Chapter two

Financial Institutions in the FinancialSystem

2.1 Financial institutions and capitaltransfer

Financial institutions serve as intermediaries by channeling the savings of individuals, business,

and governments into loans and investments. The primary suppliers of funds to financial
institutions are individuals; the primary demanders of funds are firms and governments. The
major financial institutions in the United States are the commercial banks and other savings
institutions, mutual funds, securities firms, insurance companies, and pension funds. Individuals
deposit funds at commercial banks, which use the deposited funds to provide commercial loans
to firms and personal loans to individuals, and purchase debt securities issued by firms or
government agencies. Commercial banks act as intermediaries by consolidating small deposits of
individuals into large loans for firms, and by assessing the creditworthiness of the firms wishing
to borrow funds and diversifying the loans across several borrowers on behalf of the depositors.
Because of their unique position in the economy, banks are regulated (by the Federal Deposit
Insurance Corporation, the Federal Reserve Board, and others) to help promote competition
among banking institutions and to limit the risks banks take on.

2.2 Functions of Financial Institutions

The major role of financial institution is in facilitating the flow of funds from individual surplus
units (investors) to deficit units.Three different flows of funds from surplus units to deficit units
are
a) One set of flows represents deposits from surplus units that are transformed by
depository institutions into loans for deficit units.
b) A second set of flows represents purchases of securities (commercial paper) issued by
finance companies that are transformed into finance company loans for deficit units.
c) A third set of flows reflects the purchases of shares issued by mutual funds, which are
used by the mutual funds to purchase debt and equity securities of deficit units.
The deficit units also receive funding from insurance companies and pension funds. Because
insurance companies and pension funds purchase massive amounts of stocks and bonds, they
finance much of the expenditures made by large deficit units, such as corporations and
government agencies. Financial institutions such as commercial banks, insurance companies,
mutual funds, and pension funds serve the role of investing funds that they have received from
surplus units, so they are often referred to as institutional investors. Financial institutions provide
one or more the following services
Transform financial assets acquired through the market and constitute them in to a
different and more widely preferable type of asset, which becomes their liability. This is
performed by financial intermediaries, the most important type of financial institutions.
Exchange of financial assets on behalf of customers.
 Exchange of financial assets for their accounts.
Assist in the creation of financial assets for their customers and then sell those financial
assets to other market participants.
Provide to other market participants.
Manage portfolios of other market participants.

2.3 Financial intermediaries and their roles

Financial intermediaries are financial institutions that engage in financial asset transformation.
That is, financial intermediaries purchase one kind of financial asset from borrowers -- generally
some kind of long-term loan contract whose terms are adapted to the specific circumstances of
the borrower (e.g., a mortgage) -- and sell a different kind of financial asset to savers, generally
some kind of relatively liquid claim against the financial intermediary (e.g., a deposit account).
Financial intermediaries typically hold financial assets as part of an investment portfolio rather
than as an inventory for resale. In addition to making profits on their investment portfolios,
financial intermediaries make profits by charging relatively high interest rates to borrowers and
paying relatively low interest rates to savers.

2.4 Classifications of Financial Institutions

Financial intermediaries include: Depository Institutions (commercial banks, savings and loan
associations, mutual savings banks, credit unions); Contractual Savings Institutions (life
insurance companies, fire and casualty insurance companies, pension funds, government
retirement funds); and Investment Intermediaries (finance companies, stock and bond mutual
funds, money market mutual funds).

 Depository financial institutions

Depository institutions accept deposits from surplus units and provide credit to deficit units
through loans and purchases of securities. They 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 and maturity
desired by deficit units.
They accept the risk on loans provided.
They have more expertise than individual surplus units in evaluating the creditworthiness
of deficit units.
They diversify their loans among numerous deficit units and therefore can absorb
defaulted loans better than individual surplus units could.A more specific description of
each depository institution’s role in the financial markets follows.
Commercial Banks: In aggregate, commercial banks are the most dominant depository
institution. They serve surplus units by offering a wide variety of deposit accounts, and they
transfer deposited funds to deficit units by providing direct loans or purchasing debt securities.
Commercial bank operations are exposed to risk because their loans and many of their
investments in debt securities are subject to the risk of default by the borrowers. The federal
funds market facilitates the flow of funds between depository institutions (including banks). A
bank that has excess funds can lend to a bank with deficient funds for a short term period, such
as one to five days. In this way, the federal funds market facilitates the flow of funds from banks
that have excess funds to banks that are in need of funds.

Savings Institutions: Savings institutions, which are sometimes referred to as thrift institutions,
are another type of depository institution. Savings institutions include savings and loan
associations (S&Ls) and savings banks. Like commercial banks, savings institutions offer
deposit accounts to surplus units and then channel these deposits to deficit units. Savings banks
are similar to S&Ls except that they have more diversified uses of funds. Over time, however,
this difference has narrowed. Savings institutions can be owned by shareholders, but most are
mutual (depositor owned). Like commercial banks, savings institutions rely on the federal funds
market to lend their excess funds or to borrow funds on a short-term basis.
Whereas commercial banks concentrate on commercial (business) loans, savings institutions
concentrate on residential mortgage loans.

