Chapter One: Introduction to Financial Institutions

Introduction to the Financial System

Financial system is a collection of markets, institutions, laws, regulations, and techniques
through which bonds, stocks, and other securities are traded, interest rates are determined,
and financial services are produced and delivered around the world. The financial system
is one of the most important creations of modern society. Its primary task is to move
scarce loanable funds from those who save to those who borrow to buy goods and
services and to make investments in new equipment and facilities so that the global
economy can grow and increase the standard of living enjoyed by its citizens.
Without the global financial system and the loanable funds it supplies, each of us would
lead a much less enjoyable existence. The financial system determines both the cost and
the quantity of funds available in the economy to pay for the thousands of goods and
services we purchase daily. Equally important, what happens in this system has a
powerful impact upon the health of the global economy.
When funds become more costly and less available, spending for goods and services
falls. As a result, unemployment rises and the economy's growth slows as businesses cut
back production and layoff workers. In contrast, when the cost of funds declines and
loanable funds become more readily available, spending in the economy often increases,
more jobs are created, and the economy's growth accelerates. In truth, the global financial
system is an integral part of the global economic system. We cannot understand one of
these systems without understanding the other.
Flows within the Global Economic System
The basic function of the global economic system is to allocate scarce resources—land,
labor, management skill, and capital—to their most highly valued use, producing the
goods and services needed by society. The high standard of living most of us enjoy today
depends on the ability of the global economy to turn out each day an enormous volume of
food, shelter, and other essentials of modern living. This is an exceedingly complex task
because scarce resources must be procured in just the right amounts to provide the raw
materials of production and combined at just the right time with labor, management, and
capital to generate the products and services demanded by consumers.
In short, any economic system must combine inputs (land and other natural resources,
labor and management skill, and capital equipment) to produce output goods and
services. The global economy generates a flow of production in return for a flow of
payments.

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We can depict the flows of payments and production within the global economic system
as a circular flow between producing units (mainly businesses and governments) and
consuming units (principally households).

In the modern economy, households provide labor, management skill, and natural
resources to business firms and governments in return for income in the form of wages
and other payments. Most of the income received by households is spent to purchase
goods and services from businesses and governments

The Role of Markets in the Global Economic System

Most economies around the world rely principally upon markets to carry out this complex
task of allocating scarce resources, making possible the production and sale of goods and
services that are in demand by businesses and households. What is a market? It is an
institution through which buyers and sellers meet to exchange goods, services, and
productive resources. This exchange determines what goods and services will be
produced and in what quantity.
The marketplace is dynamic. It must respond continuously not only to changes in
consumers' tastes, but also to the introduction of new goods and services, often associated
with new technology. How did the resources of the economy get redeployed to produce
those new goods? This shift in production was accomplished in the marketplace through
changes in the prices of goods and services being offered. If the price of an item rises, for
example, this stimulates business firms to produce and supply more of it to consumers. In
the long run, new firms may enter the market to produce those goods and services
experiencing increased demand and rising prices. A decline in price, on the other hand,
usually leads to reduced production of a good or service, and in the long run some less
efficient suppliers may leave the marketplace.
Markets also distribute income. In a pure market system, the income of an individual or a
business firm is determined solely by the contribution each makes to producing goods
and services demanded by the marketplace. Markets reward superior productivity and
sensitivity to consumer demands with increased profits, higher wages, and other
economic benefits. Of course, in all economies, government policies also affect the
distribution of income and the allocation of other economic benefits.

Types of Markets
There are essentially three types of markets at work within the global economic system:
(I) factor markets, (2) product markets, and (3) financial markets. In factor markets,
consuming units sell their labor and other resources to those producing units offering the
highest prices. The factor markets allocate factors of production (land, labor, managerial
skills, and capital) and distribute income (wages, rental payments, and so on) to the
owners of productive resources.

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Consuming units use most of their income from factor markets to purchase goods and
services in product markets. Food, shelter, automobiles, theater tickets, and clothing are
among the many goods and services sold in product markets.
Types of Financial Markets within the Global Financial System
The global financial system fulfills its various roles mainly through markets where
financial claims and financial services are traded (though in some lesser-developed
economies government dictation and even barter are used). These markets may be viewed
as channels through which moves a vast flow of loanable funds that is continually being
drawn upon by demanders of funds and continually being replenished by suppliers of
funds.
1. The Money Market versus the Capital Market
The flow of funds around the world may be divided into different segments, depending
on the characteristics of financial claims being traded and the needs of different investors.
One of the most important divisions in the financial system is between the money market
and the capital market. The money market is designed for the making of short-term loans.
It is the institution through which individuals and institutions with temporary surpluses of
funds meet the needs of borrowers who have temporary funds shortages (deficits). Thus,
the money market enables economic units to manage their liquidity positions. By
convention, a security or loan maturing within one year or less is considered to be a
money market instrument.
One of the principal functions of the money market is to finance the working capital
needs of corporations and to provide governments with short-term funds in lieu of tax
collections. The money market also supplies funds for speculative buying of securities
and commodities. In contrast, the capital market is designed to finance long-term
investments by businesses, governments, and households. Trading of funds in the capital
market makes possible the construction of factories, highways, schools, and homes.

Financial instruments in the capital market have original maturities of more than one year
and range in size from small loans to multimillion dollar credits. Who are the principal
suppliers and demanders of funds in the money market and the capital market? In the
money market, commercial banks are the most important institutional supplier of funds
(lender) to both business firms and governments. Business corporations with temporary
cash surpluses also provide substantial short-term funds to the money market. On the
demand-for-funds side, governments around the world are often among the leading
borrowers in their own domestic money markets. The largest and best-known
corporations and securities dealers are also active borrowers in money markets around the
world. Due to the large size and strong financial standing of these well-known money
market borrowers and lenders, money market instruments are considered to be high-
quality, "near money" instruments.

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In contrast, the principal suppliers and demanders of funds in the capital market are more
varied than in the money market. Families and individuals, for example, tap the capital
market when they borrow to finance a new home. Governments rely on the capital market
for funds to build schools and highways and provide essential services to the public. The
most important borrowers in the capital market are businesses of all sizes that issue long-
term debt instruments representing claims against their future revenues in order to cover
the purchase of equipment and the construction of new facilities. Ranged against these
many borrowers in the capital market arc financial institutions, such as insurance
companies, mutual funds, security dealers, and pension funds, that supply the bulk of
capital market funds.
2. Open versus Negotiated Markets
Another distinction between markets in the global financial system focuses on open
markets versus negotiated markets. For example, some corporate bonds are sold in the
open market to the highest bidder and are bought and sold any number of times before
they mature and are paid off. In contrast, in the negotiated market for corporate bonds,
securities generally are sold to one or a few buyers under private contract.
An individual who goes to his or her local banker to secure a loan for a new car enters the
negotiated market for auto loans. In the market for corporate stocks there are the major
stock exchanges, which represent the open market. Operating at the same time, however,
is the negotiated market for stock, in which a corporation may sell its entire stock issue to
one or a handful of buyers.
3. Primary versus Secondary Markets
The global financial markets also may be divided into primary markets and secondary
markets. The primary market is for the trading of new securities. Its principal function is
raising financial capital to support new investment in buildings, equipment, and
inventories. You engage in a primary-market transaction when you purchase shares of
stock just issued by a company or borrow money through a new mortgage to purchase a
home.
In contrast, the secondary market deals in securities previously issued. Its chief function
is to provide liquidity to security investors-that is, provide an avenue for converting
financial instruments into cash. If you sell shares of stock or bonds you have been
holding for some time to a friend or call a broker to place an order for shares currently
being traded on the American, London, or Tokyo stock exchanges, you are participating
in a secondary-market transaction.
The volume of trading in the secondary market is far larger than in the primary market.
However, the secondary market does not support new investment. Nevertheless, the
primary and secondary markets are closely intertwined. For example, a rise in security
prices in the secondary market usually leads to a similar rise in prices on primary-market

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securities, and vice versa. This happens because many investors readily switch from one
market to another in response to differences in price or yield.
4. Spot versus Futures, Forward, and Option Markets
We may also distinguish between spot markets, futures, forward markets, and option
markets. A spot market is one in which assets are traded for immediate delivery (usually
within one or two business days). If you pick up the telephone and instruct your broker to
purchase Telecon Corporation stock at today's price, this is a spot market transaction.
You expect to acquire ownership of Telecon shares today.
A futures or forward market, on the other hand, is designed to trade contracts calling for
the future delivery of financial instruments. For example, you may call your broker and
ask to purchase a contract calling for delivery to you of Birr 1 million in government
bonds six months from today. The purpose of such a contract would be to shift risk to
some individual or institution willing to bear that risk by agreeing upon a delivery price
today rather than waiting six months when government bonds might be priced much
higher.
Finally, options markets also offer investors in the money and capital markets an
opportunity to reduce risk. These markets make possible the trading of options on
selected stocks and bonds, which are contracts that give an investor the right to either buy
designated securities from or sell designated securities to the writer of the option at a
guaranteed price at any time during the life of the contract.

