Unit Three

Financial Institutions in Financial System

2.1 Financial Institutions at a Glance
Financial institutions are those organizations, which are involved in providing various types of
financial services to their customers. The financial institutions are controlled and
supervised by the rules and regulations delineated by government authorities.
Some of the financial institutions also function as mediators in share markets and
debt security markets.

These institutions include: Banks, Stock Brokerage Firms , Non Banking Financial Institutions,
Building Societies , Asset Management Firms, Credit Unions and Insurance Companies.
Financial institutions deal with various financial activities associated with bonds, debentures,
stocks, loans, risk diversification, insurance, hedging, retirement planning, investment, portfolio
management, and many other types of related functions.
With the help of their functions, the financial institutions transfer money or funds to various
tiers of economy and thus play a significant role in acting upon the domestic and the
international economic scenario. For carrying out their business operations, financial
institutions implement different types of economic models. They assist their clients and
investors to maximize their profits by rendering appropriate guidance. Financial institutions also
impart a wide range of educational programs to educate the investors on the fundamentals of
investment and also regarding the valuation of stock, bonds, assets, foreign exchanges, and
commodities.
Financial institutions can be either private or public in nature.
Granted that financial institutions manufacture loans out of money which people lend, what else
can we say about what they do? As a general rule, financial institutions are engaged in what is
called intermediation. Intermediation means acting as a go-between for two parties. The parties
here are usually called lenders and borrowers or sometimes surplus sectors or units and deficit
sectors or units.
What general principles are involved in this going between? The first thing to say is that it
involves more than just bringing two parties together. One could imagine a firm which did this.
It could keep a register of people with money to lend and a register of people who wished to
borrow. Every day, people would join and leave each register and the job of the firm would be
to scan the lists continuously, crying eureka (or some thing else of an appropriate kind) every
time it finds a potential lender whose desires match those of a potential borrower. It would then
charge a commission for introducing them to each other. Something else has to be provided.
As a general rule what financial intermediaries do is to create assets for savers and liabilities for
borrowers which are more attractive to each than would be the case if the parties have to deal
with each other directly.
2.2 The role of financial institutions
1. Providing a payments mechanism
Most transactions made today are not done with cash; instead payments are made using checks,
credit cards, debit cards and electronic transfers of funds. These methods for making payments
are provided by certain financial institutions. Financial institutions perform check clearing and
wire transfer services. A debit card differs from a credit card in that in the latter case, a bill is
sent to the credit card holder periodically (usually once a month) requiring payments for
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transactions made. In the past in the case of a debit card, funds are immediately withdrawn (that
is, debited) from the purchaser's account at the time the transaction takes place.
2. Maturity transformation
The financial institutions ( e.g. banks) perform the valuable functions of converting funds that
savers are willing to lend for only short period of time into funds the financial institution
themselves are willing to lend to borrowers for longer periods. Maturity transformation function
of financial institution has two implications. First, it provides investors with more choices
concerning maturity for their investments; borrowing has more choices for the length of their
debt obligations. Second, because investors are naturally reluctant to commit funds for a longer
period of time, they will require that long-time borrowers pay a higher interest rate than on a
short -time borrowing. A financial institution is willing to make long-term loans, and at a lower
cost to the borrower than an individual investor would, by counting on successive deposits
providing the funds until maturity. Thus, the second implication is that the cost of long-term
borrowing is likely to be reduced.
3. Reducing risk through diversification
Consider the example of an investor who places funds in an investment company. Suppose that
the investment company invests the funds received in the stock of a large number of companies.
By doing so, the investment company has diversified and reduced its risk. Investors who have a
small sum to invest would find it difficult to achieve the same degree of diversification because
they don't have sufficient funds to buy shares of a large number of companies. Because
financial institutions acquire funds from large numbers of surplus units and provide funds to
large numbers of deficit units, substantial diversification is effected and the risk of financial loss
is reduced. The diversification is the holding of many (rather than a few) assets reduces risk.
Because all assets don’t behave in the same way at the same time, therefore, the behavior of
one asset will on some occasions cancel out the behavior of another. Financial institutions
(intermediaries) also offer the risk reducing benefits of management expertise since they do
have a manpower that specializes in credit risk assessment & monitoring of borrowers.

4. Reducing transaction costs

Not only do Financial institutions have a greater incentive to collect information, but also their
average cost of collecting relevant information is lower than for individual investor
(i.e., information collection enjoys economies of scale). An economy of scale is a concept that
costs reduction in trading and other transaction services results from increased efficiency when
financial institutions perform these services.
Such economies of scale of information production and collection tend to enhance the
advantages to investors of investing via financial institutions rather than directly investing
themselves.
2.3 Classification of Financial Institutions
Financial institutions are the firms that provide financial services and advices to its clients. The
financial institutions are generally regulated by the financial laws of government authority.
Types of Financial Institutions include:
 Commercial banks,
 Credit unions,
 Stock brokerage firms,

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  Asset management firms,
 Insurance companies,
 Finance companies,
 Building Societies, and
 Retailers.
The various financial institutions generally act as the intermediaries between the capital market
and debt market. But the service provided by financial institution depends on its type. The
financial institutions are also responsible to transfer funds from investors to the companies.
Typically, these are the key entities that control the flow of money in the economy. The services
provided by the various types of financial institutions may vary from one institution to another.
For example:
The services offered by the commercial banks are: insurance services, mortgages, loans
and credit cards.
The services provided by the brokerage firms, on the other hand, are different and they
are - insurance, securities, mortgages, loans, credit cards, money market and check
writing.
The insurance companies offer – insurance services, securities, buying or selling service
of the real estates, mortgages, loans, credit cards and check writing.
 The credit union is co-operative financial institution,
which is usually controlled by the members of the union.
The stock brokerage firms are the other types of financial institutions that help both the
corporations and individuals to invest in the stock market.
Another type of financial institution is the asset management firms. The prime
functionality of these firms is to manage various securities and assets to meet the
financial goals of the investors. The firms also offer fund management advice and
decisions to the corporations and individuals.
On the other hand, these institutions are responsible for distributing financial resources in a
planned way to the potential users. There are a number of institutions that collect and provide
funds for the necessary sector or individual. Correspondingly, there are several institutions that
act as the middleman and join the deficit and surplus units. Investing money on behalf of the
client is another variety of functions of financial institutions.
 Financial institutions can also be categorized as deposit taking institutions, and this
include:
 Finance and Insurance Institutions,
 Investment Institutions,
 Pension Providing Institutions, and
 Risk Management Institutions.
At the same time, there are several governmental financial institutions assigned with regulatory
and supervisory functions. These institutions have played a distinct role in fulfilling the
financial and management needs of different industries, and have also shaped the national
economic scene. Deposits taking financial organizations are known as commercial banks,
mutual savings banks, savings associations, loan associations and so on. The primary functions
of financial institutions of this nature are:
 Accepting Deposits;
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  Providing Commercial Loans;
 Providing Real Estate Loans;
 Providing Mortgage Loans; and
 Issuing Share Certificates.
Finance companies provide loans, business inventory financing and indirect consumer loans.
These companies get their funds by issuing bonds and other obligations. These companies
operate in a number of countries. On the other hand, there are insurance companies that provide
coverage for a variety of risk factors and they also provide several investment options.
Insurance companies provide loans for a number of purposes and create investment products.
2.4 Depository Institutions
Depository institutions are financial institutions that raise loanable funds by selling deposits to
the public or in other words they are those institutions whose funds come significantly from
customer deposits. They accept deposits from individuals and firms and use these funds to
participate in the debt market, making loans or purchasing other debt instruments such as
Treasury bills.

