CHAPTER TWO

2. FINANCIAL INSTITUTIONS IN THE FINANCIAL SYSTEM

Learning Objectives:
After completing this chapter, you will be able to:
 Distinguish between depository and non-depository financial system.
 Explain the direct and indirect financing mechanism;
 Identify the properties of financial assets
 Describe the role of financial institutions
 Discus classification of Financial Institutions
 Identify the types of risks related with Financial industry
Financial Institutions and Capital Transfer
Business entities include nonfinancial and financial enterprises. Non-financial enterprises manufacture
products (e.g., cars, steel, and computers) and/or provide nonfinancial services (e.g., transportation, utilities,
computer programming). Financial enterprises, more popularly referred to as financial institutions, are those
organizations, which are involved in providing various types of financial services to their customers and are
controlled and supervised by the rules and regulations delineated by government authorities. Financial
intermediaries are financial institutions that engage in financial asset transformation. 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. Generally, financial institutions provide services related to one or more
of the following:
a) Transforming financial assets acquired through the market and constituting them into a different, and
more widely preferable, type of asset—which becomes their liability. This is the function performed by
financial intermediaries, the most important type of financial institution.
b) Exchanging of financial assets on behalf of customers.
c) Exchanging of financial assets for their own accounts.
d) Assisting in the creation of financial assets for their customers, and then selling those financial assets to
other market participants.
e) Providing investment advice to other market participants.
f) Managing the portfolios of other market participants.
Financial institutions can be either private or public in nature. 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.
The Role of Financial Institutions
We have stressed that financial intermediaries play the basic role of transforming financial assets that are less
desirable for a large part of the public into other financial assets—their own liabilities— which are more
widely preferred by the public. This transformation involves at least one of four economic functions:
 Providing a payment mechanism;
 Providing maturity intermediation;
 Reducing risk via diversification;
 Reducing the costs of contracting and information processing. Each function is described below as
follow:
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Classification of Financial Institutions
Financial institutions are responsible for distributing financial resources in a planned way to the potential
users. There are a number of institutions that collect and provide funds for the necessary sector or individual.
Correspondingly, there are several institutions that act as the middleman and join the deficit and surplus units.
Investing money on behalf of the client is another variety of functions of financial institutions. Basically, the
services provided by the various types of financial institutions may vary from one institution to another.
Broadly speaking, financial institutions are categorized in to two major parts, as follow: Depository financial
institutions and Non-depository financial institutions.
Depository Financial Institutions
Depository institutions are financial intermediaries that accept deposits from individuals and institutions and
make loans. These institutions include commercial banks and the so-called thrift institutions (thrifts):
savings and loan associations, mutual savings banks, and credit unions. The primary functions of financial
institutions of this nature are: Accepting Deposits; Providing Commercial Loans; Providing Real Estate
Loans; Providing Mortgage Loans; and Issuing Share Certificates.
Depository institutions are popular financial institutions for the following reasons: They offer deposit
accounts, they provide loan facilities, they accept the risk on loans provided, they have more expertise and
they diversify their loans among numerous deficit units
A. Commercial Banks: These financial intermediaries raise funds primarily by issuing checkable deposits
(deposits on which checks can be written), savings deposits (deposits that are payable on demand but do
not allow their owner to write checks), and time deposits (deposits with fixed terms to maturity). They
then use these funds to make commercial, consumer, and mortgage loans and to buy government
securities and municipal bonds. They are the largest financial intermediary and have the most diversified
portfolios (collections) of assets.
B. Saving institutions:-These depository institutions include saving and loan associations and mutual saving
banks and they obtain funds primarily through savings deposits (often called shares) and time and checkable
deposits. The basic motivation behind the creation of saving & loans associations was provision of funds for
financing the purchase of home. The collateral for the loans would be the homes being financed. Saving and loans
associations are either mutually owned or have corporate stock ownership. Mutually owned means there is no stock
outstanding, so technically the depositors are the owners. To increase the ability of saving and loans associations to
expand the sources of funding available to bolster/strengthen their capital, legislation facilitated the conversion of
mutually-owned companies in to a corporate stock ownership structure. To sum up, saving and loans associations
offer deposit accounts to surplus units and channel these deposits to deficit units and unlike commercial banks, they
concentrated on residential mortgage loans to the owners (shareholders) of the institutions. Saving banks are
institutions similar to, although much older than, saving and loans associations. They can be either mutually owned
in which case they are called mutual savings banks or stock holder owned. Most savings banks are of the mutual
form. While the total deposits at savings banks are less than saving and loans associations, savings banks are
typically larger institutions. Asset structures of savings banks and saving and loans associations are similar. The
principal source of funds for savings banks is deposits.
C. Credit Unions:-Credit unions are the smallest and the newest of the depository institutions. They are
varying small co-operative lending institutions organized around a particular group and owned by their
members, member deposits are called shares. The distribution paid to members is therefore in the form of
dividends, not interest. Examples of credit unions can be union members, employees of a particular firm.
Credit unions are different from other depository institutions because they: Are non- profit and restrict

