Department of accounting FBE SDC

Chapter two
2. Financial Institutions in the Financial System
2.1 Over view of financial institutions
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 those funds.

These institutions include: Banks, Stock Brokerage Firms , Non Banking Financial Institutions,
Credit Unions and Insurance Companies.
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.
With the help of their functions, the financial institutions transfer money or funds to various tiers
of economy and thus play a significant role in acting upon the domestic and the international
economic scenario. For carrying out their business operations, financial institutions implement
different types of economic models. They assist their clients and investors to maximize their
profits by rendering appropriate guidance.
Financial institutions can be either private or public in nature.
Granted that financial institutions manufacture loans out of money which people lend, what else
can we say about what they do? As a general rule, financial institutions are engaged in what is
called intermediation. Intermediation means acting as a go-between for two parties. The parties
here are usually called lenders and borrowers or sometimes surplus sectors or units and deficit
sectors or units.
What general principles are involved in this going between? The first thing to say is that it
involves more than just bringing two parties together. One could imagine a firm which did this. It
could keep a register of people with money to lend and a register of people who wished to
borrow. Every day, people would join and leave each register and the job of the firm would be to
scan the lists continuously, crying eureka (or something else of an appropriate kind) every time it

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Department of accounting FBE SDC

finds a potential lender whose desires match those of a potential borrower. It would then charge a
commission for introducing them to each other. Something else has to be provided.

As a general rule what financial intermediaries do is to create assets for savers and liabilities for
borrowers which are more attractive to each than would be the case if the parties have to deal
with each other directly.
2.2. Capital transfer in financial institutions
In a well-functioning economy, capital will flow efficiently from those who supply capital to
those who demand it. This transfer of capital can take place in the three different ways described
1. Direct transfers of money and securities: occur when a business sells its stocks or bonds
directly to savers, without going through any type of financial institution. The business
delivers its securities to savers, who in turn give the firm the money it needs.
2. Indirect transfer of capital: Borrowers borrow indirectly from lenders via financial
intermediaries.
A. Transfers may be going through an investment banking house such as Merrill Lynch, which
underwrites the issue. An underwriter serves as a middleman and facilitates the issuance of
securities. The company sells its stocks or bonds to the investment bank, which in turn sells
these same securities to savers. The businesses’ securities and the savers’ Money merely
“pass through” the investment banking house. However, the investment bank does buy and
hold the securities for a period of time, so it is taking a risk—it may not be able to resell
them to savers for as much as it paid. Because new securities are involved and the
corporation receives the proceeds of the sale, this is called a primary market transaction.
B. Transfers can also be made through a bank or mutual fund. Here the intermediary obtains
funds from savers in exchange for its own securities. The intermediary uses this money to
buy and hold businesses’ securities. For example, a saver might deposit dollars in a bank,
receiving from it a certificate of deposit, and then the bank might lend the money to a small
business as a mortgage loan. Thus, intermediaries literally create new forms of capital—in
this case, certificates of deposit, which are both safer and more liquid than mortgages and
thus are better for most avers to hold. The existence of intermediaries greatly increases the
efficiency of money and capital markets.

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2.3 The role of financial institutions

