Chapter two

FINANCIAL INSTITUTIONS IN
FINANCIAL SYSTEM
Concepts of the Financial Institutions
 are establishment that focuses on
dealing with financial transactions, such
as investments, loans and deposits
 composed of organizations such as
banks, trust companies, insurance
companies and investment dealers.
 Financial institutions deal with various
financial activities associated with bonds,
debentures, stocks, loans, risk
diversification, insurance, hedging,
retirement planning, investment,
portfolio management, and many other
types of related functions
Financial institutions are those
organizations, which are involved in
providing various types of financial services
to their customers
The financial institutions are controlled and
supervised by the rules and regulations
delineated by government authorities.
Some of the financial institutions also
function as mediators in share markets and
debt security markets.
The principal function of financial
institutions is to collect funds from the
investors and direct the funds to various
financial services providers in search for
 Contributions of Financial
Institutions
economic growth depends on the
accumulation of input factors in the
production process and on technical
progress
Financial development may also
help to realize faster technical
progress, embedded in the capital
stock, to achieve higher economic
growth
More specifically, financial development can
affect growth through three main channels:
It can raise the proportion of savings
channeled to investment, thereby reducing
the costs of financial intermediation;
It may improve the allocation of resources
across investment projects, thus increasing
the social marginal productivity of capital;
and

It can influence the savings rates of

households, for example, if it induces a higher
degree of risk sharing and specialization,
which as a result stimulates higher growth
 Important factors for stable financial
system
• a stable financial system can be described as a
financial system that is able to withstand
shocks without giving way to cumulative
processes which could impair the allocation of
savings to investments and the processing of
payments in the economy
How do we get there?
o Financial system architecture should be
carefully planned
o A solid micro supervision of the financial sector
and individual institutions should be in place
o Close co-operation and exchange of
information between the central bank and
supervisory authorities is warranted at all times
and especially in periods of financial stress.
There are several, complementary public
policies that are typically needed to sustain or
build up confidence in financial institutions.
1. Fiscal policy: If fiscal authorities are
restricted in their ability to run deficits or
accumulate large debts, an important source
of financial market stress and financial
instability is removed.
2. Monetary policy: As is now widely
accepted, monetary authorities should in the
first place try to guarantee price stability,
being the best possible contribution it can
make to growth in the medium to long-term.
In addition some day-to-day tools are
associated with
guaranteeing financial sector stability, as
for example the lending and deposit facilities
at the central bank providing upper and lower
bounds for money market fluctuations and
giving individual institutions a means to
deal with end-of-day liquidity imbalances, or
fine-tuning operations.
Financial supervision. An adequate supervisory
framework helps to enhance financial stability and
maintain overall confidence in the financial system.
A financial safety net. A financial safety net is in
place in most countries with a view to protecting
small depositors in case of a bank failure.
Market discipline :a stable financial system cannot
operate without market discipline of the financial
sector. In order to avoid costly bank runs and bank

