Chapter one

An Overview of the Financial System in an economy

Chapter Objectives:
After completing this chapter, you will be able to:
➢ Explain constitutes of financial system
➢ Explain the roles played by the financial system.
➢ Explain the role and properties of financial assets
➢ Define key terms and concepts about financial markets.
➢ Describe the role, classifications and participants of Financial markets
Introduction
By making funds available for lending and borrowing the financial system provides the means whereby
modern economies grow and increase the standard of living enjoyed by their citizens. Without the
financial system and the funds it supplies, each of us would lead a very different and probably less
enjoyable existence.
The great importance of the financial system in our daily lives can be illustrated by reviewing its different
functions.
This section discusses the different functions of the financial system in an economy.
A financial system is defined as the collection of markets, individuals, laws, polices, systems,
conventions, techniques and institutions through which bonds, stocks, and other securities are traded,
interest rates are determined and financial services are provided and delivered.
The primary task of the financial system is to move scarce loan able funds from those who save to those
who borrow to buy goods and services and to make investments so that the economy can grow and
increase the standard of living enjoyed by citizens. The end users of this system are people and firms
whose desire is to lend and to borrow.
More realistically, when Ethiopian metal and engineering corporation invents a better car, it may
need funds to bring it to market, or a county may need funds to build a road or a school. They can
access funds from financial institutions in a financial market and other surplus units if there is a
well-functioning financial system.
Well-functioning financial markets and financial intermediaries are crucial to our economic health.
When the financial system breaks down, as it has been in Greece, Italy, Spain, Russia and in East
Asia recently, severe economic hardship results.
To study the effects of financial markets and financial intermediaries on the economy, we need to
acquire an understanding of their general structure and operation.
There for as a student of this course, first you need to understand the constituents and role of the financial
system. Therefore, this chapter provides an overview of the role and structure of the financial system.
1.1. The Role of the Financial System and its constituents
Constitutes of Financial System Include:
▪ Financial institutions
▪ Financial markets
▪ Financial assets (instruments)
▪ Participants in the financial system and
▪ laws, regulations and techniques
The functions of the Financial System
The followings are the basic functions of financial system in an economy.
Savings Function
The financial system mobilizes savings. Bonds, stocks, deposits and other financial instruments sold in the
financial markets provide a profitable, relatively low risk outlet for the publics’ savings. Those savings
flow through the financial markets into investment so that more goods and services can be produced in the
future; increasing society’s standard of living. When savings flows decline; however, the growth of
investment and of living standards tends to fall.
Liquidity Function
Liquidity is related to how soon you can convert your financial instrument into cash with little cost. For
wealth that is stored in financial assets, the financial marketplace provides a means of converting those
instruments (assets) into ready cash with little risk of loss. Cash generally earns the lowest rate of return of
all assets traded in the financial system, and its purchasing power is seriously eroded by inflation. That is
why savers generally minimize their holdings of money and hold bonds and other financial assets until
spendable funds really are needed. Thus, the financial system provides liquidity for savers holding
financial instruments but in need of money.
Wealth Function
