DEBRE MARKOS UNIVERSTY

COLLEGE OF POST-GRADUATE STUDIES

DEPARTMENT OF ACCOUNTING AND FINANCE

Individual Assignment for the course of

Financial Institution, instruments & Capital Markets

BY: - Mikias Degwale

Submitted to Dr. Beza Muche

May, 2020

Debre Markos, Ethiopia

 Financial Institutions

1. Introduction

Definition of Financial Institutions

What Is a Financial Institution (FI)?

A financial institution (FI) is a company engaged in the business of dealing with financial and
monetary transactions such as deposits, loans, investments, and currency exchange. Financial
institutions encompass a broad range of business operations within the financial services sector
including banks, trust companies, insurance companies, brokerage firms, and investment dealers.
Virtually everyone living in a developed economy has an ongoing or at least periodic need for the
services of financial institutions.
Types of Financial Institutions
There are three types of financial institutions. These are Depository, non-depository and Investment
1. Depository Institutions
Depository institutions allow customers to deposit money in an account. You're probably most
familiar with these types of financial institutions if you have a checking or savings account. Examples
of depository institutions include commercial banks and credit unions. Commercial banks are for-
profit entities that provide a number of services to their account holders. These types of financial
institutions usually operate at the local, regional or national level, have large advertising budgets, and
charge higher fees than a credit union. 

Fig 1: Types of Depository Institutions

Depository institutions are allowed to accept monetary deposits from the consumers legally. These
include commercial banks, savings banks, credit unions, and savings and loan association. The
different types of depository institutions are explained as below:

A. Commercial Banks – Commercial banks accept deposits from the public and offer security to their
customers. Due to commercial banks, it is no longer required to keep huge large currency on hand.
Using commercial bank facilities, transactions can be done through checks or credit/debit cards.

B. Saving Banks – Saving banks performs the function of accepting the savings from the individuals
and lending to the other consumers. Savings banks (also called thrift institutions and savings and loan
associations, or S&Ls) were originally set up to encourage personal saving and provide mortgages to
local home buyers. Today, however, they provide a range of services similar to those offered by
commercial banks.

C. Credit Unions – Credit unions are the associations which are created, owned, and also operated by
the participants who are voluntarily associated for the purpose of saving their money and then lending
it members of their union only. As such, these institutions are the not-for-profit organizations enjoying
tax-exempt status.

D. Saving and Loan Association – These institutions collect the funds of many of the small savers
and then lend them to home buyers or other types of borrowers. They specialize in proving help to the
people in getting residential mortgages.
2. Non-Depository Financial Institutions
Non- depository institutions serve as the intermediary between the savers and the borrowers but they
do not accept the time deposits. Such institutions perform their activities of lending to the public either
by the way of selling securities or through the insurance policies. Non- depository institutions include
insurance companies, finance companies, pension funds, and mutual funds.
A. Insurance Companies
Insurance companies sell protection against losses incurred by illness, disability, death, and property
damage. To finance claims payments, they collect premiums from policyholders, which they invest in
stocks, bonds, and other assets. They also use a portion of their funds to make loans to individuals,
businesses, and government agencies.
B. Finance Companies
Finance companies are no depository institutions because they do not accept deposits from individuals
or provide traditional banking services, such as checking accounts. They do, however, make loans to
individuals and businesses, using funds acquired by selling securities or borrowed from commercial
banks.
C. Pension and Mutual Funds
A pension fund, also known as a superannuation fund in some countries, is any plan, fund, or scheme
which provides retirement income. Pension funds typically have large amounts of money to invest and
are the major investors in listed and private companies. They are especially important to the stock
market where large institutional investors dominate.
A mutual fund is a professionally managed investment fund that pools money from many investors to
purchase securities. While there is no legal definition of the term "mutual fund", it is most commonly
applied to open-end investment companies, which are collective investment vehicles that are regulated
and sold to the general public on a daily basis. They are sometimes referred to as "investment
companies" or "registered investment companies".
Mutual funds have both advantages and disadvantages compared to direct investing in individual
securities. Today they play an important role in household finances, most notably in retirement
planning.
A mutual fund invests money from a pool of investors in stocks, bonds, and other securities. Investors
become part owners of the fund. Mutual funds reduce risk by diversifying investment: because assets
are invested in dozens of companies in a variety of industries, poor performance by some firms is
usually offset by good performance by others. Mutual funds may be stock funds, bond funds,
and money market funds, which invest in safe, highly liquid securities. (Liquidity is the speed with
which an asset can be converted to cash.)
Finally, pension funds, which manage contributions made by participating employees and employers
and provide members with retirement income, are also non-depository institutions.

