CHAPTER –TWO

Financial Institutions and

operations
 Chapter outline
 Introduction
 Role of Financial Institutions
 Functions of Financial Institutions
 Types of financial institutions
 Central banks and Its role
 Deposit taking institutions
 Non deposit taking institutions
 Risk management and financial institutions
Introduction

 Financial system is composed of Financial

institutions, Financial markets, Financial
Instruments and Financial services.
 The first constituents of the financial system
comprises of financial institutions or financial
intermediaries.
 They act as a link between the savers and the
investors which results in institutionalization of
personal savings.
 Introduction
 The term financial institutions and financial
intermediaries are often used interchangeably.
 The financial institutions or intermediaries are
engaged in the business of channeling money from
savers to borrowers.
 This channeling process, which is known as financial
intermediation, is crucial to a well functioning of
modern economy
 Functions/Roles of financial institutions
 Mobilize savings in a financial form by offering instruments
with attractive yields and appropriate maturities that
people want to acquire.
 It can increase the efficiency of investment by screening
project proposals and by monitoring the behaviour of
borrowers and issuers of equity.
 Provision of finance for medium or long term projects
 Promotion of investment of public and private capital for
development of the projects in line with the national
development objectives
 Functions/Roles of financial institutions
 Provision of technical assistance to help prepare, finance
and carryout development projects and programmes
 It can provide ways of pooling and pricing risks that enable
large and high risk activities to be undertaken. Hence it
affects risk sharing between households and firms.
 It also reduces the transaction costs of market economy by
providing a convenient and cheap medium of exchange-
making it easier for both buyers and sellers to engage in
business.
 Functions/Roles of financial institutions
 Financial services allow the poor to convert flows of savings
overtime into lump sums that can be used not only for
investment to generate income but also to reduce
vulnerability to shocks, cover lifecycle needs and acquire
useful consumer durables.
 Promotion of national saving
 Promotion of capital investment and others.
 In general they provide both financial and non financial
services like appraisal, implementation, monitoring of
projects and training entrepreneurs and the like.
 Functions/Roles of Financial Institutions
 Within the main functions of channeling funds from savers
to borrowers, financial institutions perform five important
functions.
1. Pooling the savings of individuals
2. Providing safekeeping and payments system
3. Providing liquidity
4. Reducing risk by diversifying
5. Collecting , processing and providing information
 Cont’d
1. Pooling the savings of individuals
 Small savers may not have enough money individually to
make large loans or buy bonds, but through the bank they
can indirectly invest in loans, bonds, and other assets and
earn better rates of interest than they could on their own.
2. Providing safekeeping and payments system
 Financial institutions (e.g. banks) are safe places to deposit
money and other valuables and facilitate the transfer and
payment of money.
 Cont’d
3. Providing liquidity
 Liquidity refers to the ability of the financial assets to be
converted in to cash.
 Therefore, financial institutions facilitate liquidity.
4. Reducing risk by diversifying
 When financial institutions pool the savings of individuals,
they invest them in a wide variety of loans, bonds, and
other assets.
 Cont’d
5. Collecting , processing and providing information
 Financial institutions have a much easier time than
individuals do when it comes to screening out bad credit
risks and monitoring loans for complains.
 This is because financial institutions have a wealth of
information about current and past applicants, as well as
standardized procedures for evaluating creditworthiness.
 In the subsequent sections we will discuss the types of
financial institutions.
Types of Financial Institutions

Financial institutions can be classified in different ways . For

Instance they can be classified as:

1. Central banks
2. Depository Institutions
3. Non-depository Institutions
 1. Central Banks
 Nature of Central Banks:
 A central bank, reserve bank, or monetary authority is a
banking institution granted with the exclusive privilege
to lend a government its currency.
 A central bank is the apex bank in a country. It is called by
different names in different countries:
 The bank of England
 Reserve bank of India,
 The Federal Reserve System in America
 The Bank of France in France
 National Bank of Ethiopia in Ethiopia
 State Bank of Pakistan
 Functions of Central Bank

1. Regulator of currency
2. Banker, Fiscal Agent and Advisor to the Government
3. Custodian of Cash reserve of Commercial Banks
4. Custody and Management of Foreign Exchange Reserves
5. Lender of Last resort
6. Clearing House for transfer and settlement
7. Controller of Credit
 1. Regulator of currency
 It is the bank of issue. It has monopoly power to issue
currency notes (legal tender money)
 This monopoly of issuing notes has the following benefits:
 Uniformity in the notes issued which helps in facilitating

exchange and trade.

