Chapter two :Financial Institutions in the Financial

System
 Overview of Financial Institutions

• Financial institutions serve as intermediaries

by channeling the savings of individuals,
businesses, and governments into loans or
investments. They are major players in the
financial marketplace, with large amount of
financial assets under their control.
 Cont,d
• Financial institutions deal with various financial
activities associated with financial systems, such as
securities, loans, risk diversification, insurance,
hedging, retirement planning, investment, portfolio
management, and many other types of related
functions.
• With the help of their functions, 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.
 Cont,d
• The channeling process which is known as
financial intermediation is crucial to the well
functioning of modern economy, since current
economic activity depends heavily on credit
and future economic growth depends heavily
on business investment. For example, a
student loan for college which increases the
level of education and human capital, will
promote future economic growth of a country.
 Key Customers of Financial Institutions

• The key suppliers of funds to financial

institutions and the key demanders of funds
from financial institutions are:
 individuals,
 businesses, and
 governments.
 2.1 Financial institutions and capital transfer

• A financial institution is a channel that transferring

the funds between the savers and the borrowers.
• Financial institution is only focuses on the financial
transaction such as loan, bonds, debentures,
insurance, investment and other various types of
financial activities.
• The financial institutions are included insurance
companies, banks, credit unions, stock brokerage
firms, non banking financial institutions, building
societies, and asset management firms.
• There are three different ways for transferring
capital or fund from savers to borrowers in the
financial system. This are
1 direct transfers of money and securities,
2.investment banking house, and
3. financial intermediaries.
 Cont,d
1. Direct transfer of money and securities is the
easier way to transferring the capital or fund
from both borrower and saver. The borrowers no
need to go through the investment bankers or
any financial intermediaries. The scenario of
direct transfer of money and securities will only
occur when the businesses sell the shares or
bonds to the savers directly in the financial
market without go through any financial
institution.
 Cont,d
• This direct transfer of money and securities is
only suitable for the small firms and procedure
is raised by a small amount of capital
• For example, a person needs capital to starting
his new business but he is lack of capital. So
his uncle lends him money to raise fund in
order to starting business. So his uncle direct
transfer the money to that person.
 Cont,d
2. Investment banking house
• For investment banking house, if the company
needs to raise up the capital faster so the
company will prefer to go through the
investment banking house to established new
investment securities in order to help the
company to obtain financing.
• For example, ABC company is temporary
lacking in capital so ABC company need to sell
the shares or bonds to the investment banking
house in order to raise fund quickly.
 Cont,d
• The purpose implements the investment banking
house in order to exchange the securities into cash
faster than the business sell the securities itself. But
the investment might use the prices that lower
than the market price to purchase these shares or
bonds of the company.
• When the firms sell their securities to the
investment banking house, the investment banking
house will resell the securities to the savers.
• So, the investment banking house is the middleman
between the business and the savers.
 cont,d
3. Financial intermediaries

• Financial intermediaries are institutions which

are between savers and investors and moving
funds between both of them. The types of
intermediaries included banks, credit unions,
insurance companies, pension funds, mutual
fund, broker and building societies.
 Cont,d
• In this indirect transfer through a financial
intermediary, the financial intermediaries will
collect the money from the savers that wish to
invest or the savers purchase the intermediary
securities.

• After that, the financial intermediary will use

this amount of money to provide financial
service such as provide loans to the borrowers
to start up the business.
 Functions of Financial Institutions
Pooling the savings of individuals
Providing safekeeping accounting and access to
payment system
Providing liquidity
Currency exchange
Reducing risk by diversifying
Collection and processing information
 Types of Financial Institutions
• The services provided by financial institutions
depend on its type.
• For example, the services offered by the
commercial banks are different from insurance
companies.
• The most important financial institutions that
facilitate the flow of funds from investors to
firms are commercial banks, mutual funds,
security firms, insurance companies, and
pension funds.
• Generally financial institutions are classified
into two as depository and non-depository
financial
 Depository institutions
• are a financial institution (such as commercial
bank, savings bank, and credit union) that is
legally allowed to accept monetary deposits
from consumers.

