Financial Markets and Institutions

CHAPTER TWO: FINANCIAL INSTITUTIONS IN THE FINANCIAL SYSTEM

Unit Introduction
The term financial institutions and financial intermediaries are often used interchangeably.
Financial institution is a company whose primary function is to intermediate between lenders
and borrowers in the economy. Financial institutions perform the essential functions of
channeling funds from those with surplus funds to those with shortages of funds. In an
economy, financial institutions channel the flow of savings from savers to users of funds.
Intermediation improves the social welfare by channeling recourses to their most effective use.
The channeling process which is known as financial intermediation is crucial to the well-
functioning of the modern economy, since the current economic activity depends heavily on
credit and future economic growth depends heavily on business investment.

This chapter will discuss on the nature and role of financial institutions. It will identify the
various types of financial institutions that operate in various economies. It will elaborate the
different features of various types of financial institutions with the type of services they provide.
The conventional ways of doing business with these types of institutions will be looked into for
comparison purposes too.

Unit Objectives
Upon completion of this unit, you will be able to;
 Define the meaning of financial institutions
 Identify and discuss on the nature and role of financial institutions in the economy
 Explain advantages and disadvantages with direct, semi direct and indirect financing.
 Identify the various Financial institutions: Deposit-taking as well as Non-depository
institutions and their operations;
 Determine the nature and characteristics of the financial institutions
 Explain the major differences between different types of financial institutions
 Identify transaction costs

2.1 Financial Institutions and Capital Transfers

All financial systems perform at least one basic function in common. They move scarce funds
from those who save and lend (surplus-budget units) to those who wish to borrow and
invest (deficit-budget units). In the process, money is exchanged for financial assets and
the transfer of funds from savers to borrowers can be accomplished at least in three
different ways. These are:-

 Direct finance,
 Semi-direct finance, and
 Indirect finance

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1. Direct transfers: Direct transfers of money and securities occur when a business sells its stocks or
bonds directly to savers, without going through any type of financial institution. The business
delivers its securities to savers, who in turn give the firm the money it needs. You engage in direct
finance when you borrow money from a friend and give him or her IOU (a promise to pay) or when
you purchase stocks or bonds directly from the company issuing them.
Direct Financing

Borrowers/ Financial Assets/Bonds & Stocks

Lenders/
Fund Seekers/ Fund Providers/
Budget Deficit Units Surplus Budget
Funds/Money
Units

Limitations of Direct Finance:

 Both borrower and lender must desire to exchange the same amount of funds at the same time.
 The lender must be willing to accept the borrowers IOU, which may quite risky, illiquid or slow
to mature.
 There must be double coincidence of wants between surplus and deficit budget units in terms of
the amount and form of a loan. Without fundamental coincidence, direct finance breaks down.
 Both lender and borrower must frequently incur substantial information costs simply to find
each other.
2. Semi-direct finance: There are financial institutions which do not act as financial intermediaries.
They are financial institutions which facilitates funds transfers from SSUs to DSUs without
creating securities on their own. They simply act as conduit pipe between the SSUs and DSUs.
For example, a security broker in Bole Addis may provide the services of procuring shares offered by
a newly formed Share Company to an investor situated in Debre Zeit, for a commission or service
charge. In this context, the security broker does not create a secondary security (like the one created
by financial intermediaries), but simply transfers the security of the DSU (the share company) to the
SSU (the investor in DZ). This kind of financial transaction is known as „Semi-Direct Finance‟, which
is facilitated by „Financial institutions which are not financial intermediaries‟

 Broker: An individual or institution that provides information concerning possible purchases and sales of
securities
 Either a buyer or a seller of securities may contact a broker, whose job is simply to bring buyers
and sellers together.
 Dealer: also serves as a middle man between buyers and sellers, but the dealer actually acquires the
seller’s securities in the hope of marketing them at a more favourable price.
 Dealers take a position of risk because by purchasing securities outright for their own
portfolios.

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 Financial Markets and Institutions

Semi-direct Financing

Ultimate
 Borrowers/ Financial Assets/Bonds & Stocks Ultimate
 Seekers/
Fund Lenders/Fund
 Deficit Units  Brokers and
Budget Providers/ Surplus
 Dealers
 Budget Units
 Investment

Banks

3. Indirect Finance/Financial Intermediation

The limitations of both direct and semi direct finance stimulated the development of
indirect finance carried out with the help of financial intermediaries.

Financial intermediaries obtain the funds from the SSUs and offer their own securities (such
as Deposit Certificates, Insurance Contracts, and Pension Contracts, which are commonly
known as Secondary Securities) as financial claims to the SSUs. They then provide the
funds to the DSUs (in the form of advances) and accept the securities issued by DSUs
(such as Stocks and Shares, Bonds and Debentures, Treasury Bills, which are widely
known as Primary Securities) as financial claims on the DSUs. Thus, they carry out „financial
intermediation‟.

