Financial system

1. Chapter two :Financial Institutions in the Financial System

2. 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.

3. 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.

4. 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.

5. 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.

6. 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.

7. Cont,d
 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.

8. 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.

9. 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.

10. Cont,d
2. 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.

11. 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.

12. 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,
saving and loan associations, Micro finance institutions,
insurance companies, pension funds, mutual fund, broker
and building societies.
 Banks are one type of intermediary, it receiving money
from small savers and provide loan to borrowers to
purchase homes, vacations, and so on to businesses and
government units.

13. 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.

14. 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

15. 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, credit union, saving and loan
association, micro finance institutions, mutual funds,
security firms, insurance companies, and pension
funds.

16. Cont,d
 Generally financial institutions are
classified into two as depository and non-
depository financial

17. Depository Financial institutions
 are a financial institution (such as commercial bank,
savings bank, micro finance institutions 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.

18. 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).
 Deposits are money placed in an account at a
depository institution & constituting a claim on the
depository institutions.
 Loans are the borrowing of a sum of money by
households or businesses from the depository
institutions.

19. Cont,d
Depository institutions drive their income from:
 interest on loans,
 interest and dividend on securities, and
 fees income

20. 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.

21. 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).

22. 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.

23. 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.

24. Types of depository institutions
 Depository financial Institutions include:
 commercial banks,
 savings and loan associations, and
 credit unions
 microfinance institutions

25. 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.

26. 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.

27. 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.

29. 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.

30. 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.

31. 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.

32. 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.

33. 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.

34. 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.

35. 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.

36. 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.

37. 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.

38. 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.

39. 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.

40. 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.

41. 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
(g) Acts as Trustee and Executor

42. 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.

43. 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.

44. 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.

45. 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.

46. 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.

47. 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

48. 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.

49. 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

50. 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)

51. 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

52. 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.

53. 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.
 It includes:
Insurance companies
Pension funds
Mutual funds
Investment Banking Firms
Brokers and dealers

54. 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.

55. 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.

56. 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.

57. 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.

58. 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.

59. 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.

60. 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.

61. 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.

62. 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

63. Cont,d
 Like mutual funds and insurance companies,
they may periodically attempt to influence the
management of those firms to improve
performance.

64. 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.

65. 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.

66. 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:

67. 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.

68. 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.

69. 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.

70. 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.

71. 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.

72. 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.

73. 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.

74. 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.

75. 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.