• It contributes to the economy by lending

much of the money saved by depositors.
 Cont,d
• Depository institutions are financial firms that take
deposits from households and businesses and
manage, and make loans to other households and
businesses.
• In other words depository institutions are those
institutions which accept deposits from economic
agents (liability to them) and then lend these funds
to make direct loans or invest in securities (assets).
•
 Cont,d
Depository institutions drive their income from:
 interest on loans,
 interest and dividend on securities, and
 fees income
Assets and Liability Problem of DIs
• A depository institution seeks to earn a
positive spread between the assets it invests
in (loans and securities) and the cost of its
funds (deposits and other sources).
• The spread income should allow the
institution to meet operating expenses and
earn a fair profit on its capital.
 Cont,d
Depository institution makes a profit by borrowing
from depositors at a low interest rate and lending at
a higher interest rate.

The depository institution earns no interest on

reserves, but it must hold enough reserves to meet
withdrawals.

So the depository institution must perform a

balancing act to balance the risk of loans (profits for
stockholders) against the safety of reserves (the
security for depositors).
 Liquidity concerns

• Liquidity concerns for commercial banks

arises due to short-term maturity nature of
deposits.

• Besides facing credit risk & interest rate risk,

Depository institutions should always be ready
to satisfy withdrawal needs of depositors and
meet loan demand of borrowers.
 Cont,d

• Depository institutions use the following ways

to accommodate withdrawal and loan
demands:
 attract additional deposit;
 borrow using existing securities as a collateral
(from a federal agency or financial institutions);
 sell securities it owns;
 raise short-term funds in the money market.
 Types of depository institutions
• Depository financial Institutions include:
– commercial banks,
– savings and loan associations, and
– credit unions
– microfinance institutions
 Commercial Banks

• Commercial banks are the largest and most

diversified intermediaries on the basis of range
of assets held and liabilities issued. Commercial
banks provide numerous services in the
financial system.
• Commercial banks accumulate deposits from
savers and use the proceeds to provide credit to
firms, individuals, and government agencies.
Thus they serve investors who wish to “invest”
funds in the form of deposits.
 Cont,d
• Commercial banks use the deposited funds to
provide commercial loans to firms and
personal loans to individuals and to purchase
debt securities issued by firms or government
agencies. They serve as a key source of credit
to support expansion by firms.
 FUNCTIONS OF COMMERCIAL
BANKS

• Commercial banks have to perform a variety of functions

which are common to both developed and developing
countries. These are known as ‘General Banking’ functions of
the commercial banks. The modern banks perform a variety of
functions. These can be broadly divided into two categories:
• (a) Primary functions and
• (b) Secondary functions.
 A. Primary Functions

1. Acceptance of Deposits: Accepting deposits is the primary

function of a commercial bank Banks generally accept three
types of deposits viz., (a) Current Deposits (b) Savings
Deposits, and (c) Fixed Deposits.
 Advancing Loans:

• The second primary function of a commercial bank is to

make loans and advances to all types of persons,
particularly to businessmen and entrepreneurs.
a) Overdraft Facilities: In this case, the depositor in a
current account is allowed to draw over and above his
account up to a previously agreed limit.
 Cont,d
• Suppose a businessman has only Br. 30,000/- in his current
account in a bank but requires Br. 60,000/- to meet his
expenses.

• He may approach his bank and borrow the

additional amount of Br. 30,000/-. The bank allows
the customer to overdraw his account through
cheques.
 Cont,d
b)Cash Credit: Under this account, the bank
gives loans to the borrowers against certain
security. But the entire loan is not given at
one particular time, instead the amount is
credited into his account in the bank; but
under emergency cash will be given.

o The borrower is required to pay interest only

on the amount of credit availed to him.
 Cont,d

c) Discounting Bills of Exchange: This is another type of

lending which is very popular with the modern banks. The
holder of a bill can get it discounted by the bank, when he is
in need of money.
 After deducting its commission, the bank pays the present
price of the bill to the holder. Such bills form good
investment for a bank. They provide a very liquid asset
which can be quickly turned into cash.
 Cont,d

e) Term Loans: Banks give term loans to traders,

industrialists and now to agriculturialists also against some
collateral securities. Term loans are so-called because their
maturity period varies between 1 to 10 years.
 Cont,d
d) Money at Call: Bank also grant loans for a very short period,
generally not exceeding 7 days to the borrowers, usually
dealers or brokers in stock exchange markets against collateral
securities like stock or equity shares, debentures, etc., offered
by them.
 Cont,d
• f) Consumer Credit: Banks also grant credit to households in
a limited amount to buy some durable consumer goods such as
television sets, refrigerators, etc., or to meet some personal
needs like payment of hospital bills etc.
 Cont,d
• (g) Miscellaneous Advances: Among other
forms of bank advances there are packing
credits given to exporters for a short duration,
export bills purchased/discounted, import
finance-advances against import bills, finance
to the self employed, credit to the public
sector, credit to the cooperative sector and
above all, credit to the weaker sections of the
community at concessional rates.
 Cont,d
3. Creation of Credit: A unique function of the bank is to
create credit. Banks supply money to traders and
manufacturers. They also create or manufacture money.
Bank deposits are regarded as money.
 Cont,d