1. Providing a payments mechanism
Most transactions made today are not done with cash; instead payments are made using checks,
credit cards, debit cards and electronic transfers of funds. These methods for making payments
are provided by certain financial institutions. Financial institutions perform check clearing and
wire transfer services. A debit card differs from a credit card in that in the latter case, a bill is
sent to the credit card holder periodically (usually once a month) requiring payments for
transactions made. In the past in the case of a debit card, funds are immediately withdrawn (that
is, debited) from the purchaser's account at the time the transaction takes place.
2. Maturity transformation
The financial institutions ( e.g. banks) perform the valuable functions of converting funds that
savers are willing to lend for only short period of time into funds the financial institution
themselves are willing to lend to borrowers for longer periods. Maturity transformation function
of financial institution has two implications. First, it provides investors with more choices
concerning maturity for their investments; borrowing has more choices for the length of their
debt obligations. Second, because investors are naturally reluctant to commit funds for a longer
period of time, they will require that long-time borrowers pay a higher interest rate than on a
short -time borrowing. A financial institution is willing to make long-term loans, and at a lower
cost to the borrower than an individual investor would, by counting on successive deposits
providing the funds until maturity. Thus, the second implication is that the cost of long-term
borrowing is likely to be reduced.
3. Reducing risk through diversification
Consider the example of an investor who places funds in an investment company. Suppose that
the investment company invests the funds received in the stock of a large number of companies.
By doing so, the investment company has diversified and reduced its risk. Investors who have a
small sum to invest would find it difficult to achieve the same degree of diversification because
they don't have sufficient funds to buy shares of a large number of companies. Because financial
institutions acquire funds from large numbers of surplus units and provide funds to large
numbers of deficit units, substantial diversification is effected and the risk of financial loss is
reduced. The diversification is the holding of many (rather than a few) assets reduces risk.
Because all assets don’t behave in the same way at the same time, therefore, the behavior of one
asset will on some occasions cancel out the behavior of another. Financial institutions
(intermediaries) also offer the risk reducing benefits of management expertise since they do have
a manpower that specializes in credit risk assessment & monitoring of borrowers.
4. Reducing transaction costs
Not only do Financial institutions have a greater incentive to collect information, but also their
average cost of collecting relevant information is lower than for individual investor

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(i.e., information collection enjoys economies of scale). An economy of scale is a concept that
costs reduction in trading and other transaction services results from increased efficiency when
financial institutions perform these services.
Such economies of scale of information production and collection tend to enhance the
advantages to investors of investing via financial institutions rather than directly investing
themselves.
2.4 Classification of financial institutions
Depository and Non Depository Institutions

2.4.1 Depository institutions Depository institutions are financial intermediaries that accept
deposits from individuals and institutions and make loans. include commercial banks (or simply
banks), savings and loan associations (S & Ls), mutual savings banks, and credit unions. All
are financial intermediaries that accept deposits. These deposits represent the liabilities (debit) of
the deposit accepting institution. With the funds raised through deposits and other funding
sources, depository institutions make loans to various entities and also invest in securities. Their
income is derived from two sources:
i. the income generated from the loans they make (interest income)
ii. Capital gain (the difference between the purchasing price and selling price of the
security)
It is common to refer to saving and loan associations, mutual saving banks and credit unions as
“thrifts” which are specialized types of depository institutions.
Asset/Liability Problem of Depository Institutions
The asset/liability problem that depository institutions face is quite simple to explain –
although not necessarily easy to solve. A depository institution seeks to earn a positive
spread between the assets it invests in (loans and securities) and the cost of its funds
Financial Market and Institutions (deposits and other sources). The spread is referred to as
spread income or margin.The spread income should allow the institution to meet operating
expenses and earn a fair profit on its capital.
In generating spread income a depository institution faces several risks, including credit risk,
regulatory risk, and funding (or interest rate) risk.
A. Commercial Bank
Commercial banks represent the largest group of depository institutions measured by asset size.
They perform functions similar to those of savings institutions and credit unions they accept
deposits (liabilities) and make loans (assets).
-Commercial banks are distinguishable from savings institutions and credit unions, however, in
the size and composition of their loans and deposits. Specifically, while deposits are the major
source of funding, commercial bank liabilities usually include several types of non deposit
sources of funds (such as subordinated notes and debentures). Moreover, their loans are
broader in range, including consumer, commercial international, and real estate loans.
Commercial banks are regulated separately from saving institutions and credit unions. Within
the banking industry, the structure and composition of assets and liabilities also vary
significantly for banks of different asset size.

