Financial Institutions

Financial Institutions
Introduction
For financial transactions to happen, money must change hands. How do such exchanges occur?
At any given point in time, some individuals, businesses, and government agencies have more
money than they need for current activities; some have less than they need. Thus, we need a
mechanism to match up savers (those with surplus money that they’re willing to lend out) with
borrowers (those with deficits who want to borrow money). We could just let borrowers search
out savers and negotiate loans, but the system would be both inefficient and risky. Even if you
had a few extra dollars, would you lend money to a total stranger? If you needed money, would
you want to walk around town looking for someone with a little to spare? Such relevant questions
need brief answer so as to facilitate any financial activities and call an involvement of financial
institutions.
What Is a Financial Institution (FI)?
A financial institution (FI) is a company engaged in the business of dealing with financial and
monetary transactions such as deposits, loans, investments, and currency exchange. Financial
institutions encompass a broad range of business operations within the financial services sector
including banks, trust companies, insurance companies, brokerage firms, and investment dealers.
Virtually everyone living in a developed economy has an ongoing or at least periodic need for the
services of financial institutions.

Types of Financial Institutions

There are three types of financial institutions. These are Depository, non-depository and
Investment

1. Depository Institutions

Depository institutions allow customers to deposit money in an account. You're probably most

familiar with these types of financial institutions if you have a checking or savings account.
Examples of depository institutions include commercial banks and credit unions. Commercial
banks are for-profit entities that provide a number of services to their account holders. These
types of financial institutions usually operate at the local, regional or national level, have large
advertising budgets, and charge higher fees than a credit union. 

Fig 1: Types of Depository Institutions

Depository institutions are allowed to accept monetary deposits from the consumers legally.
These include commercial banks, savings banks, credit unions, and savings and loan association.
The different types of depository institutions are explained as below:

1 Commercial Banks – Commercial banks accept deposits from the public and offer security to
their customers. Due to commercial banks, it is no longer required to keep huge large currency on
hand. Using commercial bank facilities, transactions can be done through checks or credit/debit
cards.

2 Saving Banks – Saving banks performs the function of accepting the savings from the
individuals and lending to the other consumers. Savings banks (also called thrift
institutions and savings and loan associations, or S&Ls) were originally set up to encourage
personal saving and provide mortgages to local home buyers. Today, however, they provide a
range of services similar to those offered by commercial banks.
3 Credit Unions – Credit unions are the associations which are created, owned, and also operated
by the participants who are voluntarily associated for the purpose of saving their money and then
lending it members of their union only. As such, these institutions are the not-for-profit
organizations enjoying tax-exempt status.

4 Saving and Loan Association – These institutions collect the funds of many of the small savers
and then lend them to home buyers or other types of borrowers. They specialize in proving help to
the people in getting residential mortgages.
2. Non-Depository Financial Institutions
Non- depository institutions serve as the intermediary between the savers and the borrowers but
they do not accept the time deposits. Such institutions perform their activities of lending to the
public either by the way of selling securities or through the insurance policies. Non- depository
institutions include insurance companies, finance companies, pension funds, and mutual funds.
Insurance Companies
Insurance companies sell protection against losses incurred by illness, disability, death, and
property damage. To finance claims payments, they collect premiums from policyholders, which
they invest in stocks, bonds, and other assets. They also use a portion of their funds to make loans
to individuals, businesses, and government agencies.
Finance Companies
Finance companies are no depository institutions because they do not accept deposits from
individuals or provide traditional banking services, such as checking accounts. They do, however,
make loans to individuals and businesses, using funds acquired by selling securities or borrowed
from commercial banks.
Pension and Mutual Funds
A pension fund, also known as a superannuation fund in some countries, is any plan, fund, or
scheme which provides retirement income. Pension funds typically have large amounts of money
to invest and are the major investors in listed and private companies. They are especially
important to the stock market where large institutional investors dominate.
A mutual fund is a professionally managed investment fund that pools money from many
investors to purchase securities. While there is no legal definition of the term "mutual fund", it is
most commonly applied to open-end investment companies, which are collective investment
vehicles that are regulated and sold to the general public on a daily basis. They are sometimes
referred to as "investment companies" or "registered investment companies".
Mutual funds have both advantages and disadvantages compared to direct investing in individual
securities. Today they play an important role in household finances, most notably in retirement
planning.
A mutual fund invests money from a pool of investors in stocks, bonds, and other securities.
Investors become part owners of the fund. Mutual funds reduce risk by diversifying investment:
because assets are invested in dozens of companies in a variety of industries, poor performance by
some firms is usually offset by good performance by others. Mutual funds may be stock funds,
bond funds, and money market funds, which invest in safe, highly liquid securities. (Liquidity is
the speed with which an asset can be converted to cash.)
Finally, pension funds, which manage contributions made by participating employees and
employers and provide members with retirement income, are also non-depository institutions.