Financial Assets

What is a financial asset? It is a claim against the income or wealth of a business firm,
household, or unit of government, represented usually by a certificate, receipt, computer
record file, or other legal document, and usually created by or related to the lending of
money. Familiar examples include stocks, bonds, insurance policies, futures contracts,
and deposits held in a bank or credit union.
Kinds of Financial Assets
Although there are thousands of different financial assets, they generally fall into four
categories: money, equities, debt securities, and derivatives. Any financial asset that is
generally accepted in payment for purchases of goods and services is money. Thus,
checking accounts and currency are financial assets serving as payment media and,
therefore, are forms of money. In the modern world, money—even the forms of money
issued by the government—depends for its value only upon the issuer's pledge to pay as
promised. Equities (more commonly known as stock) represent ownership shares in a
business firm and, as such, are claims against the firm's profits and against proceeds from
the sale of its assets.

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 We usually further subdivide equities into common stock, which entitles its holder to
vote for the members of a firm's board of directors and, therefore, determine company
policy, and preferred stock, which normally carries no voting privileges but does entitle
its holder to a fixed share of the firm's net earnings ahead of its common stockholders.
Debt securities include such familiar instruments as bonds, notes, accounts payable, and
savings deposits. Legally, these financial assets entitle their holders to a priority claim
over the holders of equities to the assets and income of an individual, business firm, or
unit of government. Usually, that claim is fixed in amount and time (maturity) and,
depending on the terms of the indenture (contract) that accompanies most debt securities,
may be backed up by the pledge of specific assets as collateral.
Financial analysts usually divide debt securities into two broad classes: (1) negotiable,
which can easily be transferred from holder to holder as a marketable security, and (2)
nonnegotiable, which cannot legally be transferred to another party. Passbook savings
accounts and U.S. savings bonds are good examples of nonnegotiable debt securities.
Finally, derivatives are among the newest kinds of financial instruments that are closely
linked to financial assets. These unique financial claims have a market value that is tied
to or influenced by the value or return on a financial asset, such as stocks (equities) and
bonds, notes, and other loans (debt securities). Examples include futures contracts,
options, and swaps. As we will see in future chapters, these particular instruments are
often employed to manage risk in the assets to which they are tied or related.

Classification of Financial Institutions

1. Depository institutions
Financial institutions may be grouped in a variety of different ways. One of the most
important distinctions is between depository institutions (commercial banks, savings
and loan associations, savings banks, and credit unions); contractual institutions
(insurance companies and pension funds); and investment institutions (mutual funds.
and real estate investment trusts). Depository institutions derive the bulk of their loanable
funds from deposit accounts sold to the public. Contractual institutions attract funds by
offering legal contracts to protect the saver against risk.(such as an insurance policy or
retirement account). Investment institutions sell shares to the public and invest the
proceeds in stocks, bonds, and other assets in the hope of providing higher returns to their
shareholders.
There is a tendency in discussions or the financial system to minimize the role of non-
bank financial institutions and to emphasize the part played by commercial banks in the
flow of money and credit. For many years, financial experts did not consider the
liabilities of nonbank financial institutions—including deposits in savings and loan
associations, savings banks, money market funds, and credit unions—as really close

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substitutes for bank deposits. It was argued that inter-industry competition between
commercial banks and other financial institutions was slight and, for all practical
purposes, could be ignored. Today, however, an entirely different view prevails
concerning the relative importance of nonbank financial institutions.

We now recognize that these institutions play a vital role in the flow of money and credit
within the financial system and that they are particularly important in selected markets
such as the home mortgage market and the market for personal savings. In truth, many
nonbank financial institutions are becoming increasingly like commercial banks and are
competing for many of the same customers. Moreover, banks themselves are offering
many of the services traditionally offered by nonbank financial firms, such as brokering
securities and selling insurance (often through joint venture, with nonbank firms). Thus,
both bank and nonbank financial institutions are rushing toward each other in the services
they offer and the markets they serve—a phenomenon known as convergence. This is
why financial analysts today stress the importance of studying the whole financial
institutions' sector to understand how the financial system works.

1. Savings and Loan Associations

Savings and loan associations are among the largest of all thrift institutions accepting
deposits and extending loans and other services primarily to household customers. They
emphasize longer-term loans to individuals and families in contrast to the shorter-term
lending focus of most other deposit-type financial institutions. They can be a major
source of mortgage loans to finance the purchase of single-family homes and multifamily
dwellings (such as apartments and duplexes).

Savings and loans, like credit unions, are gradually broadening their role, with many
choosing to offer a full line of financial services for individuals and families. Other S&Ls
are branching out into business credit and commercial real-estate lending. Residential
mortgage loans dominate the asset side of the savings and loan business.

Savings deposits provide the bulk of funds available to the savings and loan industry.
However, there has been a significant shift in deposit mix. Savings and loans also rely on
several non-deposit sources of funds to support their loans and investments

If savings and loans are to continue to be competitive and remain successful thrift
institutions in the future, they will need help from at least four sources: (I) sound decision

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making by S&L management to further diversify their activities by geographic area and
by services offered, (2) careful management of the loan portfolio to put good loans on the
books and minimize future loan losses, (3) better use of risk-management tools (such as
financial futures, swaps, and options), and (4) a further relaxation of government
regulations to permit the offering of new services and the merging of smaller associations
into larger financial-service companies.
In USA, more aggressive S&Ls today are branching out in at least three different
directions. Some have followed a real estate model, literally becoming mortgage banking
firms. These savings associations are selling off their long-term mortgages and
converting into real estate service organizations, managing and developing property and
brokering mortgages. Many have become family financial centers, offering a full range of
retail financial services to the consumer. Home mortgages continue to dominate their
asset portfolios, but most S&Ls today offer adjustable-rate mortgages (ARMs), whose
yields adjust more readily to changing market conditions, as well as fixed-rate mortgages
(FRMs) and a wide variety of other consumer-oriented loans. Other S&Ls have adopted a
diversified model, becoming holding company organizations with ownership and control
over retail-oriented consumer banks, mortgage banking firms, commercial credit
affiliates, and other businesses. Only time will tell which of these models can adapt
successfully to the changing character of the financial marketplace.

2. Savings Banks
Savings banks began in Scotland early in the nineteenth century and then took root in the
United States approximately 150 years ago to meet the financial needs of the small saver.
These institutions play an active role in the residential mortgage market, as do savings
and loans, but they are more diversified in their investments, purchasing corporate bonds
and common stock, making consumer loans, and investing in commercial mortgages.

From their earliest origins, savings banks have designed their financial services to appeal
to individuals and families. Deposit accounts often can be opened for amounts as small as
$1, with transactions carried out by mail, electronically, or, in many instances, at 24-hour
automated tellers in convenient locations.

Technically, savings banks are owned by their depositors. All earnings available after
funds are set aside to provide adequate reserves must be paid to the depositors as owners'
dividends. The industry's role in the financial system can be seen by looking at its
financial balance sheet. On the asset side, the key instruments are mortgages and
mortgage-related instruments, which account for the majority of industry assets. Most of
the mortgage total represents direct mortgage loans to build single-family homes,
apartments, shopping centers, and other commercial and residential structures. The
rernainder of the mortgage asset total is devoted primarily to mortgage-backed securities.

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A distant second in importance to mortgages are savings bank investments in
nonmortgage loans (mainly consumer installment credit to finance purchases of furniture
and appliances, autos, educational and medical services, and other household cash needs),
corporate bonds, corporate stock, and government bonds
The principal source of funds for savings banks is deposits. Savings deposits have no
specific maturity but may be withdrawn at any time by the customer, and they generally
carry the lowest rate of interest. Time deposits, on the other hand, have fixed maturities,
and savings banks pay higher interest rates on these deposit accounts, depending on their

3. Credit Unions
The characteristics and operations of credit unions have been a neglected area of research
in the financial system. Recently, however, there has been a revival of interest in credit
union behavior. One reason has been the rapid growth of this financial intermediary.
These institutions are household-oriented intermediaries, offering deposit and credit
services to individuals and families. Their long-run survival stems mainly from being
able to offer low loan rates and high deposit interest rates to their customers and from
their relatively low operating costs.
Credit unions are cooperative, self-help associations of individuals rather than profit-
motivated financial institutions. Savings deposits and loans are offered only to members
of each association and not to the general public. The members of a credit union are
technically the owners, receiving dividends and sharing in any losses that occur. Each
member gets one vote regardless of the size of his or her credit union account. Credit
unions began in nineteenth-century Germany in order to serve low-income individuals
and families, working primarily in industrial jobs, by providing them with inexpensive
credit and a ready outlet for their savings. The credit union movement began as a
response to "loan sharking," where poorer households were charged extremely high
interest rates for small cash loans.