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 their funds to provide loans to their members only
2. Non-Depository institutions:-Non-depository financial institutions are intermediaries that cannot accept
deposits but do pool the payments in the form of premiums or contributions of many people and either
invest it or provide credit to others. Hence, non-depository institutions form an important part of the
economy. These non-depository institutions are sometimes referred to as the shadow banking system,
because they resemble banks as financial intermediaries, but they cannot legally accept deposits.
Consequently, their regulation is less stringent, which allows some non-depository institutions, such as
hedge funds, to take greater risks for a chance to earn higher returns. These institutions receive the
public's money because they offer other services than just the payment of interest. They can spread the
financial risk of individuals over a large group, or provide investment services for greater returns or for a
future income. The basic non- depository financial institutions include insurance companies, pension
funds, mutual funds, finance companies, money market mutual funds, etc.
A. Insurance Companies:-The primary function of insurance companies is to compensate individuals and
corporations (policyholders) if perceived adverse event occur, in exchange for premium paid to the insurer
by policyholder. Insurance companies provide (sell) insurance policies, which are legally binding
contracts and promise to pay specified sum contingent on the occurrence of future events, such as death or
an automobile accident. Insurance companies are risk bearers. They accept or underwrite the risk for an
insurance premium paid by the policyholder or owner of the policy. Income of insurance companies is:
 Initial underwriting income (insurance premium)
 Investment income that occur over time
Therefore, profit of insurance companies = (insurance premium + investment income) – (operating expense +
insurance payment or benefits).
Insurance companies can be classified in to life insurance and general (Property-causality) insurance.
 Life insurance companies: Life insurance companies insure people against financial insecurities
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. Because claim payments are more predictable, life insurance companies invest mostly in
long-term bonds, which pay a higher yield, and some stocks.
 Property and Casualty Insurance: These companies insure 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. For this reason,
they use their funds to buy more liquid assets than life insurance companies.
B. Pension Funds:-Pension funds receive contributions from individuals and/or employers during their
employment to provide a retirement income for the individuals. Most pension funds are provided by
employers for employees. The employer may also pay part or all of the contribution, but an employee
must work a minimum number of years to be vested—qualified to receive the benefits of the pension.
Self-employed people can also set up a pension fund for themselves through individual retirement
accounts or other types of programs. While an individual has many options to save for retirement, the
main benefit of government-sanctioned pension plans is tax savings. Pension plans allow either
contributions or withdrawals that are tax-free. As a consequence of the regular contributions and the tax
savings, pension funds have enormous amounts of money to invest. And because their payments are
predictable, pension funds invest in long-term bonds and stocks, with more emphasis on stocks for greater