failures, the sector must show some self-discipline, to

meet acceptable standards and expectations

 Classification of Financial
Institutions
Two main types of financial
institutions-with increasingly
blurred dividing line, are:
1.Depository institutions
2.Non-depository Institution
I. Depository institutions
A depository financial institution is one
that specializes in depository and lending
The depository financial institutions are
also known as deposit-taking financial
organizations
The primary functions of these
institutions are to accept deposits and to
use the money collected for lending
purposes
Includes banks and credit unions which
pay interest on deposits from the interest
earned on the loans
Depository institutions can also be
generally categorized in to
commercial banks and
other depository institutions (such
as saving and loan institutions,
credit unions, and microfinance
institutions).
Depository institutions are popular
financial institutions for the
following reasons:
They offer deposit accounts that can
accommodate the amount and liquidity
characteristics desired by most surplus
units.
They repackage funds received from
deposits to provide loans of the size &
maturity desired by deficit units.
They accept the risk on loans provided.
They have more expertise than
individual surplus units in evaluating
the credit worthiness of deficit units.
They diversify their loans among
numerous deficit units and therefore
can absorb defaulted loans better than
individual surplus units could
Commercial Banks
Commercial Banks are institutions that
offer deposit and credit services as well
as a growing list of newer services as
investment advice, security underwriting,
selling insurance and financial planning
Commercial Banks manage the
customers' current and savings accounts,
pay out checks that have been drawn on
the bank by account holders, and also
perform the collection of checks
deposited in their customers' accounts
Role of Commercial Banks in the
Economic Development
Banks promote capital formation
Investment in new enterprises
Promotion of trade and industry
Development of agriculture
Balanced development of different
regions
Influencing economic activity
Implementation of Monetary policy
Monetization of the economy
Export promotion cells
Other Depository
Institutions
The common goals for these
agencies are to promote the
development of the modern
financial systems that:
 Avoid excessive fragility and
Efficiently intermediate
between savers and borrowers
1. Savings and Loans
Associations
also known as a thrift institution
is a financial institution that
specializes in accepting savings
deposits and making mortgage and
other loans
They are often mutually held (often
called mutual savings banks
Savings and loans associations (S&Ls)
were originally designed as mutual
associations,
i.e., (owned by depositors) to convert
funds from savings accounts into
mortgage loans.
 They are the predominant home
mortgage lender in many countries, making
loans to finance the purchase of housing for
Savings and loan associations can be either
state or federally chartered and must fulfill
the state requirements to be incorporated.
The day-to-day affairs of the association
are controlled by the officers and directors
whose job responsibilities include organizing
and operating the association in compliance
with the state and federal laws
The chxcs of savings and loan
It is generally a locally owned and
associations
privately managed home financing
institution
It receives individuals' savings and
uses these funds to make long-
term amortized loans to home
purchasers
It makes loans for the
construction, purchase, repair, or
refinancing of houses
It is state or federal chartered
2. Credit Unions
A credit union is a member-
owned financial cooperative,
democratically controlled by its
members
operated for the purpose of:
promoting thrift,
providing credit at competitive rates,
and
providing other financial services to
its members
Credit union……………….
They are house hold oriented
intermediaries, offering deposit and credit
services to individuals and families.
They are cooperative, self-help association
of individuals
They offer low loan rates and high deposit
interest rates and have relatively low
operating costs.
The members of a credit union are owners
receiving dividends and sharing in any
losses that occur
Nature of Credit union
 Only a member of a credit union may deposit
money with the credit union, or borrow money
from it.
 Credit union revenues (from loans and
investments) do, however, need to exceed
operating expenses and dividends (interest paid
on deposits) in order to maintain capital and
solvency.
 Often credit unions have a lower cost of funds
than typical commercial banks, due to a higher
proportion of non/low interest bearing deposits.
Credit unions offer many of the same financial
services as banks.
nature…………
Common services include:
◦share accounts (savings
accounts),
◦share draft (checking) accounts,
◦credit cards,
◦share term certificates
(certificates of deposit), and
◦online banking
Characteristics of credit
union
Non profit status
Democratic process
Inclusiveness
Lower fees
Better interest rates on loans
Funds returned to members
Easy to join
 Class discussion

What are the

difference and
similarity between
Credit Unions and
Banks?
 3. Micro-Finance Institutions
 usually understood to entail the provision of
financial services to micro-entrepreneurs and small
businesses, which lack access to banking and
related services due to the high transaction costs
associated with serving these client categories
 Micro finance is defined as the provision of
financial intermediation through distribution of
small loans acceptance of small savings and the
provision of other financial products and services
to the poor.
 A micro finance institution (MFI) is an organization
that offers financial services to the very poor.
The two main mechanisms
for the delivery of financial
services to such clients are:
(1)Relationship-based banking
for individual entrepreneurs
and small businesses;
(2) Group-based models, where
several entrepreneurs come
together to apply for loans and
other services as a group.
The Distinguishing characteristics of micro
finance from Conventional Banks
Procedures are designed to be helpful to the
client and therefore are user friendly. They
are simple to understand, locally provided
and easily and quickly accessible.
The traditional lender's requirement for
physical collateral (such as land, house and
productive assets) is usually replaced by
system of collective guarantee groups whose
members are mutually responsible for
ensuring individual loans are repaid.
Loans are dependent not only on individual's
repayment performance, but also on that of
every other group members.
Borrowers are usually required to
be savers.
Together with their long term
sustainability they have the
objective of ending poverty and
MFI's operating costs as well as
administrative cost per loan are
higher than the conventional banks
4. Mutual Savings Banks
A mutual savings bank is a financial
institution, that is owned by its members
who subscribe to a common fund
chartered by a central or regional
government, without capital stock
Mutual savings banks are much like
savings and loans, but are owned
cooperatively by members with a
common interest, such as company
employees, union members, or
congregation members
MF……………….
Mutual savings banks were designed
to stimulate savings by individuals.
the exclusive function of these banks
is to protect deposits, make limited
security investments, and provide
depositors with interest.
Saving banks play an active role in
the residential mortgage banks
 MF…………..
Saving banks are owned by their depositors
to which all earnings not retained are paid
as owner’s dividend
 Mortgage and Mortgage related
instruments are principal assets followed by
investments in non-mortgage loans,
corporate bonds, corporate stocks and
government bonds
Unlike commercial banks, savings banks
have no stockholders; the entirety of profits
beyond the upkeep of the bank belongs to
the depositors of the mutual savings bank
MF…………..
Mutual savings banks prioritize
security, and as a result, have
historically been characteristically
conservative in their investments.
This conservatism is what allowed
mutual savings banks to remain
stable throughout the turbulent
period of the great depression,
despite the failing of commercial
banks and savings and loan
associations
MF………….
In general, it is a financial
institution chartered by state
or federal government to:

(1) Provide a safe place for

individuals to save and
(2) Invest those savings in
mortgages loans, stocks, bonds
and other securities.
5. Money Market Funds
A money market fund is a mutual
fund that invests in short-term, high-
quality fixed income securities
Money Market Funds are financial
intermediaries pooling deposits of
many individuals and investing those
in short-term, high quality, money
market instruments
Money fund offer accounts whose
yields are free to reflect prevailing
interest rates in the money market
Money market funds are investments
II. Non-depository
Institutions
Government or private organization
(such as building society, insurance
company, investment trust, or
mutual fund or unit trust) that
serves as an intermediary between
savers and borrowers, but does not
accept time deposits
Such institutions fund their lending
activities either by selling securities
(bonds, notes, stock/shares) or
insurance policies to the public
 1. Financial-Brokers
is a financial institution that facilitates the
buying and selling of financial securities
between a buyer and a seller
serve a clientele of investors who trade
public stocks and other securities, usually
through the firm's agent stockbrokers
A traditional, or "full service", brokerage
firm usually undertakes more than simply
carrying out a stock or bond trade
FB……………
The staff of this type of brokerage firm is
entrusted with the responsibility of
researching the markets to provide
appropriate recommendations and in so
doing; they direct the actions of pension
fund managers and portfolio managers
alike
These firms also offer margin loans for
certain approved clients to purchase
investments on credit
There are a number of specific finance
options that call for a specialized finance
broker.
A floor broker serves as the representative
of a client to transaction purchases and sales
on a stock market directly on the market
floor.
An upstairs broker tends to focus more on
retail markets and similar transactions.
A mortgage broker will seek to identify and
secure the best mortgage deals for clients.
Many brokers do choose to specialize in one
or two areas, it is possible to find a finance
broker that offers a one stop shopping
solution for a variety of business financing
 FB…………….
Functioning as an advocate or
finance agent for the customer
the broker will pursue options
that work well with the operating
budget of the client and
often save customers a great
deal of money, even after the
broker's commission is taken into
consideration
A discount broker or an online broker is a firm
that charges a relatively small commission by
having its clients perform trades via
automated, computerized trading systems
Most traditional brokerage firms offer
discount options and compete heavily for
client volume due to a shift towards this
method of trading.
 Other ways to lower costs for these brokers is
by executing orders only a few times a day by
aggregating orders from a large number of
small investors into one or more block trades
which are made at certain specific times
during the day
They help lower costs in two
ways:

By matching buy and sell orders

within the firm's order book the
overall quantity of stock to be traded
can be reduced thus reducing
commissions.
The broker can split the bid-ask
spread with the investor when
matching buy and sell orders - a win-
Investment Institutions
Finance Companies:
 are sometimes called department
stores of consumer and business
credit
 grant credit to businesses and
consumers for a wide variety of
purposes acquiring their funds
mainly from debt
 Types of finance
companies
• Consumer Finance companies-make
personal cash loans to individuals.
• Sales Finance Companies- make
indirect loans to consumers by
purchasing installment paper from
dealers selling automobiles and other
consumer durables.
• Commercial Finance Companies-
focus primarily on extending credit to
business firms
•Other Financial Institutions:
Security Dealers are firms that take a
position of risk in government and privately
issued securities, purchasing the instruments
from sellers and reselling them to buyers with
the expectation of a profitable spread between
purchases and sales.
Investment Banks are capital market firms
that assist businesses and governments to
issue debt and stock in order to raise new
capital.
Mortgage Banks are intermediaries that
work with other businesses or real estate
development projects and sell the mortgage
loan instruments to other investors
Other…………….
 Venture Capital Firms are institutional
investors that provide long-term capital
financing for new businesses and rapidly
emerging companies.
 Real Estate Investment Trusts are
specialized lenders and equity investors that
finance commercial and residential projects.
 Leasing Companies are financial firms that
purchase business equipment and other
productive assets and make the purchased
items available for use by others in return for
rental fee.
 Investment institutions