Interestingly enough, credit unions usually report one of the lowest default and
delinquency rates on their loans of any lending institution in the financial system. Why?
One reason is that they make fewer business loans than many competing financial
institutions (especially banks), which, particularly during downturns in the economy, can
be very risky credits. Another factor is something we are about to discuss the common
bond between credit union members which seems to encourage most borrowing members
to repay their loans in a timely fashion.
Credit unions are organized around a common affiliation or common bond among their
members. Most members work for the same employer or for one of a group of related
employers. Moreover, if one family member belongs to a credit union, other family

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members are eligible as well. Occupation-related credit unions constitute majority of
credit unions.
In the USA, credit unions are expanding the number of services they offer. Some sell life
insurance. Others act as brokers for group insurance plans where state law permits. Many
credit unions are active in offering 24-hour automated or telephone and Internet services,
travelers’ checks, financial planning services, retirement savings, credit cards, home
equity and first-mortgage loans, and money orders. Larger credit unions compete directly
with banks for transaction accounts by offering share drafts—interest-bearing
checkbook deposits. Credit unions may represent stiff competition for commercial banks,
savings banks, and other financial institutions serving consumers.

4. Money Market Funds

A fourth major nonbank thrift institution appeared on the scene as recently as 1974 in the
USA. In that year, the first money market mutual fund—a financial intermediary
pooling the savings of thousands of individuals and businesses and investing those
monies in short-term, high-quality money market instruments-opened for business.
Taking advantage of the fact that interest rates on most deposits offered by commercial
and savings banks were then restrained by government regulation, the money fund
offered share accounts whose yields were free to reflect prevailing interest rates in the
money market. Thus, the money fund represents the classic case of profit-seeking
entrepreneurs finding a loophole around ill-conceived government regulations (many of
which have since been repealed or eased).
On the whole, however, money market funds hold high-quality assets-primarily treasury
bills and commercial papers—which helps explain why money market funds remain so
popular with millions of investors. The interest-bearing securities they acquire generally
carry low risk of borrower default and limited fluctuations in price. Contributing to the
low-risk character of money fund investments is their short average maturity of only a
few weeks or months. The short maturity of fund investment results in a highly liquid
security portfolio that can be adjusted quickly to changing market conditions. Many
funds declare dividends on a daily basis, crediting their earnings to customer accounts
and often notifying the customer by mail monthly of any additional shares purchased
with the dividends earned. Most are "no load" funds that do not charge their customers
commissions for opening an account, purchasing additional shares, or redeeming shares
for cash.

Another outstanding advantage of the money funds for many investors is the ease with
which their accounts can be accessed. Most funds allow the customer to write checks to
redeem shares, provided the amount of each check exceeds a designated minimum.

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The customer is issued a book of checks and can write and deposit checks in his or her
local bank account, often receiving credit for the deposited check from the local bank the
same day, even though it may take several days for the money fund check to be collected.
Meantime, daily interest is still being earned on the monies waiting in the customer's
share account. Most money funds also offer customers the option of purchasing or
redeeming shares by wire or by telephone.

Today, money market funds serve as: (I) cash-management vehicles where market rates
of return can be earned on funds used for daily transactions; (2) tax-sheltering vehicles
for those investors who choose shares in tax-exempt money market funds; (3) a
temporary repository for liquid funds waiting for a major purchase or waiting for the
appearance of higher-return investments expected to appear later in the marketplace: and
(4) a haven of safety for savings when the rest of the financial marketplace appears to be
too volatile and risky for a conservative saver to commit his or her fund, immediately.

Certainly the money market funds are not likely to go away. They are a potent competitor
for both small individual savings accounts and businesses' liquid funds. However, barring
further restrictive regulation of bank and thrift deposits, all bank and nonbank thrift
institutions, including money market funds, will continue to compete for savings and
transaction accounts on relatively equal terms, leading to intense competition and,
perhaps, some failures among competing financial institutions in future years.
We now turn to a highly diverse group of financial institutions that attract savings mainly
from individuals and families and, for the most part, make long-term loans in the capital
market. Included in this group are mutual funds (sometimes called investment
companies), pension funds (or, as they are sometimes called, retirement plans), and life
and property-casualty insurers, which today are among the leading institutional buyers of
bonds and stocks. Finance companies, another member of this group of financial
institutions, are active lenders to both business firms and consumers (households) and
borrow heavily in the money market.
Also included is an overview of the investment banking industry, which underwrites new
security offerings for corporations and governments around the world. As we will soon
see, these institutions provide important services to participants in virtually every corner
of the money and capital markets.

5. Mutual Funds (or Investment Companies)

One of the most rapidly growing of all financial institutions over the past two decades is
the mutual fund or, as it is more properly called, the investment company. Investment
companies provide an outlet for the savings of thousands of individual investors,
directing their funds into bonds, stocks, and money market securities. These companies
are especially attractive to the small investor, to whom they offer continuous

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management services for a large and varied security portfolio. By purchasing shares
offered by an investment company, the small saver gains greater diversification, risk
sharing, lower transaction costs, opportunities for capital gains, and indirect access to
higher-yielding securities that can be purchased only in large blocks. In addition, most
investment company stock is highly liquid, because these companies stand ready at all
times to repurchase their outstanding shares at current market prices. The majority of
mutual fund shares are held by individuals and families rather than by institutional
investors.
Investment companies, first developed in Great Britain, made their initial appearance in
the United States in the city of Boston in 1924, serving as a vehicle for buying and
monitoring subsidiary corporations. Many were unsuccessful in the early years, and the
Great Depression of the 1930s forced scores of these firms into bankruptcy. New life was
breathed into the industry after World War II, however, when investment companies
appealed to a rapidly growing middle class of savers. They were also buoyed by rising
stock prices that attracted millions of investors, most of whom had only modest amounts
to invest and little knowledge of how the financial markets work.

The future of the industry seemed in doubt until a new element appeared: innovation.
Managers began to develop new types of investment companies designed to appeal to
groups of investors with specialized financial needs. By tradition, investment companies
had stressed investments in common stock, offering investors capital appreciation as well
as current income. With the stock market performing poorly, these firms turned their
focus increasingly to bonds and money market instruments.
There are two basic kinds of investment companies. Open-end investment companies
often called mutual funds-buy back (redeem) their shares any time the customer wishes,
and sell shares in any quantity demanded. Thus, the amount of their outstanding shares
changes continually in response to public demand. The price of each open-end company
share is equal to the net asset value of the fund—that is, the difference between the
values of its assets and liabilities divided by the volume of shares issued.
Open-end companies may be either load or no-load funds. Load funds offer share to the
public at net asset value plus a commission to brokers marketing their share. No-load
funds sell shares purely at their net asset value. The investor must contact the no-load
company or its representative directly, however. Whether load or no-load, open-end
investment companies are heavily invested in common stock, with corporate bonds
running a distant second.
Closed-end investment companies sell only a specific number of ownership shares, which
usually trade on an exchange. An investor wanting to acquire closed-end shares must find
another investor who wishes to sell; the investment company itself does not take part in
the transaction. These funds often attract investors by offering "double discounts," which
consist of discounted prices on the stocks they hold and discounted share prices to buy

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into the fund itself. Closed-end companies issue a variety of securities to raise funds,
including preferred stock, regular and convertible bonds, and stock warrants. In contrast,
open-end companies rely almost exclusively on the sale of equity shares to the public in
order to raise the funds they need. )
Investment companies adopt many different goals. Growth funds are interested primarily
in long-term capital appreciation and tend to invest mainly in common stocks offering
strong growth potential. Income funds stress current income in their portfolio choices
rather than growth of capital, and they typically purchase stocks and bonds paying high
dividends and interest. Balanced funds attempt to bridge the gap between growth and
income, acquiring bonds, preferred stock, and common stock that offer both capital gains
(growth) and current income.
The majority of investment companies give priority to capital growth over current
income, although funds stressing income, such as bond funds, money market funds, and
option funds (which issue options against a portfolio of common stocks), have become
more important in recent years. While most investment companies hold a highly
diversified portfolio of securities, a few specialize in stocks and bonds from a single
industry or sector (such as precious metals or oil and natural gas).
6. Pension Funds
Pension funds protect individuals and families against loss of income in their retirement
years by allowing workers to set aside and invest a portion of their current income. A
pension plan places current savings in a portfolio of stocks, bonds, and other assets in the
expectation of building an even larger pool of funds in the future. In this way, the pension
plan member can balance planned consumption after retirement with the amount of
savings set aside today.
Two main types of pension plans exist today. Defined benefit plans promise a specific
monthly or annual payment to workers when they retire based upon the size of their
salary during the working years and their length of employment. In contrast, defined
contribution plans specify how much must be contributed each year in the name of each
worker but the amount to be received when retirement is reached will vary depending
upon the amount saved and the returns earned on accumulated savings.
Defined-benefit pension programs have the advantage of guaranteed income if the
employee remains with a particular employer for a relatively long period of time, but an
employee who leaves early or is dismissed before retirement may get little or nothing.
Under the defined contribution approach, however, the funds saved belong to the
employee and are portable, provided the employee stays on the job long enough for the
savings to be "vested" in his or her name.
Competition among employers for skilled management personnel has also spurred
pension fund growth, as firms have tried to attract top-notch employees by offering