The major assets of depository institutions are loans (financial assets) and reported on the left
hand side of the balance sheet. The major liabilities (sources of funds) of depository institutions
are deposits and are presented on the right hand side of the balance sheet.
Depository institutions can also be generally categorized in to commercial banks and other
depository institutions (such as saving and loan institutions, credit unions, and microfinance
institutions). The following table shows the distinction between commercial banks and other
depository institutions:
Table 2, Distinction between commercial banks and other depository institutions
Area of Commercial Other Depository
Difference Banks Institutions
Size of Loan Large Small
Composition Diversified and Broader Few
Liabilities Include liabilities other than Principally include
deposits deposits
Regulation Stringent Not stringent
 Depository institutions are popular financial institutions for the following reasons:
1. They offer deposit accounts that can accommodate the amount and liquidity
characteristics desired by most surplus units.
2. They repackage funds received from deposits to provide loans of the size & maturity
desired by deficit units.
3. They accept the risk on loans provided.
4. They have more expertise than individual surplus units in evaluating the credit worthiness
of deficit units.
5. They diversify their loans among numerous deficit units and therefore can absorb
defaulted loans better than individual surplus units could.
When a depository institution offers a loan, it is acting as a creditor, just as if it had purchased a
debt security. Yet, the more personalized loan agreement is less marketable in the secondary
market than a debt security, because detailed provisions on a loan can differ significantly among
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loans. Any potential investors would need to review all provisions before purchasing loans in
the secondary market.
2.4.1 Commercial Banks
Commercial Banks are institutions that offer deposit and credit services as well as a growing list
of newer services as investment advice, security underwriting, selling insurance and financial
planning. Unlike the name “commercial”, commercial banks expanded their services to
consumers and Government units to be a financial department store of the financial system.
Commercial Banks manage the customers' current and savings accounts, pay out checks that
have been drawn on the bank by account holders, and also perform the collection of
checks deposited in their customers' accounts. Banks implement a number of other procedures
for payments to customers, such as: ATM's (Automated Teller Machines), telegraphic transfer,
and EFTPOS (Electronic Funds Transfer at the Point of Sale), or Debit Cards.
The borrowing process of banks is carried out by receiving funds in savings accounts and
current accounts and receiving term deposits, as well as through issuance of debt securities,
such as bonds and banknotes. Banks also provide loans to customers that are repayable in
installments as well as lending through investments in tradable debt securities and other types of
lending. Banks offer a comprehensive variety of payment facilities, and a bank account is
regarded as indispensable by the majority of Governments, business enterprises, and
individuals.
1. Functions of Commercial Banks
Commercial banks play an indispensable roll in the economic activities of every country.
Accordingly, the following are among the main functions of the commercial banks:
They process payments with the help of online banking, telegraphic transfer, debit card,
and other methods;
They issue banknotes, such as promissory notes;
Acceptance of funds on term deposits;
Issuance of bank checks and bank drafts;
Offering performance bonds, guarantees, letters of credit, and other types of documents
related to underwriting commitments for securities;
Safe custody of important documents and other valuable items in safe deposit vaults or safe
deposit boxes;
Providing loans through installment loans, overdrafts, and others; and
Selling and brokerage services related to unit trust and insurance products and
Foreign exchange services.
Correspondingly, commercial banks are business corporations that accept deposits, make loans,
and sell other financial services, especially to other business firms, to households and
Governments. They are the largest and most important depository institutions. They have the
largest and most diverse collection of assets of all depository institutions. Their main source of
funds is demand deposits (i.e., checking account deposits) and various types of savings deposits
(including time deposits and certificates of deposit).
The major use of funds by commercial banks is making loans. They are assets of the
commercial bank. These loans could include real estate loans and loans to businesses &
automobile loans. The remaining commercial banks' assets include securities (primarily federal
government bonds), vault cash, and deposits at the central bank. Commercial banks also allow

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for a diversity of deposit accounts, such as checking, savings, and time deposit. These
institutions are run to make a profit and owned by a group of individuals.
2. Importance of Commercial Banks
 Banks are principal means of making payments.
 Create money from excess reserves of public deposits.
 Use excess cash reserves to make loans and investments.
 They are principal channel for government monetary policy.
3. Classification of Commercial Banks
Commercial banks can be classified in different types depending on their activities or as per
their functions in the economy. The following classification is the common one.
I. Unit Banking
A banking business operating a single banking office
All operations housed in a single office
II. Branch Banking
A single bank that offers a full-fledged services in two or more offices across
the country, including offices abroad
Home office is the largest branch in the system
III. Correspondent Banking
An arrangement whereby a bank maintains deposit balance with other banks at a
distant place for a variety of services and assistance
The practice can take place within the local environment among local banks or
overseas
4. Activities and Services of Commercial Banks
Activities of commercial banks can be too much; however, the following are the main and
common activities that are crucial in the economic and commercial system of any country.
A. Loans and Advances
Commercial Banks gives various types of loans and advances to various business sectors. The
major ones include Domestic trade, Import and export trade, Agriculture, Hotel and tourism,
Manufacturing, Construction, Transport, Services (education, health, etc), and others. Most of
these loans are extended to customers on the basis of collaterals. The commonly acceptable
collaterals are: Buildings/Houses, Motor vehicles, Bank guarantees, and Unconditional Life
Insurance at surrender value.
 Types of Credit Facilities
The main forms of credit facilities issued by the Commercial Banks are:
1. Term Loan
A term loan is a loan granted to customers to be repaid with interest within a specific period of
time. The loan can be repaid in periodic installments or in a lump sum on the due date of the
loan, as the case may be. This loan is granted in three forms, i.e., short-term, medium-term and
long-term loan.
 Short-term Loan
A short-term loan is a loan that has a maturity period of one year or twelve months from the
date the loan contract is signed. The purpose of the loan is to finance the working capital
needs and/or to meet other short-term financial constraints of customers. Short-term loan
may be repaid monthly, quarterly, semi-annually or annually in a lump sum upon maturity,