• 4. Promote the Use of Cheques: The commercial banks

render an important service by providing to their customers
a cheap medium of exchange like cheques. It is found much
more convenient to settle debts through cheques rather than
through the use of cash.
• 5. Financing Internal and Foreign Trade: The bank
finances internal and foreign trade through discounting of
exchange bills. Sometimes, the bank gives short-term loans
to traders on the security of commercial papers.
 Cont,d

6. Remittance of Funds: Commercial banks, on account of

their network of branches throughout the country, also
provide facilities to remit funds from one place to another
for their customers by issuing bank drafts, mail transfers or
telegraphic transfers on nominal commission charges.
 B. Secondary Functions

• Secondary banking functions of the commercial banks

include:
1. Agency Services
2. General Utility Services
1. Agency Services:
(a) Collection and Payment of Credit Instruments:
(b) Purchase and Sale of Securities:
(c) Collection of Dividends on Shares:
(d) Acts as Correspondent
(e)Income-tax Consultancy:
(f) Execution of Standing Orders
 2. General Utility Services:

(a) Locker Facility: Bank provides locker facility to their

customers. The customers can keep their valuables, such as
gold and silver ornaments, important documents; shares and
debentures in these lockers for safe custody.
(b) Traveller’s Cheques and Credit Cards: Banks issue
traveller’s cheques to help their customers to travel without
the fear of theft or loss of money.
 Cont,d
(c) Letter of Credit: Letters of credit are issued by the banks to their
customers certifying their credit worthiness. Letters of credit are very
useful in foreign trade.

(d) Collection of Statistics: Banks collect statistics giving important

information relating to trade, commerce, industries, money and
banking.

(e) Acting Referee: Banks may act as referees with respect to the
financial standing, business reputation and respectability of customers.

(f) Underwriting Securities: Banks underwrite the shares and debentures

issued by the Government, public or private companies.
 Savings and loan associations

• Savings and loan associations (S&Ls) are old

institutions established to provide finance for
acquisitions of homes. They can be mutually owned
or have corporate stock ownerships.
• NB: Mutually owned means depositors are the
owners.
• They have traditionally served individual savers,
residential and commercial mortgage borrowers, take
the funds of many small savers and then lend this
money to home buyers and other types of borrowers.
• The collateral for the loan would be the home being
financed.
 Cont,d
• The institutions were not to take in demand
deposits but instead were authorized to offer
savings accounts that paid slightly higher interest
than offered by commercial banks account to
commercial customers.

 In function, Savings and loan associations are

similar to commercial banks, and in recent years
the distinction between commercial banks and
savings and loan institutions has become blurred
as the financial services industry has become more
homogeneous.
 Credit unions

• Credit unions are the smallest and the newest of

the depository institutions owned by a social or
economic group that accepts saving deposits and
makes mostly consumer loans.
• They established by people with a common bond.
They are mutually owned established to satisfy
saving and borrowing needs of their members.
• Credit unions, called by various names around the
world, are member-owned, not-for-profit financial
cooperatives that provide savings, credit and other
financial services to their members.
 Cont,d
• Credit union membership is based on a common
bond, a linkage shared by savers and borrowers
who belong to a specific community,
organization, religion or place of employment
such as employees of a given firm or union.
• Credit unions pool their members' savings
deposits and shares to finance their own loan
portfolios rather than rely on outside capital.
• Members benefit from higher returns on savings,
lower rates on loans and fewer fees on average
 Cont,d
• Regardless of account size in the credit union, each member
may run for the volunteer board of directors and cast a vote
in elections. In some countries, members encounter their
first taste of democratic decision making through their credit
unions.

