CHAPTER -2

FINANCIAL INSTITUTIONS IN THE FINANCIAL SYSTEM

A financial institution is an establishment that conducts financial transactions

such as investments, loans and deposits. Almost everyone deals with financial
institutions on a regular basis. Everything from depositing money to taking out
loans and exchanging currencies must be done through financial institutions.
Here is an overview of some of the major categories of financial institutions and
their roles in the financial system.

Commercial Banks

Commercial banks accept deposits and provide security and convenience to their
customers. Part of the original purpose of banks was to offer customers safe
keeping for their money. By keeping physical cash at home or in a wallet, there
are risks of loss due to theft and accidents, not to mention the loss of possible
income from interest. With banks, consumers no longer need to keep large
amounts of currency on hand; transactions can be handled with checks, debit
cards or credit cards, instead.

Commercial banks also make loans that individuals and businesses use to buy
goods or expand business operations, which in turn lead to more deposited
funds that make their way to banks. If banks can lend money at a higher
interest rate than they have to pay for funds and operating costs, they make
money. Banks also serve often under-appreciated roles as payment agents
within a country and between nations. Not only does banks issue debit cards
that allow account holders to pay for goods with the swipe of a card, they can
also arrange wire transfers with other institutions.

Investment Banks

The stock market crash of 1929 and ensuing Great Depression caused the
United States government to increase financial market regulation. The Glass-

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Steagall Act of 1933 resulted in the separation of investment banking from
commercial banking.

Investment banking is the process of raising capital for businesses through public floatation and
private placement of securities. Investment banks work with companies, governments, institutional
investors and wealthy individuals to raise capital and provide investment advice. Originally,
investment banking meant the underwriting and distribution of securities. Today investment
bankers also invest a lot of effort into helping companies design deals and the securities to finance
them, and then use their brokerage arms to sell the securities to the investing public, both retail and
institutional.
The investment banking industry is central to the market-based economy. By bringing together
entities in search of new capital and investors, usually institutional investors, the investment
banking industry play an important intermediation function in all market economies.

While investment banks may be called "banks," their operations are far different
from deposit-gathering commercial banks. An investment bank is a financial
intermediary that performs a variety of services for businesses and some
governments. These services include underwriting debt and equity offerings,
acting as an intermediary between an issuer of securities and the investing
public, making markets, facilitating mergers and other corporate
reorganizations, and acting as a broker for institutional clients. They may also
provide research and financial advisory services to companies. Generally,
investment banks focus on initial public offerings (IPOs) and large public
and private share offerings. Traditionally, investment banks do not deal with the
general public. However, some of the big names in investment banking, such as
JP Morgan Chase, Bank of America and Citigroup, also operate commercial
banks. Other past and present investment banks you may have heard of include
Morgan Stanley, Goldman Sachs, Lehman Brothers and First Boston.

Investment banks are subject to less regulation than commercial banks. While
investment banks operate under the supervision of regulatory bodies, like
the Securities and Exchange Commission, FINRA, and the U.S. Treasury, there

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are typically fewer restrictions when it comes to maintaining capital ratios or
introducing new products.

Insurance Companies

Insurance companies pool risk by collecting premiums from a large group of

people who want to protect themselves and/or their loved ones against a
particular loss, such as a fire, car accident, illness, lawsuit, disability or death.
Insurance helps individuals and companies manage risk and preserve wealth. By
insuring a large number of people, insurance companies can operate profitably
and at the same time pay for claims that may arise. Insurance companies use
statistical analysis to project what their actual losses will be within a given class.
They know that not all insured individuals will suffer losses at the same time or
at all.

Brokerages
A brokerage acts as an intermediary between buyers and sellers to facilitate
securities transactions. Brokerage companies are compensated
via commission after the transaction has been successfully completed. For
example, when a trade order for a stock is carried out, an individual often pays a
transaction fee for the brokerage company's efforts to execute the trade.

A brokerage can be either full service or discount. A full service brokerage

provides investment advice, portfolio management and trade execution. In
exchange for this high level of service, customers pay significant commissions on
each trade. Discount brokers allow investors to perform their own investment
research and make their own decisions. The brokerage still executes the
investor's trades, but since it does not provide the other services of a full-service
brokerage, its trade commissions are much smaller.

Investment Companies

An investment company is a corporation or a trust through which individuals

invest in diversified, professionally managed portfolios of securities by pooling
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their funds with those of other investors. Rather than purchasing combinations
of individual stocks and bonds for a portfolio, an investor can purchase
securities indirectly through a package product like a mutual fund.

There are three fundamental types of investment companies: unit investment

trusts (UITs), face amount certificate companies and managed investment
companies. All three types have the following things in common: An undivided
interest in the fund proportional to the number of shares held

 Diversification in a large number of securities

 Professional management
 Specific investment objectives

Let us take a closer look at each type of Investment Company.