Indirect Financing
Ultimate Financial Assets/Bonds & Stocks Ultimate
Borrowers/ Primary
Financial Secondary Lenders/Fund
Securities
Fund Seekers/ Intermediaries
Securities Providers/ Surplus
Budget Deficit Units /Institutions Budget Units
Loanable
Funds

Characteristics of Secondary Securities;

 They generally carry low risk of default
 The majority can be acquired in small denominations
 They are liquid (for most) and can be easily converted into cash with little risk of significant loss
for the purchaser.
2.2 The nature of Financial Intermediation
A financial intermediary is a financial institution that connects surplus and deficit parties. This is
to mean that financial intermediaries channel funds from people who have extra money or
surplus savings (savers) to those economic units who do not have enough money to carry out a
desired activity. There are three main reasons why financial intermediaries exist;
 Different requirement of lenders and borrowers
 Transaction Cots
 Problems arising out of information asymmetries

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 Different requirement of lenders and borrowers

Firms borrowing funds to finance investment will tend to want to repay the borrowing over the
expected life of the investment. In addition the claims issued by firms will be have a relatively
high default risk reflecting the nature of business investment. In contrast, lenders will generally
be looking to hold assets which are relatively liquid and low risk. To reconcile the conflicting
requirements of lenders and borrowers and finance this by issuing liabilities called deposits
which are highly liquid and have low default risk.
 Transaction Costs
The presence of transaction costs makes it very difficult for a potential lender to find an
appropriate borrower. There are four main types of transaction costs.
 Search Costs: both lender and borrower will incur costs of searching for finding
information about a suitable counter party.
 Verification costs: Lenders must verify the accuracy of the information provided by the
borrowers.
 Monitoring Costs: one a loan is created, the lender must monitor the activities of the
borrower, in particular to identify if a payment date is missed.
 Enforcement Costs: the lender will need to ensure enforcement of the terms of the
contract or recovery of the debt in the event of default.
 Asymmetric Information
Asymmetric Information refers to situation where one party to the transaction has more
information than the other party. The borrower will have more information about the
potential returns and risks of the investment project for which funds are being borrowed
compared to the lender. The existence of asymmetric information creates problems for the
lender both before the loan is made at the verification stage and after at the monitoring/
enforcement stages.

1. Adverse Selection: The first problem created by asymmetric information occurs when the
lender is selecting a potential borrower. Adverse selection can occur (i.e. a borrower who is
likely to default often referred to as a „bad risk‟ is selected) because the potential
borrowers who are the ones most likely to produce adverse outcome are the ones most
likely to be selected.
2. Moral Hazard: The second problem that arises out of asymmetric information is moral
hazard. This is the problem that occurs after the loan is made and refers to the risk that
the borrower might engage in activities that are undesirable (immoral) from the lenders
point of view because they make it is less likely that the loan is repaid.
Thus, financial intermediaries reduce transaction costs and problems arising out of asymmetric information.

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2.3 Functions or services of Financial Institutions

Direct funds transfers are more common among individuals and small businesses and in
economies where financial markets and institutions are less developed. This is what exists
presently in Ethiopia. While businesses in more developed economies do occasionally rely on
direct transfers, they generally find it more efficient to enlist the services of one or more
financial institutions when the need to raise finance becomes obvious.

Financial intermediaries play the basic role of transforming financial assets that are less
desirable for a large part of the public into more widely preferred by the public. This
transformation involves at least one of four economic functions:
1. Providing Maturity Intermediation
The function of financial institutions for taking short-term maturity deposits from the surplus
units and giving long term maturity loans to borrowers (deficit unit) is called maturity
intermediation. Maturity intermediation arises due to short-term maturity nature of deposits
and long term maturity nature of loans. For example, the commercial banks, by issuing its own
financial claims, by raising deposits in essence transforms a shorter-term asset into a longer-
term one by giving the borrower a loan for the length of time.
Maturity intermediation has two implications for financial markets.
 Borrowers have more choices for the length of their debt obligations.
 It will require that long-term borrowers pay higher interest rate than short-term borrowers.
2. Reducing risk by Diversification
 Financial institutions invest the funds received in the stock of a large number of
companies and has chance to diversify and reduce risks.
 Investors who have a small sum to invest would find it difficult to achieve the same
degree of diversification because they do not have sufficient funds to buy shares of a
large number of companies.
 Economic function of financial intermediaries–transforming more risky assets into less risky
ones–is called risk diversification.
3. Reducing the costs of contracting and information processing
 As financial institutions include investment professionals who are trained to analyze
financial assets and manage them reduces cost of contracting and information processing.
 In the case of loan agreements, either standardized contracts can be prepared, or legal
counsel can be part of the professional staff that writes contracts.
 The employment of such professionals is cost-effective for financial intermediaries and less
information processing costs.
 In other words, there are economies of scale in contracting and processing information about
financial assets because of the amount of funds managed by financial intermediaries is high.