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 depending on the nature of the business and cash-flow statement. The periodic repayment
amount incorporates both principal and interest.
 Medium- and Long-term Loan (project loan)
A medium-term loan is a loan which has a maturity period exceeding one year but less than or
equal to five years from the date the loan contract is signed. A long-term loan is a loan that has
a maturity period of five to fifteen years. The purpose of these loans is to finance new projects,
support the expansion of existing projects, investments and meet working capital needs.
Applicants can be either new or existing customers. Loans provided by commercial banks may
also be classified into various categories, according to the purpose for which they are granted.
The major classifications are: Agricultural loan Manufacturing loans, Banks avail loan,
Transport loans, Merchandise loan, Import and Exports Loan, Trade and service loans, and the
likes.
a. Agricultural Loans
Agricultural loan is a loan granted to customers who are engaged in a production business.
Agricultural loan is intended to finance working capital needs and investments of customers
involved in the sector.
Any individuals, enterprises and associations involved in the agricultural sector can apply for
this loan. Agricultural loan may be repaid monthly, quarterly, semi-annually or annually. The
Bank provides a grace period for investment-related agricultural loans. Agricultural loans
include loans granted for purchase of agricultural inputs like selected seeds, fertilizers, agro-
chemicals, rental or purchase of agricultural machinery and equipment; for crop collection,
processing and marketing of agricultural products, projects aiming at producing exportable
products like flowers, fruits, and vegetable and agro-industry developments like diary, farming,
cattle fattening etc.
b. Manufacturing loans
Manufacturing loans are loans availed to facilitate the manufacturing activities of small,
medium and large-scale industries.

c. Trade and Service loans

Trade and service loans include wholesale trade, retail trade, services other than transport such
as hotels, schools, hospitals, tour agencies, etc. Financing trade and services helps in the smooth
flow of goods and services in the economy and serve as an intermediary between producers and
consumers. Therefore, trade in essential goods whether imported or locally produced is to be
encouraged through working capital financing. Among others, goods traded include outputs of
manufacturing industries, cottage and handicraft, mining activities and agricultural products.
d. Building and construction loan
Banks avail loan to this category for building contractors, investors engaged on road and water
projects under construction, civil workers and business persons who seek financial assistance to
construct commercial or residential buildings. Loans can be provided to licensed building
contractors to cover working capital shortages i.e. to mobilize materials required to construct
buildings, roads, dams etc. based on contracts concluded with employers.
e. Transport loans
All loans to be availed for the purchase of transport vehicles like trucks, tankers and public
transport buses to licensed transport operators are to be classified here. Additionally, loans

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availed to facilitate smooth operation of trucking companies or loans to cover custom duty
charges or modification costs are also included.
f. Merchandise Loan
Merchandise loan is a credit facility provided by the Bank against which the merchandise is
held as collateral for the loan. The purpose of the loan is to overcome the cash-flow problem of
customers when money is tied up in merchandise. The loan is usually approved for a period of
three months (90 days) or it may be approved on a renewal basis.

g. Import and Exports Loan

Foreign Trade plays a key role in the development of an economy and has always been the
major force behind the economic relations among nations. In view of its paramount importance,
the bank’s role is to promote the growth of the country’s economy. International trade financing
in the form of import and export transactions is one of the priority areas of commercial banks.
 Import Letter of Credit Facility
A letter of credit (L/C) is an instrument issued by a bank whereby payments in international
trade are effected by banks through documents. It is issued by the Bank at the request of a buyer
(importer) to pay a seller (exporter) upon presentation of import documents specified in the
instrument. A letter of credit facility is a type of credit that a bank avails to importers
(applicants) to pay a certain percentage of the value of the L/C while opening L/C by setting a
limit to the total value of the L/C to be opened. The facility is secured against valid import
documents and has a tenor of six months and, in exceptional cases, one year. It alleviates
temporary working capital needs of customers while importing goods.
 Export Credit Facility
Export credit facility may take various forms. Some of them are discussed below:
i) Pre-Shipment Export Credit
Pre-shipment export credit is a loan granted to exporters starting from the procurement of
inputs until the date of shipment of goods against guarantee by banks. The availability
period is determined with the consideration of the validity dates of the sales contracts, but it
must be shorter than the validity date of banks guarantee. The pre-shipment export credit
may be settled from the export proceeds of the goods for which the loan is advanced.
ii) Revolving Export Credit Facility
Revolving export credit facility is an advance extended to exporters with a limited margin
until goods are loaded on board, upon presentation of all relevant export documents to the
Bank, except a bill of lading. The facility has tenure of six months or one year. The facility
is availed to finance the temporary working capital requirement of customers when the
goods are in transit for shipment. A revolving export credit will be settled from the export
proceeds when all relevant export documents are presented to the Bank. The facility has to
be renewed every six months or every year.
iii) Advance On Export Bills
Advance on export bills is a post-shipment export credit provided to exporters with a certain
margin against presentation of all the necessary export documents. This credit
is advanced for a period of fifteen days, and interest is charged if the loan is not settled
within this period. An advance on export bills is intended to bridge the financial gap between
the shipment of the goods and the realization of the proceeds. This export credit will be
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 advanced to all exporters who could present the following complete export documents,
including a bill of lading, as per the terms and conditions of the letter of credit.
B. Overdraft
An overdraft (O/D) is a credit facility by which a customer can withdraw in excess of her/his/its
current account balance up to the limit approved by the Bank. The purpose of the loan is to
finance the day-to-day operational needs of a viable business. In order to use O/D facility,
applicants have to open a current account. The O/D account should have a proper turnover by
way of withdrawals and deposits. However, an O/D account should not be overdrawn.