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 profits.
C. Mutual Funds:-A mutual fund (in US) or unit trust (in UK and India) raise funds from the public and
invests the funds in a variety of financial assets, mostly equity, both domestic and overseas and also in
liquid money and capital market. They are investment companies that pool money from investors at large
and offer to sell and buy back its shares on a continuous basis and use the capital thus raised to invest in
securities of different companies. Mutual funds possess shares of several companies and receive
dividends in lieu of them and the earnings are distributed among the shareholders on a pro-rata basis.
Mutual funds sell shares (units) to investors and redeem outstanding shares on demand at their fair market
value. Thus, they provide opportunity of small investors to invest in a diversified portfolio of financial
securities. Mutual funds are also able to enjoy economies of scale by incurring lower transaction costs
and commission.
Advantage of Mutual Funds
i. Mobilizing small saving
 Direct participation in securities is not attractive to small investors because of some requirements which
are difficult for them.
 Mutual fund mobilizes funds by selling their own shares, known as units. These funds are invested in
shares of different institution, government securities, etc.
To an investor, a unit in a mutual fund means ownership of a proportionate share of securities in the portfolio of a
mutual fund.
ii. Professional management
 Mutual funds employ professional experts who manage the investment portfolio efficiently and
profitably.
 Investors are relived of the emotional stress in buying and selling securities since Mutual fund take care
of this function.
 The professional managers act scientifically at the right time to buy and sell for their client, and
automatic reinvestment of dividends and capital gains, etc.
iii. Diversified investment/reduced risks
 Funds mobilized from investors are invested in various industries spread across the country/globe.
 This is advantage to the small investors because they cannot afford to assess the profitability and
viability of different investment opportunities
 Mutual funds provide small investors the access to a reduced investment risk resulting from
diversification, economies of scale in transaction cost and professional financial management
iv. Better liquidity
 There is always a ready market for the mutual fund units- it is possible for the investors to disinvest
holdings any time during the year at the Net Asset Value (NAV)
 Securities held by the fund could be converted into cash at any time. Thus, mutual funds could not face
problem of liquidity to satisfy the redemption demand of unit holders.
v. Investment protection
 Mutual funds are legally regulated by guidelines and legislative provisions of regulatory bodies (such
as SEC in US, SEBI in India etc.)
vi. Low transaction cost (economy of scale)
 The cost of purchase and sale of mutual funds is relatively lower because of the large volume of money

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 being handled by MF in the capital market (economies of Scale)
 Brokerage fees, trading commission, etc., are lower
 This enhances the quantum of distributable income available for investors
vii. Economic Developments
 Mutual funds mobilize more savings and channel them to the more productive sectors of the economy
 The efficient functioning of mutual funds contributes to an efficient financial system.
 This in turn paves ways for the efficient allocation of the financial resources of the country which in
turn contributes to the economic development.
The investors’ return in the mutual fund includes capital appreciation (capital gain from price appreciation
of the underlying assets), and the income generated by the assets of the fund.
Types of Mutual Funds
Mutual funds can be categorized in to two; open-ended mutual funds and closed-ended mutual funds
1. Open-ended Mutual Funds
Characteristics
• New investors can join the funds at any time.
• A fund (unit) is accepted and liquidated on a continuous basis by mutual fund manager
• The fund manager buys and sells units constantly on demand by investors-it is always open for the
investors to sell or buy their share units.
• It provides an excellent liquidity facility to investors, although the units of such are not listed. No
intermediaries are required. There is a certainty in purchase price, which takes place in accordance
with the declared NAV.
• Investors in Mutual fund own a pro rata share of the overall portfolio, which is managed by an
investment manager of the fund who buys some securities and sells others.
• The value or price of each share of the portfolio is called net asset value (NAV).
• NAV equals the market value of the portfolio minus the liability of the mutual fund divided by the
number of shares owned by the mutual fund investors.
NAV = Market value of portfolio – Liability
Number of shares outstanding
• The NAV is determined only once each day, at the close of the day. For example the NAV for a stock
of a mutual fund is determined from closing stock price for the day. Business publications provide the
NAV each day in their mutual fund.
• All new investments into the fund or withdrawal from the fund during a day are priced at the closing
NAV (investment after the end of the day) and a non-business day are priced at the next day’s closing
NAV)
• The total number of shares in the fund increases if more investments than withdrawals are made
during the day, and vice versa.
• The NAV of a mutual fund may increase or decrease due to an increase or decrease in the price of the
securities in the portfolio
2. Closed-ended Fund
Characteristics
 The shares of a closed-end fund are similar to the shares of common stock of a corporation. The new
shares of a closed-end fund are initially issued by an underwriter for the fund and after the new issue the
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 number of shares remains constant.
 After the initial issue, no sale or purchase of shares are made by the fund company as in open- end funds.
Instead, the shares are traded on a secondary market, either in an exchange or in the over-the-counter
market.
 Since the number of shares available for purchase, at any moment in time, is fixed, the NAV of the fund’s
shares is determined by the underlying shares as well as by the demand for the investment company’s
shares themselves.
 When demand for the investment company’s shares is high, because the supply of shares in the fund is
fixed, the shares can be traded for more than the NAV of the securities held in the fund’s assets portfolio.
In this case the shares said to be trading at a premium; if demand is low, the shares are sold for discount.
The main difference between an open-ended and a closed-ended mutual fund is; the number of shares of an
open-end fund varies because the fund sponsor sells new shares to investors and buys existing shares from
shareholders. By doing so the share price is always the NAV of the fund. In contrast, closed-ended funds
have a constant number of shares outstanding because the fund sponsor does not redeem shares and sell
new shares to investors except at the time of a new underwriting. Thus, supply and demand in the market
determines the price of the fund shares, which may be above or below NAV, as previously discussed.