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4. Providing Payments Mechanisms

 The ability to make payments without the use of cash is critical for the functioning of a
financial market.
 In short, depository institutions transform assets that cannot be used to make
payments into other assets.

2.4 Classification of Financial Institutions

Financial institutions may be grouped in a variety of ways. One of the most important
classification groups financial institutions into two as follows;

Non-depository Financial Institutions

Depository Financial Institutions
 Contractual Institutions
 Commercial Banks
 Insurance companies
 Non-bank Thrift Institutions
 Pension funds
 Savings & Loan Associations  Investment Institutions
 Savings Banks,  Mutual Funds
 Credit Unions, and  Finance Companies
 Money Market Mutual Funds  Real estate investment trusts

1. Depository financial institutions: are intermediaries that derive the bulk of their loanable
funds from deposit accounts sold to the public. These institutions are highly regulated because:
 They mobilize a significant amount of household and business deposits.
 They are used as vehicles for executing monetary policy.
2. Non-deposit financial institutions: are financial institutions that do not mobilize deposits.
2.5 Depository Financial Institutions
Depository intermediaries are institutions that derive the bulk of their loanable funds from
deposit accounts sold to the public. In other words, it means that these institutions acquire the
bulk of their funds by offering their liabilities to the public mostly in the form of deposits.

Generally speaking, the depository intermediaries are highly regulated financial intermediaries
and their day-to-day operations and financial services are closely supervised by various
government agencies and authoritative bodies. The various regulations pertaining to the
structure, portfolio characteristics, financial services, in theory, are designed at least to
promote competition and ensure the safety of the public‟s funds. Along with this, governments
and concerned agencies exercise close supervision and monitor the operations of such
intermediaries.

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2.5.1 Characteristics of Depository Institution

 Deposit taking institutions that accept and manage deposits and make loans. As a
result, they play a key role in the transmission of monetary policy to the financial
markets, to borrowers and depositors as they hold a large share of the nation‟s money
stock in various types of deposits.
 Those deposits represent the liabilities (debts) of the deposit accepting institutions
 With the funds rose through deposits and other funding sources, depository institutions
makes direct loans to various entities and invest in securities. Thus, their income is
derived from interest on loans, interest and dividend on securities, and fees income
 There are some financial institutions which are highly specialized type of depository
institutions (these are called thrifts) such as S & L associations, saving banks , credit
unions etc. because they haven‟t permitted to accept deposit transferable by check.
 They are highly regulated institutions because;
 They mobilize a significant amount of household and business deposits
 They are used as vehicles for executing monetary policy

2.5.2 Types of Depository Financial Institutions

Depository institutions are grouped as;
1. Commercial banks and
2. Non-bank thrift institutions

1. Commercial Banks
Commercial Banks are institutions that offer to the public both deposit and credit services. The
name commercial implies that the banks devote a substantial portion of their resources to
meeting the financial needs of business firms. However, in recent years the services are
expanded to consumers and units of government as well. In addition to their traditional
services, commercial banks have started to provide fewer and more innovative services such as
investment advice & investment execution and tax planning to their customers.
Functions of Commercial Banks
 Pooling the saving of individuals, business and government
 Providing safekeeping, accounting and access to payment system
 They are principal means of making payments through the checking accounts
(demand deposits) they offer
 Create money from excess reserves made available from the public‟s deposits
 Receive (deposit) excess cash of savers and provide loans and make investments;
thus, generate a multiple amount of credit
 Currency exchange
 Most important source of consumer credit

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 One of the major sources of loans to small and medium sized businesses
 Principal purchasers of debt securities issued by state, local, and federal government
 Major buyers of government treasury bills
 Play a dominant role in the money and capital markets

These functions can be summarized as follows:

 Accepting deposits
 Advancing Loans Primary functions of banks
 Credit Creation
 Promoting Cheque System
 Agency Services/ Secondary/Subsidiary functions of banks
 General Utility Services
Portfolio Characteristics
Banks are highly leveraged financial institutions, which mean that most of their funds come
from deposits and non-deposit borrowings. There are three sources of funds for banks; (1)
deposits, (2) non- deposit borrowings and (3) retained earnings and sale of equity.
 Assets: The assets of Commercial Banks generally comprise;
 Primary Reserves: cash and deposits due from other banks. These reserves also
include reserves held behind deposits as required by Federal Reserve System (or
deposits held in the “National Bank” in the case of Ethiopia.
These reserves are the bank‟s first line of defense against:
 Withdrawal by depositors,
 Customer demand for loans, and
 Immediate cash needs to cover expenses
 Secondary reserves and Security holdings: are securities or related assets which
have values nearest to cash. Commercial banks also hold securities acquired in the
open market as a long term investments. Bonds & notes issued by state, city &
local governments are largest portion of their security investments
 Loans and Equipment Leasing Schemes: As the principal business of commercial
bank is to make loans to qualified borrowers. Loans are among the highest yielding
assets of banks that provide largest portion of their operating revenue. As the long
term loans carry greater risk; long-term loans have been supplanted (or replaced) to
some extent in recent years by equipment leasing plans. Lease financing, in this
regard, carries significant tax advantage for a bank as well as cost & tax advantage
for the customer too.
 Liabilities: comprise the deposit and non-deposit financial claims

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 Financial Markets and Institutions

 Deposits: The bulk of commercial bank funds come from deposits.