• The major regulatory differences between credit unions and

other depository institutions are:
– the common bond requirement,
– the restriction that most loans are to consumers,
– their exemption from federal income tax because of their
cooperative nature.
 Microfinance institutions (MFIs)

The active poor require a full set of micro finance services

mainly in the form of saving and credit facilities.
• These services help the poor:
 Start new business or expand existing ones
 Improve productivity of farmers and micro enterprises.
 Improve human and social capital throughout their life
 Deal with vulnerabilities and poverty reduction
 Cont,d
However, the active poor, both in the urban and
rural areas, are neglected by formal bank and
non bank financial institutions because of
different reasons. Such as:
 Collateral requirement of formal bank.
 High transactions cost(mini transaction) and
High perceived risk (such as difficulty in
contract enforcement and harvest failure)
 Cont,d
Activities of MFI
• Small loans, typically, for working capital
• informal appraisal of borrowers and
investments
• collateral substitutes, such as a group
guarantee or compulsory savings
• access to repeated and large loans, based on
repayment performance
 Non-depository institutions

• Non-depository institutions are financial

intermediaries that do not accept deposits but
do pool the payments of many people in the
form of premiums or contributions and either
invest it or provide credit to others. Hence, non
depository institutions form an important part
of the economy. These institutions receive the
public's money because they offer other
services than just the payment of interest.
 Cont,d
• They can spread the financial risk of individuals over a
large group, or provide investment services for greater
returns or for a future income.

• Non-depository financial institutions are defined as

those institutions that serve as an intermediary
between savers and borrowers, but do not accept
deposits. Non depository institutions include:
• Insurance companies
• Pension funds
• Mutual funds
• Investment Banking Firms
• Brokers and dealers
 A. Insurance Companies
• Insurance offer insurance policies to the public and
make payments, for a price, when a certain event
occurs.

• Insurance companies distribute/spread risks to

individuals, through the “Rule of large number” and
they act as risk bearers.
• Insurance companies periodically receive payments
(premiums) from their policyholders, pool the
payments, and invest the proceeds until these funds are
needed to pay off claims of policyholders.
 Cont,d
• They commonly use the funds to invest in
debt securities issued by firms or by
government agencies. They also invest heavily
in stocks issued by firms. Thus they help
finance corporate expansion.
 Cont,d
• Insurance companies employ portfolio
managers who invest the funds that result
from pooling the premiums of their
customers.
• An insurance company may have one or more
bond portfolio managers to determine which
bonds to purchase, and one or more stock
portfolio managers to determine which stocks
to purchase.
 Cont,d
• The objective of the portfolio managers is to
earn a relatively high return on the portfolios
for a given level of risk.

• In this way, the return on the investments not

only should cover future insurance payments
to policyholders but also should generate a
sufficient profit, which provides a return to
the owners of insurance companies.
 Cont,d
• Like mutual funds, insurance companies tend to
purchase securities in large blocks, and they
typically have a large stake in several firms. Thus
they closely monitor the performance of these
firms.

• They may attempt to influence the management of

a firm to improve the firm’s performance and
therefore enhance the performance of the
securities in which they have invested.
 Cont,d

• Like banks, insurance companies are also challenged

by the information asymmetry problems of adverse
selection and moral hazard. Insurance companies
can solve an adverse selection by screening
applicants. That is,
– verifying information in the application,
– checking the applicant’s history and
– by applying restrictive covenant in the insurance contract.

• However, the solution of moral hazard is depending on

the type of insurance offered.
 B. Pension Funds

• A pension fund is a fund that is established for

the payment of retirement benefits. Most
pension fund assets are in employer-
sponsored plans. The entities that establish
pension plans are called the plan sponsors.

• pension plans can be established by both

governmental & private organizations on
behalf of their employees.
 Cont,d
• Pension funds receive payments (called
contributions) from employees, and/or their
employers on behalf of the employees, and
then invest the proceeds for the benefit of the
employees.

• They typically invest in debt securities issued

by firms or government agencies and in equity
securities issued by firms.
 Cont.d
• Pension funds employ portfolio managers to invest
funds that result from pooling the
employee/employer contributions.

• They have bond portfolio managers who purchase

bonds and stock portfolio managers who purchase
stocks. Because of their large investments in debt
securities or in stocks issued by firms, pension funds
closely monitor the firms in which they invest
 Cont,d
• Like mutual funds and insurance companies,
they may periodically attempt to influence the
management of those firms to improve
performance.
 C. Mutual Funds

• Mutual funds are corporations that accept money

from savers and then use these funds to buy stocks,
long-term bonds, or short-term debt instruments
issued by businesses or government units.
• Mutual funds sell shares to individuals, pool these
funds, and use them to invest in securities.