Financial instruments provide an excellent means to store purchasing power until needed at a future date
for spending on goods and services. One might choose to store wealth in real assets (e.g. gold, clothes);
however, such items are subject to depreciation and often carry great risk of loss. However, bonds, stocks,
deposits and other financial instruments do not wear out over time, usually generate income, and
normally, their risk of loss is much less than would be true of other forms of stored wealth.
Credit Function
The financial system facilitates trade and investment by extending credit. The financial system provides
credit to finance consumption and investment spending.
Payments Function
The financial system provides us with financial instruments that can be used to effect payment. Financial
instruments such as currency, demand deposits, and credit card accounts are used as a medium of
exchange in the making of payments. Thus, the financial system provides a mechanism for making
payments for goods and services without resorting to the barter system.
Risk Function
The financial system offers households, firms and governments protection against life, health, property
and income risks. protection against the first three risks is accomplished by the sale of insurance policies.
The financial institutions particularly the insurance companies serve to bear such risks. The financial
system reduces the income risk by spreading investors’ savings across many different investment
opportunities. Spreading savings diversifies the risk for households and reduces their exposure to the
uncertainties associated with individual projects. The investment companies are of great importance to this
end.
Policy Function
The financial system is best instrument for government policy to achieve the nation’s goals of high
employment, low inflation, and sustainable economic growth. By manipulating interest rates and there by
affecting the availability of credit, government can influence the borrowing and spending plans of the
public which, in turn, influence the growth of jobs, production and the price of goods and services.
1.2. Financial Asset: Role, Properties
Financial assets
An asset is any possession that has value in an exchange.
Assets can be classified as:
▪ Tangible and/ or
▪ Intangible.
The value of a tangible asset depends on particular physical properties-examples include:
✓ Buildings,
✓ land,
✓ machinery and equipment
✓ Furniture and fixtures etc
Intangible assets, by contrast, represent:
✓ Legal claims to some future benefit. Their value bears no relation to the form, physical or
otherwise, in which the claims are recorded.
Financial assets are intangible assets that help to channel the surplus funds to an economy and then to
make real asset investments.
This is basically a piece of paper (e.g. document or certificate of title) that represents a physical asset.
Financial assets (also referred to as financial instruments or securities) are intangible assets. For these
instruments, the typical future benefit comes in the form of a claim to future cash. The entity that agrees to
make future cash payments is called the issuer of the financial asset; the owner of the financial asset is
referred to as the investor.
The claims of the holder of a financial asset may be either:
▪ a fixed dollar amount or
▪ a varying, or
▪ Residual amount.
In the former case, the financial asset is referred to as a debt instrument. Bonds and bank loans are
examples of debt instruments.
An equity claim (also called a residual claim) obligates the issuer of the financial asset to pay the holder
an amount based on earnings, if any, after holders of debt instruments have been paid.
Common stock is an example of an equity claim.
Some financial assets fall into both categories. Preferred stock, for example, represents an equity claim
that entitles the investor to receive a fixed dollar amount. This payment is contingent, however, due only
after payments to debt instrument holders are made.
Another instrument is convertible bonds, which allow the investor to convert debt into equity under
certain circumstances.