An O/D facility is approved only for a period of six months and, in some cases, for a year.
Therefore, it has to be renewed every six months or year. The request for renewal is usually
presented to the Bank some months before the expiry date of the facility. Overdrafts can be
considered for manufacturing, trading and service-giving enterprises.
An O/D facility can be approved against any collateral acceptable by the Bank, except motor
vehicles and machinery. As far as repayment on over draft facility is concerned, interest is
calculated on the amount used by the customers. Customers have to pay the accrued interest
regularly so that the facility will not be overdrawn. At the time of the request for renewal, the
outstanding overdraft balances have to be fully settled. The Bank can claim the outstanding
balance of the O/D facility at any time.
C. Deposits Services
Commercial Banks also provide different types of deposit services. The main ones are described
in the following section:
1. Special Demand Deposit Account
Special Demand Deposit Account (SDDA) is a non-interest bearing deposit account
operated by a saving like passbook and vouchers. The main features of this account are (1)
Non-interest-bearing deposit account (2) The initial deposit for opening a Special Demand
Deposit Account is Birr 50. It is a deposit account service for those customers demanding
non-interest bearing saving deposit account.
Who is eligible?
Individuals, Trade operators, Organizations, Cooperatives and associations, Domestic banks,
financial institutions, Government Local/Central, Private sector, and Public Agencies and
Enterprises are all eligible to open and operate Special Demand Deposit Account.
2. Saving Account
It is an interest-bearing deposit account. Saving account may be opened and operated by
individuals and organizations, resident and non-resident. Saving account is maintained for
various reasons.
 Saving accounts may be classified in to various categories. The major ones are discussed
below:
a. Private saving account: Such account is opened by individual Person
b. Joint Accounts:
 And Account
 And/or Accounts.
c. Company Accounts
d. Accounts of Churches, Mosques, Missions, etc.
e. Earmarked Accounts: This includes Club Accounts, Private Accounts, and the like.
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 f. Special Accounts
 Tutor account: Tutor accounts are opened in the name or names of minors followed by
the word “minor” or “minors.”
 Liquidator account: Liquidators’ account is opened in the name of a person or
company but appointed by court as liquidator in bankruptcy.
 Interdicted accounts: Interdicted accounts are saving accounts opened in the name of
the interdicted person.
 Staff accounts: Staff accounts are saving accounts like the individual accounts opened
for the employee of the Bank.
g. Non-Private Accounts. It can be for thrift and credit co-operatives society. Mandate file is
a must to open such an account. The opening of such accounts must first be approved by
a regional organization of the co-operatives, and the approval letter, indicating the names
of the persons authorized to operate the account, must be submitted to the Bank.
3. Fixed (time) Deposit
A time-deposit account is a deposit account that bears interest based on the duration of the
deposit. Parties who can open such account include individuals, sole-proprietorship, and
partnership.
4. Current Account
Current account, also called demand deposit or checking account, is a non-interest-bearing
deposit account that is operated by checks. The unique features of current account are: A non-
interest-bearing deposit account with a check book facility and Overdraft facility permitted in
connection with checking account. Current account may be opened by individuals and
organizations, resident and non-resident, and Non-literates and minors. Current or Demand
Deposits may be classified under the following categories:
i) Demand Deposit Non-resident: This account includes correspondents’ accounts, Non-
Resident Foreign Currency Account (NRFCY), Non-Resident Non-Transferable Birr
Account (NRNT), and Non-Resident Transferable Birr Account (NRT).

ii) Demand Deposit Resident :

 Cooperatives and Associations: accounts opened for mass organizations such as
Kebeles, Farmers Association, Trade Unions, Savings and Credit Associations, etc. are
classified under the above categories.
 Domestic Banks: accounts of local banks are included in this category. A license from
the National Bank of Ethiopia should be obtained to open accounts for commercial
banks.
 Financial Institutions: These are accounts of insurance companies.
 Government Accounts: (Local and Central) all accounts opened in the names of
Ministries (Offices, Bureaus) budgetary and town developments of municipalities are
classified under this account. The authority to open these accounts emanates from either
the local or the central Finance Bureau and local or central urban development and
housing offices.
 Private Sector: the following demand deposit accounts are subsumed under this
account:
 Private individuals,

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 Private companies, and

 Ikubs, Edirs, Religious Private and International Organizations.
 Public Agencies and Public Enterprises: The chairman of the Board of the enterprise
should produce a letter of appointment from the Public Enterprises Supervising
Authority.
5. Diaspora Account
These types of accounts are opened for people living abroad (who live more than one year
abroad) and citizens by origin but with different nationalities that are referred as eligible citizen.
D. Money Transfers
It is a means of transferring funds through banks to individuals or organizations. Users of
money transfer include individuals, workers, students, members, travelers, organizations,
private organizations, cooperatives, public enterprises, and government.
The main features of money transfers include:
 Transfers are made between branches of the bank
 Transfers are made between branches of different cities or towns.
 Availability of telecommunication and local post offices enhances the smooth flow of
transfers between branches.

Some of the major benefits include:

 It facilitates the operations of trade and other economic sectors and helps to accomplish
their organizational objective as a whole.
 It is an easy and convenient way for both the sender and the receiver.
 Transfer of money can be done with a minimum cost, time, and energy.
 It reduces the risk of losing money.
 Types of Local Transfer
1. Telegraphic Transfer (TT): Transfers are made through telephone, telegram, telex or
radio. It is relatively the fastest means, and is usually preferred by most transfer users.
2. Mail Transfer (MT): Transfers are made through post offices. It is considered to be an
ordinary type and takes a longer time to reach the paying branch.
3. Demand Draft (DD): Transfers are made with the use of a special bank instrument called
“draft”. Drafts are usually called “demand drafts” or “sight drafts” because they are paid
immediately, on demand or on sight. They are negotiable within twelve months from the
date of issue after which the drawer's confirmation is required for payment.
4. Cashier’s Payment Order: It is a special bank instrument negotiable within six months
from the date of the issue. They are issued to Finance Bureaus, Land Revenue Office,
Customs Authority, Maritime and Transit Service Corp., and to secure bids only.
E. Foreign Currency
It involves buying and selling foreign currency, cash notes, traveler's checks, and drafts for the
following purposes:
 holiday travel expenses,
 Business travel allowances,
 medical expenses,
 Educational expenses, and
 seminars, workshops, symposium, conference, and training fees, etc
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F. Guarantee Services
A guarantee is a promise to answer ' for the debt, default or miscarriage of another' if that
person fails to meet the obligation in a contractual agreement. Primary liability for the debt is
incurred by the principal debtor. The guarantor incurs secondary liabilities (becomes liable if
the principal debtor fails to pay or perform). A guarantee is evidenced by a written document
signed by the guarantor. There are various types of guarantees.
Some of them are discussed below:
1. Bid bond guarantee. It is issued by the bank upon the request by the bidder expressing
the bank's commitment to meet the claims of the beneficiary in case the bidder
withdraws from the bid during the bid period or fails to accept the award when s/he
becomes a winner.
2. Performance bond guarantee It is issued by the bank in favor of a bid organizer
(beneficiary) at the request of the bid winner to meet any claims to be made by the
beneficiary in case the bid winner fails to deliver the goods or perform the service as
per their agreement.
3. Advance payment guarantee: It is issued by the bank in favor of the buyer who makes
the advance, at the request of the seller or contractor who received the advance
payment, representing the bank's commitment to repay the sum in the event that the
seller fails to honor the contract terms in their entirety or in part.
4. Suppliers credit guarantee: It is issued by the bank to meet any claims to be made by
the local or foreign supplier (beneficiary) in case the debtor (buyer) fails to repay in
accordance with the terms and conditions of the contract.
5. Customers duty guarantee: It is issued by the bank to meet the requests of the
beneficiary in respect of customs duties in circumstances where the goods imported
without payment of customs duties are not re-exported and the respective customs
duties have not been paid.
G. Information & Advisory services
 information on foreign trade through periodic publications
 special reports on commodities and markets
 Information to foreign investors about:
 Business climate
 legal requirements
 Banking and insurance
 Foreign exchange
 tax laws etc
 Advisory services on:
 working capital management
 project studies and financing
2.4.2 Other Depository Institutions
Stable financial institutions are an important component of well-functioning financial Systems,
as it has been vividly demonstrated by recent developments around the globe. When banking or,
other depository financial institutions temporarily break down or operate ineffectively, the
ability of firms to obtain funds necessary for continuing existing projects and pursuing new

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endeavors is curtailed. Severe disruptions in the intermediation process can even lead to
financial crises and, in some cases, undo years of economic and social progress.

The importance of depository institutions for economic growth coupled with their fragility has
led governments to establish official agencies to regulate and supervise them. The common
goals for these agencies are to promote the development of the modern financial systems that
(a) avoid excessive fragility and (b) efficiently intermediate between savers and borrowers. The
following are among the other depository institutions (in addition to banks) which play
significant role in the economic and financial system of every country.
1. Savings and Loans Associations
A savings and loan association is a financial institution that specializes in accepting savings
deposits and making mortgage loans. They are often mutually held (often called mutual savings
banks), meaning that the depositors and borrowers are members with voting rights and have the
ability to direct the financial and managerial goals of the organization. It is possible for a
savings and loan to be stock-based and even publicly traded. This means, however, that it truly
no longer is an association and depositors and borrowers no longer have any managerial
control.
Savings and loans associations (S&Ls) were originally designed as mutual associations, (i.e.,
owned by depositors) to convert funds from savings accounts into mortgage loans. They are the
predominant home mortgage lender in many countries, making loans to finance the purchase of
housing for individuals and families. The purpose is to ensure a market for financing housing
loans. Today, the distinction between S&Ls and commercial banks is minimal. However, S
&Ls continue to hold a less diversified set of assets than commercial banks do.
S and Ls accept deposit and extend loans primarily to household customers. S and Ls emphasize
on longer-term loans to households in contrast of most other deposit type financial institutions.
Many S and Ls are mutual and therefore have no stockholders but owned by depositors.
 The characteristics of savings and loan associations
The most important purpose of these institutions is to make mortgage loans on residential
property. These organizations, which also are known as savings associations, building and loan
associations, cooperative banks and homestead associations, are the primary source of financial
assistance to a large segment of many countries homeowners. As home-financing institutions,
they give primary attention to single-family residences and are equipped to make loans in this
area.
Some of the most important characteristics of a savings and loan association are:
1. generally it is a locally owned and privately managed home financing institution.
2. it receives individuals' savings and uses these funds to make long-term amortized loans to
home purchasers.
3. it makes loans for the construction, purchase, repair, or refinancing of houses.
4. it is state or federally chartered.
2. Credit Unions
Credit Unions are house hold oriented intermediaries, offering deposit and credit services to
individuals and families. They are cooperative, self-help association of individuals rather than
profit motivated institutions accepting deposits from and making loans to their members, all of
whom have a common bond, such as working for the same employer. They offer low loan rates
and high deposit interest rates and have relatively low operating costs. The members of a credit
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union are owners receiving dividends and sharing in any losses that occur. Credit Unions
usually report low default and delinquency rates and organized around a common affiliate.
They are organized as cooperative depository institutions, much like mutual savings banks.
Depositors are credited with purchasing shares in the cooperative, which they own and operate.
Like savings and loans. Credit unions were originally restricted by law to accepting savings
deposits and making consumer loans. Recent regulatory changes allow them to accept
checkable deposits and make a broader array of loans.
Credit union policies governing interest rates and other matters are set by a volunteer Board of
Directors elected by and from the membership itself. Only a member of a credit union may
deposit money with the credit union, or borrow money from it. As such, credit unions have
historically marketed themselves as providing superior member service and being committed to
helping members improve their financial health.
Credit unions typically pay higher dividend (interest) rates on shares (deposits) and charge
lower interest on loans than banks. Credit union revenues (from loans and investments) do,
however, need to exceed operating expenses and dividends (interest paid on deposits) in order
to maintain capital and solvency. Often credit unions have a lower cost of funds than typical
commercial banks, due to a higher proportion of non/low interest bearing deposits.
Credit unions offer many of the same financial services as banks, often using a different
terminology. Common services include: share accounts (savings accounts), share draft
(checking) accounts, credit cards, share term certificates (certificates of deposit), and online
banking.
Credit unions exist in a wide range of sizes, ranging from volunteer operations with a handful of
members to institutions with several billion dollars in assets and hundreds of thousands of
members.