Table 1: Summary of Major Financial Institutions

Institutions Description

Commercial Accepts both demand (checking) and time (savings) deposits. Offers interest-earning
Bank savings accounts (NOW accounts) against which checks can be written. Offers
money market deposit accounts, which pay interest at rates competitive with other
 short-term investment vehicles. Makes loans directly to borrowers or through the
financial markets.

Pools funds of savers and makes them available to business and government
demanders. Obtains funds through sales of shares and uses proceeds to acquire bonds
and stocks. Creates a diversified and professionally managed portfolio of securities to
Mutual Fund
achieve a specified investment objective. Thousands of funds, with a variety of
investment objectives, exist. Money market mutual funds provide competitive returns
with very high liquidity.

Securities Provides investment banking services by helping firms to obtain funds. Provides
Firm brokerage services to facilitate the sales of existing securities.

The largest type of financial intermediary handling individual savings. Receives

Insurance premium payments and places these funds in loans or investments to cover future
Company benefit payments. Lends funds to individuals, businesses, and governments or
channels them through the financial markets.

Accumulates payments (contributions) from employees of firms or government units,

and often from employers, in order to provide retirement income. Money is
Pension Fund
sometimes transferred directly to borrowers, but the majority is lent or invested via
the financial markets.

Similar to a commercial bank except that it may not hold demand (checking)
deposits. Obtains funds from savings, NOW, and money market deposits. Also raises
Savings
capital through the sale of securities in the financial markets. Lends funds primarily
Institution
to individuals and businesses or real estate mortgage loans. Channels some funds into
investments in the financial markets.

Similar to a savings institution in that it holds savings, NOW, and money market
Savings Bank
deposit accounts. Makes residential real estate loans to individuals.

Finance Obtains funds by issuing securities and lends funds to individuals and small
Company businesses.

Credit Union Deals primarily in transfer of funds between consumers. Membership is generally
 based on some common bond, such as working for a given employer. Accepts
members' savings deposits, NOW account deposits, and money market accounts.

3. Sources and Uses of Funds at Commercial Banks

Commercial banks obtain most of their funds by accepting deposits from investors. These investors are
usually individuals, but some are firms and government agencies that have excess cash. Some deposits
are held at banks for very short periods, such as a month or less. Commercial banks also attract
deposits for longer time periods by offering certificates of deposit, which specify a minimum deposit
level (such as $1,000) and a particular maturity (such as 1 year). Because most commercial banks offer
certificates of deposit with many different maturities, they essentially diversify the times at which the
deposits are withdrawn by investors.

Deposit insurance tends to reduce the concern of depositors about the possibility of a bank failure, and
therefore it reduces the possibility that all depositors will try to withdraw their deposits from banks
simultaneously. Thus the U.S. banking system efficiently facilitates the flow of funds from savers to
borrowers.

Commercial banks use most of their funds either to provide loans or to purchase debt securities. In
both cases they serve as creditors, providing credit to those borrowers who need funds. They provide
commercial loans to firms, make personal loans to individuals, and purchase debt securities issued by
firms or government agencies. Most firms rely heavily on commercial banks as a source of funds.