Unit Investment Trusts (UITs)
A unit investment trust, or UIT, is a company established under an indenture or
similar agreement. It has the following characteristics:

 The management of the trust is supervised by a trustee

 Unit investment trusts sell a fixed number of shares to unit holders, who
receive a proportionate share of net income from the underlying trust.
 The UIT security is redeemable and represents an undivided interest in a
specific portfolio of securities.
 The portfolio is merely supervised, not managed, as it remains fixed for the
life of the trust. In other words, there is no day-to-day management of the
portfolio.

Face Amount Certificates

a face amount certificate company issues debt certificates at a predetermined
rate of interest. Additional characteristics include:

 Certificate holders may redeem their certificates for a fixed amount on a

specified date, or for a specific surrender value, before maturity.

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  Certificates can be purchased either in periodic installments or all at once
with a lump-sum payment.
 Face amount certificate companies are almost nonexistent today.

Management Investment Companies

The most common type of Investment Company is the management investment

company, which actively manages a portfolio of securities to achieve its
investment objective. There are two types of management investment
company: closed-end and open-end. The primary differences between the two
come down to where investors buy and sell their shares - in the primary or
secondary markets - and the type of securities the investment company sells.

 Closed-End Investment Companies: A closed-end investment company

issues shares in a one-time public offering. It does not continually offer
new shares, nor does it redeem its shares like an open-end investment
company. Once shares are issued, an investor may purchase them on the
open market and sell them in the same way. The market value of the
closed-end fund's shares will be based on supply and demand, much like
other securities. Instead of selling at net asset value, the shares can sell at
a premium or at a discount to the net asset value.

 Open-End Investment Companies: Open-end investment companies, also

known as mutual funds, continuously issue new shares. These shares
may only be purchased from the investment company and sold back to the
investment company.

Nonbank Financial Institutions

The following institutions are not technically banks but provide some of the
same services as banks.
Savings and Loans

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Savings and loan associations, also known as S & Ls or thrifts, resemble banks
in many respects. Most consumers do not know the differences between
commercial banks and S&Ls. By law, savings and loan companies must have
65% or more of their lending in residential mortgages, though other types of
lending is allowed.

S & Ls emerged largely in response to the exclusivity of commercial banks. There

was a time when banks would only accept deposits from people of relatively high
wealth, with references, and would not lend to ordinary workers. Savings and
loans typically offered lower borrowing rates than commercial banks and higher
interest rates on deposits; the narrower profit margin was a byproduct of the fact
that such S & Ls were privately or mutually owned.

Credit Unions
Credit unions are another alternative to regular commercial banks. Credit
unions are almost always organized as not-for-profit cooperatives. Like banks
and S&Ls, credit unions can be chartered at the federal or state level. Like S&Ls,
credit unions typically offer higher rates on deposits and charge lower rates on
loans in comparison to commercial banks.
In exchange for a little added freedom, there is one particular restriction on
credit unions; membership is not open to the public, but rather restricted to a
particular membership group. In the past, this has meant that employees of
certain companies, members of certain churches, and so on, were the only ones
allowed to join a credit union. In recent years, though, these restrictions have
been eased considerably, very much over the objections of banks.
Shadow Banks
The housing bubble and subsequent credit crisis brought attention to what is
commonly called "the shadow banking system." This is a collection of investment
banks, hedge funds, insurers and other non-bank financial institutions that
replicate some of the activities of regulated banks, but do not operate in the
same regulatory environment.

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The shadow banking system funneled a great deal of money into
the U.S. residential mortgage market during the bubble. Insurance companies
would buy mortgage bonds from investment banks, which would then use the
proceeds to buy more mortgages, so that they could issue more mortgage bonds.
The banks would use the money obtained from selling mortgages to write still
more mortgages.
How Money is Created and Destroyed:
There are three types of money denominated in Euros in the Euro zone:
1. Cash & Coins
Cash and coins are created and issued by the national central banks (NCBs) of
the Euro zone under the approval of the European Central Bank (ECB). The
profit that the NCBs of the 1 In The Treaty on the Functioning of the European
Union (The Lisbon Treaty); Article 128 states that the ‘The ECB shall have the
exclusive right to authorize the issue of euro banknotes within the Union. The
ECB and the NCBs may issue such notes. Euro zone receive from the low-cost
production and sale of cash is known as seignior age. The profits from seignior
age and other activities that the NCBs record are pooled together and
redistributed to the various departments of finance of the governments of the
Euro zone. Seignior age is a source of non-tax revenue and the proportion a
country receives from the ‘profit pool’ depends on its population and its
contribution to GDP. Both factors hold equal weighting. Cash makes up less
than 3% of the Eurozone’s money supply.
2. Reserve-Account-Money
Reserve-account-money is a type of electronic money, created by the NCBs and
used by banks to settle payments with each other. This type of money is only
available to those organizations, which have accounts at the NCBs, i.e. financial
institutions. It is not in general circulation and is not counted as part of the
either the M1, M2 or M3 money supplies of the Euro zone.
3. Bank-Account-Money
The third type of money accounts for approximately 97% of the Euro zone M3
money supply. This money exists as the balance of all current accounts and/or