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Department of accounting FBE SDC

Assets :The majority of the assets held by commercial banks are loans. Total loans fell
into four Classes: business or commercial and industrial loans; commercial and residential real
estate loans; individual loans, such as consumer loans for auto purchases and credit card loans;
and all other loans, such as loans to emerging market countries. Investment securities consist of
items such as interest-bearing deposits purchased from other financial institutions, federal
funds sold to other banks, repurchase agreements (RPs or repos), and other debt and equity
securities. Investment securities generate interest income for the bank and are also used for
trading and liquidity management purposes. Many investment securities held by banks are
highly liquid, have low default risk, and can usually be traded in secondary markets. While loans
are the main revenue-generating assets for banks, investment securities provide banks with
liquidity. Unlike manufacturing companies, commercial banks and other financial institutions
are exposed to high levels of liquidity risk. Liquidity risk is the risk that arises when a financial
institution’s liability holders such as depositors demand cash for the financial claims they hold
with the financial institution. Because of the extensive levels of deposits held by banks, they
must hold significant amounts of cash and investment securities to make sure they can meet
the demand from their liability holders if and when they liquidate the claims they hold.
Liabilities and Equity
Commercial banks have two major sources of funds (other than the equity provided by
owners and stockholders): (1) deposits and (2) borrowed or other liability funds. As noted above,
a major difference between banks and other firms is their high leverage or debt-to assets ratio.
Overall, the liability structure of banks’ balance sheets tends to reflect a shorter maturity
structure than that of their asset portfolio. Further, relatively more liquid instruments such as
Deposits and interbank borrowings are used to fund relatively less liquid assets such as loans.
Thus, interest rate risk – or maturity mismatch risk – and liquidity risk are key exposure
Concerns for bank managers.
Commercial bank equity capital consists mainly of common and preferred stock (listed at par
value), surplus or additional paid-in capital, and retained earnings. Because of the relatively low
cost of deposit funding, banks tend to hold equity close to the minimum levels set by regulators.
Balance sheet of commercial bank
Assets Liabilities & Equity
-Loans - Deposits
-Other financial assets -Other liabilities & owner’s Equity

1. Functions of Commercial Banks

 They process payments with the help of online banking, telegraphic transfer, debit card,
and other methods;
 They issue banknotes, such as promissory notes;
 Acceptance of funds on term deposits;
 Issuance of bank checks and bank drafts;
 Offering performance bonds, guarantees, letters of credit, and other types of documents
related to underwriting commitments for securities;
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 Safe custody of important documents and other valuable items in safe deposit vaults or safe
deposit boxes;
Activities and Services of Commercial Banks
Activities of commercial banks can be too much; however, the following are the main
and common activities that are crucial in the economic and commercial system of any
country.
A. Loans and Advances
Commercial Banks gives various types of loans and advances to various business sectors. The
major ones include Domestic trade, Import and export trade, Agriculture, Hotel and tourism,
Manufacturing, Construction, Transport, Services (education, health, etc), and others. Most of
these loans are extended to customers on the basis of collaterals. The commonly acceptable
collaterals are: Buildings/Houses, Motor vehicles, Bank guarantees, and Unconditional Life
Insurance at surrender value.
Types of Credit Facilities
The main forms of credit facilities issued by the Commercial Banks are:
1. Term Loan
A term loan is a loan granted to customers to be repaid with interest within a specific period of
time. The loan can be repaid in periodic installments or in a lump sum on the due date of the
loan, as the case may be. This loan is granted in three forms, i.e., short-term, medium-term and
long-term loan.
Short-term Loan
A short-term loan is a loan that has a maturity period of one year or twelve months from the date
the loan contract is signed. The purpose of the loan is to finance the working capital needs and/or
to meet other short-term financial constraints of customers. Short-term loan may be repaid
monthly, quarterly, semi-annually or annually in a lump sum upon maturity, depending on the
nature of the business and cash-flow statement. The periodic repayment amount incorporates
both principal and interest.
Medium- and Long-term Loan (project loan)
A medium-term loan is a loan which has a maturity period exceeding one year but less than or
equal to five years from the date the loan contract is signed. A long-term loan is a loan that has a
maturity period of five to fifteen years. The purpose of these loans is to finance new projects,
support the expansion of existing projects, investments and meet working capital needs.
Applicants can be either new or existing customers.

