Chapter-2: Depository Institutions

Depository Institutions
Depository Institutions mean financial institutions that accept deposits. These deposits
represent the liabilities of the deposit accepting institutions. With these funds, depository
institutions both make direct loans to various entities and invest in securities.
Example : 1) Commercial Banks
2) Savings & Loans Associations
3) Credit Unions etc.

Thrifts
A specialized type of depository institutions that do not allow to accept deposits transferable
by cheque, is called thrift.
Example: 1) Savings & Loans Associations
2) Savings Banks
3) Credit Unions etc.

Sources of Income:
Income of depository institutions derived from sources, such as-
 The income generated from the loans they make & the securities they purchase.
 Fee income

Features of Depository Institutions:

 Depository institutions are highly regulated because of the important role that they play
in the country’s financial system.
 Depository institutions are afforded special privileges that provide funds for liquidity or
emergency needs. Such as- “Access to a Government Entity”

Functions of Depository Institutions:

 Receive funds through deposits & other funding sources.
 Make direct loans to various entities.
 Make investment in securities.

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Asset- Liability Problem / Risk faced by
Depository Institutions in generating Spread
Income
A depository institution seeks to earn spread income or Margin which is the difference
between the income received from the assets invested loans and securities and the cost of funds
arises from deposits and other sources. It should allow the institutions to meet operating
expenses & earn a fair profit on its capital.
In generating spread income , a depository institution faces some risks. These are-

1. Credit/Default Risk:
It refers to the risk that a borrower of a loan or issuer of a security that the depository
institution holds will default on its obligation.

2. Regulatory Risk:
It refers to the risk that regulators will change the rules so as to adversely impact the
earnings of the institution.

3. Interest Rate Risk:

It refers to the risk that the investment’s value will change due to change in the absolute
level of interest rate.

Steps Depository Institutions should follow for

Liquidity Concern

Beside facing credit risk and interest rate risk, a depository institution must be prepared to
satisfy withdrawals of depositors and to provide loans to customers. There are several ways that
a depository institution can accommodate withdrawal and loan demand. These are-

 Attract additional deposit

 Use existing securities as collateral for borrowing from a state agency or other financial
institution, such as an investment bank.
 Raise short term funds in the money market.
 Sell securities that it owns. It requires that the depository institution invest a portion of its
funds in securities that are both liquid and have a little price risk.
Secondary Reserve:
Securities held for the purpose of satisfying net withdrawals and customer loan demands are
called Secondary Reserves.
The percentage of a depository institutions assets held as secondary reserves will depend
both on-

 The institutions ability to raise funds from the other sources, and
 It’s management’s risk preference for liquidity versus yield.

However, depository institutions hold liquid assets not only for operational purposes but also
because of the regulatory requirements.

Disadvantage:
The only disadvantage of secondary reserve is that securities with short maturities offer a
lower yield than securities with a longer maturities in most interest rate environment’s.

Bank Services
Commercial bank provide numerous services in our financial system. The services can be
broadly classified as follows:

A. Individual Banking
It encompasses consumer lending, residential mortgage lending, consumer installment loans,
credit card financing , student loans, automobile financing etc. Interest income and fee income
are generated from this services.

B. Institutional Banking
It encompasses loans to non-financial corporations, financial corporations, government
entities, commercial real estate financing, leasing activities etc. Both interest income and fee
income are generated from institutional services.
 C. Global Banking
It covers a broad range of activities involving corporate financing and capital market and
foreign exchange products and services. Most global banking activities generate fee income
rather than interest income.
Here corporate financing involves two components:
- The procuring of funds for a bank’s customer
- Advice on such matters as strategies for obtaining funds, corporate restructuring and
acquisitions.
Capital Market and Foreign- Exchange Products and Services involve transactions where
the bank may act as a dealer or broker in a services. Some banks for example, are dealer in
government and other securities. Some banks maintain a foreign-exchange operation, where
foreign currency is bought and sold.

Traditional Services of Banks

 Exchange of currency
 Commercial notes and loans
 Offering savings deposits
 Safekeeping of valuables
 Supporting government activities with credit
 Checking accounts
 Trust services

Recent Services of Banks

 Consumer Loan
 Financial Advice
 Cash Management
 Equipment leasing
 Venture Capital Loan
 Selling Insurance Products
 Security Underwriting and Brokerage Services
  Mutual Funds and Annuities
 Merchant Banking Services

Bank Funding
1) Deposits:
There are several types of demand deposit accounts. These are:
i. Demand Deposits: pay no interest and can be withdrawn upon demand
ii. Savings Deposits: Pay interest typically below market interest rates, do
not have specific maturity & usually can be withdrawn upon demand.
iii. Time Deposits: Have fixed maturity date & pay either a fixed or floating
interest rate. Some certificates of deposit can be sold in the open market prior
to their maturity if the depositors needs fund. If the depositors elects to
withdraw the funds from the bank prior to the maturity date, a withdrawal
penalty is imposed.
2) Non- Deposits:
These deposits refer borrowing from the Central Bank and borrowing by issuing
various instruments in the money and bond market.
3) Common Stock & R/E:
Common Stock is the primary source of funds that represents the ownership of the
corporation and retained earning is the percentage of net earnings retained by the
company to be reinvested in its core business or to pay debt.

