Chapter 3: Financial Institutions: Deposit Type, Contractual, and Other Financial

Institutions

Financial institutions are the firms that provide access to the financial markets, both to savers
who wish to purchase financial instruments directly and to borrowers who want to issue them.
Because financial institutions sit between savers and borrowers, they are also known as financial
intermediaries, and what they do is known as intermediation. Banks, insurance companies,
securities firms, and pension funds are all financial intermediaries. These institutions are
essential; any disturbance to the services they provide will have severe adverse effects on the
economy. To understand the importance of financial institutions, think what the world would be
like if they didn’t exist. Without an intermediary, individuals and households wishing to save
would either have to hold their wealth in cash or figure out some way

To funnel it directly to companies or households that could put it to use. The assets of these
household savers would be some combination of government liabilities and the equity and debt
issued by corporations and other households. All finance would be direct, with borrowers
obtaining funds straight from the lenders. Such a system would be unlikely to work very well,
for a number of reasons. First, individual transactions between saver-lenders and spender-
borrowers would likely be extremely expensive. Not only would the two sides have difficulty
finding each other, but even if they did, writing the contract to effect the transaction would be
very costly. Second, lenders need to evaluate the creditworthiness of borrowers and then monitor
them to ensure that they don’t abscond with the funds. Individuals are not specialists in
monitoring. Third, most borrowers want to borrow for the long term, while lenders favor more
liquid short-term loans. Lenders would surely require compensation for the illiquidity of long-
term loans, driving the price of borrowing up A financial market could be created in which the
loans and other securities could be resold, but that would create the risk of price fluctuations. All
these problems would restrict the flow of resources through the economy. Healthy financial
institutions open up the flow, directing it to the most productive investments and increasing the
system’s efficiency.

The Role of Financial Institutions:- Financial institutions reduce transactions costs by

specializing in the issuance of standardized securities. They reduce the information costs of
screening and monitoring borrowers to make sure they are creditworthy and they use the

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proceeds of a loan or security issue properly. In other words, financial institutions curb
information asymmetries and the problems that go along with them, helping resources flow to
their most productive uses. At the same time that they make long-term loans, financial
institutions also give savers ready access to their funds. That is, they issue short-term liabilities
to lenders while making long-term loans to borrowers. By making loans to many different
borrowers at once, financial institutions can provide savers with financial instruments that are
both more liquid and less risky than the individual stocks and bonds they would purchase
directly in financial markets.

The Structure of the Financial Industry In analyzing the structure of the financial industry, we
can start by dividing intermediaries into two broad categories called depository and non-
depository institutions. Depository institutions take deposits and make loans; they are what most
people think of as banks, whether they are commercial banks, savings banks, or credit unions.
Non depository institutions include insurance companies, securities firms, mutual fund
companies, hedge funds, private equity or venture capital firms, finance companies, and pension
funds. Each of these serves a very different function from a bank. Some screen and monitor
borrowers; others transfer and reduce risk. Still others are primarily brokers. Here is a list of the
major groups of financial institutions, together with a brief description of what they do.

1. Depository institutions (commercial banks, savings banks, and credit unions) take deposits
and make loans.

2. Insurance companies accept premiums, which they invest in securities and real estate (their
assets) in return for promising compensation to policyholders should certain events occur (their
liabilities). Life insurers protect against the risk of untimely death. Property and casualty insurers
protect against personal injury loss and losses from theft, accidents, and fire.

3. Pension funds invest individual and company contributions in stocks, bonds, and real estate
(their assets) in order to provide payments to retired workers (their liabilities).

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Figure 3.1. Flow of Funds through Financial Institutions

Financial institutions perform both brokerage and asset transformation services. As brokers, they
provide access to financial markets, allowing households and firms to buy and sell direct claims
on other firms and on governments. Institutions transform assets by taking deposits or
investments or issuing insurance contracts to households at the same time that they make loans
and purchase stocks, bonds, and real estate.

4. Securities firms: - include brokers, investment banks, underwriters, mutual-fund companies,

private equity firms, and venture capital fi rms. Brokers and investment banks issue stocks and
bonds for corporate customers, trade them, and advise customers. All these activities give

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customers access to the financial markets. Mutual-fund companies pool the resources of
individuals and companies and invest them in portfolios of bonds, stocks, and real estate. Hedge
funds do the same for small groups of wealthy investors. Customers own shares of the portfolios,
so they face the risk that the assets will change in value. But portfolios are less risky than
individual securities, and individual savers can purchase smaller units than they could if they
went directly to investors: They acquire controlling stakes in a few firms and manage them
actively to boost the return on investment before reselling them. In contrast, most mutual funds
consist of passive investors, who do not seek to influence management.