Both debt and preferred stock that pays a fixed dollar amount are called fixed income instruments.
The Functions of Financial Assets
Financial assets have two principal economic functions.
1. The first is to transfer funds from those who have surplus funds to invest to those who need funds to
invest in tangible assets.
2. The second economic function is to transfer funds in such a way as to redistribute the unavoidable
risk associated with cash flow generated by tangible assets among those seeking and those providing
the funds.
 Properties of Financial Assets.
Financial assets possess the following properties that determine or influence their attractiveness to
different classes of investors:
moneyness; currency
divisibility and denomination; cash flow
reversibility; return predictability
term to maturity; Tax status.
liquidity; Complexity
convertibility;
Moneyness
Some Financial assets are used as a medium of exchange or to effect payment. These assets are
called money and consist of currency and demand (checking) deposit. Other assets such as
Treasury bill, saving and time deposits are referred to as near money because they can be
transformed into money at little cost, delay, or risk. If there are two or more financial assets
exactly alike but with different degree of moneyness, then investors would definitely choose the
one with the highest degree of moneyness. Hence, Moneyness is clearly a desirable property for
investors.
Divisibility and Denomination
Divisibility relates to the minimum size in which a financial asset can be liquidated and
exchanged for money. The smaller the size, the more the financial asset is divisible. A financial
asset such as a deposit in a bank is typically infinitely divisible, but other financial assets have
varying degrees of divisibility depending on their denomination, which is the money value of the
amount that each unit of the asset will pay at maturity
Reversibility
Reversibility is the round-trip cost or turnaround cost because it is the cost of buying a security
and then selling the security when circumstances motivate or force you to do so. In other words,
in buying and selling a security there are transaction costs which affect the reversibility of the
financial asset. The higher the round- trip cost (transaction cost), the lower is the reversibility of
the financial asset. A financial asset such as a deposit at a bank is obviously highly reversible
because usually there is no charge for adding to or withdrawing from it. Financial assets that are
highly reversible are more desirable for the investor than those that are not.
Cash Flow
Every financial asset provides a return to the investor which is measured by considering all the
cash distributions that the financial asset will pay its owners. This cash distribution includes
dividends on shares and coupon payments on bonds. It also includes the repayment of principal
for a debt security and the expected sales price of a stock.
Term to Maturity
Term to maturity is the length of the period until the date at which the instrument is scheduled to
make its final payment, or the owner is entitled to demand liquidation. Some financial assets entitle
the owner to ask for repayment at any time (e.g. checking deposit). Financial assets such as debt
securities do have specified maturity dates ranging from one day to a few decades. Financial assets
such as equity securities and perpetual bond have no maturity.
Convertibility
Some financial assets are convertible into other types of financial assets. The conversion could
take place within one class of assets, as when a bond is converted in to another bond or it may
involve converting in to a different class of assets, as when a bond is converted into equity
securities. Conversion provisions are desirable to the investor.
Currency
Because of the volatile exchange rates among currencies, the currency in which the financial asset
will make cash flow payments is an important factor in determining the attractiveness of a security.
Most financial assets are denominated in one currency and investors must choose them with that
feature in mind. In order to reduce currency risk, some issuers have issued dual- currency
securities. Interest payment will be made in one currency but principal in a second. Some financial
assets carry a currency option that allows the investor to specify that payments of either interest or
principal be made in either one of two major currencies.
Liquidity
A useful way to think of liquidity and illiquidity is in terms of how much sellers stand to lose if
they wish to sell immediately as against engaging in a costly and time consuming search. The
most important factor affecting the liquidity of a financial asset is the thickness of the market.
Thick market unlike thin market has many buyers and sellers. Thus, financial assets which have
thick market are more liquid than those having thin market. For many other financial assets,
liquidity is determined by contractual arrangements. Demand deposits, for example, are perfectly
liquid because the bank has a contractual obligation to convert them at par value on demand.
Liquidity is a desirable property to investors.
Return Predictability
Return predictability is associated with the uncertainty of returns of a financial asset. Uncertainty
varies greatly across financial assets. The value of a financial asset depends on the cash flow expected
and on the interest rate used to discount this cash flow. Hence, risk will be a consequence of the
uncertainty about future interest rates and future cash flow. For some financial assets, the future cash
flow may be contractual in which case the sole source of its uncertainty is the reliability of the debtor
with regard to fulfilling the obligation. The change in interest rates (discount rates) will in principle
affect all prices in the opposite direction, but the effect is much larger in the case of the price of a
financial asset with a long maturity than are with a short remaining life.
Complexity
Some financial assets are complex in the sense that they are actually combinations of two or more
simpler assets. A good example of a complex asset is the callable bond, which is a bond whose issuer
is entitled to repay the debt prior to the maturity date. Another example is the putable bond (a bond
that can be sold back to the issuer at the option of the investor). The correct or true price of a callable
bond is equal to the price of a similar non- callable bond less the value of the issuer’s right to retire the
bond early. The true price of a putable bond is equal to the price of a similar non- putable bond plus
the value of the investor’s right to sell back to the issuer early. Therefore, to find the correct price of a
complex financial asset, one must break it down into its component parts and price each separately. A
complex asset may be viewed as a bundle or package of cash flows and options belonging to either the
issuer or the holder, or both. Other examples of a complex asset include a convertible bond and a
bond that has payments that can be made in a different currency at the option of the bond holder.

