FINANCIAL INSTITUTIONS

AND OPERATIONS

Chapter 3
 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.
 Cont’d
 Current economic activity depends heavily on
credit (most of which goes through financial
intermediaries, as with bank credit cards) and
future economic growth depends heavily on
business investment.
 For example, a student loan for college which

increases the level of education and human

capital will promote future economic growth of a
country.
 Functions 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, accounting and access to
payments system
3. Providing liquidity
4. Reducing risk by diversifying
5. Collecting and processing 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, accounting and access to
payments system
 Financial institutions (e.g. banks) are safe places to
deposit money, especially since bank deposits are
insured up to a certain level 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 and processing 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:
 Roleand function of central banks
 Depository institutions and
 Non-depository institutions
Part I: Central Banks
 Nature of Central Banks:
 A central bank, reserve bank, or monetary authority is a
banking institution granted 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:
 Reserve bank of India,
 The bank of England
 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 of notes (legal
tender money) issue.
 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:
 bank keeps the deposits of the government and makes
payment on behalf of the government (state and/or central).
 But it does not pay interest on gov’t deposits.
 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 of Commercial
Banks

 Commercial Banks are required to keep reserve

equal to a certain percentage of both time and
demand deposits within the Central bank.
 It is on the basis of these reserve 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.
 (As the case of federal funds)
4.Custody and Management 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 as 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 methods and qualitative

methods for this function.

 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 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 MP:
 MP- refers to credit control measures
adopted by central banks of a country.
 MP refers to a policy employing central
bank’s control of the supply of money as an
instrument for achieving the objective of
general economic policy.
 MP= 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 as 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.

Price Stability as 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 to saving and Investment
3. Balance of Payment objective
 A balance of payment deficit is defined as equal to
the excess of money supply through domestic
credit creation over extra money demand for cash.
 BP deficit reflects excess money supply in the
economy.
 As the result, people exchange their excess holdings
for foreign goods and services.
 Then increased in import over export; and outflow
of currency will be more than the inflow of currency.
3. Balance of Payment objective…
(cont’d)
 Under this situation, the monetary
authority has to sell foreign exchange
reserves and buy the domestic currency
for eliminating excess supply of domestic
currency until equilibrium is maintained.
4. Full Employment Objective
 Definition of Full Employment:
 Full employment is a situation in which
every body who wants to work get
work. ( Keynes).
4.Full Employment-cont’d
 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 MP
 The monetary authority use different instruments to
achieve the objectives of MP of their country. They
are divided into two categories:
1. A 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

controls in the economy through commercial banks.

Instruments of MP…Cont’d

2. Qualitative, selective or direct-

include changing margin requirement,
and regulation of consumer credit.
They aim at controlling specific types of

credit.
1. Bank rate Policy: as Instrument of MP

 The bank rate is the minimum lending rate of the

central bank at which it rediscounts first class 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 which affects the cost of
credit:
 Borrowing from the Central bank becomes costly and
commercial banks borrow less from it.
 The Commercial Banks in turn raise their lending to the
business communities and borrowers borrow less from CBs.
 There is contraction of credit and prices are checked from
rising further.
Cont’d

 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: as instrument of MP

 Open market operation refers to sale and purchase of securities

in the money market by central bank.
 With rising price (inflation), the NB sells securities.
 The reserve of CBs 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 NB buys securities.
 The reserves of CBs are raised.
 They lend more.
 Investment, output, income and demand rise, and
 The fall in price is checked.
3. Change in reserve ratio: as Instrument of MP

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

its total deposits in the form of a reserve fund in its vault and
also a certain percentage 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.
4. Selective Credit Controls
 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.
 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

 Part II: 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
 Depository …
 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.
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
 Funding 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.
 Funding risk- is the risk that the interest rate
movement may move in such a manner that
profits will be adversely affected.
 Example of funding rsik
 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
 Commercial Banks are those FIs
which accept deposit from the
public repayable on demand and
lend them for short periods.
 Commercial 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:

Interestfrom 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 (cont’d)
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 (cont’d)
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 (cont’d)
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 (cont’d)
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 (cont’d)
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 (cont’d)
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 (cont’d)
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 CBs

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 Function of CBs

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 of CBs (cont’d)
 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 (CBs) 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 regulation, 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-
 InUS banks are prohibited from making loans exceeding 10%
of their own equity capital fund to any one company or
borrower.
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 depositors otherwise have to
withdraw their funds at the first hint of
trouble.
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 hold a
minimum amount of assets (loan) in one 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 is regulated, as the their activities
once they have been established.
 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 (cont’d)

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 (cont’d)
 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 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 (cont’d)

 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 (cont’d)

 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.
 Assets of Saving and Loan Associations (cont’d)

 Traditionally, the only assets in which saving and

loans associations were allowed to invest have
been:
 Mortgages (Loanssecured by a property).
 Mortgage – backed securities
 Government securities
 Saving and Loans Associations invest in short-term
assets for operational (liquidity) and regulatory
purpose.
 Funding of Saving and Loan Associations (cont’d)

 The principal source of funds for Saving and Loans

Associations consisted of passbook savings accounts
and time deposits.
 Then it was expanded to negotiable order of
withdrawal (NOW) account, which is similar with
demand account.
 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 (cont’d)
 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.
 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 (cont’d)
 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.
PART III. NON DEPOSITORY
INSTITUTIONS

These Non-depository institutions are financial

institutions that do not mobilize deposits:
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 (cont’d)
 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 (cont’d)

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.
 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
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
Income of Insurance Companies
 Initial underwriting income (insurance
premium)
 Investment income that occur over time

 The profit of the insurance companies

= insurance premium + investment income –
operating expense + insurance payment or
benefits.
B. Mutual Funds
 Nature of Mutual Fund
 A mutual fund (in US) or unit trust (in UK and India)
raise funds from the pubic and invests the funds in a
variety financial asset, mostly equity both domestic
and overseas and also in liquid money and capital
market. (Keith)
Nature of Mutual Fund
 Mutual funds 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.
Nature of Mutual Fund (cont’d)
 The stocks these mutual funds are very fluid and
are used for buying or redeeming and/or selling
shares at a net asset value.
 Mutual funds posses shares of several companies
and receive dividends in lieu of them and the
earnings are distributed among the share
holders.
Nature of Mutual Fund (cont’d)
 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 (cont’d)

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
Advantage of Mutual Funds
(Cont’d)
7.Economic Development
 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.
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 net asset value
(NAV).
 Open-ended mutual funds-
Characteristics (cont’d)
 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 NF 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 (cont’d)
 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 (cont’d)
 Overall, the NAV of a mutual fund increase or
decrease due to an increase, or decrease in the
price of the securities in the portfolio.
 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 (cont’d)
 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 (cont’d)
 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 (cont’d)
 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 manager has $13,010 additional funds
to invest.
 Suppose that the fund manager decides to use these
additional funds to buy additional shares in ABC.
Open-ended: NAV (cont’d)
 At today’s mkt price, the manager 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 (cont’d)

 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 (cont’d)
 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 (cont’d)
 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 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.
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 (cont’d)
 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.
 D. Investment Banking Firms
 It is a 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.
 Investment Banking Firms
(cont’d)
 Thus, they perform two general functions:
1. They assist both government and
nongovernmental companies in obtaining
funds by selling securities, i.e., raise funds for
clients.
2. They act as brokers or dealers in the buying and
selling of securities in secondary markets, i.e.,
assisting clients in the sale or purchase of securities.
 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 and they 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.
END OF CHAPTER THREE