TOPIC 5

FINANCIAL INSTITUTIONS

Lecturer: Tran Huu Tuyen

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 CONTENTS

Depository institutions

Contractual saving institutions

Investment intermediaries

Function of financial institutions

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 CLASSIFICATION

FIs

Deposit taking Non-deposit taking

institutions institutions

Contractual Investment
Commercial banks and the
savings Intermediaries
so-called thrift institutions
institutions including finance
(thrifts) such as savings and
such as insurance companies, mutual
loan associations, mutual
companies and funds, and money
savings banks, and credit
pension funds. market mutual
unions.
funds.

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 CLASSIFICATION

Distinguish between deposit-taking and

non-deposit-taking institutions?

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 DEPOSITORY INSTITUTIONS

•Definition: depository institutions are financial intermediaries

that accept deposits from individuals and institutions (which
then become their liabilities) and make loans (which then
become their assets).

•Types:
Commercial Banks

Saving and Loan associations

Mutual Savings banks

Credit Unions

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 DEPOSITORY INSTITUTIONS
BANKS
•A bank is a financial intermediary which holds deposits and
makes loans.
•For most banks, deposits and loans are their core activities
but this is not true for investment banks which are mainly
concerned with securities trading.
•Bank deposits function as money. Thus, a bank failure can have
serious effects and so banks are generally subject to close
regulation.

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 DEPOSITORY INSTITUTIONS
BANKS (Cont.)
A typical bank’s balance sheet

Assets Liabilities

Cash Deposits
Liquid assets Equity
Loans
Other investments
Fixed assets

Bank Assets = Bank Liabilities + Bank Capital

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DEPOSITORY INSTITUTIONS
BANKS (Cont.)

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 DEPOSITORY INSTITUTIONS
SOURCES OF BANK FUNDS
1. Checkable Deposits
a. Demand deposits (non-interest-bearing checking)
b. NOW accounts - interest-bearing checking
c. Money market deposit accounts (MMDAs) - money market mutual funds.

2. Nontransaction Deposits are the Primary source of bank funds

a. Savings accounts (passbook savings)
b. Small-denomination Time Deposits (CDs, certificate of deposits)
c. Large-denomination Time Deposits, over $100,000

3. Borrowings of bank funds:

a. From other banks - Fed Funds Market - to meet reserve requirements
b. From FRS - discount rate - to meet reserve requirements
c. From parent companies - bank holding companies
d. From corporations and from foreign banks - negotiable CDs and Eurodollar
deposits

4. Bank capital: equity from issuing new stock or capital from retained
earnings. Bank capital is also a cushion against a drop in the value of its
assets, to protect against insolvency, bankruptcy.
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 DEPOSITORY INSTITUTIONS
USES OF BANK FUNDS
1. Reserves:
•Deposits kept on account at central bank (all banks have an
account at the central bank)
•Vault cash on hand at bank, stored in the vault overnight.

2. Securities :
3. Loans :
•Most bank profits come from Loans.
a. Commercial loans to businesses
b. Real estate loans (mortgages, home improvement loans, etc.)
c. Consumer loans (credit card, automobiles)
d. Interbank loans
e. Other loans

4. Other Assets: Property, plant and equipment. Buildings, office

equipment, computer systems, etc.

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 DEPOSITORY INSTITUTIONS
BANKS (Cont.)
A typical bank’s income statement
Net interest income
(interest income – interest expense)
Net fees and commissions income
Net trading income
Net investment income
Staff and other admin costs
Amortisation and depreciation
Income before tax
Tax
Profit after tax
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 DEPOSITORY INSTITUTIONS
BANKS (Cont.)

•Deposit institutions base their business on net interest

income: spread (difference) between interest income and
interest expense.

Savers Lend to Lend to Borrowers

BANK
at 2% annual at 5% annual

Interest spread: 5% - 2% = 3%
If total deposits and loans = 1,000,000,000 VND
Net interest income = 3% * 1bn VND = 30,000,000 VND
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 DEPOSITORY INSTITUTIONS
BANKS (Cont.)