Some of the more popular means by which commercial banks extend credit to firms are term loans,
lines of credit, and investment in debt securities issued by firms. 

Term loans are provided by banks for a medium-term period to finance a firm's investment in
machinery or buildings. For example, consider a manufacturer of toys that plans to produce toys and
sell them to retail stores. It will need funds to purchase the machinery for producing toys, to make
lease payments on the manufacturing facilities, and to pay its employees. As time passes, it will
generate cash flows that can be used to cover these expenses. However, there is a time lag between
when it must cover these expenses (cash outflows) and when it receives revenue (cash inflows). The
term loan can enable the firm to cover its expenses until a sufficient amount of revenue is generated.
The term loan typically lasts for a medium-term period, such as 4 to 8 years. The interest rate charged
by the bank to the firm for this type of loan depends on the prevailing interest rates at the time the loan
is provided. The interest rate changed on term loans is usually adjusted periodically (such as annually)
to reflect movements in market interest rates.

Commercial banks can also provide credit to a firm by offering a line of credit, which allows the firm
access to a specified amount of bank funds over a specified period of time. This form of bank credit is
especially useful when the firm is not certain how much it will need to borrow over the period. For
example, if the toy manufacturer in the previous example was not sure of what its expenses would be
in the near future, it could obtain a line of credit and borrow only the amount that it needed. Once a
line of credit is granted, it enables the firm to obtain funds quickly.

Commercial banks also invest in debt securities (bonds) that are issued by firms. When a commercial
bank purchases securities, its arrangement with a firm is typically less personalized than when it
extends a term loan or a line of credit. For example, it may be just one of thousands of investors who
invest in a particular debt security the firm has issued. Nevertheless, recognize that a bank's credit
provided to firms goes beyond the direct loans that it provides to firms, because it also includes all the
securities purchased that were issued by firms.

4. Role of Commercial Banks as Financial Intermediaries

Commercial banks play several roles as financial intermediaries. First, they repackage the
deposits received from investors into loans that are provided to firms. In this way, small deposits by
individual investors can be consolidated and channeled in the form of large loans to firms. Individual
investors would have difficulty achieving this by themselves because they do not have adequate
information about the firms that need funds.

Second, commercial banks employ credit analysts who have the ability to assess the
creditworthiness of firms that wish to borrow funds. Investors who deposit funds in commercial banks
are not normally capable of performing this task and would prefer that the bank play this role.

Third, commercial banks have so much money to lend that they can diversify loans across several
borrowers. In this way, the commercial banks increase their ability to absorb individual defaulted
loans by reducing the risk that a substantial portion of the loan portfolio will default. As the lenders,
they accept the risk of default. Many individual investors would not be able to absorb the loss of their
own deposited funds, so they prefer to let the bank serve in this capacity. Thus the commercial bank is
a means by which funds can be channeled from small investors to firms without the investors having
to play the role of lender.

Fourth, some commercial banks have recently been authorized (since the late 1980s) to serve as
financial intermediaries by placing the securities that are issued by firms. Such banks may facilitate
the flow of funds to firms by finding investors who are willing to purchase the debt securities issued
by the firms. Thus they enable firms to obtain borrowed funds even though they do not provide the
funds themselves.

5. Regulation of Commercial Banks

The banking system is regulated by the Federal Reserve System (the Fed), which serves as the central
bank of the United States. The Fed is responsible for controlling the amount of money in the financial
system. It also imposes regulations on activities of banks, thereby influencing the operations that
banks conduct. Some commercial banks are members of the Federal Reserve and are therefore subject
to additional regulations.

Commercial banks are regulated by various regulatory agencies. First, they are regulated by the
Federal Deposit Insurance Corporation, the insurer for depositors. Because the FDIC is responsible for
covering deposits of banks, it wants to ensure that banks do not take excessive risk that could result in
failure.