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attractive fringe benefits. This growth factor is likely to persist into the future due to a
possible shortage of skilled entry-level workers as the population ages. Workers in the
future are likely to demand better performance from their retirement plans and greater
control over how their long-term savings are invested.
Pension funds are long-term investors with limited need for liquidity. Their incoming
cash receipts are known with considerable accuracy because a fixed percentage of each
employee's salary is usually contributed to the fund. At the same time, cash outflows are
not difficult to forecast, because the formula for figuring benefit payments is stipulated in
the contract between the fund and its members. This situation encourages pensions to
purchase common stock, long-term bonds, and real estate and to hold these assets on a
permanent basis.

7. Life Insurance Companies

The recent rapid growth of mutual funds and pension funds contrasts sharply with the
somewhat more moderate growth of one of the oldest financial-service firms—the life
insurance company. Life insurers have been operating for centuries in Europe, and the
life insurance company was one of the first financial institutions founded in the American
colonies.
Today life insurers have branched out to include not only traditional life insurance
policies in their service menus, but also health insurance and annuity plans. Health
insurance programs cover a portion of their policyholders' medical and dental bill, while
annuity plans aid clients in building their long-term savings for college educations, new
home purchases, and especially retirement funding. Many of the largest life carriers have
now branched far afield from their origins, insuring damage to personal and business
property, which places them in the territory of another insurance industry—property
casualty insurers.
Life insurance companies offer their customers a hedge against the risk of financial loss
that often follows death, disability and ill health, or retirement. Policy holders receive risk
protection in return for the payment of policy premiums that are set high enough to cover
estimated benefit claims against the company, all operating expenses, and a target profit
margin. Additional funds to cover claims and expenses are provided by the earnings from
investments made by life insurance companies in bonds, stocks, and other assets
approved by law and government regulation.
The insurance business is founded upon the law of large numbers. This mathematical
principle states that a risk that is not predictable for one person can be forecast with
reasonable accuracy for a sufficiently large group of people with similar characteristics.
For example no insurance company can accurately forecast when anyone person will die,
but its actuarial estimates of the total number of policyholders who will die in any given
year are usually quite accurate.

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Life insurance companies today insure policyholders against three basic kinds of risk:
premature death, the danger of living too long and outlasting one's accumulated assets,
and serious illness or accident. Many policies combine financial protection against death,
disability, and retirement with savings plans to help the policyholder prepare for some
important future financial need, such as the purchase of a home or meeting the costs of a
college education. Actually, most benefit payments are made to living, rather than
deceased, policyholders, who receive annuity payments or health insurance benefits of
various kinds.
Life insurers invest the bulk of their funds in long-term securities such as bonds, stocks,
and mortgages, thus helping to fund real capital investment by businesses and
governments. They are inclined to commit their funds long term due to the high
predictability of their cash inflows and outflows. This predictability normally would
permit a life insurance company to accept considerable risk in the securities it acquires.
However, both law and tradition require a life insurer to act as a "prudent person." This
restriction is imposed to ensure that sufficient funds are available to meet all legitimate
claims from insurance policyholders or their beneficiaries at precisely the time those
claims come due.
Life insurance companies generally pursue income certainty and safety of principal in
their investments. The majority of corporate securities they purchase are in the top four
credit-rating categories.' Life insurers frequently follow a "buy and hold" strategy, acting
as long-term holders of securities rather than rapidly turning over their portfolios. This
investment approach reduces the risk of fluctuations in income and avoids having to rely
as heavily on forecasting interest rates.
The primary income source for life insurers comes from premium receipts from sales of
various kinds of insurance policies: premiums from sales of annuity plans and health
insurance policies, sales of traditional life insurance policies,

8. Property-Casualty Insurance Companies

Property-casualty (PIC) insurers offer protection against fire, theft, bad weather,
negligence, and other acts and events that result in injury to persons or property. So broad
is the range of risk for which these companies provide protection that PIC insurers are
referred to as insurance supermarkets. In addition to their traditional insurance lines of
automobile, fire, marine, personal liability, and property coverage insurances, many of
these firms have branched into the health and medical insurance fields, clashing head-on
with life insurers offering the same services. Others have merged with wholesales
industries and, thereby, reached out to large numbers of potential new customers with an
expanded menu of new services.

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Property-casualty insurance is a riskier business than life insurance. The risk of
policyholders’ claims arising from crime, fire, personal negligence, and similar causes is
less predictable than is the risk of death. Moreover, inflation has had a potent impact on
the cost of property and services for which this form of insurance pays.
The majority of funds received by PIC companies are invested in corporate and foreign
bonds, and common stock. Like life insurance firms, PIC insurers plan to roughly break
even on their insurance product lines and earn most of their net return from their
investments.
9. Finance Companies
Finance companies are sometimes called department stores of consumer and business
credit. These institutions grant credit to businesses and consumers for a wide variety of
purposes, including the purchase of business equipment, automobiles, vacations, and
home appliances. Most authorities divide firms in the industry into one of three groups—
consumer finance companies, sales finance companies, and commercial finance
companies.
Consumer finance companies make personal cash loans to individuals. The majority of
their loans are home equity loans and loans to support the purchase of passenger cars,
home appliances, and mobile homes. However, a growing proportion of consumer
finance-company loans centers on aiding customers with medical and hospital expenses,
educational costs, vacations, and household expenses. Loans made by consumer finance
companies are considered to be riskier than other consumer installment loans and,
therefore, generally carry steeper finance charges than those assessed by most other
lending institutions.
Sales finance companies make indirect loans to consumers by purchasing installment
paper from dealers selling automobiles and other consumer durables. Many of these firms
are "captive" finance companies controlled by a dealer or manufacturer, whose principal
function is to promote sales of the sponsoring firm's products by providing credit.
Generally, sales finance companies specify in advance to retail dealers the terms of
installment contracts they are willing to accept. Frequently they will give the retail dealer
sample contract forms, which the dealer fills out when a sale is made. The contract is then
sold to the finance company.
Commercial finance companies focus principally on extending credit to business firms.
Most of these companies provide accounts receivable financing or factoring services to
Small-or medium-sized manufacturers and wholesalers. With accounts receivable
financing, the commercial finance company may extend credit against the borrower's
receivables in the form of a direct cash loan. Alternatively, a factoring arrangement may
be used in which the finance company acquires the borrowing firm's credit accounts at an
appropriate discount rate to cover the risk of loss. Most commercial finance companies

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today do not confine their credit-granting activities to the financing of receivables but
also make loans secured by business inventories and fixed assets.

Finance companies are heavy users of debt in financing their operations. Principal
sources of borrowed funds include bank loans, commercial paper, and debentures (bonds)
sold primarily to banks, insurance companies, and nonfinancial corporations. The source
of funds that these companies emphasize most heavily at any given time depends on the
structure of interest rates. When long-term rates are high, these companies tend to
emphasize commercial paper and short-term bank loans as sources of funds; when long-
term rates are relatively low, bonds have been drawn on more heavily.
10. Investment Banks
One of the most important institutions in the financial system (and also one of the
riskiest) is the investment bank. These financial firms are not deposit-takers like the
commercial and savings banks we discussed previously. Rather, investment banks raise
funds for and provide financial advice to corporations and government agencies around
the world. The principal function of investment banks is to help market large volumes of
new stocks, bonds, and other financial instruments issued by their corporate and
governmental customers in order to raise new money.
These specialized "banks" are especially prominent in the offering of new corporate debt
and equity securities, bonds and notes, and securities issued by various units of
government. They underwrite new offerings of these financial instruments, purchasing
them from the original issuer and placing them in the hands of buyers, hopefully at a
higher price than the price paid the issuer.
Security underwriting places investment banks at substantial risk because the market
value of the securities being underwritten may fall, presenting the underwriter with
substantial losses on resale. To mitigate these risks, often several investment bankers will
band together to form a syndicate in order to bid for and market a new security issue,
thereby spreading the risk exposure among multiple underwriters.