 Demand Deposits are (also called transaction accounts) are checking accounts
 Significant portion of bank funds are generated through demand deposits.
 Demand deposits are principal means of making payments.
 They are safer than cash & widely accepted as a means for paying on various
transactions and expenditures.
 Savings Deposits: are deposits accepted through customers‟ saving accounts
 Saving deposits are small in Birr amount.
 Saving deposits bear relatively low-interest rate and the funds can be withdrawn by
customers with little or no notice with no specified maturity.
 Time Deposits: Carry a fixed maturity and bear highest interest rates
 Non-negotiable CDs: contracts negotiated between two parties and hence, liability
cannot be transferred to third party. They are consumer type accounts usually small in
amount.
 Negotiable CDs: traded in the open market and purchased mainly by corporations
 Non-Deposit sources of Funds
 Borrowed funds to meet bank cash needs (when competition for deposits increase)
 Purchases of reserves (federal funds from other banks)
 Security repurchase agreement (where securities are sold temporarily by a bank
and then bought back later)
 Issuance of capital notes and bonds.
 Equity Capital: Net worth supplied by a bank‟s shareholders
 Provides only a minor portion of the total funds of most firms
 The most important functions of equity capital is to keep a bank open even in the face
of operating losses until management can correct its problems.
 Revenues
 Interest and fees on loans
 Interest and dividends on securities held (for instance, interests on bonds held and
dividends on stocks held as a collateral)
 Earnings from trust (fiduciary) activities
 Commissions and service charges on checking accounts
 Expenses
 Interest on deposits
 Salaries and wages
 Interest cost on non-deposit sources of funds

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2. Non-Bank Thrift Institutions

Non-Bank thrift institutions are depository institutions that accept deposits from the public
as commercial banks do. Historically, they have not been authorized to accept demand
accounts, but more recently thrifts have been offering some types of deposits equivalent to
checking accounts.

Nowadays, it is recognized that these institutions play a vital role in the flow of money and
credit within the financial system and are particularly important in selected markets, such
as the mortgage market, and in the market for personal savings. This new awareness of the
critical importance of non-bank financial institutions in the economy and financial system
stems from a number of sources:

 The rapid growth of selected non-bank financial intermediaries in recent years.

 The increasing penetration of traditional financial service s by non-bank institutions
 The thrift institutions started to provide competitive services like banks do.
 Governments started to authorize savings and loan associations to provide services
provided by commercial banks
 Greatly expanded the powers of non -bank thrifts to loans comparable to many forms of
bank credit.

Types of Non-Bank Thrift Institutions

A. Credit Unions
These are cooperative associations whose members are supposed to have a „„common bond’’,
such as being employees of the same firm. Members‟ savings are loaned only to their members,
generally for various personal needs, home improvement loans, and home mortgages.
 Credit unions are often the cheapest source of funds available to individual borrowers.
 They are institutions, exclusively household oriented intermediaries
 Offer deposit plans & credit resources only to individual & families.
 Provide low loan rates and high deposit interest rates to individual and families
compared to other institutions
 Credit unions often accept a smaller spread between their loans and deposit interest
rates; this is made possible because their operating costs are usually so low.
 They are really cooperatives, self-help associations of individuals, rather than profit-
motivated financial institutions.
 Established to satisfy saving and borrowing needs of their members.
 They are classified (or considered) as tax-exempt mutual organizations.

Organization of Credit Unions: They are organized around;

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 Occupation related credit unions; work for the same employer or for one of a group of
related employers
 Around a non-profit association (Labor union, church, fraternal, or social organization
 Common areas of residence – such as Kebele, towns, etc.

Like commercial banks, credit unions are heavily regulated with respect to the following aspects:

 In the services they are permitted to offer

 The rates charged for credit
 Dividends paid on members‟ deposits
B. Savings and Loan Associations (S&Ls)
Savings and Loan associations are similar to credit unions because they extend financial
services to households; they differ from credit unions, however, their heavily emphasis on long-
term rather than short-term lending.
They are major sources of mortgage loans to finance purchase of homes by households.
 S & L Associations are established to provide finance for acquisitions of homes
 S & Ls can be mutually owned(by depositors) or have corporate stock ownerships
Growth of S & L Associations: The first S & Ls were started early in the 19th C as building and
loan associations.
 Money was solicited from individuals and families so that certain members of the group
could finance the building of new homes.
 The same individuals and families who provide the funds were also borrowers from the
association. Today, however, savers and borrowers are frequently different individuals.
 Apart from only providing a single product (i.e., lending funds to home buyers), more
recently, competition from commercial banks & credit unions have forced the S& Ls
associations to diversify their operations.

