Chapter Two

FINANCIAL
INSTITUTIONS
Chapter content

Overview of Financial Institutions

Functions of Financial Institutions
Depository Financial Institutions
Non-Depository Financial
Institutions

Financial Institutions & markets 2

INTRODUCTION
 The term financial institutions and
financial intermediaries are often used
interchangeably.
 Financial institutions deal with

various financial activities associated

with financial systems, such as
◦securities, loans, risk diversification,
insurance, hedging, retirement planning,
investment, portfolio management, and
many other types of related functions.

Financial Institutions & markets 3

Intro….Cont’d
 With the help of their functions,
financial institutions transfer
money or funds to various tiers of
economy and thus play a significant
role in acting upon the domestic and
the international economic scenario.
 Financial institutions/intermediaries
are institutions engaged in the
business of channeling money from
savers to borrowers.
Financial Institutions & markets 4
Intro…..Cont’d
 Thechanneling process which is known
as financial intermediation is
crucial to the well functioning of
modern economy,
◦ since current economic activity depends
heavily on credit 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. Financial Institutions & markets 5
Functions of Financial Institutions

1. pooling the savings of individuals

2. providing safekeeping, accounting
and access to payment system
3. providing liquidity
4. Currency exchange
5. Reducing risk by diversifying
6. Collection and processing
information

Financial Institutions & markets 6

Information Asymmetries
 Asymmetric information is the unequal
knowledge that each party to a
transaction has about the other party.
◦When one party to a financial transaction
has better knowledge than the other.
 Because of the lack of information about
the trust worthiness and other
characteristics of the other party, many
mutual beneficial transactions never take
place.

Financial Institutions & markets 7

Information….cont’d
 For instance, people routinely pay
several thousands of birr extra for
new car instead of buying used car
in excellent condition is because of
a problem of getting information
about the car’s true condition or
about the reliability of the person
selling it.

Financial Institutions & markets 8

Information….cont’d
 Thus,having unequal knowledge
about each other, will result in the
following two problems:
 Adverse selection
 Moral hazard
 Adverse selection: it is the problem
created by asymmetric information
before a transaction occurs or a loan
is made in case of banks.

Financial Institutions & markets 9

Information….cont’d
 Adverse selection occurs when seller
of a financial asset knows more than
the buyer.
 Under such circumstances the seller

will try to sell low quality assets and

hold high quality ones.
 It is a pre-contractual asymmetries

of information

Financial Institutions & markets 10

Information….cont’d
 One possible solution to adverse
selection problem is to eliminate the
asymmetric information.
 For instance, in the above used car

example, the owner of the car is the

most likely to resell a recently
purchased car by hiding the car’s
defect.
 As a result prospective car buyers will

decide not buying used cars at all.

Financial Institutions & markets 11
Information….cont’d
 Incase of insurance market, an
imperfect driver will tend to be the
first in line to purchase an insurance
premium for his car.
 As a result, car insurance companies
will charge high premium to all
people who fit a particular high risk
profile.

Financial Institutions & markets 12

Information….cont’d
 In case of banking industry, bad
credit risks tend to be those who
most actively seek out loans.
 Therefore, since the adverse

selection problem stems from a lack

of information, financial institutions
can help solve this problem by
gathering information about the
party who is interested to enter a
financial contract.
Financial Institutions & markets 13
Information….cont’d
 Moral hazard: is the risk that one party
to a transaction will engage in behavior
that is undesirable from the other
party’s point of view, after a transaction
has taken place.
 One party to a financial contract may

have a strong monetary incentive to

break that contract because they can
conceal their actions.

Financial Institutions & markets 14

Information….cont’d
 It results from post-contractual
asymmetries of information.
 Asymmetric information can worsen

moral hazard.
 Such as, If your laundry machine is

fully insured and no longer of much

use to you, why not burn it down and
collect the insurance money? Burning
down a fully insured house to collect
on fire insurance.
Financial Institutions & markets 15
 Information….cont’d
 Solutions to moral hazard problems include:
◦ Monitoring the activities of the other party to restrict
“bad behavior”
◦ Contracting devices designed to minimize the incentives
to chisel
 Paying attractive salary and incentives to their managers
to avoid corruption.
◦Putting some restrictive measures:
 require the borrower to keep a minimum bank balance
/tangible assets as a collateral,
 to abstain the borrowers from certain goods and services,
 covenants
Financial Institutions & markets 16
Types of Financial
Institutions
 The services provided by a financial
institution depends on its type.
 Services provided by the various
types of financial institutions may
vary from one institution to another.
◦For example, the services offered by
the commercial banks are different
from insurance companies.