11. Other Financial Institutions

In addition to the financial firms we have discussed thus far, a number of other financial-
service institutions have developed over the years to meet the specialized needs of their
customers. For example, security brokers and dealers provide a conduit for buyers and
sellers of stocks, bonds, and other marketable financial instruments to adjust their
holdings of these assets. For their part, security dealers stand ready to buy private and
government securities from their clients and sell those same instruments to other clients
who need to make adjustments in their investment portfolios. By standing ready to buy
and sell particular assets, dealers literally "make a market for the assets they trade. In
contrast, security brokers do not "take a position of risk" as dealers do when they buy

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and hold assets from their customers. Rather, brokers merely bring buyers and sellers
together and facilitate the exchange of assets.
Both brokers and dealers reduce information costs for buyers and sellers of financial
instruments and help increase the liquidity of the instruments they trade. Brokerage
commissions and dealer fees are charged to compensate these financial firms for the
services they provide, although intense competition in this field (especially with the
appearance of discount brokers) and the development of efficient computer software to
support online trading have led to downward pressure on brokerage commissions and
dealer fees.
A rising but highly volatile financial-service industry today consists of venture capital
firms. These businesses gather funds from private investors and other sources and then
look for promising new businesses or rapidly emerging companies in which to invest.
They often fund the development of innovative new products or services, such as new
computer software or medicines, in the hope of earning exceptional returns if these new
products or services succeed. Many large banks, insurance companies, and other
traditional financial intermediaries have set up affiliated venture-capital companies to
make these risky investments and hold the stock of promising new or rapidly growing
businesses.
A related type of dealer firm is the mortgage bank. Mortgage bankers commit
themselves to take on new mortgage loans used to fund the construction of homes, office
buildings, and other structures. They carry these loans for a short time until the mortgages
can be sold to a long-term (permanent) lender such as an insurance company or savings
bank. As in the case with other dealer operations, the financial risks to the mortgage
banker are substantial. A rise in interest rates sharply reduces the market value of existing
fixed rate mortgage loans, presenting the mortgage banker with a loss when it sells the
loans out of its portfolio. The risk of rising interest rates and falling mortgage prices
encourages mortgage banks to turn over their portfolios rapidly and to arrange lines of
credit from lending institutions to backstop their operations. These firms also service the
mortgage loans they sell to other lenders, collecting loan payments and inspecting
mortgaged property.
Leasing companies represent still another kind of specialized financial institution that
provides customers with access to productive assets, such as airplanes, automobiles, and
equipment through the writing of leases. These leases allow a business or household to
rent assets often at a lower cost than borrowing money and owning those same assets.
The leasing company, on the other hand, benefits from the stream of lease payments and
gains substantial tax benefits from depreciating the leased assets. Competition is intense
in this industry because of the entry of scores of banks and bank holding companies,
insurance and finance companies, and manufacturing firms that have either opened
leasing departments or formed subsidiary leasing companies.

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 Role of Non-bank Financial Intermediaries
Non-bank financial intermediaries have been playing an important role in the following
directions.
Reduce Hoarding. By bringing the ultimate lenders (or savers) and ultimate borrowers
together, NBFIs reduce hoarding of cash by the people under the "mattress", as is
commonly said.
Help the Household Sector. The household sector relies on NBFIs for making profitable
use of its surplus funds and also to provide consumer credit loans, mortgage loans, etc.
Thus they promote saving and investment habits among the ordinary people.
Help the Business Sector. NBFIs also help the non-financial business sector by financing
it through loans, mortgages, purchase of bonds, shares, etc. Thus they facilitate
investment in plant, equipment and inventories.
Help the State and Local Government. NBFIs help the state and local bodies financially
by purchasing their bonds.
Help the Central Government. Similarly, they buy and sell central government securities
and thus they help the central government.
Lenders and NBFIs both Earn. When savers deposit their funds with NBFIs, they earn
interest. When NBFIs lend to ultimate borrowers, they earn profits. In fact, the reward of
intermediation arises from the difference between the rate of return on primary securities
held by NBFIs and the interest or dividend rate they pay on their indirect debt. .
Provide Liquidity. NBFIs provide liquidity when they convert an asset into cash easily
and quickly without loss of value in terms of money. When NBFIs issue claims against
themselves and supply funds they, especially banks, always try to maintain their liquidity.
This they do by following two rules: first, they make short-term loans and finance them
by issuing claims against themselves for longer periods; and second, they diversify loans
among different types of borrowers.
Help in lowering Interest Rate. Competition among NBFIs leads to the lowering of
interest rates. NBFIs prefer to keep their saving with NBFIs rather than in cash. The
NBFIs, in turn, invest them in primary securities. Consequently, prices of securities are
bid up and interest rates fall. Moreover, when people keep their cash holdings with
NBFIs which are safe and liquid, the demand for money falls thereby lowering interest
rates.
Low Interest Rates Benefit both Savers and Investors. When interest rates decline, both
savers and investors benefit. First, the real costs of lending to borrowers are reduced.
These, in turn, tend to reduce costs and prices of goods and services. With reduction in
interest rates, the return on time deposits is also reduced which induces savers to deposit
their funds with NBFIs even though the latter pay lower interest rates. Still the savers
benefit because NBFIs provide greater safety, convenience and other related services to
them thereby increasing the savers' real return and income. .

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Brokers of Loanable Funds. NBFIs play an important role as brokers of loanable funds.
They act as intermediaries between the ultimate saver and the ultimate investor. They sell
indirect securities to savers and purchase primary securities from investors. Indirect
securities are the short-term liabilities of financial intermediaries. On the other hand,
primary securities are their earning assets but they are the debts of the borrowers. Thus
NBFIs act as brokers of loanable funds by changing debt into credit.
Reduce Risks. When the non-bank financial intermediaries convert debt into credit, they
reduce the risk to the ultimate lender. First, they create1iabilities on themselves by selling
indirect securities to the lenders. Then they buy primary securities from borrowers of
funds. So by acting as intermediaries between the lenders and borrowers of funds, NBFIs
take the risk on themselves and reduce it on the ultimate lenders. Moreover, by holding
varied types of financial assets, they decrease their own risks. Low returns on some assets
can be offset by high returns on others.
Mobilizing Savings. NBFIs raise funds in the capital market and supply credit to
investors. Expert financial services provided by them have been attracting larger share of
public savings. Such services include easy liquidity, safety of principal, and ready
divisibility of savings into direct securities of different values. They have been able to
mobilize more funds due to the development of two types of non-bank financial
intermediaries.. The first are the depository intermediaries which include savings and
loan associations, credit unions, and mutual savings banks. There is high liquidity of
savings in such institutions which attract small savers. Moreover, they issue fixed price
assets whose value does not change like the market price of other types of assets. The
second are the contractual intermediaries which enter into contract with savers and
provide them various types of benefits over the long run. Such are pension funds, life
insurance companies and public provident funds. These two types of financial
intermediaries in particular help in mobilizing public savings.
Investment of Funds. NBFIs exist because they want to earn profit by investing the
mobilized savings. Different financial intermediaries follow different investment policies.
For instance, savings and loan associations and mutual savings banks invest in
mortgages, and insurance companies invest in bonds and securities. Thus intermediaries
mobilize public savings, invest them and thereby help in capital formation and economic
growth.
Create New Assets and Liabilities. Gardner Ackley has shown that in intermediating
between ultimate lenders and direct investors, NBFIs add greatly to the stock of financial
assets available to savers and for every extra asset, they also create an equal new financial
liability. But intermediation does not affect total net worth. He concludes that although
intermediation does not increase total wealth or income, it can be assumed that it
increases welfare.
Economies of Scale. NBFIs reap a number of economies of specialization and scale in
mobilizing savings and making investments. It would be costly and cumbersome for
individual savers to lend their funds to individual borrowers. NBFIs make larger
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transactions with ultimate lenders and borrowers. They specialize in trading large
financial assets and thus have lower costs in buying and selling securities. They employ
expert staff and efficient machinery and equipment, thereby increasing productivity in the
transfer of funds.
Bring Stability in the Capital Market. NBFIs deal in a variety of assets and liabilities
which are mostly traded in the capital market. If there were no NBFls, there would be
frequent changes in the demand and supply of financial assets and their relative yields,
thereby bringing instability in the capital market. As NBFls function within a legal
framework and set rules, they provide stability to the capital market and benefit savers
and firms through diversified financial services.
Benefit to the Economy. NBFIs are of immense help in the working of financial markets,
in executing monetary and credit policies of the central bank and hence in promoting the
growth of an economy. By transferring funds from surplus to deficit units, NBFIs create
large financial assets and liabilities.
In Economic Growth. NBFIs help in the growth process of the economy. They
intermediate between ultimate lenders who are savers and ultimate borrowers who are
investors. By performing this function, they discourage hoarding by-the people, mobilize
their savings and lend them to investors. Thus NBFIs encourage saving and investment
which are essential for promoting economic growth. Goldsmith's study has shown that
the growth of NBFIs has been responsible for the economic growth of developed
countries in a significant way.
We may conclude that NBFIs provide liquidity and safety to financial assets, and help in
transferring funds from ultimate lenders to ultimate borrowers for productive purposes.
They increase capital formation and consequently lead to economic growth.
Role of Commercial Banks in a Developing Country
Besides performing the usual commercial banking functions, banks in developing
countries play an effective role in their economic development. The majority of people in
such countries are poor, unemployed and engaged in traditional agriculture. There is
acute shortage of capital. People lack initiative and enterprise. Means of transport are
undeveloped. Industry is depressed. The commercial banks help in overcoming these
obstacles and promoting economic development. The role of a commercial bank in a
developing country is discussed as under.
1. Mobilizing Savings for Capital Formation. The commercial banks help in mobilizing
saving through a network of branch banking. People in developing countries have low
incomes but the banks induce them to save by introducing variety of deposit schemes to
suit the needs of individual depositors. They also mobilize idle savings of the few rich.
By mobilizing savings, the banks channelize them into productive investments. Thus they
help in the capital formation of a developing country.