 Enhances stability in the monetary system and creates

confidence among the public

 The central bank can restrict or expand the supply of

cash according to the requirement of the economy

2.Banker, Fiscal Agent and Advisor to the
Government
 As banker to the government the central bank:
 keeps the deposits of the government and makes

payment on behalf of the government (state and/or

central)
 It buys and sells foreign currency on behalf of the

government
 It keeps the stock of gold of the government
 Thus, it is the custodian of government money and

wealth.
2. Banker, Fiscal Agent and Advisor to the Gov’t
….Cont’d
 As fiscal agent of the gov’t, Central bank:
 Makes short term loans to the gov’t
 It floats loans, pays interest on them, and finally repays

them on behalf of the gov’t

 Thus, it manages the entire public debt
2. Central Bank as Banker, Fiscal Agent and
Advisor to the Gov’t ….Cont’d
 As Advisor of the gov’t the central bank
 Advises the gov’t on such issues as

 economic and monetary matters as controlling inflation

or deflation,
 devaluation or revaluation of the currency,
 Deficit financing
 Balance of payment etc
3. Custodian of Cash Reserve Requirement
of Comm. Banks
 Commercial banks are required to keep reserve equal to
a certain percentage of deposits with the Central bank.
 It is on the basis of these reserves that central bank
transfers funds from one bank to another to facilitate
clearing of checks.
 The central bank acts as the custodian of the cash
reserve requirement of commercial banks and helps in
facilitating their transactions.
 4.Custody and Mgt of Foreign Exchange

 It keeps and manages the foreign exchange reserve of the

country
 It sells gold at fixed price to the monetary authority of
other countries
 It buys and sells foreign currencies at international prices
 It fixes the exchange rates within narrow limits in keeping
its obligation as a member of IMF
 It manages exchange control operations by supplying
foreign currencies to importers and persons visiting foreign
countries on business, studies, etc in keeping with the rules
laid down by the gov’t
 5.Central Bank Lender of Last resort
 As lender of last resort, the central bank grants
accommodations in the form of re-discounts and
collateral advances to commercial banks, bill brokers,
dealers, or other financial institutions
 This facilities help such institutions in order to help them
in times of stress so as to save financial structure of the
country from collapse.
 6. Clearing House for transfer and settlement

 It acts as a clearing house for transfer and settlement of

mutual claims of commercial banks
 7. Controller of Credit
 This is the most important function of central bank in order
to control inflation and deflation.
 It adopts quantitative and qualitative methods
 Quantitative methods aim at controlling the cost and
quantity of credit by adopting:
 Bank rate policy
 Open market operation and
 By variation in reserve ratio of commercial banks
 7. Controller Of Credit…. Cont’d

 Qualitative methods control the use and direction of credit.

 These involve:
 Selective credit control
 Direct action
 7. Controller of Credit…. Cont’d
 Additional controlling functions of Central banks include
the supervising and controlling of commercial banks:
 Issue of licences
 The regulation of branch expansion
 To see that every bank maintains the minimum paid up

capital and reserve as provided by law

 Inspection or auditing the accounts of banks
 7.Controller of Credit…. Cont’d
 To approve the appointment of chairpersons and
directors of such banks in accordance with the rules and
qualifications
 To control and recommend merger of weak banks in
order to avoid their failures and to protect interest of
depositors
 To recommend nationalization or privatization of certain
banks to the government in public interest
 To publish periodical reports relating to different aspects
of monetary and economic policies
 Central Bank and objectives of Credit Control

 The credit control is the means to control the lending policy

of Commercial banks by the central bank to achieve the
following objectives
 To stabilize the internal price level
 To stabilize the rate of foreign exchange
 To protect the outflow of gold
 To control business cycles
 To meet business needs
 To have growth with stability.
 Monetary Policy (MP)
 Definition of Monetary policy (MP):
 MP refers to credit control measures adopted by central
banks of a country
 MP refers to a policy employed by central bank to control
the supply of money as an instrument for achieving the
objective of general economic policy.
 MP is any conscious action undertaken by the monetary
authorities to change the quantity, availability, or cost of
money
 Objectives of MP
 The following are the Principal objectives of Monetary
Policy:
1. Price Stability
2. Economic Growth
3. Balance of Payment
4. Full Employment
1. Price Stability objective of Central Banks
 Price Stability means relative controlling of inflation or
deflation.
 Deflationary price level raises increasing unemployment
and falling level of out put and income. It ultimately leads
to depression.
 Inflation is unjust and ruins the general economic welfare
of the community.
 Hence both deflation and inflation are not good for the
economy, price stability is very much important.
 Price Stability objective of Central Banks
(cont’d)

 The goal of price stabilization implies that in general the

average price level as measured by the whole sale price
index or consumers’ price index should not be allowed to
vary beyond narrow margins.
 2. Economic Growth Objective
 Economic growth can be defined as the process whereby
the real per capita income of a country increases over a
long period of time.
 It is measured by the increase in the amount of goods
and services produced in a country.
2. Economic Growth Objective… Cont’d

 How Monetary Policy contribute to Economic Growth?