Figure 3.2 the Simplified Balance Sheet of a Financial Institution

5. Finance companies raise funds directly in the financial markets in order to make loans to
individuals and fi rms. Finance companies tend to specialize in particular types of loans, such as
mortgage, automobile, or certain types of business equipment. While their assets are similar to a
bank’s, their liabilities are debt instruments that are traded in financial markets, not deposits.

6. Government-sponsored enterprises (GSEs) are federal credit agencies that provide loans
directly for farmers and home mortgagors. They also guarantee programs that insure loans made
by private lenders. Aside from GSEs, the government also provides retirement income and
medical care to the elderly through Social Security and Medicare. Pension funds and insurance
companies perform these functions privately.

As we continue our study of the relationship between the financial system and the real economy,
we will return to the importance of financial institutions, the conduits that channel resources
from savers to investors. These intermediaries are absolutely essential to the operation of any
economy. When they cease to function, so does everything else. the measures of money include
checking deposits, savings deposits, and certificates of deposit, among other things. These are all

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important liabilities of banks. Because they are very liquid, they are accepted as a means of
payment. Clearly, the financial structure is tied to the availability of money and credit.

3.1 Deposit type institutions

A financial institution that is legally permitted to solicit and accept monetary deposits from the
general public. Which accepts deposits from surplus units and provides credit to deficit units
through loans and purchase of securities.

Functions of a Depository

1. Serves as a link between public companies and investors/shareholders

A depository functions as a connecting link between the public companies that issue financial
securities, and the investors or shareholders. The securities are issued by agents associated with
depositories, who are known as depository participants. The agents are responsible for
transferring the securities from the depositories to the investors. A depository participant can be
a bank, an institution, or a brokerage.

2. Eliminates risk related to owning physical financial securities

A depository allows traders and investors to hold securities in dematerialized form; thus,
eliminating the risk related to holding physical financial securities. The buyers and sellers now
do not need to check whether the securities have been transferred successfully without any loss
or theft. The depository system reduces such risks by allowing the securities to be held and
transferred in electronic form.

3. Allows the provision of loans of mortgages to interested parties

A depository holds the securities of customers and gives them back when the customers want.
The customers receive interest on the deposits, while the depository earns even more interest by
lending the deposits to other people or businesses in the form of loans or mortgages.

4. Reduced paperwork and accelerates the process of transferring securities

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When a trade occurs, a depository transfers the ownership of securities from the account of one
investor to another. It helps in reducing the paperwork associated with the finalization of a trade
and accelerates the process of transfer of securities.

Types of Depository Institutions

The following are the three main categories of depository institutions:

1. Commercial Banks

A commercial bank is a kind of financial institution that carries all the operations related to
deposit and withdrawal of money for the general public, providing loans for investment, and
other such activities. These banks are profit-making institutions and do business only to make a
profit. The two primary characteristics of a commercial bank are lending and borrowing. The
bank receives the deposits and gives money to various projects to earn interest (profit). The rate
of interest that a bank offers to the depositors is known as the borrowing rate, while the rate at
which a bank lends money is known as the lending rate.es offered by the large banks is the most
diverse among all depository institutions.

Commercial banks offer consumers and small to mid-sized businesses with basic banking
services including deposit accounts and loans.
These banks make money from a variety of fees and by earning interest income from
loans.
Banks have traditionally been located in physical locations, but a growing number now
operates exclusively online.
Commercial banks are important to the economy because they create capital, credit, and
liquidity in the market.

How Commercial Banks Work

Commercial banks provide basic banking services to the general public—to both individual
consumers and small to mid-sized businesses. As mentioned above, these services include
checking and savings accounts, loans and mortgages, basic investment services such as CDs, as

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well as other services such as safe deposit boxes.Banks make money from service charges and
fees. These fees vary based on the products, ranging from account fees (monthly maintenance
charges, minimum balance fees, overdraft fees, non-sufficient funds (NSF) charges), safe deposit
box fees, and late fees. Many loan products also contain fees in addition to interest charges.
Banks also earn money from interest they earn by lending out money to other clients. The funds
they lend comes from customer deposits. However, the interest rate paid by the bank on the
money they borrow is less than the rate charged on the money they lend. For instance, a bank
may offer savings account customers an annual interest rate of 0.25%, while charging mortgage
clients 5.75%in interest annually.