B. Import Letter of Credit Facility

A letter of credit (L/C) is an instrument issued by a bank whereby payments in international trade
are effected by banks through documents. It is issued by the Bank at the request of a buyer
(importer) to pay a seller (exporter) upon presentation of import documents specified in the
instrument. A letter of credit facility is a type of credit that a bank avails to importers (applicants)
to pay a certain percentage of the value of the L/C while opening L/C by setting a limit to the
total value of the L/C to be opened. The facility is secured against valid import documents and

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Department of accounting FBE SDC

has a tenor of six months and, in exceptional cases, one year. It alleviates temporary working
capital needs of customers while importing goods.
C. Deposit service:
Accepting deposits is the primary function of a commercial bank. Banks generally accept three
types of deposits (a) Current Deposits (b) Savings Deposits, and (c) Fixed Deposits.
A. Current Deposits: These deposits are also known as demand deposits. These deposits can be
Withdrawn at any time. Generally, no interest is allowed on current deposits, and in case, the
customer is required to leave a minimum balance undrawn with the bank. Cheques are used to
withdraw the amount. These deposits are kept by businessmen and industrialists who receive and
make large payments through Banks. The bank levies certain incidental charges on the customer
for the services rendered by it.
B. Savings Deposits: This is meant mainly for professional men and middle class people to help
them Deposit their small savings. It can be opened without any introduction. Money can be
deposited at anytime but the maximum cannot go beyond a certain limit. There is a restriction on
the amount that can be withdrawn at a particular time or during a week. If the customer wishes to
withdraw more than the specified amount at any one time, he has to give prior notice. Interest is
allowed on the credit balance of this account. The rate of interest is less than that on fixed
deposit. This system greatly encourages the habit of thrift or savings.
C. Fixed Deposits: These deposits are also known as time deposits. These deposits cannot be
withdrawn before the expiry of the period for which they are deposited or without giving a prior
notice for Withdrawal. If the depositor is in need of money, he has to borrow on the security of
this account and pay slightly higher rate of interest to the bank. They are attracted by the
payment of interest which is usually higher for longer period. Fixed deposits are liked by
depositors both for their safety and as well as for their interest. In India, they are accepted
between three months and ten years.
D. Money Transfers
It is a means of transferring funds through banks to individuals or organizations. Users of money
transfer include individuals, workers, students, members, travelers, organizations, private
organizations, cooperatives, public enterprises, and government.
The main features of money transfers include:
 Transfers are made between branches of the bank
 Transfers are made between branches of different cities or towns.
● Availability of telecommunication and local post offices enhances the smooth flow of
transfers between branches.
Credit Unions
Credit Unions are house hold oriented intermediaries, offering deposit and credit services to
individuals and families. They are cooperative, self-help association of individuals rather than
profit motivated institutions accepting deposits from and making loans to their members, all of
whom have a common bond, such as working for the same employer. They offer low loan rates

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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. Credit Unions usually
report low default and delinquency rates and organized around a common affiliate.
They are organized as cooperative depository institutions, much like mutual savings banks.
Depositors are credited with purchasing shares in the cooperative, which they own and operate.
Like savings and loans. Credit unions were originally restricted by law to accepting savings
deposits and making consumer loans. Recent regulatory changes allow them to accept checkable
deposits and make a broader array of loans.
Difference between Credit Unions and Banks
The credit unions are the co-operative financial institutions that are owned by the members of the
union. The major difference between the credit unions and banks is that the credit unions are
owned by the members unlike banks. The policies of credit unions are governed by a volunteer
Board of Directors that is elected by and from the membership itself. This board of directors also
decides on the interest rates to be charged.
According to the regulation of credit unions, only the members of the credit union are eligible to
deposit money in the union or borrow money from the union. The credit unions are always
committed and dedicated to the members and ensure to improve the financial status of the
members. The size of the credit unions may vary in a large manner. There are credits unions
available both with handful of members to thousands of members.

