Unit 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. They often serve as the
main source of funds for businesses and individuals. Some financial institutions accept
customers’ savings deposits and lend this money to other customers or to firms. In fact, many
firms rely heavily on loans from institutions for their financial support. Financial institutions are
required by the government to operate within established regulatory guidelines.

The term financial institutions and financial intermediaries are often used interchangeably.
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.

Financial institutions/intermediaries are institutions engaged in the business of channeling

money from savers to borrowers. i.e., channel funds between borrowers and lenders.
Intermediation improves social welfare by channeling resources to their most effective use. 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.
The savings that individual consumers place in financial institutions provide these institutions
with a large portion of their funds. Individuals not only supply funds to financial institutions but
also demand funds from them in the form of loans. However, individuals as a group are the net
suppliers for financial institutions: They save more money than they borrow.

Firms also deposit some of their funds in financial institutions, primarily in checking accounts
with various commercial banks. Like individuals, firms also borrow funds from these
institutions, but firms are net demanders of funds. They borrow more money than they save.

Governments maintain deposits of temporarily idle funds, certain tax payments, and Social
Security payments in commercial banks. They do not borrow funds directly from financial
institutions, although by selling their debt securities to various institutions, governments
indirectly borrow from them. The government, like business firms, is typically a net demander of
funds. It typically borrows more than it saves.

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 are direct transfers of money and securities, investment banking house, and
financial intermediaries. This are

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. The
securities of the company will straight away sell to the seller exchange with money to the
borrower. This direct transfer of money and securities is only suitable for the small firms
and procedure is raised by a small amount of capital.

The concept is the business deliver the securities to savers in return its give the firm the money it
needs.

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.

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. 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. However, the investment banking house will buy in bulk of
the securities or the bonds from the business and slowly resell to the seller who are willing to
purchase those securities and bonds. The primary market transaction is corporation receives the
proceeds of the sale and new securities are involved.
 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. 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.

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.

2.2 Functions of Financial Institutions

1. Pooling the savings of individuals

2. Providing safekeeping, accounting and access to payment system

3. Providing liquidity

4. Currency exchange

5. Reducing risk by diversifying

6. Collection and processing information

2.3 Types of Financial Institutions

The services provided by financial institutions depend on its type. Services provided by the
various types of financial institutions may vary from one institution to another. For example, the
services offered by the commercial banks are 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
institutions. The different types of financial institutions are discussed as follows:

2.3.1 Depository Institutions

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.

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.

The deposits accepted by these institutions represent their liabilities (debts). With the fund raised
through deposits and other funding sources depository institutions make direct loans to various
entities and also invest in securities.

Depository institutions drive their income from:

 interest on loans,
 interest and dividend on securities, and
 fees income
2.3.1.1 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 is referred to as
spread income or margin. The spread income should allow the institution to meet operating
expenses and earn a fair profit on its capital.

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).

2.3.1.2 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.

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.

2.3.1.3 Types of depository institutions

Can you list some of the financial institutions which accept and manage deposits of its customers
and avail them for lending and other different activities? If you could not, do not worry we are
going to discuss each of them in detail. Depository financial Institutions include:
 commercial banks,
  savings and loan associations, and

 credit unions

 microfinance institutions

A. 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. 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. Historically, commercial banks were the dominant direct lender to firms. In
recent years, however, other types of financial institutions have begun to provide more loans to
firms. Commercial banks Collect funds from different sources, & Put them in to different uses. In
addition they have also concerns in foreign exchange products and services and agency services
(such as collection of cheques, draft, and bill for their customers, etc).

B. 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.

These institutions were to aggregate depositors’ funds and use the money to make long term
mortgage loans. 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
(they issue NOW (Negotiable Order of Withdrawal–pays interest) account to commercial
customers. Which are traditionally reserved for commercial banks).

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. In the past, savings institutions
were legally required to engage primarily in home mortgage finance, and even though they now
may hold other types of assets, their traditional emphasis continues to be a major difference
between savings institutions and commercial banks.

C. 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.

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.

Credit unions worldwide offer members from all walks of life much more than financial services.
Their investment is primarily devoted to short term installment consumer loans. They provide
members the chance to own their own financial institution and help them create opportunities
such as starting small businesses, growing farms, building family homes and educating their
children.
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.

Savings and loan associations and credit unions are collectively known as thrift institutions. As
they obtain funds primarily by tapping the savings of households

D. 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

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)
Therefore, the microfinance institutions can play invaluable contributions to narrow the gap
between the demand for and supply of financial products. Micro finance is the provision of a
broad range of financial services to the poor and low income households, for their micro
enterprises and small business.