 Through:
 Management of Aggregate Demand
 Encouragement of saving and Investment
 3. Balance of Payment objective

 A balance of payment deficit is defined an excess of import

over export; and outflow of foreign currency will be more
than the inflow of currency).
 In this case the monetary policy might be adjusted to
improve exports and restrict important and even measures
might be taken to the extent of adjusting the exchange
rate.
 4. Full Employment Objective

 Full employment is a situation in which every body who

wants to work gets work.
 It should be noted that full employment is not an end in
itself. It is a precondition for maximum social welfare.
 Along with the full employment of labor, other economic
resources must be used with maximum efficiency and
productivity.
 Instruments of Monetary policy

 The monetary authority uses different instruments to

achieve the objectives of MP of the country. They are
divided in to two categories:
 1 Quantitative, general or indirect includes:
 Bank rate variations,
 Open market operations, and
 Changing reserve requirements.
 They are meant to regulate the overall level of credit in

the economy provided through commercial banks.

 Instruments of MP…Cont’d

2. Qualitative, selective or direct mechanisms: These

include changing margin requirement, and regulation of
the direction of credit of flow).
 They aim at controlling specific types of credit.
 These controls are used to influence specific types of
credit for particular purpose.
 When there is brisk speculative activity in the economy
or in particular sector in certain commodity, and prices
are rising, the NB raises margin loans against specified
securities. The result is that the borrowers are given
less money in loans against specific securities.
 1. Bank rate Policy
 The bank rate is the minimum lending rate of the central
bank at which it rediscounts the bill of exchange and
government securities held by Commercial Banks (CBs).
 When there is inflation in the economy the central bank
raises the bank rate to restrict the borrowing demand of
commercial banks.
 Borrowing from the Central bank becomes costly and
commercial banks borrow less from it.
 The Commercial Banks in turn raise their lending rate to
the business communities and borrowers borrow less
from CBs.
 Thus this will lead to contraction of credit and prices are
checked from rising further
 1. Bank rate Policy

 When prices are depressed, the central bank lowers the

bank rate:
 It is cheap to borrow from national bank (NB) on the part

of the CBs.
 The latter also lower their lending rates.
 Business people are encouraged to borrow more.
 Investment is encouraged.
 Output, employment, income and demand start rising

and the downward movement of prices is checked.

 2. Open Market Operation
 Open market operation refers to sale and purchase of
securities in the money market by central bank.
 With rising price (inflation), the National bank sells
securities. The reserve of Commercial banks are reduced
and they are not in a position to lend more to business
people. Further investment is discouraged and the rise in
prices is checked.
 When recessionary forces start in the economy, the
National bank buys securities. The reserves of
Commercial banks are raised. They lend more.
Investment, output, income and demand rise, and fall in
price is checked.
 3. Change in reserve ratio

 Every bank is required by law to keep a certain percentage

of its total deposits in the form of a reserve fund with the
central bank (NB).
 For instance, when prices are rising, the NB raises the

reserve ratio. Banks are required to keep more with the

central bank. Their reserves are reduced and they lend
less. The volume of investment, output, and employment
are adversely affected
 Types of financial institutions

 Financial institutions can be classified in many different

ways. The standard classification, however, will be as
follows:

Depository Institutions Non-Depository Institutions

Commercial Banks Insurance Companies
Savings and Loan Associations Pension Funds
Saving Banks Investment Companies
Credit Unions Investment Banking firms
 2. Depository Institutions (DIs)

 Next to central banks ,the second category of financial

institutions are depository institutions.
 Depository financial institutions can be further classified
as follows: These are:
1. Commercial Banks
2. Savings and Loan Associations
3. Saving Banks
4. Credit Unions
 2. Depository Institutions (DIs)

 DIs accept deposits from economic agents (liability to

them) and then lend these funds to make direct loans or
invest in securities (assets)
 Income of DIs:
 Income generated from loans
 Income generated from investment in securities, and
 Fee income
 2. Depository…
 Depository institutions, which are usually just called
banks, are categorized as such because their primary
source of funding is the deposits of savers.
 In other words, depository institutions are financial
intermediaries that accept deposits.
 These deposits are the liabilities (debts) of accepting
financial institutions.
 With the fund raised through deposits and other funding
sources, they make direct loans to various entities and
invest in securities.
 Depository …
 In U.S.A., the Federal Deposit Insurance Corporation
(FDCI) insures the savings accounts of such institutions
up to a certain limit.
 Depository institutions are further subcategorized
depending on the market they serve, their primary
source of funding, type of ownership, how they are
regulated and the geographic extent of their market.
 Thus, depository institution includes commercial banks,
saving and loan associations, saving banks and credit
union.
 Depository …
 Depository institutions are highly regulated because of
the important role that they play in the financial system.
 Because of their important role, they are affording
special privileges such as:
 access to federal deposit insurance, and
 access to a government entity that provides funds for
liquidity of emergency needs.
 Constituents of DIs

 DIs include:
 Commercial Banks
 Saving and loan associations
 Saving Banks
 Credit unions
 Asset/ Liability Problems of DIs
 Spread Income (margined Income)=
 Income from loan and Investment Less cost of its funds