Chartering & Regulation: Currently, S & Ls receive their charters from the states (regions) or
from the federal government.
 Authorities supervise their activities & regularly examine their books.
 Most S & Ls are mutual and, therefore, have no stockholders
 Technically, they are owned by their depositors; however, a growing number of S & Ls
associations are converting to stock form
 Stockholder-owned S & Ls can issue capital stock to increase their net worth
 Such forms are much larger in size than the mutual associations.
How Funds are raised and allocated: S & Ls are broadening their role;
 Many choosing to offer a full line of financial services for individuals & families
 Other S & Ls are branching out into business credit and commercial real estate lending.

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 Asset Portfolios: Residential Mortgage loans still are the dominant assets of S & Ls. In
addition to this, the following are also assets included in their portfolio:
 Mortgaged backed securities issued by governments.
 Consumer loans
 Commercial paper
 Corporate debt securities
 Mutual funds and municipal revenue bonds
 Liabilities of S & Ls: Savings deposits are the bulk sources of the available funds.
 The deposit mix has significantly been shifting in recent years from saving accounts that
earn lowest interest rate to deposits earning much higher and more flexible returns such
as money market deposit accounts and CDs
 S & Ls also relay on non-deposit sources of funds.
 Federal home funds bank system advances (Borrowed funds)
 Provides extra liquidity in periods where withdrawals are heavy or when loan
demand exceeds incoming deposits
 Securitized assets – where mortgages or portfolios of S & L assets are packed (often
backed by the guarantee of a government agency) and debt securities are issues against
these pooled assets are sold to investors to raise longer term, lower cost funds –due to
guarantee & less risk of default
 Loan sales – sales of mortgages and other loans to investors in the secondary market
 When loan demand is high & deposit growth is sluggish
 Give S & Ls the opportunity to invest in new, higher yielding loans
 Trends in Revenues & Costs (U.S. case)
S & Ls have experienced one of the darkest periods in their long history
 Many S & Ls remain unprofitable
 Are becoming cling to desperately thin net worth positions
Circumstances that brought a trouble in the U.S. S & Ls are:
 S & Ls historically have issued mortgage loans with fixed interest rates, while accepting
deposits whose interest rates are sensitive to changing market conditions.
 Their assets are rate insensitive (Loans); whereas
 Their liabilities are rate sensitive (deposits & borrowing)
 In periods of rapidly raising interest rates, the S & L net interest margin– the difference
between the interest earning on assets & its interest cost on borrowed funds has been
severely squeezed.
 In several recent periods, short –term interest rates paid on deposits exceeded interest rates
earned on long-term loans, turning the net interest margin in to negative.

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 Individuals & families whose savings provide the bulk of the S & Ls association funds have
become more financially sophisticated, withdrawing deposits whenever higher returns were
available elsewhere or whenever there was even a hint of trouble in the thrift industry.
 Federal regulations in the past limited interest rates S & Ls could pay on savings accounts,
hurting their ability to compete with money market funds (i.e. limited in flow of funds).
 High & rising operating costs & default risk on loans is also contributing to trouble of S & Ls.
 Trends in Industry Structure
The pressure of rising costs & the resulting squeeze on earnings have caused many savings &
loans to merge or be absorbed by larger associations.

 They are unable to take advantages of economies of scale & scope

 Thus, the number of S & Ls is declining but the average size S & L has increased.
 With large numbers of relatively small S & Ls, continuing increases in costs and
competition, and heavy pressures on earnings, more savings & loans are likely to be
absorbed into larger financial institutions in the future.
 Possible remedies for S & Ls Industry’s Problems
1. Sound decision making by management to diversify operations and identifying
innovative (or new) services to offer to the public.
2. Further relaxation of government regulations to permit the offering of new services and
the merging of smaller associations into larger ones.
C. Savings Banks
These are similar to S&Ls, traditionally, they accept savings primarily from individuals, and
lend it to, mainly on a long-term basis, home buyers and consumers.
 Initially started to meet the financial needs of small savers.
 Plays active role in the residential mortgage market as do S &Ls but are more
diversified in their investments.
 Purchase corporate bonds and common stock
 Make consumer loans
 Invest in commercial mortgage
 Designated their financial services to appeal to individual and families. The saving
banks investment is limited (as required by law) for
 First mortgage loans
 U.S government and federal agency securities
 High grade corporate bonds and stocks
 Municipal bonds
 Technically saving banks are owned by their depositors.
 The principal sources of funds for saving banks are deposits.