Financial Institutions & markets 17

Types….cont’d
 Financial institutions can be classified as follows:
1. Depository financial institutions
a. Commercial Banks
b. Saving and Loan Associations
c. Credit Unions
d. Microfinance institutions
2. Non-depository financial institutions
a. Insurance companies
b. Pension funds
c. Mutual funds
d. Investment Banking Firms
e. Brokers and Dealers
Financial Institutions & markets 18
 Depository Institutions
A depository institution is a
financial firm that takes deposits from
households and businesses and
manage, and makes loans to other
households and businesses.
 include commercial banks, savings and
loan associations, and credit unions
 income derived from interest on loans,
interest and dividend on securities, and
fees income
Financial Institutions & markets 19
Depository….cont’d
 Deposit: Money placed in an account at a
depository institution & constituting a
claim on the depository institution.
 Loan: The borrowing of a sum of money by
households or businesses from the
depository institution.
 The deposits accepted by these institutions

represent their liabilities (debts).

 With the fund raised through deposits and

other funding sources depository

institutions make direct loans to various
entities and also invest in securities.
Financial Institutions & markets 20
Assets & Liability Problem of DIs
DIs are exposed to the ff risks:
 Credit risk- default by borrower or by
issuer of security.
 Regulatory risk-adverse impact of
regulations on earnings.
 Funding (interest rate) risk-caused
by interest rate changes when DIs
borrow long(short) and lend
short(long).
 i.e., the interest rate paid for depositors
& received from borrowers.
Financial Institutions & markets 21
 Cont’d….

 Example: Awash bank raises birr 100 million by

issuing a deposit account that has a maturity
period of one year at the interest rate of 5%.
Then the bank has invested all its birr 100
million in government security for 10 years at
the interest rate of 8%.
 In this case

◦ The income spread of the bank is known only

for the first year and it is unknown for the next
9 years.
◦ The income spread for year one is 3% (8%-5%)
and the spread for the future (for 9 years) will
depend on the interest rate that Awash bank
will have to pay to depositors in order to raise
Financial Institutions & markets 22
 Cont’d….

 Thus, if interest rates decline, the spread

will increase and if the interest rates rise
the spread will decline because the
ceiling (the upper limit) was locked to 8%.
 But if Awash bank must pay more than
8% to depositors. The spread will be
negative. This is because it will cost the
bank more to finance the government
securities than it will earn on the funds
invested in those securities.

Financial Institutions & markets 23

 Cont’d….

 Think about the opposite situation. A short

term loan (1 year) financed by a 5 year
deposit.
 After one year the loan needs to be
reinvested and find a new borrower for the
next four years (i.e. from year two up to
year five).
 The interest rate might have changed. If it
goes down there will be a loss, if it goes up
there will be a profit.

Financial Institutions & markets 24

 Cont’d….
 A depository institutions seeks to earn a
positive spread between the assets it
invests in (loans and securities) and the cost
of its funds (deposits and other sources).

 The spread is referred to as spread income

or margin.
 The spread income should allow the

institution to meet operating expenses and

earn a fair profit on its capital.
 Depository institution makes a profit by
borrowing from depositors at a low interest
rate and lending at a higher interest rate.
Financial Institutions & markets 25
 Cont’d….

 The depository institution earns no

interest on reserves, but it must hold
enough reserves to meet
withdrawals.
 Sothe depository institution must
perform a balancing act to balance
the risk of loans (profits for
stockholders) against the safety of
reserves (the security for
depositors).
Financial Institutions & markets 26
Liquidity concerns

arises due to short-term maturity nature of

deposits.
 Besides facing credit risk & interest rate risk,
DIs should always be ready to satisfy
withdrawals & meet loan demand
 Sources of funds include
• attract additional deposit
• borrow using existing securities as a collateral
(from a federal agency or financial
institutions).
• sell securities it owns
• raise short-term funds in the money market

Financial Institutions & markets 27

 Sample Balance sheet

Eg. Commercial Banks

Assets
Liabilities
Reserves & cash xxx Checkable deposits xxx
Loans xxx Saving deposits xxx
Liquidity assets xxx Small time deposits xxx
Gov’t Securities xxx Borrowing xxx

Own Capital xxx

Total xxx
xxx Financial Institutions & markets 28
 Cont’d….
 Reserves (reserve requirement) are
an obligation on a bank or other
depository institutions to maintain a
specified proportion of total assets in
liquid form.
◦Depository institutions are required to hold a
minimum percentage of deposits as reserves,
which is known as a required reserve ratio (rrr).
 Loans are commitments of fixed

amounts of money for agreed-upon

periods of time.
Financial Institutions & markets 29
 Cont’d….
 Liquidity assets are government
Treasury bills and commercial bills.
◦Liquidity assets can be sold and instantly converted
into reserve (cash) with virtually no risk of loss.
Because they have a low risk, they also earn a low
interest rate.
 Securities are government bonds and

other bonds such as mortgage-backed

securities.
◦ Because their prices fluctuate, these assets are riskier than
liquidity assets, but they also have a higher interest rate.