Credit Unions and Banks

The credit unions are the co-operative financial institutions that are owned by the members of
the union. The major difference between the credit unions and banks is that the credit unions are
owned by the members unlike banks. The policies of credit unions are governed by a volunteer
Board of Directors that is elected by and from the membership itself. This board of directors
also decides on the interest rates to be charged.
According to the regulation of credit unions, only the members of the credit union are eligible
to deposit money in the union or borrow money from the union. The credit unions are always
committed and dedicated to the members and ensure to improve the financial status of the
members. The size of the credit unions may vary in a large manner. There are credits unions
available both with handful of members to thousands of members.
Even if they are generally non-profit organizations, the credit unions can perform to earn profit
for their members. The profits earned by the union are received by the members in the forms of
dividends. The dividends are paid on savings that are taxed as ordinary income. The credit
unions also offer several financial services like banks, but the terminology used here are
different from the banks. The credit unions offer the services of share accounts, share draft
accounts, share term certificates, credit cards and online banking services. Depending on the
financial structure of the country, the functionality of credit unions may vary in different
countries.

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Due to their status as not-for-profit financial institutions, credit unions in some countries are
exempt from federal and state income taxes (but, not from employment or property taxes,
among others). Additionally, credit union members pay income taxes on dividends earned
through financial participation in the credit union; this is similar to the taxation structure
enjoyed by many banks.
Bank holding companies and their affiliates aggressively compete to provide services to credit
unions through their ATM networks, corporate checking accounts, and certificate of deposit
programs.

3. Micro-Finance Institutions
Micro finance is defined as the provision of financial intermediation through distribution of
small loans acceptance of small savings and the provision of other financial products and
services to the poor. A micro finance institution (MFI) is an organization that offers financial
services to the very poor. They are making small loans available to the poor through schemes
specially designed to meet the Poor’s particular needs and circumstances. The main focus of
micro financing is on the poor through provision of small credit and acceptance of small
savings.
Micro-finance clients are typically self-employed, entrepreneurs. In rural areas, they are
usually small farmers and others who are engaged in small income generating activities such as
food processing and petty trade. In urban areas, micro-finance activities are more diverse and
include shopkeepers, service providers, artisans, street vendors, etc.
Types of Services Provided by Micro-Financing Institutions
Credit provision & saving mobilization are the core financial products /services provided by
MFIs. But there are other services provided by MFI. Micro financial Institutions provide the
Credit provision, Saving mobilization and other types of services:
1. Credit provision (Small size credit/loans) to:
Rural and urban poor households;
Petty traders;
Handcraft producers;
Unemployed youth and women ...etc.
2. Saving mobilization
One of the objectives of MFIs is to encourage the saving habit of the poor society.
3. Other services
Now a days, in addition to credit provision and saving mobilization, some MFIS provide
other financial services like local money transfer, insurance and pension fund
administration and short-term training to clients.
 The Distinguishing characteristics of micro finance from Conventional Banks
The most distinguishing characteristics of MFIs from the conventional banks are:
1. Procedures are designed to be helpful to the client and therefore are user friendly. They
are simple to understand, locally provided and easily and quickly accessible.
2. The traditional lender's requirement for physical collateral (such as land, house and
productive assets) is usually replaced by system of collective guarantee groups whose
members are mutually responsible for ensuring individual loans are repaid. Loans are
dependent not only on individual's repayment performance, but also on that of every
other group members.
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 3. Loan amounts especially at the first loan cycle are too small, much smaller than the
traditional banks would find it viable to provide and service.
4. Borrowers are usually also required to be savers.
5. Together with their long term sustainability they have the objective of ending poverty and
6. MFI's operating costs as well as administrative cost per loan are higher than the
conventional bank's.
 Objectives of the Micro finance Institutions
The goal of MFIs as development organizations is to service the financial needs of un-served or
underserved markets (the poor) as a means of meeting development objectives. The
development objectives generally include one or more of the following:
To reduce poverty.
To help existing businesses grow or diversify their activities and to encourage the
development of new businesses.
To create employment and income opportunities through the creation and expansion
of micro enterprise and ,
To increase the productivity and income of vulnerable group, especially women and
the poor.
4. Mutual Savings Banks
Mutual savings banks are much like savings and loans, but are owned cooperatively by
members with a common interest, such as company employees, union members, or
congregation members.
Saving banks play an active role in the residential mortgage banks but are more diversified in
their investments, purchasing corporate bonds and common stocks, making customer loans and
investing in commercial mortgage banks. Saving banks are owned by their depositors to which
all earnings not retained are paid as owner’s dividend. Mortgage and Mortgage related
instruments are principal assets followed by investments in non-mortgage loans, corporate
bonds, corporate stocks and government bonds.
 The principal source of funds for saving banks is deposits, which is a liability for them.
5. Money Market Funds
Money Market Funds are financial intermediaries pooling deposits of many individuals and
investing those in short-term, high quality, money market instruments. Money fund offer
accounts whose yields are free to reflect prevailing interest rates in the money market.
2.5 Non-depository Institutions
Unlike depository institutions, non-depository institutions do not accept checkable deposits.
With one exception that will be noted shortly, you cannot simply write a "check" to withdraw
funds from a non-depository institution.
Types and Role of Non-depository Financial Institutions
Non-depository institutions serve various functions in financial markets, ranging from financial
intermediation to selling insurance against risk. The following are some of the types of non-
depository financial institutions with their role in the financial system.
A. Financial brokers
Brokerage Houses or firms: buy/sell old securities on behalf of individuals. Brokerage firms
serve the valuable function of linking buyers and sellers of financial assets. In this regard, they
function as intermediaries, earning a fee for each transaction they create. Modern brokerage
firms compete with depository institutions in the deposit market, where they attract depositors
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with money market mutual funds.
B. Investment Institutions (Finance Companies, Investment Companies and Mutual Funds)
i) Finance Companies: are sometimes called department stores of consumer and business credit.
They grant credit to businesses and consumers for a wide variety of purposes acquiring their
funds mainly from debt. Like banks, they use people's savings to make loans to businesses, but
instead of holding deposits, they sell bonds and commercial papers.
 Types of finance companies
 Consumer Finance companies-make personal cash loans to individuals.
 Sales Finance Companies- make indirect loans to consumers by purchasing installment
paper from dealers selling automobiles and other consumer durables.
 Commercial Finance Companies- focus primarily on extending credit to business firms.
 Other Financial Institutions:
Security Dealers are firms that take a position of risk in government and privately
issued securities, purchasing the instruments from sellers and reselling them to buyers
with the expectation of a profitable spread between purchases and sales.
Investment Banks are capital market firms that assist businesses and governments to
issue debt and stock in order to raise new capital.
Mortgage Banks are intermediaries that work with other businesses or real estate
development projects and sell the mortgage loan instruments to other investors.
Venture Capital Firms are institutional investors that provide long-term capital
financing for new businesses and rapidly emerging companies.
Real Estate Investment Trusts are specialized lenders and equity investors that finance
commercial and residential projects.
Leasing Companies are financial firms that purchase business equipment and other
productive assets and make the purchased items available for use by others in return
for rental fee.
ii) Investment companies: provide an outlet for the savings of many individual investors
towards bonds, stocks, and money market securities. Most investment companies stocks
are highly liquid because they repurchase their outstanding shares at current market price.
iii) Mutual funds: are especially attractive to small investor, which purchase shares of these
funds and gain greater diversification, risk sharing, lower transaction cost, opportunities
for capital gains and indirect access to higher yielding securities that can be purchased
only in large blocks. They pool funds of savers and make them available to business and
government demanders.
They obtain funds through sale of shares and uses proceeds to acquire bonds and stocks issued
by various business and government units. They create a diversified and professionally
managed portfolio of securities to achieve a specified investment objective, such as liquidity
with high return. Some mutual funds, called money market mutual funds, invest in short-term,
safe assets like Treasury bills and large bank certificates of deposit.