(deposit and other sources)

 Asset/ Liability Problems of DIs (Cont’d)

 DIs face the following risks:

 Credit (Default) risk
 Regulatory risk
 interest rate risk)
 Risks of DI

 Credit risk (Default risk) refers to the risk that a

borrower will default on a loan obligation or that the
issuer of the security that the DIs holds will default
 Regulatory risk is the risk that regulators will change
the rules and affect the earnings of the institutions
unfavourably
 Interest rate risk is the risk that the interest rate
movement may move in such a manner that profits will
be adversely affected
 Example of funding risk

 Suppose a DI raise $100 million by issuing a deposit

account with a 1 year maturity and agreeing to pay
interest rate of 7%. Ignoring the reserve requirement,
let’s assume that the DI can invest the entire amount, in
a government security at 9% interest rate for 15 years
 Thus spread for the first year = 2%
 Example (cont’d)

 Spread for the remaining 14 years depends on the future

interest rate that DI pays for its new depositors in order to
raise the $100 million:
 If interest rate increases, spread declines
 If interest rate decreases, spread increases
 If the DI must pay more than 9%, the spread will be
negative.
 DI benefit from decline in interest rate but suffers from
increases
 Example (cont’d)

 Suppose the DI could borrow funds for 15 years at 7% and

invest it in a government security maturing in 1 year
earning 9%:
 Spread income for Year 1= 2%.
 Note that the deposit interest rate is fixed in this case,
while the investment in gov’t securities could vary.
 Spread after the first year:
 If interest rate on investment increases, DI benefit
 If interest rate on investment declines, spread reduces
 Example (cont’d)
 Justification:
 A rise in interest rate benefits the DI b/s it can reinvest

the proceeds from the maturing 1-year government

security offering a higher interest rate.
 A. Commercial Banks

 Com. Banks are those FIs which accept deposit from the
public repayable on demand and lend them for short
periods
 Bank Services
 Commercial banks provide numerous services in the
financial system.
 The services can be broadly classified as:
1. Individual banking;
2. Institutional banking; and
3. Global banking.
 1. Individual banking:
 It encompasses consumer lending, residential mortgage
lending, consumer installment loans, credit card financing,
student loan & individual oriented financial investment
service.
 They generate income:
 Interest from loans
 Fee income from credit card financing
 2. Institutional banking:
 loans to non-financial corporations & financial
corporations (like insurance companies), government,
leasing companies etc.
They generate:
 Interest from loan to corporation & leasing
 Fees from management of private assets pension funds,
custodial services.
 3. Global banking:
 It concerns a broad range of activities involving corporate
financing & capital market & foreign exchange products
& services.
 Most global banking generates fee income rather than
interest income.
 Bank Balance Sheet

1. Bank Assets
 Assets earn revenue for the bank and includes cash,
securities, loans, and property and equipment that
allows it to operate.
A. Cash
 One of the major services of a bank is to supply cash on
demand, whether it is a depositor withdrawing money
or writing a check or a bank customer drawing a credit.
 Hence, a bank must maintain a certain level of cash
compared to its liabilities to maintain solvency.
 Bank Balance Sheet

B. Securities
 The primary securities that banks own are Treasury
Bills and Government Bonds.
 These securities can be sold quickly in the

secondary market when a bank needs more cash.

 Therefore, they are often referred to as secondary

reserves.
 Bank Balance Sheet

C. Loans
 Loans are the major assets for most banks. They earn more
interest than banks have to pay on deposits, and, thus, are
a major source of revenue for a bank.
 Loans include the following major types:
 Business loans, usually called commercial and industrial
loans.
 Real estate loans, e.g., residential mortgages
 Consumer loans, e.g., credit cards
 Inter-bank loans, i.e., the loan given to other banks.
 Bank Balance Sheet

2. Bank Liabilities
 Liabilities are either the deposits of customers or
money that banks borrow from other sources to use
to fund assets that earn revenue.
A. Checkable/Demand deposits

 Checkable or demand deposits are deposits where

depositors can withdraw the money at will.

 Most checkable or demand accounts pay very little

interest or no interest.
 Bank Balance Sheet
B. Saving and Time deposits
 Since saving accounts are not used as a payment
system, banks are forced to pay more interest for it.
 Saving deposits are mostly passbook saving accounts,
where all transactions were recorded in a passbook.
C. Certificate of Deposit (CD)
 CD is a deposit where the depositor agrees to keep the
money in the account until the certificate of deposit
expires.
 The bank compensates the depositor with a higher
interest rate.
 Bank Balance Sheet

D. Borrowing
I. Banks usually borrow money from other banks in what
is called the central/federal funds market.
II. Banks also borrow funds from non-depository
institutions, such as insurance companies, pension fund.
However, most of these loans are collateralized in the
form of repurchase agreement, where the bank gives
the lender securities, usually Treasury bills, as collateral
for a short-term loan.
 Bank Balance Sheet