Credit Unions: Credit unions differ from commercial banks and savings institutions in that they
(1) are nonprofit and (2) restrict their business to the credit union members, who share a common
bond (such as a common employer or union). Like savings institutions, they are sometimes
classified as thrift institutions in order to distinguish them from commercial banks. Because of
the “common bond” characteristic, credit unions tend to be much smaller than other depository
institutions. They use most of their funds to provide loans to their members.

 Non-depository institutions

Non depository institutions generate funds from sources other than deposits but also play a major
role in financial intermediation.
Finance Companies: Most finance companies obtain funds by issuing securities and then lend
the funds to individuals and small businesses. The functions of finance companies and depository
institutions overlap, although each type of institution concentrates on a particular segment of the
financial markets.
Mutual Funds: Mutual funds sell shares to surplus units and use the funds received to purchase
a portfolio of securities. They are the dominant non depository financial institution when
measured in total assets. Some mutual funds concentrate their investment in capital market
securities, such as stocks or bonds. Others, known as money market mutual funds, concentrate in
money market securities. Typically, mutual funds purchase securities in minimum denominations
that are larger than the savings of an individual surplus unit. By purchasing shares of mutual
funds and money market mutual funds, small savers are able to invest in a diversified portfolio of
securities with a relatively small amount of funds.
Insurance Companies: Insurance companies provide individuals and firms with insurance
policies that reduce the financial burden associated with death, illness, and damage to property.
These companies charge premiums in exchange for the insurance that they provide. They invest
the funds received in the form of premiums until the funds are needed to cover insurance claims.
Insurance companies commonly invest these funds in stocks or bonds issued by corporations or
in bonds issued by the government. In this way, they finance the needs of deficit units and thus
serve as important financial intermediaries. Their overall performance is linked to the
performance of the stocks and bonds in which they invest.

Pension Funds: Many corporations and government agencies offer pension plans to their
employees. The employees and their employers (or both) periodically contribute funds to the
plan. Pension funds provide an efficient way for individuals to save for their retirement. The
pension funds manage the money until the individuals withdraw the funds from their retirement
accounts. The money that is contributed to individual retirement accounts is commonly invested
by the pension funds in stocks or bonds issued by corporations or in bonds issued by the
government. Thus pension funds are important financial intermediaries that finance the needs of
deficit units.

2.5 Risks in Financial Industry

A depository institution seeks to earn a positive spread between the assets in which it invests
(loan and securities) and the cost of its funds (deposits and other sources). The spread is referred
to as spread income or margin. The spread income allows 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,
also called default risk, refers to the risk that a borrower will default on a loan obligation to the
depository institution or that the issuer of a security that a depository institution holds will
default on its obligation. Regulatory risk is the risk that regulators will change the rules and the
earnings of institutions unfavorably.
Funding risk
Funding risk can be explained best by illustration. Suppose that a depository institution raises
$100 million by issuing a deposit with a maturity of 1 year and by agreeing to pay an interest rate
of 7%. Ignoring for the time being the fact that the depository institution cannot invest the entire
$100 million because of the reserve requirements, which we discuss later in this chapter, suppose
that $100 million is invested in U.S. government security that matures in 15 years, paying an
interest rate of 9%. Because the funds are invested in U.S. government security, the depository
institution faces no credit risks in this case.
At first, the depository institution appears to lock in a spread of 2% (9%-7%). This spread can be
counted on only for the first year, though, because the spread in future years depends on the
interest rate this depository institution will have to pay depositors in order to raise $100 million
after the 1- year time deposit matures. If interest rates decline, the spread increases because the
depository institution locked in the 9% rate. If interest rates rise, however, spread income
declines. In fact, if this depository institution must pay more than 9% to depositors at any time
during next 14 years, the spread becomes negative. That is it costs the depository institution
more to finance the government securities than it earns on the funds invested in those securities.
In our example, the depository institution borrowed short (borrowed for 1 year) and lend long
(invested for 15 years). This policy benefits from a decline in interest rates and suffers if interest
rate rises. Suppose the institution could borrow funds 15 years at 7% and invested in U.S
government security maturing in 1 earning 9% that is borrow long (15 years) and loan short(1
year). A rise in interest rate benefits the depository institution because it can then reinvest the
proceeds from the maturing 1-year government security in a new 1-yeargovernment security
offering a higher interest. In this case a decline in interest rates reduces the spread. An interest
rate falling below 7% results in a negative spread.
All depository institution faces this funding problem. Managers of adepository institution with
particular expectations about the future direction of interest rates will seek to benefit from these
expectations. Those who expect interest rates to rise may pursue a policy to borrow funds for a
long time horizon (borrow long) and lend funds for a short time horizon (lend short).if interest
rates are expected to drop; managers may elect to borrow short and lend long. The problem of
pursuing a strategy of positioning a depository institution based on expectations is that
considerably adverse financial consequences will result if those expectations are not realized.
The evidence on interest rate forecasting suggests that it is risky business. No manager of a
depository institution can accurately forecast interest rate moves consistently the institution can
benefit in the long run.
Funding risk exposure is inherent in any balance sheet of adepository institution. Managers must
be willing to accept some exposure, but they can take various measures to address the interest
rate sensitivity of the institutions liabilities and its assets. The asset/liability committee of
depository institution assumes a responsibility for monitoring the interest rate risk exposure.