• In other words a mutual fund pools the funds of

many people and managers invest the money in a
diversified portfolio of securities to achieve some
stated objective.
 Cont,d
• These organizations pool funds and thus reduce
risks by diversification. They also achieve
economies of scale in analyzing securities,
managing portfolios, and buying and selling
securities.
• They continually stands ready to sell new shares
to the public and to redeem its outstanding shares
on demand at a price equal to an appropriate
share of the value of its portfolio which is
computed daily at the close of the market.
 Cont,d
• Different funds are designed to meet the
objectives of different types of savers.

• Hence, there are bond funds for those who

desire safety, stock funds for savers who are
willing to accept significant risks in the hope of
higher returns, and still other funds that are
used as interest-bearing checking accounts
(the money market funds).
• Thus, mutual funds are classified into three
broad types. These are:
 Cont,d
 Money market mutual funds pool the
proceeds received from individual investors to
invest in money market (short-term) securities
issued by firms and other financial institutions.
 Bond mutual funds pool the proceeds
received from individual investors to invest in
bonds, and
 Stock mutual funds pool the proceeds
received from investors to invest in stocks.
 Cont,d
• Mutual funds are regulated by the Securities
and Exchange Commission (SEC). Primary
objective of regulation is the enforcement of
reporting and disclosure requirements to
protect the investor.
 Investment Banking Firms
• Investment bank is a financial institution engaged
in securities business. Investment banking firms
perform activities related to the issuing of new
securities and the arrangement of financial
transactions.
• They mainly involved in primary markets, the
market in which new issues are sold and bought
for the first time. They advice issuers on how best
raise funds, and then they help sell the securities.
 Cont,d
• Investment banking is a type of financial
service that focuses on helping companies
acquire funds and grow their portfolios.

• Investment banking firms assist client

companies in obtaining funds by selling
securities, i.e., raise funds for clients and act
as brokers or dealers in the buying and selling
securities in secondary markets, i.e., assisting
clients in the sale or purchase of securities.
Types of Modern investment banks
• 1. The Corporate Business. The corporate side of
investment banking is a fee-for service business;
that is, the firm sells its expertise. The main
expertise banks have is in underwriting
securities, but they also sell other services.
• They provide merger and acquisition advice in
the form of prospecting for takeover targets,
advising clients about the price to be offered for
these targets, finding financing for the takeover,
and planning takeover tactics or, on the other
side, takeover defenses.
 Cont,d
• 2. The Sales and Trading Business. Investment
banks that underwrite securities sell them on
the sales and trading end of their business to
the bank’s institutional investors.
• These investors include mutual funds, pension
funds, and insurance companies. Sales and
trading also consists of public market making,
trading for clients, and trading on the
investment banking firm’s own account.
 Cont,d
• 3. Market making requires that the investment bank act
as a dealer in securities, standing ready to buy and sell,
respectively, at wholesale (bid) and retail (ask) prices.
• The bank makes money on the difference between the
bid and ask price, or the bid-ask spread. Banks do this
not only for corporate debt and equity securities, but
also as dealers in a variety of government securities.
• In addition, investment banks trade securities using
their own fund, which is known as proprietary trading.
Proprietary trading is riskier for an investment bank
than being a dealer and earning the bid-ask spread, but
the rewards can be commensurably larger.
 Risks in Financial Industry
• Credit or default risk: is the risk that a Deficit
Spending Unit (DSU) will not pay as agreed,
thus affecting the rate of return on an asset.
• Interest rate/Funding/ risk: is the risk of
fluctuations in a security's price or reinvestment
income caused by changes in market interest rates. It
is a risk caused by interest rate changes when DIs
borrow long(short) and lend short(long).

• Liquidity risk: is the risk that the financial

institution’s cash inflows will not be able to
meet its cash outflows.
 Risks in Financial Industry

• Foreign exchange risk: is the risk that

fluctuations in the foreign exchange rates will
affect the profit of the financial institution.
• Political/regulatory/ risk is the risk that actions
of foreign governments or regulators will affect
the profit of the financial institution.

• It is the risk that regulators will change the rules

so as to impact the earnings of the institution
unfavorably.