Commercial banks are an important part of the economy. Not only do they provide consumers
with an essential service, but they also help create capital and liquidity in the market. This entails
taking money that their customers deposit for their savings and lending it out to others.
Commercial banks play a role in the creation of credit, which leads to an increase in production,
employment, and consumer spending, thereby boosting the economy. As such, commercial
banks are heavily regulated by central banks. For instance, central banks impose reserve
requirements on commercial banks. This means banks are required to hold a certain percentage
of their consumer deposits at the central bank as a cushion if there's a rush to withdraw funds by
the general public.

Function of Commercial Bank

The functions of commercial banks are classified into two main divisions.

(a) Primary functions

Accepts deposit: The bank takes deposits in the form of saving, current, and fixed deposits.
The surplus balances collected from the firm and individuals are lent to the temporary
requirements of the commercial transactions. There are various products offered by the bank
to the customers for the deposit of their money, which includes savings account, current
account, fixed deposit and recurring deposit.

Provides loan and advances: Another critical function of this bank is to offer loans and
advances to the entrepreneurs and business people, and collect interest. For every bank, it is
the primary source of making profits. In this process, a bank retains a small number of

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 deposits as a reserve and offers (lends) the remaining amount to the borrowers in demand
loans, overdraft, cash credit, short-run loans, and more such banks

Credit cash: When a customer is provided with credit or loan, they are not provided with
liquid cash. First, a bank account is opened for the customer and then the money is
transferred to the account. This process allows the bank to create money.

(b) Secondary functions

Discounting bills of exchange: It is a written agreement acknowledging the amount of money to

be paid against the goods purchased at a given point of time in the future. The amount can also
be cleared before the quoted time through a discounting method of a commercial bank.

Overdraft facility: It is an advance given to a customer by keeping the current account to

overdraw up to the given limit. Purchasing and selling of the securities: The bank offers you with
the facility of selling and buying the securities.

Locker facilities: A bank provides locker facilities to the customers to keep their valuables or
documents safely. The banks charge a minimum of an annual fee for this service.

Paying and gathering the credit: It uses different instruments like a promissory note, cheques,
and bill of exchange

There are three different

types of commercial
banks.
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 Private bank –: It is a type
of commercial banks where
private individuals and
businesses own a majority
of the share capital. All
private banks are recorded
as
companies with limited
liability. Such as Housing
Development Finance
Corporation (HDFC) Bank,
Industrial Credit and

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Investment Corporation of
India
(ICICI) Bank, Yes Bank,
and more such banks.
Public bank –: It is a type
of bank that is nationalized,
and the government holds
a significant stake. For
example, Bank of Baroda,
State Bank of India (SBI),
Dena
Bank, Corporation Bank,
and Punjab National Bank.
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Foreign bank –: These
banks are established in
foreign countries and have
branches in other countries.
For instance, American
Express Bank, Hong Kong
and
Shanghai Banking
Corporation (HSBC),
Standard & Chartered
Bank, Citibank,
and more such banks.
There are three different types of commercial banks.

Private bank –: It is a type of commercial banks where private individuals and businesses own a
majority of the share capital. All private banks are recorded as companies with limited liability.

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Public bank –: It is a type of bank that is nationalized, and the government holds a significant
stake.

2. Credit Unions

Credit unions are financial cooperatives implying that these depository institutions are owned by
members of a particular group. The profits earned are either paid to the members as dividends or
reinvested into the organization. The members of the credit unions are the ones that own
accounts in the institution; hence, the depositors are also partial owners and receive dividends.

Since credit unions are non-profit institutions, they pay no federal or state tax. Hence, the interest
rate charged by credit unions on loans is lower, and they pay a higher interest rate on deposits.

3. Savings Institutions

The banks serving a local community and loan institutions are called savings institutions. The
local residents deposit money in the banks, and their money is offered back in the form of
mortgages, consumer loans, credit cards, and loans for small businesses.

Savings institutions can sometimes be set up as corporations or as financial cooperatives

allowing the depositors to get an ownership share in the organization.

3.2 Contractual saving institutions

Contractual savings institutions, such as insurance companies and pension funds, are financial
intermediaries that acquire funds at periodic intervals on a contractual basis. Because they can
predict with reasonable accuracy how much they will have to pay out in benefits in the coming
years, they do not have to worry as much as depository institutions about losing funds quickly.
As a result, the liquidity of assets is not as important a consideration for them as it is for
depository institutions, and they tend to invest their funds primarily in long-term securities such
as corporate bonds, stocks, and mortgages.