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 Financial Markets and Institutions

 All net earnings available after funds are set aside to provide adequate reserves
must be paid to the depositors as owner‟s dividends.
 Regulations exercised primarily by the states are designed to ensure maximum
safety of deposits.
D. Money Market Mutual Funds
Money Market Mutual Funds are also among the non-bank thrift institutions that appeared
most recently as compared to credit unions, S & Ls, and saving banks. They are mutual funds
that invest in short-term securities with low default risk.

The first money market mutual fund- financial intermediary pooling the savings of thousands
of individuals and businesses and investing those moneys in short terms high quality money
market instruments – opened for businesses in the U.S. in the year 1972. Taking advantage of
the fact that interest rate on the most deposit offered by commercial and saving banks were
then restrained by federal ceilings, the money market mutual fund offered share accounts
whose yield reflected prevailing interest rate in the nation‟s money market. Thus, the money
market mutual funds represent the classic case of profit seeking entrepreneurs finding a
loophole around ill-conceived government regulations. By now, there is no such interest rate
ceiling limit on deposited funds in the U.S. financial system

2.6 Non-Depository Intermediaries

The non-depository institutions are financial institutions that do not mobilize deposits.
Contractual institutions attract funds by offering legal contracts to the public in order to
protect the savers against potential risks. Investment institutions sell shares to the public and
invest the proceeds in stocks, bonds, and other securities.

This category comprises contractual institutions (like insurance companies and pension funds)
and investment institutions (like investment companies or mutual funds, finance companies,
and real estate investment trusts).

 Contractual institutions attract funds by offering legal contracts to protect the savers
against risk.
 Investment institutions sell shares to the public and invest the proceeds in stocks,
bonds, and other securities.
Depository institutions seek to generate income by the spread between the returns that they
earn on assets and the cost of their funds i.e. they are considered as spread business. Some of
the non-depository institutions such as life insurance companies and property –casualty
insurance companies are also considered as spread businesses.

The other non-depository institutions like pension funds are not in the spread business

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because they do not raise funds themselves in the business. They seek to cover the cost of
pension fund obligations at a minimum cost that is borne by the sponsor of the pension plan.

A. Insurance Companies
 The primary function of insurance companies is to compensate individuals and
corporations (policyholders) if perceived adverse event occur, in exchange for premium paid
to the insurer by policyholder.
 Insurance firms provide (sell service) insurance policies which are legally binding contracts.
 Insurance companies promise to pay specified sum contingent on the occurrence of future
events, such as death or an automobile accident.
 Insurance companies are risk bearer. They accept or underwrite the risk for an insurance
premium paid by the policyholder or owner of the policy.
 Insurance industry is classified in to;
 Life insurance and
 General or Property-causality insurance.
 Life Insurance Companies: deal with death, illness disablement and retirement policies. It
is insurance against death or retirement. Up on death of policyholder, a life insurance
company agrees to make either a lump-sum payments or a series of payments to the
beneficiaries of the policy.

Source of funds for Life Insurance Company: The primary income source of life
insurance companies is premium receipts from sale of various kinds of insurance policies.
Three basic factors influence premium determinations in life insurance.
 Expected mortality rate
 Investment income earned by insurers on premium income
 Expenses to be incurred in running the business.
 General (Property-casualty) Insurance/Non-Life: provide broad range of insurance
protections against;
 Losses, damages or destruction of property
 Losses or impairment of income-producing capacity
 Claims for damages by third party because of negligence
 Loss resulting from injury, or death due to occupational accidents.

P&C insurance is normally divided into two: personal line and commercial line insurance
companies. Personal line includes automobile insurance and home owner insurance and
commercial line insurance includes product liability and commercial property insurance.

 The costs of the policies underwritten by a P&C insurance company consists of;
 Claims for loss that have been incurred and reported during the year
 Estimated claims on policies written during the year that will not be paid until later years.

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 P&C companies must establish reserves to satisfy the actuarially estimated claims by law.
Reserves can be increased or decreased depending on whether actual claims are above or
below those actuarially estimates.

Source of funds for P&C insurance companies: Obviously, the primary source of fund is
premium from the policyholder. P&C Company generates revenues from two sources:
i. Initially underwriting income (insurance premium)
ii. Investment income that occur over time.
 The profit of P&C Company is calculated by subtracting the following costs from revenues;
 Funds that must be added to reserves for new claims for policies written during the
year called (claim expenses).
 Funds that must be added to reserve because of underestimates of actuarially
projected claims from previous years (claim adjustment expense.
 Taxes, administrative and marketing expenses related with issuing policies.
 If revenues for the year exceed the total expenses, then the difference is surplus and the
surplus of the P&C Company is increased; it is decreased if the reverse occurs. Surplus
also changes when funds are distributed to shareholders.
 The growth of surplus of a P&C company will determine how much future business it can
underwrite. The ability of P&C Company to take on risk is measured by the ratio of annual
premium to the capital plus surplus. Usually, this ratio is kept at between 2:1 & 3: 1
consequently, $3 in annual premium be supported for each $1 increase in surplus.
 If annual premium exceeds the sum of claim expenses, claim adjustment expenses and
administrative and marketing expenses, the difference is said to be the underwriting profit.
And if the sum of all expenses exceed annual premium the difference is underwriting loss.