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savings accounts. However, unlike reserve-account-money and cash, it is not
created by the central bank. Instead, bank-account-money is created by the
commercial banks usually in the process of advancing loans. Today, this type of
money is created electronically by typing a higher bank balance into a borrower’s
account. Prior to computers, banks created the vast majority of money in the
economy by writing a higher bank balance to a loan recipient’s account, which
was recorded on their ledgers.
CREATING RESERVE-ACCOUNT-MONEY AND CASH
Under normal circumstances, reserve-account-money is created by the NCBs of
the Euro zone in order to facilitate payments between the commercial banks. The
ECB ultimately creates very few Euros, printed or otherwise, as it does not create
any bank-account-money
HOW BANKS CREATE AND DESTROY MONEY
This section describes how commercial banks create and destroy bank-account-
money. The main way banks create money is through processing loans. A
customer, who we shall call Joe, walks into AIB and asks to borrow €4. In theory
the bank will check that it has ‘excess’ reserve-account-money such that it can
take on an additional liability of €4 and still meet its minimum reserve
requirements. In practice, it is more likely the bank processes the loan first and
then looks for the additional reserve-account-money afterwards. In any case, Joe
signs 11 Alan Holmes, then Senior Vice President Federal Reserve Bank of New
York (1969) said ‘‘in the real world, banks extend credit, creating deposits in the
process, and look for the reserves later.’’
The Bank of England’s mandate states that ‘‘If there is a shortage of liquidity the
central bank will (almost) always supply the need’’. Victoria Chick (1992) states
‘‘Banks are now able to meet any reasonable rise in the demand for loans.
Deposits will rise as a result and the shortfall of reserves is met by the system’’.
Kydland and Prescott, Federal Reserve Bank of Minneapolis, (1990) state ‘’There
is no evidence that the monetary base or M1 leads the cycle, although some
economists still believe this monetary myth. Both the monetary base and M1
series are generally procyclical and, if anything, the monetary base lags the cycle

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slightly’’. Distayat, Bank for International Settlements, (2010) states, ‘’If anything
the process works in reverse, with loans driving deposits’’. Furthermore Keynes
argued that if the rate of bank lending is similar between all banks in the system
a restraint in reserve-account-money may have no restraint on the creation of
money by banks because the net difference of daily money exchange between
banks can remain the same. ‘It is evident that there is no limit to the amount of
bank money which the contract confirming that he will repay €4 plus interest
over a period of five years. This legally enforceable contract represents a future
income stream for the bank and it will be included as an additional asset on
their balance sheet worth €4. The interest Joe agrees to pay is not recorded on
the bank’s balance sheet. Once the contract is signed, AIB is in a position to
create a liability on itself in the form of an increase in Joe’s current account
balance, thus creating a new ‘deposit’ and brand new money
Why do Banks need Depositors and Savers?
This is an interesting question since banks do not need a depositor or saver
before they can lend money. However, banks need customers and hence they
need depositors to bank with them. Many ‘depositors’ originate through the loan
process also. Banks sometimes encourage customers to open up savings
accounts and they do so to manage the maturity of their liabilities and ‘free up’
some reserve-account-money. If an existing customer the bank opens a savings
account swaps a short-notice liability (the customer’s current account balance)
for a longer term one (the customer’s savings account balance). No money/asset
is created but the bank will know the customer cannot transfer this money for
some time and so no other bank will come looking for a portion of it in reserve-
account-money.
How Banks Destroy Money
It is also the case that when a loan is repaid to a bank the money used to do so
no longer exists. The principle is the same for all electronic money including
reserve-account-money. This section explains it in terms of bank-account-
money. In the example above, Joe borrowed €4 conveniently at 20% interest
such that he ultimately owes €5. For simplicity let's imagine the loan is repaid in

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one lump sum, rather than in installments as is usually the case. Recall the
situation from Box 4 directly after Joe secured the loan: the bank had an
additional asset of €4, which is Joe's promise to repay the loan, and new
liabilities totaling the same amount. Imagine his employer who banks with
National Irish Bank (NIB) pays Joe €6. When Joe’s employer transfers €6 to Joe’s
account, NIB will transfer €6 in reserve-account-money to AIB.

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