset and then stand ready to buy or
sell units of this asset with anyone who chooses to trade at these posted prices. The dealers
provide customers more flexibility in trading than brokers, because dealers can offset
imbalances in the demand and supply of assets by trading out of their own accounts.
Intcrmcdiation Financial Markcts:
An intermediation financial market is a financial market in which financial intermediaries
help transfer funds from savers to borrowers by issuing certain types of financial assets to
savers and receiving other types of financial assets from borrowers. The financial assets
issued to savers are claims against the financial intermediaries, hence liabilities of the
financial intermediaries, whereas the financial assets received from borrowers are claims
against the borrowers, hence assets of the financial intermediaries.

Rcgulatory Framcork in thc Zambian Financial Markcts

The enactment of the Banking and Financial Services Act, Securities Act, the Pension
Scheme Regulations Act and the Insurance Act and related legislation have resulted in
distinct and separate regulatory responsibilities for the banking, securities, pensions and
insurance 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 bureaucratic
tendencies to creep in. Technological improvements and globalisation have resulted in the
emergence of complex financial structures which have blurred the traditional product
boundaries among the banking, securities and insurance sectors as products and financial
service activities are becoming more integrated.




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2.5 CIRRINT 8ITIATION IN THI ZAMBIAN FINANCIAL 8Y8TIM

A National Committee (the Financial Sector Development Committee (FSDC)) to develop a
Financial Sector Development Pan was constituted in October 2002 following weaknesses
noted in the financial sector. The FSDC's role has been to identify and analyse the factors
that 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 the
attainment of the Bank of Zambia (BoZ) vision of a robust and effectively functioning
financial sector. The FSDP process is being led by the BoZ with the involvement, through the
FSDC, of key stakeholders including the Pensions and Insurance Authority, the Securities
and Exchange Commission, National Pension Scheme Authority, Bankers Association of
Zambia, Ministry of Finance and National Planning, IMF and the World Bank.
Wcakncsscs in thc Zambian Financial 8cctor

Concerned with the limited contribution of the financial sector to economic development,
the Government devised and formulated policy mechanisms for addressing the identified
obstacles 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 the
International Monetary Fund undertook an assessment of the financial system through the
Financial Sector Assessment Programme (FSAP) which identified the following weaknesses
in the Zambian financial sector:

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

Public financial institutions that were established to provide various financial services
to 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 cater
for all the credit needs of the economy. As such, there is a financial intermediary
gap in the formal financial sector.

Net interest margin and the ratio of fee income to average assets in banks are
among the highest in Africa. The operating costs of commercial banks are high by
international standards, especially given moderate lending and depository services.
This makes the provision of financial services unaffordable. In addition, commercial
banks are increasingly relying on income from treasury bills and foreign exchange
operations. This makes them vulnerable to adverse changes in the financial markets
and could threaten their long-term solvency.

Banks are highly exposed to an array of potential risks specific to structural
weaknesses 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 and
exchange rates.

There are no formal structures for a financial safety net in Zambia, thereby leaving
the public exposed to suffer losses every time there is a bank failure, although an
explicit 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 for
implementation.

Despite compliance to most international standards, problems still exist in the
supervisory process, such as low minimum capital requirements, lack of
independence from the Government, non-implementation of consolidated
supervision, and lack of adequate procedures for the orderly liquidation of banks
and other financial institutions.
Several weaknesses in the regulation and supervision of contractual savings exist.
Specifically the Insurance Act does not adequately provide for effective prudential
regulations, the Securities and Exchange Commission and the Pensions and
Insurance Authority are under-funded and lack requisite supervisory skills to
effectively carry out their duties. Further, NAPSA is not supervised by an
independent regulatory body.
There exists weak responsiveness of the labour market to the skill and knowledge
needs of the financial sector;

There are limited resources to train supervisory staff. While market activities of some
banks and non-bank financial institutions are becoming more complex in line with
developments in the international financial systems, the supervisory skills gap
continues 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 main
borrower from the financial system, client and major depositor and user of financial
services. These roles create problems of lack of transparency and potential conflict
of interest.


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

While certain improvements have been registered in primary market activity for
government securities, secondary market activity remains extremely low. The
commercial banks holding of securities to maturity has stifled secondary market
activity.