III. As a last resort, banks can also borrow funds from the
central bank.
But since borrowing from the central bank shows that
banks are under financial stress and unable to get
funding elsewhere, they do this rarely.
 Bank Balance Sheet

3. Bank Capital
 Banks can also get more funds either from the bank’s
owners if it is a corporation or by issuing more stocks.
 Functions of Commercial Banks

1. Primary Functions (Accepting deposits and lending

money)
2. Secondary Functions (agency services and general utility
service)
 Primary Functions of Comm. Banks

1. Accepting deposits
 Current or demand deposits
 Saving deposits
 Fixed or time deposits

2. Lending Money
 Overdrafts
 Cash credit
 Loans and Advances
 Discounting of bill of Exchange
 Secondary Services of Comm. Banks

1. Agency services: as an agent banker renders the following

services
 Collection of cheques, drafts, and bill for their
customers
 The collection of standing orders, e.g., payment of
commercial bills, collection of dividend warrants and
interest coupons, payment of insurance premiums,
rents, etc
 Secondary Functions:
Agency service (Cont’d)
 Conduct of stock exchange transaction such as purchase
and sale of securities for the customers,
 Acting as executor and trustee,
 Providing income tax services,
 Conduct of foreign exchange business
 Secondary Functions :
General Utility service
 Safe keeping of valuables
 Issue of Commercial letters of credit and travellers’
cheque,
 Collecting trade information from foreign countries for
their customers
 Arrange business tours
 etc
 Regulation of Commercial Banks

 Financial Institutions provide various services:

 the provisions of a payments mechanism;
 maturity transformations;
 risk transformations;
 liquidity provisions; and
 reduction of transaction, information and search costs.
 Regulation……

 Failure to provide these services or a breakdown in their

efficient provision can be costly to both the ultimate
providers (households) and users (firms) of funds.
 Because of the vital nature of the services they provide,
Commercial Banks (CmBs) are regulated to protect against
a disruption in the provision of these services and the cost
this would impose on the economy and society at large.
 Types of Regulations of CBs

1. Safety and soundness regulation,

2. Monetary policy regulation,
3. Credit allocation regulation,
4. Consumer protection regulation,
5. Investor protection, and
6. Entry and chartering regulation
 1. Safety and soundness regulation

 Objective of this regulation is to protect depositors and

borrowers against the risk of commercial banks failure.
These regulation include:
Layer 1 protection: Commercial banks should diversify their
assets-
 In US banks are prohibited from making loans
exceeding 10% of their own equity capital fund to any
one company or borrower (credit limit )
1. Safety and soundness regulation (cont’d)

Layer 2 protection:
 Stockholders’ contribution (equity) to the total fund of

the banks should be adequate in such a way that it

protects liability claim holders against insolvency risk.
 The higher the proportion of capital contributed by

owners the greater the protection

1. Safety and soundness regulation (cont’d)

Layers 3 protection: Provision of guarantee fund (such as

Bank insurance Fund in US)
Deposit insurance mitigates a rational incentive for
depositors otherwise have to withdraw their funds at the
first hint of trouble, creating banking panic or bank run-
sudden withdrawal of deposits by depositors.
 2. Monetary Policy Regulation

 In most countries, regulators commonly impose a minimum

level of required cash reserve to be held against deposits
 (see cash reserve ratio requirements of MP instruments)
 3. Credit Allocation Regulation
 Credit allocation regulation supports the commercial bank’s
lending to socially important sectors as housing, farming
etc. For example;
 a commercial bank may be required to extend a certain

amount to a particular sector of the economy

 The regulator may set maximum interest rate, price or

fees to subsidize certain sectors

 4. Consumer Protection Regulation
 This regulation is concerned about the discrimination on
the basis of age, race, sex, of income-( Banks should not
discriminate on such grounds).
 For example, the US congress passed the Home
Mortgage Disclosure Act (MHDA) in 1975 to prevent
discrimination by lending institutions.
 Since 1992, CBs have had to submit reports to regulators
summarizing their lending on a geographic basis, showing
the relationship between the demographic area to which
they are lending and the demographic data (such as
income and percentage of minority population) for that
location.
 CBs must now report the reason that they granted or
denied credit.
 5. Investor Protection Regulation

 In US a considerable laws protect investors who use CBs

directly to purchase securities and/or indirectly to access
securities markets through investing in mutual banks or
pension funds managed by CBs.
 Various laws protect investors against abuse such as insider
trading, lack of disclosure, outright , and breach of fiduciary
responsibilities.
 6. Entry and Chartering Regulation

 The entry of CBs and branch expansion might be regulated.