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

In addition to the above activities MFIs have the following objectives

 to reduce poverty
 to empower women and other disadvantaged population group
 to create employment
 to help existing business grow or diversity their activities
 to encourage the development of new business

2.4.2 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. 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 institutions include: Insurance companies, Pension Funds, mutual funds, etc.
Non-depository financial institutions are defined as those institutions that serve as an
intermediary between savers and borrowers, but do not accept deposits. They receive the
public’s money because they offer other services than just the payment of interest. Non
depository institutions include:

 Insurance companies

 Pension funds

 Mutual funds

 Investment Banking Firms

 Brokers and dealers

A. Insurance Companies

Insurance companies provide various types of insurance for their customers, including life
insurance, property and casualty insurance, and health insurance. They offer insurance policies to
the public and make payments, for a price, when a certain event occurs. They provides social
security and promotes individual welfare. 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. 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.

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. 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. The
performance of insurance companies depends on the performance of their bond and stock
portfolios.

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.

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.

Types of Insurance Companies

Mainly there are two types of insurance companies. These are Property and casualty insurance
company, and Life Insurance Company.

i. Property and Causality Insurance

They provide financial protection against:

◦ loss,damage, or distruction of property caused by accidents

◦ natural disasters or from the action of others

 ◦ loss from injury or death due to occupational accidents

The most common type of this insurance is auto insurance. Property and causality insurers use
the principles of indemnity, which is to pay for financial losses suffered by the insured, but no
more. If people made profit from insurance, it would motivate them to cause losses for profits.
For the same reason, insurance companies will not pay for losses that are covered by other
insurance or other forms of compensation. The claim of property and causality insurance is
uncertain, i.e., the amount and the timing of liability ascertainable only after the event.

ii. Life Insurance

Though the death of a single individual is an uncertain event, the number of deaths in a large
group is very predictable. Furthermore, the amount of the claim for any single death is certain
since it is specified in the contract. The Life insurance claim is fixed and certain.

There is no as such moral hazard problem in life insurance because most people want to live. The
only real moral hazard in life insurance is the possibility of suicide commit for providing a
benefit for his beneficiaries after he commits suicide. This moral hazard is reduced by a suicide
clause – not paying for suicides.

Characteristics of insurance companies

1. Insurance policy and premium: Insurance policy is a legally binding contract for which
the policy holder (owner) pays premium in exchange for the insurance company’s
promise to pay a price contingent of future events. The company is said to underwrite the
owner’s risk and act as a buffer against the uncertainties of future. When the policy is
accepted by an insurance company, it becomes an asset for the owner and a liability for
the insurance company.
2. Surplus & reserves: The surplus of an insurance company is the difference between its
assets and liabilities. Reserve is the amount of cash set aside by insurance company as a
contingent liability.
 3. Determination of profits: An insurance company’s revenue for a fiscal year is generated
from two sources:
 premium earned (underwriting income)during the fiscal period

 investment income earned from invested assets

4. Government guarantees: unlike the liabilities of depository institutions insurance

policies are not guaranteed by any federal entity.

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.

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.

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. 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. 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.

Mutual funds are owned by investment companies. Many of these companies have created
several types of money market mutual funds, bond mutual funds, and stock mutual funds so that
they can satisfy many different preferences of investors.

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:

 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.

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. Such Institutional investors include mutual funds, pension funds, and insurance
companies—are a growing force in developed markets.

D. 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.

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. Much of this comes in the form of stock and bonds transfer, but investment capital and
wholesale corporate acquisitions are also part of the equation.

Bankers within this sector are usually highly trained, and are widely recognized as some of the
most elite participants in the financial marketplace. They are often sought as much for their
consulting and advising services as they are for actually executing transactions. Modern
investment banks are made up of two parts: the corporate business and the sales and trading
business.

 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. The major investment banking
houses are also actively engaged in the design of new financial instruments.
 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.
  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.

2.5 Depository Institutions Risks

In the process of generating spread income depository institutions are exposed to the following
risks:

◦ Credit or default risk: refers to the risk that a borrower will default on a loan
obligation to the depository institution. i.e., default by borrower or by issuer of
security

◦ Regulatory risk: refers to the risk that regulators will change the rules so as to
impact the earnings of the institution unfavorably. i.e., adverse impact of
regulations on earnings

◦ Funding /Interest rate/ risk: refers to the risk associated with the amount of
interest paid for depositors and received from borrowers. In other words it is a
risk caused by interest rate changes when DIs borrow long(short) and lend
short(long).