C. Pension Funds
A Pension fund is a pool of assets forming an independent legal entity that are bought with the
contributions to a pension plan for the exclusive purpose of financing pension plan benefits.

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Pension funds are savings plan through which fund participants accumulate savings during their
working days so that they withdraw the fund during their retirement years.
A pension plan is a promise by a pension plan sponsor to a plan member to provide a pension
upon retirement. The sponsor may be a company, an employer, a union or a jointly trusteed plan
where both management and unions in an industry appoint trustees to a board which manages
the plan. This promise is legally stated in the "pension plan document" which states the
provisions for the plan. Pension plans may be regulated by governments or financial
institutions.
A trustee is appointed to hold the assets in trust for the benefit of the plan members. Usually the
trustee is also the custodian, which holds the plan investments. Pension plans usually hire an
outside investment manager to invest the plan assets. The sponsor may also appoint an
"investment consultant" to advice on investment issues and help select and assess the
performance of investment managers.
D. Insurance

Insurance can be defined from the view points of the individual and the society. From an
individual point of view insurance is an economic device whereby the individual substitutes a
small certain cost (the premium) for a large uncertain financial loss (the contingency insured
against) that would exist if it were not for the insurance. Insurance is the protection against
financial loss. The creation of the counterpart of risk is the primary function of insurance.
Insurance doesn’t decrease the uncertainty for the individual as to whether the event will occur,
nor does it alter the probability of occurrence, but it does reduce the probability of financial loss
concerned with the event.
From the viewpoint of the society, insurance is an economic device for reducing and
eliminating risk through the process of combining a sufficient number of homogenous
exposures into a group to make the losses predictable for the group as a whole. From the
viewpoint of the insured, insurance is a transfer device. From the viewpoint of the insurer,
insurance is a retention and combination device. The distinctive feature of insurance as a
transfer device is that it involves some pooling of risks; i.e., the insurer combines the risks of
many insured. Insurance does not prevent losses, nor it reduces the cost of losses to the
economy as a whole. The existence of insurance encourages some losses for the purpose of
defrauding the insurer, and in addition, people are less careful and may exert less effort to
prevent losses than they might if the insurer did not exist.
 Major Classes of Insurance Companies
Insurance companies create insurance policies by grouping risks according to their focus. This
provides a measure of uniformity in the risks that are covered by a type of policy, which in turn
allows insurers to anticipate their potential losses and set premiums accordingly. Insurance
Companies may be classified in to life insurance companies and Non-life (Property-casualty)
insurance companies.
I. Life Insurance Companies
Human values are far greater and more important than all the different property values
combined. Human resource is the most important resource for a nation’s development than
other resources. A human life has value for many reasons. Many of these reasons are
philosophical in nature, and would lead us in to the realm of religion, esthetics, sociology,
psychology and other behavioral sciences. A human life has an economic value to all depends
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on the earning capacity of that life, particularly to two central economic groups - the family and
the employer.
There are four major perils that can destroy, wholly or partially, the economic value of a human
life. These include premature death, loss of health, old age, and unemployment which are
categorized under personal risk. Every person faces two basic contingencies concerning life.
 First, he/she may die too soon, or this is a physical death.
 Second, he/she may live too long. It means that the person may outlive his/her financial
usefulness or his/her ability to provide for his/her needs.
Life insurance is designed to provide protection against these two distinct risks: premature
death and superannuation. Thus, life insurance may be defined as a social and economic device
by which a group of people may cooperate to ameliorate (to make better) the loss resulting from
the premature death or living too long of members of the group. The main purpose of life
insurance, therefore, is financial protection i.e. to provide dependents of the insured with
financial compensation amounting to the sum assured if the insured faces premature death while
the policy is in force. It gives the family financial security for a certain period.
In general, there are many different types of life insurance, but the standard arrangement is a
contact specifying that upon death of the person whose life is insured, a stated sum of money
(the policy's face amount) is paid to the person designated in the policy as he beneficiary.
Life insurance is a risk-pooling plan, which is an economic plan through which the risk of
premature death is transferred from the individual to the group. However, there are
characteristics that differentiate from other types of insurance contract. That is,

 The event insured against is an eventual certainty;