 Increasing or decreasing the cost of entry into a financial
sector affects the profitability of firms already competing
in that industry.
 Thus, the industries heavily protected against new entries
by high direct costs (e.g. through capital requirements) and
high indirect costs (e.g. by restricting the type of individuals
who can establish CBs) of entry, produce larger profits for
existing firms than those in which entry is relatively is easy
 Risks faced by Commercial Banks
 A depository institution has many risks that must be
managed carefully, especially since a bank uses a large
amount of leverage.
 Without effective management of its risks, it could very
easily become insolvent.
 In addition to the previously mentioned risks faced by
depository institutions, commercial banks face the
following risks.
1. foreign exchange risk
2. sovereign risk and
3. operational risk
 Risks faced by Commercial Banks

1. foreign exchange risk

 International banks trade large amounts of currencies,
which introduces foreign exchange risk, when the value
of a currency falls with respect to another.
 A bank may hold assets denominated in a foreign
currency while holding liabilities in their own currency.
 If the exchange rate of the foreign currency falls, then
both the interest payments and the principal repayment
will be worthless than when the loan was given, which
reduces a bank’s profits.
 Risks faced by Commercial Banks
 Banks can reduce this risk by hedging the risk with
forward contract, future contract or swaps which will
guarantee an exchange rate at some future date.
2. Sovereign risk:
 Many foreign loans are paid in U.S. dollars and repaid
with dollars.
 Some of these foreign loans are made to countries with
unstable governments.
 If political problems arise in the country that threatens
investments, investors will pull their money out to
prevent losses arising from sovereign risk.
 Risks faced by Commercial Banks
 In this case, the local currency declines rapidly compared
to foreign currencies, and governments will often impose
capital controls to prevent more capital from leaving the
country.
3. Operational risk:
 It arises from faulty business practices or when buildings,
equipment, and other property required to run the
business are damaged or destroyed.
 Risks faced by Commercial Banks
 Many types of operational risk, such as the destruction of
property, are covered by insurance.
 However, good management is required to prevent
losses due to faulty business practices, since such losses
are not insurable.
 B.Saving & loan Association
 The basic purpose of establishing saving and loans
associations was pooling the savings of local residents for
financing the construction and purchase of a homes.
 The collateral for the loan would be the home being
financed.
 Saving and loans are either mutually owned (means there
is no stock outstanding) or have corporate stock
ownership, so technically the depositors are the owners.
 Saving & loan Association

 Traditionally, the only assets in which saving and

loans associations were allowed to invest have
been:
 Mortgages (Loans secured by a property).
 Mortgage – backed securities
 Government securities
 Saving and Loans Associations invest in short-term assets
for operational (liquidity) and regulatory purpose.
 C.Saving banks

 Saving banks are institutions similar to saving and

loans associations even though they are much older
than S & Ls.
 Originally, they were established to provide a

means for small depositors and earn a return on

their deposits.
 They can be either mutually owned (i.e., mutually

saving banks) or stockholder owned.

 However, most saving banks are of the mutual

form.
 Saving banks
 Asset structure of saving banks and S & Ls are almost
similar.
 The principal assets of saving banks are residential
mortgages.
 The principal source of funds for saving banks is deposits
which is very similar with S & Ls.
 They have obtained funds primarily by tapping the
savings of households.
 Thrift institution
 Thrift is the quality and practice of being careful with
money and not wasting things.
 Thrift institution: An organization formed as a depository
for primarily consumer savings. Savings and loan
associations and savings banks are thrift institutions.
 A thrift bank—also just called a thrift—is a type of financial
institution that specializes in offering savings accounts and
originating home mortgages for consumers. Thrift banks
are also sometimes referred to as Savings and Loan
Associations (S&Ls).
 Cont’d
 Thrift banks operate similarly to traditional banks, but
they are designed to serve consumers rather than
businesses. In other words, thrifts primarily offer
consumer accounts and loans, while commercial banks
also offer financial services to businesses.
 Thrift banks focus on taking deposits and originating
home mortgages. They provide low-cost mortgages and
high-interest savings accounts. Thrift banks can be used
by anyone seeking local banking services and often offer
competitive rates.
 D.Credit Unions


 They are the smallest & nonprofit depository institution.

 They can obtain either a state or federal charter.
 Their unique aspect is the “common bond” requirement for
membership, such as:
 the employees of a particular company,
 unions,
 religious affiliations or who
 live in a specific area etc.
 They are governed by a board of volunteers.
 Credit Unions
 Credit Unions are either cooperatives or mutually owned.
 There is no corporate stock ownership.
 Since they are nonprofit and owned by their customers,
they charge lower loan rates and pay higher interest
rates on savings.
 Therefore, the dual purpose of credit unions is to serve
their members saving and borrowing needs.
 3: Non depository Institutions

 These Non-depository institutions are financial

institutions that do not mobilize deposits as their primary
function. But this does not mean that they never mobilize
savings
 These include (among others):
• Insurance companies
• Mutual funds
• Pension funds
• Investment Banking Firms
 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

 Insurance companies provide (sell and service) insurance

policies, which are legally binding contracts.
 Insurance companies promise to pay specified sum
contingent on the occurrence of future events, such as
death or an automobile accident.
 Insurance companies are risk bearer. They accept or
underwrite the risk for an insurance premium paid by the
policyholder or owner of the policy.
 Types of Insurance Business