Micro-Finance Institutions
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. They are making small loans available to the poor through schemes
specially designed to meet the Poor’s particular needs and circumstances. The main focus of
micro financing is on the poor through provision of small credit and acceptance of small savings.
Micro-finance clients are typically self-employed, entrepreneurs. In rural areas, they are usually
small farmers and others who are engaged in small income generating activities such as food
processing and petty trade. In urban areas, micro-finance activities are more diverse and include
shopkeepers, service providers, artisans, street vendors, etc.

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Types of Services Provided by Micro-Financing Institutions

Credit provision & saving mobilization are the core financial products /services provided by
MFIs. But there are other services provided by MFI. Micro financial Institutions provide the
Credit provision, Saving mobilization and other types of services:
1. Credit provision (Small size credit/loans) to:
Rural and urban poor households;
Petty traders;
Handcraft producers;
Unemployed youth and women ...etc.
2. Saving mobilization
One of the objectives of MFIs is to encourage the saving habit of the poor society.
3. Other services
Now days, in addition to credit provision and saving mobilization, some MFIS provide
other financial services like local money transfer, insurance and pension fund
administration and short-term training to clients.
 Objectives of the Micro finance Institutions
The goal of MFIs as development organizations is to service the financial needs of un-served or
underserved markets (the poor) as a means of meeting development objectives. The
development objectives generally include one or more of the following:
i. To reduce poverty.
ii. To help existing businesses grow or diversify their activities and to encourage the
development of new businesses.
iii. To create employment and income opportunities through the creation and expansion of
micro enterprise
iv. To increase the productivity and income of vulnerable group, especially women and the
poor.

Distinction between commercial banks and other depository (thrift) institutions

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Area of Commercial Other Depository

Difference
Banks Institutions

Size of Loan Large Small

Composition Diversified and Broader Few

Liabilities Include liabilities other than deposits Principally include deposits

Regulation Stringent Not stringent

2.4.2 Non-depository Institutions of Financial Institutions

In the financial market, there are many types of financial institutions or intermediaries exist for
the flow of funds. Some of them involve in a depositary type of transactions whereas other
involve in a non-depositary type of transactions.
Non-depository institutions are not banks in the real sense. They make contractual arrangement
and investment in securities to satisfy the needs and preferences of investors. The non-depository
institutions include insurance companies, pension funds, finance companies and mutual funds.
 Insurance Companies
Insurance companies are the contractual saving institutions which collect periodic premium from
an insured party and in return agree to compensate against the risk of loss of life and
properties. They pool the small premiums of the insured to pay the larger claims to those who
have losses. The premium payments are regular while the losses are irregular, both in timing and
amount.
 Pension/Provident Funds
Pension funds are financial institutions which accept saving to provide pension and other kinds
of retirement benefits to the employees of government units and other corporations. Pension
funds are basically funded by corporation and government units for their employees, which make
a periodic deposit to the pension fund and the fund provides benefits to associated employees on
the retirement. The pension funds basically invest in stocks, bonds and other type of long-term
securities including real estate.

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 Finance Companies
Finance companies are the financial institutions that engage in satisfying individual credit needs
and perform merchant banking functions. In other words, finance companies are non-bank
financial institutions that tend to meet various kinds of consumer credit needs. They involve in
leasing, project financing, housing and other kind of real estate financing.
 Mutual Funds
Mutual funds are open-end investment companies. They are the associations or trusts of public
members and invest in financial instruments or assets of the business sector or corporate sector
for the mutual benefit of its members. Mutual funds are basically a large public portfolio that
accepts funds from members and then use these funds to buy common stocks, preferred stocks,
bonds and other short-term debt instruments issued by government and corporation.

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