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2. Financing Industry. The commercial banks finance the industrial sector in a number of
ways. They provide short-term, medium-term and long-term loans to industry. Thus they
not only provide finance for industry but also help in developing the capital market which
is undeveloped in such countries.
3. Financing Trade. The commercial banks help in financing both internal and external
trade. The banks provide loans to retailers and wholesalers to stock goods in which they
deal. They also help in the movement of goods from one place to ,another by providing
all types of facilities such as discounting and accepting bills of exchange, providing
overdraft facilities, issuing drafts, etc. Moreover, they finance both exports and imports
of developing countries by providing foreign exchange facilities to importers and
exporters of goods.
4. Financing Agriculture. The commercial banks help the large agricultural sector in
developing countries in a number of ways. They provide loans to traders in agricultural
commodities. They open a network of branches in rural areas to provide agricultural
credit. They provide finance directly to agriculturists for the marketing of their produce,
for the modernization and mechanization of their farms, for providing' irrigation
facilities, for developing land, etc. They also provide financial assistance for animal
husbandry, dairy farming, sheep breeding, poultry farming, and horticulture. The small
and marginal farmers and landless agricultural workers, artisans and petty shopkeepers in
rural areas are provided financial assistance through the regional rural banks. These
regional rural banks operate under a commercial bank. Thus the commercial banks meet
the credit requirements of all types of rural people.
5. Financing Consumer Activities. People in underdeveloped countries being poor and do
not possess sufficient financial resources to buy durable consumer goods. The
commercial banks advance loans to consumers for purchase of such items as houses,
scooters, fans, refrigerators, etc. In this way, they also help in raising the standard of
living of the people in developing countries by providing loans for consumptive
activities.
6. Financing Employment Generating Activities. The commercial banks finance
employment generating activities in developing countries. They provide loans for the
education of young persons studying in engineering, medical and other vocational
institutes of higher learning. They advance loans to young 'entrepreneurs, medical and
engineering graduates, and other technically trained persons in establishing their own
business. Thus the banks not only help in human capital formation but also in increasing
entrepreneurial activities in developing countries.
7. Help in Monetary Policy. The commercial banks help the economic development of a
country by faithfully following the monetary policy of the central bank. In fact, the
central bank depends upon the commercial banks for the success of its policy of monetary
management in keeping with requirements of a developing economy.

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Thus the commercial banks contribute much to the growth of a developing economy by
granting loans to agriculture, trade and industry, by helping in physical and human capital
formation and by following the monetary policy of the country.

Distinction between Banks and Non-Bank Financial Intermediaries

Before we discuss how far commercial banks differ from NBFIs, let us study their
similarities.
From a functional viewpoint the operations of commercial banks are similar to those of
NBFIs on the following counts:
1. Like NBFIs, commercial banks acquire the primary securities of borrowers, loans and
deposits, and in turn, they provide their own indirect securities and demand deposits to
the lenders. Commercial banks resemble NBFIs in that both create secondary securities in
their role as borrowers.
2. Commercial banks create demand deposits when they borrow from the central bank,
and NBFIs create various forms of indirect debt when they borrow from commercial
banks.
3. Both commercial banks and NBFIs act as intermediaries in bringing ultimate
borrowers and ultimate lenders together and facilitate the transfer of currency balances
from non-financial lenders to non-financial borrowers for the purpose of earning profits.
4. Both commercial banks and NBFIs provide liquid funds. The bank deposits and other
assets of commercial banks and the assets provided by NBFIs are liquid assets. Of course,
the degree of liquidity varies in accordance with the nature and the activity of the
concerned financial intermediaries.
5. Both banks and NBFIs are important creators of loanable funds. The commercial banks
by net creation of money and the NBFIs by mobilizing existing money balance in
exchange for their own newly issued financial liabilities.
How are Commercial Banks Different from NBFIs?
Commercial banks are different from NBFIs in the following respects:
1. Credit Creation. The existence of NBFIs significantly modifies the conventional view
of commercial banks as creators of money because they can directly issue their own new
liabilities to acquire other assets. On the other hand, NBFIs do not create money. Like all
other financial intermediaries (FIs), commercial banks lend to borrowers only currency
deposited with them and make profit by charging borrowers a high rate than they pay to
lenders. But both differ in the effects of their operations so far as secondary securities are
concerned. The two main financial assets that serve as money are currency, known as
high powered money, and demand deposits of commercial banks. Demand deposits are
the secondary securities issued by commercial banks which are substitutes for currency.
They represent a promise to pay currency on demand and are transferred direct by cheque
without encashment in settlement of debt. Banks offer convenient safe-keeping,

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bookkeeping and a large' number of other services to depositors that are not available by
holding currency. Consequently, depositors who lend their currency to commercial banks
receive in return a secondary security that itself serves as a medium of payment. Loans
made or deposits created by any bank through the issue of cheques will ultimately be
deposited by' the borrowers or by other persons to whom they made cheque payments in
the commercial banking system. Thus cheques help in creating credit by the bank credit
multiplier. Money lent by an individual bank is retained as cash reserves by the, banking
system minus only a small leakage in money used by the borrower. The bank credit
multiplier implies that banks if uncontrolled would have an unlimited power to expand
deposits, since the latter are determined only by the amount of primary securities that the
banking system 'purchases. "Bank money, once created in the process of bank lending,
lives on as a virtually permanent part of the, money supply. Thus, banks do manufacture
money; and once manufactured, it is relatively immortal." It is in this sense that
commercial banks are unique among FIs in their ability to create money. But in the case
of NBFIs, the amount of primary securities they can buy is limited by the amount of
indirect securities they can sell to lenders. Since they do not possess the bank credit
multiplier power of commercial banks, they perform the brokerage function of simply
transferring to borrowers the funds entrusted to them by lenders. Moreover, government
regulations prevent NBFIs from offering chequing facilities on their liabilities and
convertibility into currency on demand. But a number of secondary securities, such as
commercial bank time and demand deposits and deposits in some thrift institutions while
directly not transferable by cheque can be turned into cash quickly, easily, conveniently
and without cost. Therefore, they are a close substitute of money than other assets, are
called near money assets. Thus NBFIs can create liquidity and not money. Since the
majority of NBFIs are small, the banking system multiplier does not operate fully in their
case because of the leakage:' to banks of the money lent. Suppose a small non-banking
financial institution lends and issues a cheque on its bank as payment. This will lead to a
drain on its resources unless an equal amount is redeposited by some other borrower. In
the case of small NBFIs, the redeposit ratio is low which makes it difficult for them to
continue in business unless they have sufficient assets. But a commercial bank faces no
problem of the type and can create money as well as liquidity to meet its lending
requirements.
2. Cash Reserve Requirements. Commercial banks, like other FIs, have to earn a higher
rate on their total assets than they pay on their total liabilities. They have to keep cash
reserves. But cash reserves do not earn income. So banks wish to maintain their cash
reserves as low as possible. But, unlike NBFIs, they are legally required to maintain a
minimum cash reserve ratio. This ratio is always more than what the banks would wish to
maintain. As a result, banks do not normally hold cash reserves in excess of those legally
required and invest all excess cash in earning assets. With a reduction of required cash
reserve ratio, the volume of bank intermediation would expand, and vice versa.