B. Pension Fund
Pension plan is a fund that established for the payment of retirement benefits. Pension funds
offer savings plans through which fund participant accumulate tax deferred savings during
their working years.

 Pension funds are retirement plans funded by corporations or government agencies for
their workers and administered primarily by the trust departments of commercial
banks or by life insurance companies. Pension funds invest primarily in bonds, stocks,
mortgages, and real estate.
 The entities that establish pension plans are called plan sponsors. They can be private
businesses acting for their employees or public organizations -on behalf of their
employees, unions on behalf of their members or individuals for themselves.
 Pension funds are financed by contributions by employers and employees. In some fund
plans employers contribution are matched in some measure by employees.

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 Pension plan assets are legally illiquid. It cannot be used before retirement even as
collateral. Pension fund is the most growing financial institution currently. The key
factors for the pension fund growth are;
 The employees and employers‟ contribution are tax exempt.
 As well as the earnings of the fund‟s assets are also, tax exempt.

In essence, a pension fund is a form of employer remuneration for which the employee is not
taxed until funds are withdrawn. The pension fund company comprises two distinct sectors.

1. Private Pension Funds: are those funds administered by private corporations (insurance
companies, mutual funds etc.).
2. Public Pension Funds:-are those funds administered by federal, state, or local
government (social security).

Types of Pension Plans

Pension plans can be defined contribution or defined benefit plan or combination of the two.

(1) Defined Contribution Plans

 Contributions are defined, but not the benefits.

 Sponsors do not guarantee any certain amount upon retirement

 Payment depends on investment performance of the asset

 Employee bears risk of investment

(2) Defined Benefit Plans

 Benefits are defined
 Amount of benefit is determined based on length of service and earnings of the
employee
 All investment risks are borne by plan sponsors
(3) Hybrid Pension Plans
 Contributions are defined with a guaranteed minimum benefit.
 In case the fund does not generate sufficient growth to attain pre-set level of
benefit then the employee is obliged to add amount of the deficit
 Investment risk is shared

Investment Comapnies
Investment companies are financial intermediaries that sell shares to the public and invest the
proceeds in a diversified portfolio of securities. Each share that they sell represents a
proportionate interest in the portfolio of securities owned by the investment company. The type
of securities purchased depends on the company‟s investment objective. There three types of
investment companies: open-end funds (mutual funds), close-end funds and unit trusts.

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 Financial Markets and Institutions

A. Mutual Funds
 A mutual fund (in US) or unit trust (in UK and India) raise funds from the public and
invests the funds in a variety financial asset, mostly equity both domestic and overseas
and in liquid money and capital market.
 In mutual fund, depositors are legal owners of the institution though no stock is issued.
 Mutual funds are investment companies that pool money from investors at large and
offer to sell and buy back its shares on a continuous basis and use the capital thus
raised to invest in securities of different companies.
 The stocks these mutual funds are very fluid and are used for buying or redeeming
and/or selling shares at a net asset value.
 Mutual funds possess shares of several companies and receive dividends in lieu of them
and the earnings are distributed among the share holders
 Mutual funds sell shares (units) to investors and redeem outstanding shares on
demand at their fair market value. Thus, they provide opportunity of small investors to
invest in a diversified portfolio of financial securities.
 Mutual funds are also able to enjoy economies of scale by incurring lower transaction
costs and commission.

Advantage of Mutual Funds

 Mobilizing small savings
 Professional management
 Diversified investment/ reduced risks; Investment protection
 Better liquidity
 Low transaction cost (economy of scale)
 Economic Development
Return to Investors in the Mutual Fund
 Investors in the mutual fund have the potential to gain:
 They are entitled to a share in the capital appreciation of the underlying values of existing
assets, adds to the value of MF assets.
 They have claim on the income generated by the underlying assets of the fund i.e. dividend
 Capital gain when MF sells an asset at a price higher than the purchase price of the asset.
B. Investment Banking
Investment banking involves all capital market activities except those involving retail-oriented
sales. They are institutions provide a number of services to both investors and companies
planning to raise capital. Such organizations;
a. Help corporations design securities with features that are currently attractive to investors
b. Then buy these securities from the corporation, and