 Insurance industry is classified in to two

 Life insurance
 General or Property-causality insurance
 Types of Insurance Business

1. Life insurance: deals with death, illness disablement and

retirement policies. Products of life insurance companies
include:
1. Term insurance
2. Whole of life insurance
3. Endowment policies
4. Annuities
2. General insurance: deals with theft, property, house, car
and general accident insurance. Property insurance is
normally divided into two: personal and commercial
 Insurance Companies

 Income of Insurance Companies:

 Insurance premium
 Investment income that occur over time

 The profit of the insurance companies = )insurance

premium + investment income) – (operating expense +
insurance payment or benefits)
 Types of Insurance business-Cont’d

 According to Fabozzi, insurance products and contracts

are classified as:
1. Life insurance
2. Health insurance
3. Property and causality insurance
4. Liability insurance
 Types of Insurance business-Cont’d

5.Disability insurance
6. Long-term care insurance
7. Structured settlements
8. Investment-Oriented Products
 Students are advised to read about types of insurance
and other insurance related topics
 B. Mutual Funds
 A mutual fund is a special type of investment institution
which acts as an investment conduit.
 It pools the savings of relatively small investors and
invests them in a well-diversified portfolio of sound
investments, thus enabling them to participate indirectly
in the benefits of investment in industrial securities.
 B. Mutual Funds

 Mutual funds are also able to enjoy economies of scale by

incurring lower transaction costs and commission.
 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.
 B. Mutual Funds
 As an investment intermediary, it offers a variety of
services to small investors such as:
 diversification of portfolio and consequent reduction of
risk
 expert professional management
 liquidity of investment
 tax shelter and reduced cost.
 It is called a mutual fund in USA, unit trust in UK and
India
 B. Mutual Funds

Advantage of Mutual Funds

1. Mobilizing small saving
2. Professional management
3. Diversified investment/ reduced risks
4. Better liquidity
5. Investment protection
6. Low transaction cost (economy of scale)
7. Economic Development
 Return to Investors in the Mutual Fund
 Investors in the mutual fund have the potential to gain:
 They are entitled to a share in the capital appreciation of

the underlying assets,

 They have a claim on the income generated by the

underlying assets of the fund

 Types of Mutual Funds

1. Open-ended mutual funds

2. Closed-ended mutual funds
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.
Open-ended mutual funds-Characteristics
 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 MF divided by the No of shares owned by the
MF investors.
 Open-ended: NAV

 NAV= Mkt V of Portfolio-Liabilities

No of shares outstanding
 The NAV is determined only once each day, at the close

of the day. For e.g. the NAV for a stock MF is determined

from closing stock price for the day. Business publications
provide the NAV each day in their MF.
 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 or a non-business
day are priced at the next day’s closing NAV)
 Open-ended: NAV
 The total No of shares in the fund increases if more
investments than withdrawals are made during the day,
and vice versa.
 If the price of the securities in the portfolio change, both
the total size of the portfolio and therefore, the NAV will
change.
 Open-ended: NAV
 Overall, the NAV of a mutual fund increase or decrease
due to an increase, or decrease in the price of the
securities in the portfolo.
 The No of shares in the fund increase or decrease due to
the net deposits or withdrawal from the fund.
 And the total value of the fund increases or decreases for
both reasons.
 Open-ended: NAV
 Examples 1:
 Suppose today a MF contains 1000 shares of ABC which

are traded at $37.75 each, 2,000 shares of Exxon

(currently traded at $43.70) and 1,500 shares of Citigroup
currently trading at $46.67. The MF has 15,000 shares
outstanding held by investors. Thus, today’s NAV is
calculated:
(1000x 37.75) + (2,000x43.7) +1,500 x 46.67 =13.01
15,000
 Open-ended: NAV

 If tomorrow ABC’s shares increase to $45, Exxon’s shares

increase to $48, and Citigroup’s shares increase to $50, the
NAV (assuming the No of shares outstanding remains the
same) would increase to:
1000x45 + 2000 x 48 + 1500x 50 = 14.40
15,000
 Open-ended: NAV
 Example2:
 Suppose that today 1,000 additional investors buy one

share each of the mutual fund (MF) at the NAV of $13.01.