 Life insurance is not a contract of indemnity;
 The application of principle of insurable interest is different;
 Life insurance contracts are long-term contract; and
 There is no possibility of partial loss.
Not all people need exactly the same kind of protection from life insurance. It is so because
there are differences in ages; incomes and financial obligations; the number of their dependents;
and other related variables. To provide all the different types of protection that are needed,
insurance companies offer a variety of policies. The basic types of contracts are: Term
insurance, Whole life insurance, Endowment insurance, and Annuities.
A. Term Insurance
Term insurance provides protection only for a definite period (term) of time. A term insurance
policy is a contract between the insured and the insurer where by the insurer promises to pay
face amount of the policy to a third party (the beneficiary) if the insured dies within a given
period of time. If the insured manages to survive during the period for which the policy was
taken, the insurance company is not required to pay anything. Common types of term life
insurance are 1-year term, 5-years term, 10-years term, 20-years term, and to age 60 or 65.
B. Whole life insurance
As the name suggests, it is a permanent insurance that extends over the life time of the insured.
It provides for the payment of the face value upon the death of the insured, regardless of when it
may occur. Whole life insurance policies promise to pay the beneficiary whenever death occurs.
It also promise payment if the insured reaches age 100. Whole life insurance premium is greater
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than that of term, as claims are certain and the insurer must collect enough premiums to pay
them.
Whole life insurance contracts contain savings elements called cash values. The cash values are
due to the overpayment of the insurance premiums during early years. As a result policy owner
builds cash equity in the policy. If the policyholder decides to terminate it prior to the insured's
death, the cash value can be refunded which is not in the case of term insurance.
C. Endowment Insurance
It differs from other policies in that the death of the insured is not required for payoff. At the
maturity' date, the value of the policy is remitted to the insured, if surviving, otherwise to the
beneficiary. It is to mean that endowment contracts provide death benefits for a specified period
of time, just as term insurance does.

D. Annuity Contracts
An annuity may be defined as a periodic payment to commence at a stated date and to continue
for a fixed period or the duration of a designated life. The person who receives the periodic
payments or whose life governs the duration of payments is known as the annuitant.
In one sense, an annuity may be described as the opposite of life insurance. Life insurance
creates an immediate estate and provides protection against dying too soon before financial
assets can be accumulated. The fundamental purpose of a life annuity is to provide a lifetime
income that cannot be outlived to an individual. An annuity insurance operation transfers funds
from those who die at a relatively early age to those who live to a relatively old ages.
E. Credit Life Insurance
Credit life insurance is meant to protect lenders against a borrower’s death prior to repayment of
a debt contract. It can be issued through other financial institutions.
II. Non-life Insurance
Non-life insurance is also called property-casualty insurance and can be divided in to property
insurance and casualty (liability) insurance. Property insurance involves coverage related to
loss, damage or destruction of real and personal property.
Properties to be covered, range from personal jewelry to industrial plant and machinery.
Property insurance is intended to indemnify the loss suffered by the insured. Indemnity may be
in the form of payment of money, repair, replacement or re-instatement. Casualty insurance, on
the other hand, provides protection against legal liability exposure resulting from negligence.
Payment is made to the injured third party by the insurance company.
 Distinction between life insurance and non-life insurance companies
Insurance contracts can be classified commonly (most of the time) in to life insurance and
non-life insurance contracts or risk coverage’s. As the name imply their detailed
agreements and contract may vary so. Accordingly,

1. Asset portfolios of non-life insurance companies largely contain liquid assets or short term
investments due to the fact that events are difficult to predict statistically than are death rates
in population.
2. Non-life insurance companies are riskier and administratively more expensive than life
insurance because of the following reasons:
 Greater complexity in asset valuation and determination of payouts
 Higher incidence of claims
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  Higher likelihood of fraudulent claims which requires significant administrative
resources to verify the claim and the cause of loss
3. Life insurance company’s claims and liabilities are relatively long term in nature

 Reinsurance
Reinsurance is the shifting of part or all of the insurance originally written by one insurance to
another insurer. The insurer that initially writes the business is called Ceding Company. Ceding
company may get commission from the reinsurer on the account of bringing business for the
reinsurer. The insurer that accepts part or all of the insurance from the ceding company is called
the reinsurer. The amount of insurance retained by the ceding company for its own account is
called the retention limit or net retention. The amount of the insurance ceded to the reinsurer is
known as a premium cession. The reinsurer in turn may obtain reinsurance from another
insurer. This is known as a retrocession. In this case, the second reinsurer is called a
retrocessionaise.
The main Reasons for Reinsurance include increase underwriting capacity (allows the
reinsured to write larger amounts of insurance, and a ceding company’s capacity for retaining
such coverage is limited by capital and surplus, regulatory and other factors), and stabilize
profit. Loss experience can fluctuate widely because of social and economic conditions, natural
disaster, and chance. If a large, unexpected loss (catastrophe) occurs, the reinsurer would pay
the portion of the loss in excess of some specified limit.
E. Investment Banking Firms
Investment is the commitment of money or capital to purchase financial instruments or other
assets in order to gain profitable returns in the form of interest, income, or appreciation of the
value of the instrument. Investment is related to saving or deferring consumption.
An investment involves the choice by an individual or an organization such as a pension fund,
after some analysis or thought, to place or lend money in a vehicle, instrument or asset, such as
property, commodity, stock, bond, financial derivatives (e.g. futures or options), or the foreign
asset denominated in foreign currency, that has certain level of risk and provides the possibility
of generating returns over a period of time.
When an asset is bought or a given amount of money is invested in the bank, there is
anticipation that some return will be received from the investment in the future. Investment is a
term frequently used in the fields of economics, business management and finance. It can mean
savings alone, or savings made through delayed consumption. Investment can be divided into
different types according to various theories and principles. While dealing with the various
options of investment, the defining terms of investment need to be kept in mind.
Investment banking firms provide their clients with the opportunity to generate funds through
different processes. At the same time, they also provide professional services to the investors
for identifying different investment opportunities and to invest in the same. The investment
banking firms provide various financial services to a wide range of clients. There are both
institutional as well as individual clients of these firms. At the same time, these firms also offer
a number of services to different national Governments.
 Services provided by Investment Banking Firms
The clients of the investment banking firms are provided with advisory services. The firms also
offer a range of capital raising opportunities to the clients. They help the clients to place their
equities in such a manner that they can produce highest yields. At the same time, the firms are
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also involved in the syndication of primary market on behalf of their clients. The investment
banking firms also play a major role in arranging debt securities for their clients. The corporate
clients of the companies are offered with several other services as well. The mergers and
acquisitions are a very important part of the business expansion plans.
The investment banking firms play an important role in creating customized strategies for all
these activities. The investment banking services are also available for the activities like
divestitures, restructurings, buyouts and others. All these activities need huge amount of money
and the investment banking firms are responsible for arranging these funds. At the same time,
there are individual clients of investment banking firms. These clients are helped in a number of
ways. The firms help the clients to identify the growth prospect of different investment options
and to invest in the best one.
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