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As deposits are preferred to currency, an increase in the stock of high powered money
results in an increase in the public demand for bank deposits. This leads to an increase in
deposits with the banking system. So long as the average cost of providing and servicing
demand deposits is low relative to the interest rate earned on primary securities, banks
have a profit incentive to lend all excess cash by buying securities and granting loans.
Consequently, the volume of bank intermediation expands. This process will continue
until bank assets and deposits have risen to a level where the required cash reserves and
actual reserves are equal. It should, however, be noted that the foreign exchange
liabilities of commercial banks are not required to meet cash reserve requirements. So
this part of the bank business can be regarded like an NBFI.
On the other hand, NBFIs are not subject to any such restrictions. They are thus in an
advantageous position over the banks. But this regulatory distinction between banks and
NBFIs does not apply now in almost all the developed and developing countries of the
world because reserve requirements have been enforced in one form or another on NBFIs
with the exception of insurance companies, pension funds, and investment and unit trusts.
3. Portfolio Structure. Commercial banks differ from NBFIs in their portfolio structure.
Bank liabilities are very liquid. The liabilities of a bank are large in relation to its assets,
because it holds a small proportion of its assets, in cash. But its liabilities are payable on
demand at a short notice. Many types of assets are available to a bank with varying
degree of liquidity. The most liquid is cash. The next most liquid assets are deposits with
the central bank, treasury bills and other short-term bills issued by governments and large
firms, and call loans to other banks, firms, dealers and brokers in government securities.
The less liquid assets are the various types of loans to customers and investment in
longer-term bonds and mortgages. Thus banks have a large and varied portfolio on the
basis of which they create liquidity. NBFls also create liquidity but in the form of savings
and time deposits which not used as a means of payment. They are limited in the choice
of their assets, and also prohibited from holding certain assets. Thus the size of their
portfolio is very small as compared to banks. They generally issue claims against
themselves that are fixed in money terms and have maturities shorter than the direct
securities they hold. They borrow for short period, and lend for long period. This is
because of the small size of their portfolio and they hold less liquid assets than banks.
4. Risk. Banks have to follow certain norms at the time of advancing loans. There are
detailed appraisals of projects and hence delays in sanctioning loans. On the other hand,
NBFIs do not enter into detailed appraisals of projects; they have to follow less stringent
rules for advances. There are no time delays in granting loans. Thus NBFIs are able to
take greater risk and lesser supervision as compared to banks.
5. Security. NBFIs insist on greater security than banks before lending. Normally, it is in
the form of shares and post-dated cheques. This is to ensure that if one project goes bad,
they can recover from the others.
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6. Recovery. NBFIs are very innovative in their methods of recovery and calculation of
interest rates. They combine a good security with other factors such as upfront fee, and
higher lending rates. Consequently, their recovery rates are good and the percentage of
bad debts to their assets is very low. Banks, on the other hand, have to follow specific
norms in making loans. Their prime lending rates are much lower than the NBFIs. Since
banks advance huge loans to corporates, the rate of default is very high in their case.
As a whole, the entire discussion can be summarized as follows:
(a) The distinction between commercial banks and NBFIs has been too sharply drawn.
The differences are of degree rather than of kind. (b) The differences which do exist have
little intrinsically to do with the monetary nature of bank liabilities. (c) The differences
are more importantly related to the special reserve requirements. If NBFIs are subject to
the same kind of regulations, they would behave in much the same way. (d) In
commercial banks any expansion of assets will generate a corresponding expansion of
deposit liabilities. Despite these differences, commercial banks are unique among
financial intermediaries.

Money and Characteristics of a Developed Money Market

The study of money and capital markets in all their facets is so exhaustive that it is not
possible to discuss them in one topic. We shall, therefore, confine our analysis to the
nature and scope of money and capital markets.
1. The Money Market
The money market is a market for short term instruments that are close substitutes for
money. The short term instruments are highly liquid, easily marketable, with little chance
of loss. It provides for the quick and dependable transfer of short term debt instruments
maturing in one year or less, which are used to finance the needs of consumers, business,
agriculture and the government. The money market is not one market but is a collective
name given to the various forms and institutions that deal with the various grades of near-
money. In other words, it is a network of markets that are grouped together because they
deal in financial instruments that have a similar function in the economy and are to some
degree substitutes from the point of view of holders.
Thus the money market consists of call and notice market, commercial bills market,
commercial paper market, treasury bills market, inter-bank market and certificates of
deposit market. All these markets are closely interrelated so as to make the money
market. It is a wholesale market where large number of financial assets or instruments is
traded.
The money market is divided into direct, negotiated, or customers' money market and the
open or impersonal money market. In the former, banks and financial firms supply funds
to local customers and also to larger centers such as London for direct lending. In the
open money market, idle funds drawn from all over a country are transferred through

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intermediaries to the New York City market or the London market. These intermediaries
comprise the Federal Reserve Banks in the USA or the Bank of England in England,
commercial banks, insurance companies, business corporations, brokerage houses,
finance companies, state and local government securities dealers.
The money market is a dynamic market in which new money market instruments are
evolved and traded and more participants are permitted to deal in the money market.

Institutions of the Money Market

The various financial institutions which deal in short term loans in the money rnarket are
its members. They comprise the following types of institutions:
1. Central Bank. The central bank of a country is the pivot around which the entire
money market revolves. It acts as the guardian of the money market and increases or
decreases the supply of money and credit in the interest of stability of the economy. It
does not itself enter into direct transactions, but controls the money market through
variations in the bank rate and open market operations.
2. Commercial Banks. Commercial banks also deal in short-term loans which they lend to
business and trade. They discount bills of exchange and treasury bills, and lend against
promissory notes and through advances and overdrafts.
3. Non-bank Financial Intermediaries. Besides the commercial banks, there are non-bank
financial intermediaries which lend short-term funds to borrowers in the money market.
Such financial intermediaries are savings banks, investment houses, insurance companies,
provident funds, and other financial corporations.
4. Discount Houses and Bill Brokers. In developed money markets, private companies
operate discount houses. The primary function of discount houses is to discount bills on
behalf of other. They, in turn, form the commercial banks and acceptance houses. Along
with discount houses, there are bill brokers in the money market who act as
intermediaries between borrowers and lenders by discounting bills of exchange at a
nominal commission. In underdeveloped money markets, only hill brokers operate.
5. Acceptance Houses. The institution of acceptance houses developed from the merchant
bankers who transferred their headquarters to the London Money Market in the 19th and
the early 20th century. They act as agents between exporters and importers and between
lender and borrower traders. They accept bills drawn on merchants whose financial
standing is not known in order to make the bills negotiable in the London Money Market.
By accepting a trade bill they guarantee the payment of bill at maturity. However, their
importance has declined because the commercial banks have undertaken the acceptance
business.
All these institutions which comprise the money market do not work in isolation but are
interdependent and interrelated with each other.
Instruments of the Money Market
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The money market operates through a number of instruments.
1. Promissory Note. The promissory note is the earliest type of bill. It is a written promise
on the part of a businessman to pay to another a certain sum of money at an agreed future
date. Usually, a promissory note falls due for payment after 90 days with three days of
grace. A promissory note is drawn by the debtor and has to be accepted by the bank in
which the debtor has his account, to be valid. The creditor can get it discounted from his
bank till the date of recovery. Promissory notes are rarely used in business these days,
except in the USA.
2. Bill of Exchange or Commercial Bills. Another instrument of the money market is the
bill of exchange which is similar to the promissory note, except in that it is drawn by the
creditor and is accepted by the bank of the debtor. The creditor can discount the bill of
exchange either with a broker or a bank. There is also the foreign bill of exchange which
becomes due for payment from the date of acceptance. The rest of the procedure is the
same as for the internal bill of exchange. Promissory notes and bills of exchange are
known as trade bills.
3. Treasury Bill. The major instrument of the money markets is the treasury bill which is
issued for varying periods of less than one year. They are issued by the Secretary to the
Treasury in England and are payable at the Bank of England. There are also the short-
term government securities in the USA which are traded by commercial banks and
dealers in securities. In India, the treasury bills are issued by the Government of India at a
discount generally between 91 days and 364 days. There are three types of treasury bills
in India - 91 days, 182 days and 364 days. In Ethiopia, treasury bills are issued by the
National Bank of Ethiopia in favor of the central government.
4. Call and Notice Money. There is the call money market in which funds are borrowed
and lent for one day. In the notice market, they are borrowed and lent up to 14 days
without any collateral security. But deposit receipt is issued to the lender by the borrower
who repays the borrowed amount with interest on call.
5. Inter-bank Term Market. This market is exclusively for commercial and cooperative
banks in India which borrow and lend funds for a period of over 14 days and up to 90
days without any collateral security at market-determined rates.
6. Certificates of Deposits (CD). Certificates of deposits are issued by commercial banks
at a discount on face value. The discount rate is determined by the market.
7. Commercial Paper (CP). Commercial papers are issued by highly rated companies to
raise short-term working capital requirements directly from the market instead of:
borrowing from the banks. CP is a promise by the borrowing company to repay the loan
at a specified date, normally for a period of 3 months to 6 months. This instrument is very
popular in the USA, UK, Japan, Australia and a number of other countries.
The money market operates through a number of sub-markets.