Investment companies
 provide an outlet for the savings of
many individual investors towards
bonds, stocks, and money market
securities.
 Most investment companies stocks
are highly liquid because they
repurchase their outstanding
shares at current market price.
Investment institutions
Mutual funds
 are especially attractive to small investor,
which purchase shares of these funds and
gain greater diversification, risk sharing,
lower transaction cost, opportunities for
capital gains and indirect access to higher
yielding securities
 They pool funds of savers and make them
available to business and government
demanders.
Pension Funds
is an entity set up to collect monies
from employer(s) and workers, invest
the proceeds in securities and other
assets, and pay benefits to retirees from
the fund's accumulated resources.
It is a pool of assets forming an
independent legal entity that are bought
with the contributions to a pension plan
for the exclusive purpose of financing
pension plan benefits.
Pension Funds
 Itis a fund established by an employer to
facilitate and organize the investment of
employees' retirement funds contributed by
the employer and employees..
 A pension plan is a promise by a pension
plan sponsor to a plan member to provide a
pension upon retirement.
 The sponsor may be a company, an
employer, a union or a jointly trustee plan
where both management and unions in an
industry appoint trustees to a board which
manages the plan.
A pension fund ordinarily has an
investment policy statement that describes
the nature of the assets in which the
pension fund can invest
A trustee is appointed to hold the assets
in trust for the benefit of the plan
members.
Pension plans usually hire an outside
investment manager to invest the plan
assets.
The sponsor may also appoint an
"investment consultant" to advice on
investment issues and help select and
assess the performance of investment
 Basic characteristics of
Pension Trust Fund
 Every organization maintains a pension trust
fund for its employees and protects liabilities
of misappropriation and mishandling of
pension funds
 A pension plan is a fund that is established by
private employers, governments, or unions for
the payment of retirement benefits.
 Pension plans have grown rapidly largely
because of favorable tax treatment
 Qualified pension funds are exempt from
federal income taxes, as are employer
contributions
The two types of pension funds
are
Defined contribution plan: the
sponsor is responsible only for
making specified contributions into
the plan on behalf of qualifying
employees but does not guarantee
any specific amount at retirement.
A Defined benefit plan: sponsor
agrees to make specified payments
to qualifying employees at
retirement
The financial condition of a
pension plan depends on a
number of factors, including
The demographic
characteristics: dictate the time
horizon for investment
The financial state of the
company itself
The historical investment
performance
Insurance Companies
Insurance companies allow people to choose
the certainty of a slightly reduced current
income (reduced by the premiums they pay)
in exchange for avoiding a catastrophic loss
of income (or wealth) if some accident should
occur.
The amount to be charged for a certain
amount of insurance coverage is called the
premium.
The insured receives a contract, called the
insurance policy, which details the conditions
and circumstances under which the insured
will be financially compensated.
 Types of insurance
companies
Captive insurance company
 is a stock insurance company that is formed
to underwrite the risks of its parent company
or in some, cases a sponsoring group or
association
Mutual
 is also is a company in which each policy
holder is an owner, and where earnings are
distributed as dividends.
 If a net loss results, policyholders may be
subject to extra assessments. In most cases,
however, non-assessable policies are issued
Reciprocal organization:

is an association of insured

companies that is independently
operated by a manager.
Advance deposits are made, against
which are charged the proportionate
costs of operations.
Stock company can have an
insurance company that behaves like
a normal corporation – earnings not
retained in the business are
distributed to shareholders as
dividends and not to policyholders.
 way to categorize insurance
Another

companies is by the type of service

offered;
mono line company provides only
one type of insurance coverage,
multiple line company provides
more than one kind of insurance. A
financial services company provides
not only insurance but also financial
 Investment Banking
 An
Firms
investment bank is a financial
institution that assists individuals,
corporations and governments in raising
capital by underwriting and/or acting as
the client's agent in the issuance of
securities.
 An investment bank may also assist
companies involved in mergers and
acquisitions, and provide ancillary services
such as market making, trading of
derivatives, fixed income instruments,
foreign exchange, commodities, and equity
securities.
 Investment Banking
Firms
 They also provide professional services to
the investors for identifying different
investment opportunities and to invest in the
same.
 The investment banking firms provide
various financial services to a wide range of
clients.
 There are both institutional as well as
individual clients of these firms. At the same
time, these firms also offer a number of
services to different national governments
There are two main lines of business in
investment banking:
Trading securities for cash or for other
securities (i.e., facilitating transactions,
market-making), or
The promotion of securities (i.e.,
underwriting, research, etc.) is the "sell
side", while dealing with pension funds,
mutual funds, hedge funds, and the
investing public (who consume the
products and services of the sell-side in
order to maximize their return on
investment) constitutes the "buy side".
Benefits of Investment Banking Firms
•The investment banking firms play an
important role in creating customized
strategies for business activities.
•The investment banking services are
also available for the activities like
divestitures, restructurings, buyouts and
others.
•All these activities need huge amount of
money and the investment banking firms
are responsible for arranging these funds.
The clients of the investment
banking firms are provided with
advisory services. The firms also offer
a range of capital raising
opportunities to the clients.

At the same time, the firms are also

involved in the syndication of primary
market on behalf of their clients.
The investment banking firms also
play a major role in arranging debt
securities for their clients.
 Reading Assignment

CORE INVESTMENT BANKING ACTIVITIES

AND THEIR DEVELOPMENT
End of chapter two

CHAPTER
THREE