•Banks are deposit taking institutions (DTIs) and are also

known as monetary financial institutions (MFIs)
•Monetary financial institutions play a major role in a
country’s economy as their deposit liabilities form a major
part of a country’s money supply and are therefore very
relevant to Governments and Central Banks for the
transmission of monetary policy
•Banks’ deposits function as money; as a consequence an
expansion of bank deposits results in an increase in the stock
of money circulating in an economy
•All other things being equal, the money supply, that is the
total amount of money in the economy, will increase

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 DEPOSITORY INSTITUTIONS
Savings and Loan Associations (S&Ls): has traditionally
specialized in mortgage lending
•Sources of funds: issue deposits.
•Uses of funds: make loans, mainly mortgage loans.
Mutual Savings Banks: like S&Ls, but structured as “mutuals,”
meaning that the depositors own the bank.
•Sources of funds: issue deposits.
•Uses of funds: make loans, mainly mortgage loans.
Credit Unions: Set up to serve small groups: union members,
employees of a particular firm, etc.
•Sources of funds: issue deposits
•Uses of funds: make loans, mainly consumer loans

à S&Ls, mutual savings banks, and credit unions are called

thrift institutions.

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 CONTRACTUAL SAVING INSTITUTIONS
•Definition: contractual savings institutions as a group that
acquire funds at periodic, or regular, intervals on a contractual
basis.

•Types:

Life Insurance Companies

(Long – term insurance companies)

Fire (Property) and Casualty Insurance

Companies (General insurance companies)

Pension Funds

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 CONTRACTUAL SAVING INSTITUTIONS
INSURANCE COMPANIES

•Insurance companies are non-deposit institutions, and

as a result they do not participate in the payments
system.
•Insurance companies carry out the intermediation
function by gathering funds from policy holders
(premiums) and investing them in the capital markets.
•In exchange for the premiums paid, insurance
companies provide policy holders with compensation
should a particular event occur.

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 CONTRACTUAL SAVING INSTITUTIONS
INSURANCE COMPANIES
•Engaged in two distinct forms of business: Long-term (Life-
Insurance) and General Insurance
•All provide insurance against financial loss
•By collecting premiums or contributions from large number
of people

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 CONTRACTUAL SAVING INSTITUTIONS
INSURANCE COMPANIES
v An agreement to compensate policyholders in event of
specified event occurring within a specified time.
v Theft, fire, illness or even death: within year(s), many years
or life time
v Level of premium depends on likelihood or risk of event
occurring, level of compensation or benefit to be paid
vPools of fund invested in earning assets if sufficient funds
available

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CONTRACTUAL SAVING INSTITUTIONS
INSURANCE COMPANIES

https://medium.com
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CONTRACTUAL SAVING INSTITUTIONS
INSURANCE COMPANIES

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 CONTRACTUAL SAVING INSTITUTIONS
PENSION FUNDS
•Receive contributions from employees of companies and
governments.
•Invest money in securities.
•Money is paid back to plan members in the form of
endowments.
•In some countries (e.g. US & UK), the government role in the
pension business is limited. The burden of retirement
planning falls on employees. In other countries (e.g France &
Italy), the government plays an active role.

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 CONTRACTUAL SAVING INSTITUTIONS
PENSION FUNDS

Funded Unfunded

- Contributions invested - PAYG—current employee

in financial assets contribution used to pay pension to
the retired. (Each generation of
workers paying for predecessors’
pension. They hope next generation
- Return intended to exceed pay for theirs. No pool of investible
rate of inflation funds created.
- Risk—not sufficient employees to
-Private sector firms usually pay retired.
funded schemes
- Public sector firms usually
unfunded

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 INVESTMENT INTERMEDIARIES
INVESTMENT COMPANIES

•Finance Companies: specializes in making loans to relatively high-risk

individuals and businesses
oSources of funds: sell commercial paper, stocks, bonds.
oUses of funds: make consumer and business loans.

•Mutual Funds: allow individual investors to pool their resources and

thereby hold a more diversified portfolio of assets with lower transaction
costs.
oSources of funds: sells shares to individuals.
oUses of funds: buy stocks and bonds.
àThe advantage of mutual funds is that the investments are picked by
professionals; they are very diverse so the risk is low, and there is
potential for long term growth.

•Money Market Mutual Funds: are sort of a combination of mutual funds

and depository institutions.
oSources of funds: sell shares to individuals.
oUses of funds: buy money market instruments.
oShareholders can often write checks against the value of their
shareholdings.