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Tax Status
Governmental regulations for taxing the income from the ownership or sale of financial assets vary
widely. Tax rates differ from year to year, from county to county, and even among municipal units
with in a country. The rates may also differ from financial asset to financial asset, depending on the
type of the issuer, the length of time the asset is held, the nature of the owner, and so on. For example,
income from Treasury bills and coupon payments on municipal bonds are tax exempted.
1.3. Financial Markets: functions, Classification and Participants.
Financial market
A financial market is a market where financial assets are traded. The existence of a financial market is
not a necessary condition for the creation and exchange of a financial asset; however, in most
economies financial assets are created and subsequently traded in some type of financial market. In
this section we will learn about the role, classification and participants of financial market.

Functions of Financial Markets

Financial markets perform the essential economic function of channeling funds from households, firms,
and governments that have saved surplus funds by spending less than their income to those who have a
shortage of funds because they wish to spend more than their income. This function is shown
schematically in Figure 1. Those who have saved and are lending funds, the lender-savers, are at the left
and those who must borrow funds to finance their spending, the borrower-spenders, are at the right.
The principal lender-savers are households, but business enterprises and the government (particularly
state and local government), as well as foreigners and their governments, sometimes also find
themselves with excess funds and so lend them out. The most important borrower-spenders are
businesses and the government (particularly the federal government), but house-holds and foreigners
also borrow to finance their purchases of cars, furniture, and houses. The arrows show that funds flow
from lender-savers to borrower-spenders via two routes.
In direct finance, borrowers borrow funds directly from lenders in financial markets by selling them
securities (also called financial instruments), which are claims on the borrower's future income or
assets.
Securities are assets for the person who buys them but liabilities (IOUs or debts) for the individual or
firm that sells (issues) them. For example, if General Motors needs to borrow funds to pay for a new
factory to manufacture computerized cars, it might borrow the funds from a saver by selling the saver a
bond, a debt security that promises to make payments periodically for a specified period of time.
Why is this channeling of funds from savers to spenders so important to the economy?
The answer is that the people who save are frequently not the same people who have profitable
investment opportunities available to them, the entrepreneurs. Let's first think about this on a
personal level. Suppose that you have saved $1000 this year, but no borrowing or lending is
possible because there are no financial markets. If you do not have an investment opportunity that
will permit you to earn income with your savings, you will just hold on to the $1000 and will earn
no interest.
Without financial markets, it is hard to transfer funds from a person who has no investment
opportunities to one who does have.

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The existence of financial markets is also beneficial even if someone borrows for a purpose other
than increasing production in a business.

Say that you are recently married, have a good job, and want to buy a house. You earn a good
salary, but because you have just started to work, you have not yet saved much. Over time you
would have no problem saving enough to buy the house of your dreams, but by then you would be
too old to get full enjoyment from it. Without financial markets, you are stuck; you cannot buy the
house and will continue to live in your boring condominium.

If a financial market were set up so that people who had built up savings could lend you the funds to
buy the house, you would be more than happy to pay them some interest in order to own a home
while you are still young enough to enjoy it. Then, when you had saved up enough funds, you
would pay back your loan. The overall outcome would be such that you would be better off, as
would the per-sons who made you the loan. They would now earn some interest, whereas they
would not if the financial market did not exist.

Now we could see why financial markets have such an important function in the economy. They
allow funds to move from people who lack productive investment opportunities to people who
have such opportunities. Thus financial markets are critical for producing an efficient allocation of
capital, which contributes to higher production and efficiency for the overall economy.

Well-functioning financial markets also directly improve the well-being of consumers by allowing
them to time their purchases better. They provide funds to young people to buy what they need and
can eventually afford without forcing them to wait until they have saved up the entire purchase price.
Financial markets that are operating efficiently improve the economic welfare of everyone in the
society.
When we summarize Financial markets are important in a financial system because they provide
different economic functions. Financial markets provide the following three additional functions
beyond that of financial assets themselves:
✓ The price discovery process
✓ Liquidity function
✓ Reducing the cost of transacting
The price discovery process
First, the interactions of buyers and sellers in a financial market determine the price of the traded asset.
Or, equivalently, they determine the required return on a financial asset. As the inducement for firms
to acquire funds depends on the required return that investors demand, it is this feature of financial
markets that signals how the funds in the economy should be allocated among financial assets. This is
called the price discovery process.
Liquidity Function
Financial markets provide a mechanism for an investor to sell a financial asset when circumstances
either force or motivate him / her to sell. Because of this feature, it is said that a financial market offers
liquidity. In the absence of financial markets, the owner would be forced to hold a debt instrument
until it matures and an equity instrument until the company is either voluntarily or involuntarily