If several large banks failed, the FDIC would not be able to cover the deposits of all the depositors,
which could result in a major banking crisis.

Those commercial banks that apply for a federal charter are referred to as national banks and are
subject to regulations of the Comptroller of the Currency. They are also subject to Federal Reserve
regulations, because all national banks are required to be members of the Federal Reserve.
Alternatively, banks can apply for a state charter.

The general philosophy of regulators who monitor the banking system today is to promote competition
among banks so that customers will be charged reasonable prices for the services that they obtain from
banks. Regulators also attempt to limit the risk of banks in order to maintain the stability of the
financial system.

6. Other Financial Institutions

Other financial institutions also serve as important intermediaries. Savings institutions (also called

thrift institutions or savings and loan associations) accept deposits from individuals and use the
majority of the deposited funds to provide mortgage loans to individuals. Their participation is crucial
in financing the purchases of homes by individuals. They also serve as intermediaries between
investors and firms by lending these funds to firms.

Finance companies issue debt securities and lend the proceeds to individuals or firms in need of funds.
Their lending to firms is focused on small businesses. When extending these loans, they incur a higher
risk that borrowers will default on (will not pay) their loans than is typical for loans provided by
commercial banks. Thus they charge a relatively high interest rate.
7. Comparison of the Key Financial Institutions
A comparison of the most important types of financial institutions that provide funding to firms
appears in Figure 1. The financial institutions differ in the manner by which they obtain funds, but all
provide credit to firms by purchasing debt securities the firms have issued. All of these financial
institutions except commercial banks and savings institutions also provide equity investment by
purchasing equity securities issued by firms.
A securities firm also sells the debt and equity securities to individual investors, which results in some
funds flowing directly from individuals to firms without first passing through a financial institution.

8. Consolidation of Financial Institutions

There has recently been a great deal of consolidation among financial institutions, and a single
financial conglomerate may own every type of financial institution. Many financial conglomerates
offer commercial banking services, investment banking services, brokerage services, mutual funds,
and insurance services. They also have a pension fund and manage the pension funds of other
companies. The most notable example of a financial conglomerate is Citigroup Inc., which offers
commercial banking services through its Citibank unit, insurance services through its Travelers'
insurance unit, and investment banking and brokerage services through its Salomon Smith Barney
unit.

In recent years, many commercial banks have attempted to expand their offerings of financial services
by acquiring other financial intermediaries that offer other financial services. Some banks even serve
in advisory roles for firms that are considering the acquisition of other firms. Thus, much of the bank
expansion is focused on services that were traditionally offered by securities firms. In general, the
expansion of banks into these services is expected to increase the competition among financial
intermediaries and therefore lower the price that individuals or firms pay for these services.

Question no 2: Discuss about the current opportunities and Challenges of the Ethiopian financial
institutions

Opportunities and Challenges of financial institutions in Ethiopia

From the commercial banks side

Commercial banks do not have units for SMEs loan and are not interested to provide loan to
SMEs. Because of this they do not provide continued/sustained loan access, and when they
provide the amount is limited.
Private banks have recently raised their paid up capital in order to increase their single
borrower limit and hence scaled up their loans portfolio to the large and corporate entities
away from the small borrowers;
The new regulations that has raised the startup capital for new commercial banks discouraged
new banks to join the industry;

From MFIs side

Are not also in a position to ensure continued financial access to SMEs and the poorer
segments of society.