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c. Resell the securities to savers. Although the securities are sold twice, this process is
really one primary market transaction, with the investment banker acting as a facilitator
to help transfer capital from savers to businesses.
The principal activities that generate revenues include the following:
 Public offering (underwriting) of securities: underwriting process involves three functions
1. Advising the issuer on the terms and timing of the offering.
2. Buying the securities from the issuer
3. Distributing new issues of debt & equity securities.
 Private placement of securities: In addition to underwriting securities for distribution to the
public, investment banking firms place securities with a limited number of institutional
investors such as insurance companies, investment companies and pension funds.
 Securitization of Assets: refers to the issuance of securities that have a pool of assets as
collateral. The securitization of home mortgage loans to create pass- through securities is a
good example.
 Mergers and Acquisitions: Investment banking firms are active in mergers and acquisitions.
Mergers and acquisition activity also include leveraged buyouts (LBOs), restructuring and
recapitalization of companies. Investment banks participate in mergers and acquisition in
one of several ways;
 Finding mergers and acquisition candidates
 Advising acquiring companies with respect to price and non-price terms of an
exchange or helping target companies defend off an unfriendly takeover attempts
 Assisting acquiring companies in obtaining necessary funds to finance a purchase
 Merchant Banking: When investment banking firm commits its own funds by either taking
equity interest or creditor position in companies, this activity is referred as merchant banking.
 Trading and creation of risk control instruments: Futures, options interest rate swaps and
customized interest rate agreements are examples of instruments that can be used to
control the risk of an investor‟s portfolio, risk associated with the issuance of a security.
 Money Management: Investment banking firms have created subsidiaries that manage
funds for either individual investors or institutional investors such as pension funds.
Investment banking advices the investment bankers to design security structures:
 More palatable
 Low cost of borrowing for their clients
 More attractive to investors
When the investment banking agrees to buy the securities from the issuer at a set price, the
underwriting arrangement is referred to as a firm commitment. The investment banking accepts

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the risk in the firm commitment underwriting arrangement when the price it pays to purchase
the securities from the issuer will be more than the price it receive when it offers the security to
the public.

The fee earned from underwriting a security is the difference between the price paid to the
issuer and the price at which the investment banker offers the security to the public. This
difference is called gross spread or the underwriter discount.

2.7 Nature of Liabilities of Financial Institutions

Based on the amount and timing of cash outlays, any financial institutions‟ liability can be
classified under the following groups.

1. Type –I Liabilities: both the amount and timing of liabilities are known with certainty.
Example: liability amount of $150,000.00 that financial institution that knows to be paid after
six months from now.

Banks and thrifts have type –I liabilities, they know the amount that they are committed to pay
(principal plus interest) on the maturity date of fixed deposit. Life insurance companies shall
have also type-I liability if it issues guaranteed investment contract (GIC). The obligation of life
insurance under this contract is for sum of money (called premium) and of will guarantee an
interest rate up to some specific maturity date.

Example, suppose a life insurance company for a premium of $10million issues a five year GIC
agreeing to pay 10%copmonded annually. The life insurance company knows that it must pay
$16,105,100 = ((1.1)5*10,000,000).

2. Type-II Liabilities: The amount of cash outlay is known but the timing of cash outlay is
uncertain. The most obvious example of type- II liability is life insurance policy which
agrees to make a specific dollar amount to policy beneficiaries up on the death of insured.
3. Type-III Liabilities: the timing of cash outlay is known but the amount of cash outlay is
uncertain. Example, Floating rate GIC falls into the type-III liability category.
4. Type-IV Liabilities: there are numerous insurance products and pension obligation where
there is uncertainty to both the amount and timing of the cash outlays. Most of the
property-casualty insurance companies have such type of liabilities.

Liabilities of Financial Institutions (Summary)

Description Amount of Cash Outlay Timing Cash Outlay
Type I Liabilities Known Known
Type II Liabilities Known Unknown
Type III Liabilities Unknown Known
Type IV Liabilities Unknown Unknown

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Exercises:
Instruction: Read and analyze the following questions carefully and answer them
correctly.
1. Define and discuss on each of the following terms and statements:
A. Financial Intermediaries and their role in the economy
B. Explain reasons for the existence of financial intermediaries
C. Classifications & sub-classifications of financial institutions
D. Characteristics of financial institutions
E. Describe the characteristics of secondary securities
F. Describe functions of commercial banks
G. Distinguish between brokers and dealers
H. Distinguish and explain between life and non-life insurance
2. Identify and describe the difference between the types of fund/resource transfers.
3. What are the differences between brokers and dealers?
4. Bank assets generally differ from bank liabilities in terms of maturity and
liquidity. Explain.
5. List and distinguish between types of pension plans.
6. List down and describe functions of commercial banks.
7. Describe the problems caused by asymmetric information in the lending and
explain how financial intermediaries are able to reduce these problems?
8. What are types of transaction costs related to financial intermediation in the
financial system?
9. Explain how balance sheet of depository financial institutions differs from balance
sheet of non- depository financial institutions. Explain portfolio characteristics of
commercial banks.
10. List down types of liabilities of financial institutions and describe them in terms of
amount outlay and timing.

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Habtamu A.