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. For example, Ford Motor Credit Company makes loans to
consumers who purchase Ford automobiles.
D. Money Market Mutual Funds:-These relatively new 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 then 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.
Risks in Financial Industry
One of the major objectives of a financial institution’s managers is to increase the financial institution returns
for its owners. Increased returns often come at the cost of increased risk, which comes in many forms:

1. Credit Risk (Default Risk): the risk that promised cash flows from loans and securities held by financial
institutions may not be paid in Full. Therefore, financial institutions face credit risk or default risk if their
clients default on their loans and other obligations.
2. Liquidity Risk: the risk that a sudden and unexpected increase in liability withdrawals may require a
financial institution to liquidate assets in a very short period of time and at low prices. They encounter
liquidity risk as a result of excessive withdrawals of liabilities by customers.
3. Interest Rate Risk: the risk incurred by financial institution when the maturities of its assets and
liabilities are mismatched and interest rates are volatile. Financial institutions face interest rate risk
when the maturities of their assets and liabilities are mismatched.
4. Market Risk: the risk incurred in trading assets and liabilities due to changes in interest rates, exchange
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 rates, and other asset prices. They incur market risk for their trading portfolios of assets and liabilities if
adverse movements in the prices of these assets or liabilities occur.
5. Off-Balance -Sheet Risk: the risk incurred by financial institution as the result of its activities related to
contingent assets and liabilities. Modern-day financial institutions also engage in significant amount of
off-balance-sheet activities, thereby exposing them to off-balance-sheet risks —changing values of their
contingent assets and liabilities.
6. Foreign Exchange Risk: the risk that exchange rate changes can affect the value of financial institution’s
assets and liabilities denominated in foreign currencies. If financial institutions conduct foreign business,
they are subject to foreign exchange risk.
7. Country or Sovereign Risk: Business dealings in foreign countries or with foreign companies also
subject financial institutions to sovereign risk. It is the risk that repayments by foreign borrowers may
be interrupted because of interference from foreign governments or other political entities.
8. Technology Risk: the risk incurred by financial institution when its technological investments do not
produce anticipated cost savings.
9. Operational Risk: the risk that existing technology or support systems may malfunction, that fraud
may occur that impacts the financial institution’s activities, and/or external shocks such as hurricanes
and floods occur.
10. Insolvency Risk: the risk that financial institution may not have enough capital to offset a sudden
decline in the value of its assets relative to its liabilities. FIs face insolvency risk when their overall
equity capital is insufficient to withstand the losses that they incur as a result of such risk exposures.
The effective management of these risks—including the interaction among them—determines the ability
of a modern financial institution to survive and prosper over the long run.

QUICK CHECK
1. Distinguish between depository and non-depository financial institutions and identify their category?
2. Explain the different market classifications
3. How money markets differ from capital market?