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

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sufficiently smoothened out, causing volatility in the inter-bank money market. A
complicating factor in BoZs liquidity management is the uncertainty in the
governments financing operations. The difficulty in reliably projecting
Governments cash flow and absorbing liquidity through open market operations
(OMO) and Treasury bills auctions hamper BoZs control of liquidity. These
unanticipated 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 reserve
ratios, are still prominent in Zambias monetary framework. The relatively high
statutory reserve ratios tend to raise the cost of funds for banks. The final incidence
of this cost is often passed over by the banks to the public by offering lower deposit
and or higher lending rates.


The financing of persistent fiscal deficits has created distortions in the financial
markets. Government borrowing through issuance of government securities to
finance 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 subsequent
crowding-out of private investment. Furthermore, Government borrowing from the
BoZ, to supplement deficit financing has often left BoZ with a daunting task of
keeping the growth of money supply within the desired realm.

Despite having a potentially unsustainable stock of domestic debt, there is no
deliberate programme in place to manage this debt stock. With a domestic debt to
GDP 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 weaknesses
identified above and to provide for a systematic and coherent approach for the realisation
of the vision for the financial system.


afp`rppflk nrbpqflkp Et ^F
1. What would happen to the standard of living in Zambia if people lost faith in the safety
of our financial institutions? And why?
2. Suppose you feel that the economy is just entering a recession. Your firm must raise
capital immediately, and debt will be used. Should you borrow on a long term basis or short
term basis?




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nrf`h obsfbt nrbpqflkp Et ^F
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?

AN8WIR:
Qucstion 1
Moncy Markct
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 some
individuals, businesses, governments, and financial institutions have temporarily idle funds that
they wish to put to some interest-earning use.
Thc Capital Markct
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. The
backbone of the capital market is formed by various securities exchanges that provide a
forum for bond and share transactions.
Thc primary markct
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 new
stock or bond issue. This is typically done through a syndicate of securities dealers. The
process of selling new issues to investors is called underwriting. In the case of a new stock
issue, this sale is called an initial public offering (IPO). Dealers earn a commission that is built
into the price of the security offering, though it can be found in the prospectus.
8ccondary Markct
In the secondary market, the trading of shares is between investors. This trading usually
takes 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 already
been issued in an initial private or public offering. Alternatively, secondary market can refer
to the market for any kind of used goods. The market that exists in a new security just after
the new issue is often referred to as the aftermarket. Once a newly issued stock is listed
on a stock exchange, investors and speculators can easily trade on the exchange, as market
makers provide bids and offers in the new stock.
In the secondary market, securities are sold by and transferred from one investor or
speculator to another. It is therefore important that the secondary market be highly liquid
and transparent. Before electronic means of communications, the only way to create this
liquidity was for investors and speculators to meet at a fixed place regularly. This is how
stock 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 not
to tie up his or her money for a long period of time, in case the investor needs it to deal
with unforeseen circumstances) with the capital user's preference to be able to use the
capital for an extended period of time. For example, a traditional loan allows the borrower
to pay back the loan, with interest, over a certain period. For the length of that period of
time, the bulk of the lender's investment is inaccessible to the lender, even in cases of
emergencies. Likewise, in an emergency, a partner in a traditional partnership is only be
able to access his or her original investment if he or she finds another investor willing to buy
out his or her interest in the partnership. With a securitized loan or equity interest (such as
bonds) or tradable stocks), the investor can relatively easily sell his or her interest in the
investment, particularly if the loan or ownership equity has been broken into relatively small
parts. This selling and buying of small parts of a larger loan or ownership interest in a
venture 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 own
circumstances change.
Qucstion 2
The term financial intermediary may refer to an institution, firm or individual who
performs intermediation between two or more parties in a financial context. Typically the
first party is a provider of a product or service and the second party is a consumer or
customer. A financial institution, such as a commercial bank or savings and loan
association, 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 in
the economy (savers) and deficit spending units (borrowers), a financial intermediary makes
it 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-in
banks and other depository financial institutions.


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The movement of capital from surplus units through financial institutions to deficit units
seeking bank credit is an indirect form of financing known as intermediation-consumers are
net suppliers of funds, whereas business and government are net borrowers. A bank gives
its depositors a claim against itself, meaning that the depositor has recourse against the
bank (and, if the bank fails, the deposit insurance fund protecting insured deposits), but has
no claim against the borrower who takes out a bank loan.



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