Life Insurance Companies Life insurance companies insure people against financial hazards
following a death and sell annuities (annual income payments upon retirement). They acquire
funds from the premiums that people pay to keep their policies in force and use them mainly to
buy corporate bonds and mortgages. They also purchase stocks, but are restricted in the amount
that they can hold.

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Fire and Casualty Insurance Companies These companies insure their policyholders against loss
from theft, fire, and accidents. They are very much like life insurance companies, receiving funds
through premiums for their policies, but they have a greater possibility of loss of funds if major
disasters occur.

Pension Funds and Government Retirement Funds Private pension funds and state and local
retirement funds provide retirement income in the form of annuities to employees who are
covered by a pension plan. Funds are acquired by contributions from employers and from
employees, who either have a contribution automatically deducted from their paychecks or
contribute voluntarily. The largest asset holdings of pension funds are corporate bonds and
stocks. The establishment of pension funds has been actively encouraged by the federal
government, both through legislation requiring pension plans and through tax incentives to
encourage contributions.

3.3 Investment funds

This category of financial intermediaries includes finance companies, mutual funds, and money
market mutual funds.

Finance Companies; Finance companies raise funds by selling commercial paper (a short-term
debt instrument) and by issuing stocks and bonds. They lend these funds to consumers (who
make purchases of such items as furniture, automobiles and home improvements) and to small
businesses. Some finance companies are organized by a parent corporation to help sell its
product.

Mutual Funds; These financial intermediaries acquire funds by selling shares to many
individuals and use the proceeds to purchase diversified portfolios of stocks and bonds. Mutual
funds allow shareholders to pool their resources so that they can take advantage of lower
transaction costs when buying large blocks of stocks or bonds. In addition, mutual funds allow
shareholders to hold more diversified portfolios than they otherwise would. Shareholders can sell
(redeem) shares at any time, but the value of these shares will be determined by the value of the

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mutual fund’s holdings of securities. Because these fluctuate greatly, the value of mutual fund
shares will, too; therefore, investments in mutual funds can be risky.

Money Market Mutual Funds

A money market fund is a kind of mutual fund that invests in highly liquid, near-term
instruments. These instruments include cash.
These financial institutions have the characteristics of a mutual fund but also function to some
extent as a depository institution because they offer deposit-type accounts. Like most mutual
funds, they sell shares to acquire funds that are then used to buy money market instruments that
are both safe and very liquid. The interest on these assets is paid out to the shareholders. A key
feature of these funds is that shareholders can write checks against the value of their
shareholdings. In effect, shares in a money market mutual fund function like checking account
deposits that pay interest.

Investment Banks; Despite its name, an investment bank is not a bank or a financial
intermediary in the ordinary sense; that is, it does not take in deposits and then lend them out.
Instead, an investment bank is a different type of intermediary that helps a corporation issue
securities. First it advises the corporation on which type of securities to issue (stocks or bonds);
then it helps sell (underwrite) the securities by purchasing them from the corporation at a
predetermined price and reselling them in the market. Investment banks also act as deal makers
and earn enormous fees by helping corporations acquire other companies through mergers or
acquisitions.

3.4 Other types of financial institutions

Market makers are broker-dealer institutions that quote both a buy and sell price for an asset held
in inventory. Such assets include equities, government and corporate debt, derivatives, and
foreign currencies. Once an order is received, the market maker immediately sells from its
inventory or makes a purchase to offset the loss in inventory. The difference in the buying and
selling quotes, or the bid-offer spread, is how the market-maker makes profit. Market makers
improve the liquidity of any asset in their inventory.

Specialized sectoral financiers provide a limited range of financial services to a targeted sector.
For example, leasing companies provide financing for equipment, while real estate financiers

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channel capital to prospective homeowners. Leasing companies generally have two unique
advantages over other specialized sectoral financiers. They are somewhat insulated against the
risk of default because they own the leased equipment as part of their collateral agreement.
Additionally, leasing companies enjoy the preferential tax treatment on equipment investment.

Other financial service providers include brokers (both securities and mortgage), management
consultants, and financial advisors. They operate on a fee-for-service basis. For the most part,
financial service providers improve informational efficiency for the investor. However, in the
case of brokers, they do offer a transactions service by which an investor can liquidate existing
assets.

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