Key Challenges of financial institutions In the context of Ehiopia

The stability of the Ethiopian financial sector depends on a number of factors including the
macroeconomic environment, the foreign exchange situation, the business/regulatory
environment, corruption, corporate governance, risk management, etc
Unpredictable inflation: According to Thorat (2013) inflation and financial instability are the
biggest threats to inclusive growth. Since, 2008/09, Ethiopia has become vulnerable to inflation
arising from monetary policy mismanagement, supply rigidities, inflation expectation and the
pass through from the global economic turmoil.
Foreign exchange shortage: Availability of foreign exchange is critical for banking business in
Ethiopia as it affects lending especially for international trade and the interest income on
foreign exchange deposits in correspondent banks.
Worsening business environment: On account of intended and unintended consequence of
government policies, the investment climate in Ethiopia is poor and deteriorating.
Corruption: Although difficult to properly quantify its magnitude, Ethiopia is observing rising
corruption in a number of sectors including the Revenue and Customs, the Telecom, Ethiopian
Electric Power Corporation, banks, etc. Unless concrete actions are taken to tackle the problem
from its roots, this will lead to erosion of business confidence in the country.
Weak risk management practices: Risk management is getting attention in the financial sector
in recent years. Each bank established a small unit to deal with risk management and in some
banks we have seen risk management analysis in their annual report.
Other risk factors: This could include lack of skilled manpower in the financial sector, lack of
alternative financing mechanism; ineffective ICT infrastructure on account of very weak
internet connectivity, lack of standardized accounting, auditing and reporting practices.
The potential crowding out of private banks through the 27% NBE bill requirement would lead
to tight liquidity and funding conditions for banks. This would affect banks performance in
terms of credit growth and overall profitability.
Low literacy rate is a serious impediment for the adoption of financial insinuations in Ethiopia
as it hinders the accessibility of financial insinuations services.
Every economic activity need suitable legal and regulatory framework to meet its goal. In
financial insinuations, the adoption of financial insinuations needs legal and regulatory
framework that prevents any challenges related to security before happening so Lack of
suitable legal and regulatory framework
Cybercrime in Finance
Big Data Use in Finance
Customer Retention in the Financial Services Industry Competition for financial service
clients has never been fiercer. While brand loyalty may not be dead, it is definitely on life
support.
Block chain Integration in Finance We talked earlier about block chain as a key component
in the battle against cybercrime. But data security is not the only application for block chains in
the financial sector.
 Political and institutional independence may not be present or respected. Financial controls to
ensure price and currency stability may be over-ridden by political short-term decisions that
can undermine efforts to create a stable economy and stable financial sector. Instability of
prices and interest rates force greater required margins for lending and restrict borrowing and
lending and the stability if financial institutions suffer as a result.
Most developing economies are not large enough or developed enough to enforce trading and
transactions in local currency and through official channels and banking institutions.
The regulatory and legal structures may simply not be in place or respected or sufficiently free
from corruption to allow financial institutions to engage in traditional intermediary functions at
reasonable cost due to the hazards and risks of operating in the economy.

The current Prospect of financial institutions in Ethiopian context

Providing almost all modern banking services to its customers along with its
basic functions like deposit mobilization and lending of various types of loans, from the
early establishment till now.
an important tool of poverty alleviation,
Macroeconomic stability; interests rate de-regulation; easing of setting up banks, branches,
and MFIs with low capital requirements
Many of the poor can save, invest, and repay their loans.
To develop their agricultural activities and microenterprises, prepare for emergencies and
provide for the future, they need access to a range of microfinance services, including
savings deposit facilities as a priority, credit and insurance.
This requires a diversified financial infrastructure of competing institutions and diverse
strategies adjusted to a given socio-economic context.
Outreach can only be maximized by sustainable financial institutions, which cover all their
costs, mobilize their own resources, protect their funds against erosion from inflation and
non-repayment, and make a profit to finance their expansion.
With sound practices, any type of financial institution can become sustainable and combine
outreach and viability; but in most regions, institutions built on self-help and private
ownership have the better prospects.
Through technical and financial assistance, donors can greatly contribute to the
development of an efficient rural and microfinance sector, but must be effectively guided
by goals of viability and self-reliance of rural and microfinance institutions.
transforming national small farmer programs into user-owned local financial institutions
reforming agricultural development banks which in many countries continue to be the
biggest provider of microfinance service
it promotes economic growth and battles poverty