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First, the money market operates through the call loan market. It has been defined as "a
market for marginal funds, for temporarily unemployed or unemployable funds." In this
market, the commercial banks use their unused funds to lend for very short periods to bill
brokers and dealers in stock exchange. In developed countries, even big corporations lend
their dividends before distribution to earn interest for a very short period. The central
bank also lends to commercial banks for very short periods. Such loans are mostly for a
week even for a day or a night and can be recalled at a very short notice. That is why a
short period loan is known as call loan or call money market. Bill brokers and stock
brokers who borrow such funds use them to discount or purchase bills or stocks. Such
funds are borrowed at the "call rate" which is generally one per cent below the bank rate.
But this rate varies with the volume of funds lent by the banks. If the brokers are asked to
payoff loans immediately, then they are forced to get funds from large corporations and
even from the central bank at high interest rates.
Second, the money market also operates through the bill market. The bill market is the
short-period loan market. In this market, loans are made available to businessmen and the
government by the commercial banks, discount houses and brokers. The instruments of
credit are the promissory notes, internal bills of exchange and treasury bills. The
commercial banks discount bills of exchange, lend against promissory notes or through
advances or overdrafts to the business community. Similarly, the discount houses and bill
brokers lend to businessmen by discounting their bills of exchange before they mature
within 90 days. On the other hand, government borrows through the treasury bills from
the commercial banks and non-bank financial institutions.
Third, the money market operates through the collateral loan market for a short period.
The commercial banks lend to brokers and discount houses against collateral bonds,
stocks, securities, etc. In case of need, commercial banks themselves borrow from the
large banks and the central bank on the basis of collateral securities.
Finally, the other important sub-market through which the money market operates is the
acceptance market. The merchant bankers accept bills drawn on domestic and foreign
traders whose financial standing is not known. When they accept a domestic or foreign
trade hill, they guarantee its payment at maturity.
A money market performs a number of functions in an economy.
1. Provides Funds. It provides short-term funds to the public and private institutions
needing such financing for their working capital requirements. It is done by discounting
trade bills through commercial banks, discount houses brokers and acceptance houses.
Thus the money market helps the development of commerce, industry and trade within
and outside the country.
2. Use of Surplus Funds. It provides an opportunity to banks and other institutions to use
their surplus funds profitably for a short period. These institutions include not only

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commercial banks and other financial institutions but also large non-financial business
corporations, states and local governments.
3. No Need to Borrow from Banks. The existence of a developed money market removes
the necessity of borrowing by the commercial banks from the central bank. If the former
find their reserves short of cash requirements they can call in some of their loans from the
money market. The commercial banks prefer to recall their loans rather than borrow from
the central bank at a higher rate of interest.
4. Helps Government. The money market helps the government in borrowing short-term
funds at low interest rates on the basis of treasury bills. On the other hand, if the
government were to issue paper money or borrow from the central bank, it would lead to
inflationary pressures in the economy.
5. Helps in Monetary Policy. A well-developed money market helps in the successful
implementation of the monetary policies of the central bank. It is through the money
market that the central bank is in a position to control the banking system and thereby
influence commerce and industry.
6. Helps in Financial Mobility. By facilitating the transfer for funds from one sector to
another, the money market helps in financial mobility. Mobility in the flow of funds is
essential for the development of commerce and industry in an economy.
7. Promotes Liquidity and Safety. One of the important functions of the money market is
that it promotes liquidity and. safety of financial assets. It thus encourages savings and
investments.
8. Equilibrium between Demand and Supply of Funds. The money market brings
equilibrium between the demand and supply of loanable funds. This it does by allocating
savings into investment channels. In this way, it also helps in rational allocation of
resources.
9. Economy in Use of Cash. As the money market deals in near-money assets and not
money proper, it helps in economizing the use of cash. It thus provides a convenient and
safe way of transferring funds from one place to another, thereby immensely helping
commerce and industry.
Characteristics of an Undeveloped Money Market
The money markets in the majority of underdeveloped countries are mostly undeveloped
or unorganized. In fact, they are dualistic, both developed and undeveloped money
markets exist side by side.
The developed money market consists of the central bank, the commercial banks, bill
brokers, discount houses, acceptance houses, etc. On the other hand, the undeveloped
money market consists of the moneylenders, the indigenous bankers, traders, merchants,
landlords, pawnbrokers, etc.

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 Since the majority of the people in underdeveloped countries lives in rural areas and is
poor, the undeveloped market controls a major portion of the money market. The main
characteristics of such a market are:
1. Personal Touch. The lenders have a personal touch with the borrowers. The lender
knows every borrower personally in the village because the latter resides there.
2. Flexibility in Loans. There is no rigidity in loan transactions. The borrower can have
more or less amount of loan according to his requirements depending upon the nature of
security or his goodwill with the moneylender.
3. Multiplicity of Lending Activities. Mostly people do not specialize in moneylending
alone. They combine moneylending with other economic activities. A merchant may
supply goods on loan instead of money in cash.
4. Varied Interest Rates. There is multiplicity of interest rates. Interest rates are much
higher than rates in the developed sector of the money market. The interest rates are not
even uniform. The rate depends on the need of the borrower, the amount of loan, the time
for which it is required and the nature of security. The greater the urgency, the higher will
be the interest rate.
5. Defective System of Accounting. In the unorganized sector of the money market, the
system of maintaining accounts is highly defective. Proper accounts are never
maintained. Formal receipts are not issued for interest and the principal repaid by the
borrowers. Besides, there is utmost secrecy in maintaining accounts and lending
procedures in the undeveloped money market. The accounts of the moneylenders are not
liable to checking by any higher authority.
6. Absence of Link with the Developed Money Market. The undeveloped sector is not
linked with the developed sector of the money market in such countries. The former
works independently of the latter and is also not under the control of the developed
market. This has the effect of reducing the volume of monetary transactions and savings,
and prevents their use in productive investments.
Characteristics of a Developed Money Market
The developed money market is a well-organized market which has the following main
features:
1. A Central Bank. A developed money market has a central bank at the top which is the
most powerful authority in monetary and banking matters. It controls, regulates and
guides the entire money market. It provides liquidity to the money market, as it is the
lender of the last resort to the various constituents of the money market.
2. Organized Banking ·System. An organized and integrated banking system is the second
feature of a developed money market. In fact, it is the pivot around which the whole
money market revolves. It is the commercial banks which supply short-term loans, and

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discount bills of exchange. They form an important link between the borrowers, brokers,
discount houses and acceptance houses and the central bank in the money market.
3. Specialized Sub-Markets. A developed money market consists of a number of
specialized sub-markets dealing in various types of credit instruments. There is the call
loan market, the bill market, the treasury bill market, the collateral loan market and the
acceptance market, and the foreign exchange market. The larger the number of sub-
markets, the more developed is the money market. But the mere number of sub-markets
is not enough. What is required is that the various sub-markets should have a number of
dealers in each market and the sub-markets should be properly integrated with each other.
4. Existence of Large Near-Money Assets. A developed money market has a large number
of near-money assets of various types such as bills of exchange, promissory notes,
treasury bills, securities, bonds, etc. The larger the number of near-money assets, the
more developed is the money market.
5. Integrated Interest-Rate Structure. Another important characteristic of a developed
money market is that it has an integrated interest-rate structure. The interest rates
prevailing in the various sub-markets are integrated to each other. A change in the bank
rate leads to proportional changes in the interest rate prevailing in the sub-markets.
6. Adequate Financial Resources. A developed money market has easy access to
financial sources from both within and outside the country. In fact, such a market attracts
adequate funds from both sources, as is the case with the London Money Market.
7. Remittance Facilities. A developed money market provides easy and cheap remittance
facilities for transferring funds from one market to the other. The London Money Market
provides such remittance facilities throughout the world.
8. Miscellaneous Factors. Besides the above noted features, a developed money market is
highly influenced by such factors as restrictions on international transactions, crisis,
boom, depression, war, political instability, etc.

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