This means the MF mgr has $13,010 additional funds to
invest.
 Suppose that the fund mgr decides to use these additional
funds to buy additional shares in ABC.
 Open-ended: NAV
 At today’s mkt price, the mgr could buy 344
($13,010/$37.75 = 344) shares of ABC additional shares:
Thus,
 its new portfolio of shares has 1344 in ABC, 2000 in Exxon, and
1,500 in Citigroup.
 Given the same rise in share value as assumed above, tomorrow’s

NAV will be:

1,344 x $45 + 2,000 x $48 + 1,500 x $50 = 14.47
16,000
 Open-ended: NAV
 The additional shares and the profitable investment
made with the new funds from these resulted in a slight
higher NAV than had the No of shares remained static
($14.47 versus $14.40)
 Closed End Fund
 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 No of shares remains constant.
 After the initial issue, no sale or purchase of fund shares
are made by the fund company as in open-end funds.
 Instead, the shares are traded on a secondary market,
either on an exchange or in the over-the-counter market
 Closed End Fund

 Since the number of shares available for purchase, at any

moment in time, is fixed, the NAV of the fund is
determined by the underlying shares.
 The return for holders of the fund’s shares is determined
by the underlying shares as well as by the demand for
the investment company’s shares themselves.
 Closed End Fund
 When demand for the investment company’s shares is
high, because the supply of shares in the fund is fixed the
shares can trade for more than the NAV of he 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.
 Difference b/n Open-end and Closed-end MF

1. The No 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.
2. In contrast, closed-end fund 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.
 C. Pension Funds
 Pension funds are major institutional investors and
participants in the financial markets.
 Pension plan is established for the eventual
payment of retirement benefits
 The entities that establish pension plans-called plan
sponsors- may be private business entities acting
for their employees, federal, state, and local entities
on behalf of their employees.
 Pension funds are financed by contribution from
employer and/or employees
 Pension Funds

 The key factor explaining pension fund growth is that the

employer’s contribution and a specified amount of the
employee’s contribution, as well as the earnings of the
fund’s assets, are tax exempt.
 In essence, a pension is a form of employee remuneration
for which the employee is not taxed until funds are
withdrawn.
 Types of pension Plans

 Two basic and widely used types of pension plans are:

 Defined benefit plans- sponsor agrees to make specified
(or defined) payment to qualifying employees at
retirement and
 Defined contribution plans- sponsor is responsible only
for making specified (or defined) contribution into the
plan on behalf on qualifying employees, but does not
guarantee any specified amount at retirement.
 In addition a hybrid of plans, called a cash plan,
combination features of both pension plan types may be
used.
 C, Pension Funds
 Brain Strom
 How is the pension fund being managed and used in
Ethiopia?
 Is there any possibility of using this fund for investment
purpose to benefit the pensioners and the national
economy?
 D. Investment Banking Firms
 It is specialized financial institution engaged in securities
business.
 They perform activities related to the issuing of new
securities and the arrangement of financial transactions.
 They mainly involve in primary markets, the market in
which new issues are sold and bought for the first time.
 They advice issuers on how best to raise funds, and then
they help to sell the securities.
 They are also involved in planning and executing other
types of financial transactions such as merger, acquisition
and restructuring.
 Activities of investment banking firms

1. Public offering (underwriting of securities)

 Investment bankers performing one or more of the
following three functions:
 Advising the issuer on the terms and the timing of the

offering.
 Buying the securities from the issuers.
 Distributing the issue to the public.
 Activities of investment banking firms

2. Private Placement of Securities

 In addition to underwriting securities for
distribution to the public, investment banking
firms place securities with a limited number of
institutional investors like insurance companies,
pension fund etc.
3. Securitization of Assets
 Securitization of Assets refers to the issuance of
securities that have a pool of assets as collateral.
 Activities of investment banking firms

4. Merger and Acquisition

 They may participate in merger and acquisition activity in
one of the following ways:
 Finding merger and acquisition candidates.
 Adjusting acquiring companies or target companies with

respect to price and non price terms of exchanges or

helping companies fend off (defend) an unfriendly
takeover.
 Assisting acquiring companies in obtaining the necessary

funds to finance a purchase.

 Activities of investment banking firms

5. Merchant Banking
 When an investment banking firm commits its
own fund by either taking an equity interest or
credit position in companies, this activity referred
to as merchant banking.
 Activities of investment banking firms

6. Trading and Creation of Derivative Instruments

 derivative instruments allow an investment banking firms
to realize revenue in the following ways:
 Customers generate commissions from the
exchange traded instruments they buy and sell. That
is, commission generated by the brokerage service
performed for customers when they are bought and
sold.
 There are certain derivative instruments that an
investment banking firm creates for its clients. Eg.
Swap.
 Activities of investment banking firms

7. Money Management
 Investment banking firms have created subsidiaries that
manage funds for individual investors or institutional
investors such as pension funds.
 Micro Finance Institutions

 Microfinance is a form of financial services for

entrepreneurs and small businesses lacking access to
banking and related services
 Microfinance is a type of financial service that is provided
to unemployed or low-income individuals or groups who
would otherwise have no access to the formal banking
source of finance.
 Microfinance refers to a variety of financial services that
target low-income clients, particularly women
 Micro Finance Institutions

 Microfinance is the provision of savings accounts, loans

and money transfers and other banking services to
customers that lack access to traditional financial
services, usually because of poverty.
 Making small loans to individuals who lack the necessary
resources to secure traditional credit is known as micro
credit
 END OF CHAPTER TWO

Thank You!!