Financial Institutions & markets 30

 Cont’d….
 Deposits include
◦Checkable deposits: are bank accounts
that allow the owner of the account to
write checks to third party.
 Are deposits that are payable on
demand.
◦Saving deposits: owners cannot write
check.
◦Time deposits: (also called certificates
of deposit, or CDs) have a fixed
maturity length, and have penalties for
early withdrawal.
Financial Institutions & markets 31
 Cont’d….

 Borrowing is that a depository

institution borrows reserves (cash)
from the federal funds market. It is
called inter-bank loan.
◦The interest rate in this market is the federal funds
rate.
 Own capital is a depository
institution's equity or net worth.

Financial Institutions & markets 32

Regulations
 Depository institutions are highly
regulated because of the important role
that they play in the financial system.
 Because of their role, depository
institutions are affording special
privileges, such as access to a
government entity that provides funds
for liquidity of emergency needs.

Financial Institutions & markets 33

a. Commercial Banks
 Commercial banks are the largest and
most diversified intermediaries on the
basis of range of assets held and
liabilities issued.
 Commercial banks provide numerous

services in the financial system.

◦Collect funds from different sources,
&
◦Put them in to different uses.

Financial Institutions & markets 34

Bank Funding (sources)
 Deposits-savings, demand, time
deposits
 Reserve requirement-portion of
deposit kept as a caution against
possible bank illiquidity
 Non-deposit borrowings:
borrowing from money market
 Common stock and Retained
earnings
Financial Institutions & markets 35
 Cont’d….
Reserve requirements
 All banks must maintain a specified
percentage of their deposits in non-
interest bearing account of a central
bank.
 i.e., a bank can not invest one birr for
every one birr obtained in deposit.
 The central bank is banker’s bank or
the last resort.
 Banks with temporarily short of funds
can borrow from the central bank
Financial Institutions & markets 36
Uses of Funds
 Usesof funds or assets:
◦Commercial Banks provide consumer
lending, residential mortgage
lending, consumer installment loans,
credit card financing, student loan
and financial investment service
 Theyhave also concerns in foreign
exchange products and services.

Financial Institutions & markets 37

Regulations
◦ Regulated by the central bank
◦ Areas of regulation include,

Ceilings on deposit interest rate
 Permissible activities: Eg: banks can
neither underwrite securities and stock not
act as dealers in the secondary market for
securities and stocks.
 Capital requirements
 Geographical restriction on branch banking.

Financial Institutions & markets 38

 Cont’d….

Capital requirements for CBs:

 aimed at preventing insolvency
 banks have high debt to equity ratio

• Capital structure of CBs consists of

equity & debt.
• highly financial levered institutions
because of deposits.

Financial Institutions & markets 39

b. Saving and loan association
 They are old institutions.
 established to provide finance for
acquisitions of homes.
 The collateral for the loan would be the
home being financed.
 S & Ls can be mutually owned(by

depositors) or have corporate stock

ownerships.
◦ Mutually owned means depositors are the
owners.

Financial Institutions & markets 40

 ASSETS include:
 mortgages, mortgage-backed
securities, and government securities
 consumer loans, non-consumer loans
and municipal securities
 Like banks they are also subjected to reserve
requirements.
 FUNDING include:
 Saving and time deposits
 Issue NOW (Negotiable Order of Withdrawal–
pays interest) account to commercial customers.
(Which are traditionally reserved for commercial
banks.)
 Borrow from the federal home loan banks
Financial Institutions & markets 41
 c. Credit unions
 Are the smallest and the newest of the
depository institutions owned by a social
or economic group that accepts saving
deposits and makes mostly consumer
loans.
established by people with a common
bond
 they are mutually owned
Sources of funds
◦deposit by members called shares
Assets
◦consumer loans extended to members
Financial Institutions & markets 42
 Cont’d….
 Membership is limited to groups having a
common bonds like:
 occupational,
 Associational, or
 residential
such as employees of a given firm or
union.
 established to satisfy saving and borrowing
needs of their members
 Their investment is primarily devoted to

short term installment consumer loans.