Savings & Loan Association

Savings and Loan Associations are one kind of depository institution that offer deposit
accounts to surplus units and then channel these deposits to deficit unit.
Basic Motivation: To provide funds for financing the purchase of a home.
Ownership: These Associations can be either mutually owned (no stock outstanding,
depositors are the owners) or with stock ownership.
 Principal Assets:
- Mortgages including fixed rate mortgages and adjustable rate mortgages.
- Mortgage backed securities
- Government Securities
Principal Sources of Funds:
- Passbook savings accounts
- Time deposits
- Raising of funds by issuing commercial papers, medium term notes, repurchase
agreement and other money market instruments.

Savings Banks
Savings banks are institutions similar to savings and loan associations. These banks are
mutually owned or stockholder owned.
Principal Assets: Residential Mortgages
Principal source of funds: Deposits

Credit Unions
Credit Unions are owned by members. Here, most members work for the same employer or
for one of a group of related employers. Moreover, if one family member belongs to a credit
union, other family members are eligible as well. Credit Unions are owned by their members,
members deposits are called “Shares”. The distribution paid to the members is in the form of a
dividend, not interest. Membership in a credit union shall be limited-
- To groups having a common bond of occupation or association
- To groups within a well defined neighborhood, community or rural district.
Ownership: Credit unions are either co-operatives or mutually owned. There is no stock
ownership.
Motivation: The purpose of credit union is to serve their members credit and borrowing
needs.
Principal Assets:
- Small consumer loans
- Residential Mortgages
- Securities
Principal Source of Funds:
- Member Deposits

Forms of Intermediation of
Depository Institution
The forms of intermediation of depository institutions are as follows-
I. Denomination Intermediation:
It occurs when intermediaries accept small amounts of savings from individuals and
others, and pool these funds to make large loans, Principally to corporations &
Governments.
II. Default Risk Intermediation:
It refers to the willingness of financial intermediaries to make loans to risky
borrowers and at the same time, issue relatively safe & liquid securities in order to
attract loanable funds from savers.
III. Maturity Intermediation:
It refers to the practice of borrowing comparatively short term funds from savers and
making long term loans to borrowers who require a lengthy commitment of funds.
IV. Information Intermediation:
It refers to the process by which financial intermediaries substitute their skill in the
market place for that of the savers who frequently has neither the time nor access to
relevant information about market conditions & opportunities.
V. Risk Pooling:
By investing in assets with a wide variety of risk-return characteristics,
intermediaries enhance the safety of funds supplied by savers.
 VI. Economies of Scale:
As the intermediaries increases in size, it’s operating cost per unit may decline,
which can reduce the cost of many financial services supplied to the public.
VII. Transmission of Monetary Policy:
Depository intermediaries are the conduits through which monetary policy actions
impact the rest of the financial sector & the economy in general.
VIII. Time Intermediation:
It means the ability of savers to transfer wealth between youth and old age and across
generation.

Instruments of Monetary Policy/

Tools used by Central Bank to
control Money Supply
Central Bank has several tools by which it influences, indirectly and to a greater or lesser
extent, the amount of money in the economy and the general level of interest rates. These tools
are-
 Reserve Requirement:
A bank must hold or reserve some portion of the funds approved by the central bank
such as CRR, SLR. A bank’s total reserves equal –
Bank’s required reserve + Any excess reserves

 Open Market Operations:

Central bank can buy & sell government securities in open debt markets, such as-
- Treasury Bills
- Treasury Bonds
  Open Market Repurchase Agreements:
In a repurchase agreement (repo), Central Bank buys a particular amount of securities
from a seller that agrees to repurchase the same securities at a higher price at some future
time. The difference is the return for the Central Bank.
On the other hand, in a reserve repo, the central bank sells securities and makes a
commitment to buy them back at a higher price later. The difference in the two prices is
the cost of the central bank.
 Discount Rate/ Bank Rate:
Central Bank makes loans to scheduled banks at a rate, which is commonly known as
“Discount Rate”. As the rate rises, banks are understandably less likely to borrow.

Existing rates:
 Cash Reserve Ratio - 5.5%
 Statutory Liquidity Ratio- 13%
 Bank Rate -5%
 Repo Rate - 6%
 Reverse repo – 4.75%