Challenges of financial institution

From the commercial banks side

Commercial banks do not have units for SMEs loan and are not interested to provide loan
to SMEs. Because of this they do not provide continued/sustained loan access, and when
they provide the amount is limited.
Private banks have recently raised their paid up capital in order to increase their single
borrower limit and hence scaled up their loans portfolio to the large and corporate entities
away from the small borrowers;
The new regulations that has raised the startup capital for new commercial banks
discouraged new banks to join the industry;

From MFIs side

Are not also in a position to ensure continued financial access to SMEs and the poorer
segments of society.

Key Challenges of financial institution

The stability of the Ethiopian financial sector depends on a number of factors including
the macroeconomic environment, the foreign exchange situation, the business/regulatory
environment, corruption, corporate governance, risk management, etc
Unpredictable inflation: According to Thorat (2013) inflation and financial instability are
the biggest threats to inclusive growth. Since, 2008/09, Ethiopia has become vulnerable to
inflation arising from monetary policy mismanagement, supply rigidities, inflation
expectation and the pass through from the global economic turmoil.
Foreign exchange shortage: Availability of foreign exchange is critical for banking
business in Ethiopia as it affects lending especially for international trade and the interest
income on foreign exchange deposits in correspondent banks.
Worsening business environment: On account of intended and unintended consequence of
government policies, the investment climate in Ethiopia is poor and deteriorating.
Corruption: Although difficult to properly quantify its magnitude, Ethiopia is observing
rising corruption in a number of sectors including the Revenue and Customs, the Telecom,
Ethiopian Electric Power Corporation, banks, etc. Unless concrete actions are taken to
tackle the problem from its roots, this will lead to erosion of business confidence in the
country.
Weak risk management practices: Risk management is getting attention in the financial
sector in recent years. Each bank established a small unit to deal with risk management
and in some banks we have seen risk management analysis in their annual report.
Other risk factors: This could include lack of skilled manpower in the financial sector,
lack of alternative financing mechanism; ineffective ICT infrastructure on account of very
weak internet connectivity, lack of standardized accounting, auditing and reporting
practices.
The potential crowding out of private banks through the 27% NBE bill requirement would
lead to tight liquidity and funding conditions for banks. This would affect banks
performance in terms of credit growth and overall profitability.
Low literacy rate is a serious impediment for the adoption of financial insinuations in
Ethiopia as it hinders the accessibility of financial insinuations services.
Every economic activity need suitable legal and regulatory framework to meet its goal. In
financial insinuations, the adoption of financial insinuations needs legal and regulatory
framework that prevents any challenges related to security before happening so Lack of
suitable legal and regulatory framework
Cybercrime in Finance
Big Data Use in Finance
 Customer Retention in the Financial Services Industry Competition for financial
service clients has never been fiercer. While brand loyalty may not be dead, it is definitely
on life support.
Block chain Integration in Finance We talked earlier about block chain as a key
component in the battle against cybercrime. But data security is not the only application
for block chains in the financial sector.
Political and institutional independence may not be present or respected. Financial
controls to ensure price and currency stability may be over-ridden by political short-term
decisions that can undermine efforts to create a stable economy and stable financial sector.
Instability of prices and interest rates force greater required margins for lending and
restrict borrowing and lending and the stability if financial institutions suffer as a result.
Most developing economies are not large enough or developed enough to enforce trading
and transactions in local currency and through official channels and banking institutions.
The regulatory and legal structures may simply not be in place or respected or sufficiently
free from corruption to allow financial institutions to engage in traditional intermediary
functions at reasonable cost due to the hazards and risks of operating in the economy.

The current Prospect of financial institutions in Ethiopian context

Providing almost all modern banking services to its customers along with its
basic functions like deposit mobilization and lending of various types of loans, from
the early establishment till now.
an important tool of poverty alleviation,
Macroeconomic stability; interests rate de-regulation; easing of setting up banks,
branches, and MFIs with low capital requirements
Many of the poor can save, invest, and repay their loans.
To develop their agricultural activities and microenterprises, prepare for emergencies
and provide for the future, they need access to a range of microfinance services,
including savings deposit facilities as a priority, credit and insurance.
This requires a diversified financial infrastructure of competing institutions and
diverse strategies adjusted to a given socio-economic context.
Outreach can only be maximized by sustainable financial institutions, which cover all
their costs, mobilize their own resources, protect their funds against erosion from
inflation and non-repayment, and make a profit to finance their expansion.
 With sound practices, any type of financial institution can become sustainable and
combine outreach and viability; but in most regions, institutions built on self-help and
private ownership have the better prospects.
Through technical and financial assistance, donors can greatly contribute to the
development of an efficient rural and microfinance sector, but must be effectively
guided by goals of viability and self-reliance of rural and microfinance institutions.
transforming national small farmer programs into user-owned local financial
institutions
reforming agricultural development banks which in many countries continue to be the
biggest provider of microfinance service
it promotes economic growth and battles poverty