Financial Institutions & markets 43
 Cont’d….

 The major regulatory differences

between credit unions and other
depository institutions are:
◦the common bond requirement,
◦the restriction that most loans are to
consumers
 Savings and loan associations and credit

unions are collectively known as thrift

institutions.
 They obtain funds primarily by tapping

the savings of households

Financial Institutions & markets 44
Microfinance institutions(MFIs)
 The active poor require a full set of micro finance
services mainly in the form of saving and credit facilities
These services help the poor (active poor):
 Start new business or expand existing ones

 Improve productivity of farmers and micro

enterprises.
 Improve human and social capital throughout

their life
 Deal with vulnerabilities and poverty reduction

Financial Institutions & markets 45

Cont….
However, the active poor, both in the urban
and rural areas, are neglected by formal bank
and non bank financial institutions because of
different reasons
 Collateral requirement of formal bank.
 High transactions cost(mini transaction)
 High perceived risk

*Difficulty in contract enforcement

*Harvest failure

Financial Institutions & markets 46

Activities of MFI
 Small loans, typically, for working capital
 informal appraisal of borrowers and

investments
 collateral substitutes, such as a group

guarantee or compulsory savings

 access to repeated and large loans, based

on repayment performance

Financial Institutions & markets 47

In addition to the above activities MFIs have
the following objectives
 to reduce poverty
 to empower women and other

disadvantaged population group

 to create employment
 to help existing business grow or diversity

their activities
 to encourage the development of new

business

Financial Institutions & markets 48

2.2 Non-depository
institutions
 Non-depository financial institutions are
defined as those institutions that serve
as an intermediary between savers and
borrowers, but do not accept
deposits.
 They receive the public’s money

because they offer other services than

just the payment of interest.
 Includes: insurance companies, pension

funds, mutual funds and brokers and

dealers.
Financial Institutions & markets 49
a. Insurance Companies
 offers insurance policies to the public.
 make payments, for a price, when a
certain event occurs
 Life and non-life insurance companies
 It provides social security and promotes
individual welfare.
 Distribute/spread risks to individuals,

through the “Rule of large number”.

 They function as risk bearers.
Financial Institutions & markets 50
 Cont’d….
 Like banks, insurance companies are
challenged by the information asymmetry
problems of adverse selection and moral
hazard.
 Insurance companies can solve an adverse

selection by screening applicants.

 That is,

◦ verifying information in the application,

◦ checking the applicant’s history and
◦ by applying restrictive covenant in the
insurance contract.
 However, the solution of moral hazard is
depending on the type of insurance offered.
Financial Institutions & markets 51
b. Pension Funds
 A pension fund is a fund that is
established for the payment of
retirement benefits.
 Most pension fund assets are in

employer-sponsored plans.
 The entities that establish pension plans

are called the plan sponsors.

 pension plans can be established by both

governmental & private organizations on

behalf of their employees
Financial Institutions & markets 52
c. Mutual Funds
 A mutual fund pools the funds of many
people and managers invest the money
in a diversified portfolio of securities to
achieve some stated objective
 It continually stands ready to sell new

shares to the public and to redeem its

outstanding shares on demand at a price
equal to an appropriate share of the
value of its portfolio which is computed
daily at the close of the market.

Financial Institutions & markets 53

Cont’d…
 Mutual funds are regulated by the
Securities and Exchange Commission
(SEC)
 Primary objective of regulation is the
enforcement of reporting and
disclosure requirements to protect the
investor
 Institutional investors—including

mutual funds, pension funds, and

insurance companies—are a growing
force in developed markets.
Financial Institutions & markets 54
Brokers and Dealers

 Involved in the secondary market,

trading “used” or already outstanding
securities
 Brokers match buyers and sellers and

earn a commission
 Dealers commit their own capital in

the buying and selling of securities

and hope to make profit on the
transaction
Financial Institutions & markets 55
 Investment Banking Firms
 Investment bank is a financial institution
engaged in securities business.
 Investment banking firms perform

activities related to the issuing of new

securities and the arrangement of
financial transactions.
 They mainly involved in primary

markets, the market in which new issues

are sold and bought for the first time.
 They advice issuers on how best raise

funds, and then they help sell the

securities. Financial Institutions & markets 56
Cont’d…
 Investmentbanking firms perform two
general functions:
i. They assist client companies in
obtaining funds by selling securities,
i.e., raise funds for clients.
ii. They act as brokers or dealers in the
buying and selling securities in
secondary markets, i.e., assisting
clients in the sale or purchase of
securities.
Financial Institutions & markets 57