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 INVESTMENT INTERMEDIARIES
MUTUAL FUNDS

•Mobilize money by selling units (i.e. shares) to (retail)

investors.
•Invest money in various types of securities.
à ‘Mutual funds’: enable savers to pool their (usually small)
savings on an equal basis in order to invest them in tradable
securities.
•Mutual funds in UK: Unit Trusts and Investment Trusts

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 INVESTMENT INTERMEDIARIES
MUTUAL FUNDS
Advantages of mutual funds compared
to direct individual investments

•Reduce transaction cost: Economies of scale

E.g: Bonds and shares have to be bought through a broker.

The broker will charge a commission which will decrease
with the size of the deal. On a £100,000 purchase it might
charge 0.25% rising to 1% on £10,000 and may be subject to
a minimum, say £25 àthis penalises small transactions.
à By pooling lots of small savings before making large
purchases, the unit trust manager helps reduce transaction
costs.

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 INVESTMENT INTERMEDIARIES
MUTUAL FUNDS
Advantages of mutual funds compared
to direct individual investments

v Reduce risk: portfolio diversification

à the unit trust manager spreads one’s wealth across a range
of risky assets would normally reduce risk relative to the
rate of return.

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 INVESTMENT INTERMEDIARIES
MUTUAL FUNDS

•Open-ended funds
oNew shares or units are issued when investors contribute
more money or existing ones are retired when investors
take money out.
oThe fund value is equal to the current market value of all
its investments.
•Closed-ended funds
oNumber of shares is fixed.
oShares are traded in an exchange whose value can be
above or below the fund’s net asset value.

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 INVESTMENT INTERMEDIARIES
HEDGE FUNDS

•A hedge fund is an investment fund that can undertake a wider

range of investment and trading activities than other funds,
but which is only open for investment from particular types of
investors specified by regulators.

•A private investment fund with large, unregulated pool of

capital and very experienced investors who use a range of
sophisticated strategies to maximize returns—hedging,
leveraging and derivative trading.

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 INVESTMENT INTERMEDIARIES
HEDGE FUNDS

•Is allowed to engage in short-selling

•Can trade in derivatives
•Aims for an absolute positive rate of return whatever the state
of the markets
•Is required to make a little public disclosure of its activities
•Pay its management by results
•Consist of a small group of wealthy investors

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 INVESTMENT INTERMEDIARIES
SECURITIES MARKET INSTITUTIONS

•Specialize in intermediating risks in securities markets

•Types:

Investment Banks

Securities Brokers and Dealers

Organized exchanges

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QUESTION

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 THE FUNCTION OF FIs

Maturity transformation

Size transformation

Risk transformation

Liquidity provision

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 THE FUNCTION OF FIs

• MATURITY TRANSFORMATION: savers generally prefer

investing their money in safe short-term investment
whereas borrowers prefer long-term loans, to finance
their projects.

→ if FIs did not exist, either part (or both) should accept a
non-optimal solution (e.g. borrowers should be satisfied
with short-term loans, or lenders should forego their
money for long periods of time)

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 THE FUNCTION OF FIs

• SIZE TRANSFORMATION: (bank) depositors usually

have small sight/saving accounts in comparison with
loans required by borrowers

→ if FIs did not exist, depositors would have to pool their

funds together to lend them to borrowers

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 THE FUNCTION OF FIs

• RISK TRANSFORMATION: depositors are generally not

willing to take great risks when investing their money;
however, borrowers often look for funds in order to
finance risky projects.

→ if FIs did not exist, many risky (but profitable) projects

would not be implemented. FIs are willing to take the risks
involved in the borrowers’ activities, if an adequate
compensation for taking such risks is provided.

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 THE FUNCTION OF FIs

•LIQUIDITY PROVISION: surplus agents prefer that the assets

they invest in be “liquid”, i.e easily convertible into cash; on the
other hand, borrowers prefer long-term funding to carry out
their projects.
•FIs are able to provide liquidity by maintaining a sufficiently
large number of “lenders” (depositors) and ensuring that
potential withdrawals (outflows) are covered by cash
introduced by new accounts.
→ if FIs did not exist, surplus agents would not be willing to
hold highly illiquid assets to finance borrowers.

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