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liquidated. While all financial markets provide some form of liquidity, the degree of liquidity is one of
the factors that characterize different markets.
Reducing the cost of transacting
The two costs associated with transacting are search costs and information costs. Search costs
represent explicit costs, such as the money spent to advertise one’s intention to sell or purchase a
financial asset, and implicit costs, such as the value of time spent in locating counterparty. The
presence of some form of organized financial market reduces search costs. Information costs are
associated with assessing the investment merits of a financial asset, that is, the amount and likelihood
of the cash flow expected to be generated from a financial asset. In an efficient market, prices reflect
the aggregate information collected by all market participants. So as an individual, if you don’t have
the skill to evaluate the amount and likelihood of the cash flow from a financial asset, you can rely on
the market to buy or sell a security.
Classification of financial Markets
There are number of classifications of financial markets; the common ways of classifications of
financial markets is as follows:
▪ Nature of the claim
▪ Maturity of the claims,
▪ new versus seasoned claims,
▪ cash versus derivative instruments, and
▪ Organizational structure of the market.
▪ By globalization
1. Based on the Nature of the claim (Debt vs. Equity Markets (Legal obligation
vs. Ownership position in the business)
The claims traded in a financial market may be either for a fixed dollar amount or a residual
amount and financial markets can be classified according to the nature of the claim.
As explained above, the financial assets are referred to as debt instruments, and the financial
market in which such instruments are traded is referred to as the debt market.
The latter financial assets are called equity instruments and the financial market where such
instruments are traded is referred to as the equity market or stock market. Preferred stock
represents an equity claim that entitles the investor to receive a fixed dollar amount.
Consequently, preferred stock has in common characteristics of instruments classified as part of
the debt market and the equity market. Generally, debt instruments and preferred stock are
classified as part of the fixed income market.
2. Based on Maturity of the claims( money vs. capital)
A second way to classify financial markets is by the maturity of the claims. For example, a
financial market for short-term financial assets is called the money market, and the one for
longer maturity financial assets is called the capital market.
The traditional cutoff between short term and long term is one year. That is, a financial asset
with a maturity of one year or less is considered short term and therefore part of the money
market.

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A financial asset with a maturity of more than one year is part of the capital market. Thus, the
debt market can be divided into debt instruments that are part of the money market, and those
that are part of the capital market, depending on the number of years to maturity.
3. Based on new issues vs. previously issued securities (Primary vs. Secondary
Because equity instruments are generally perpetual, a third way to classify financial markets is
by whether the financial claims are newly issued. When an issuer sells a new financial asset to
the public, it is said to “issue” the financial asset.
The market for newly issued financial assets is called the primary market. After a certain
period of time, the financial asset is bought and sold (i.e., exchanged or traded) among investors.
The market where this activity takes place is referred to as the secondary market.
4. By Immediate vs. future settlement or delivery (Cash/Spot vs. Futures/
derivative instruments)
Some financial assets are contracts that either obligate the investor to buy or sell another
financial asset or grant the investor the choice to buy or sell another financial asset. Such
contracts derive their value from the price of the financial asset that may be bought or sold.
These contracts are called derivative instruments and the markets in which they trade are referred
to as derivative markets. The array of derivative instruments includes options contracts, futures
contracts, forward con- tracts, swap agreements, and cap and floor agreements.
A financial market in which there is immediate cash payment or exchange is referred as cash or
spot market
5. Based on organizational structure Auction vs. OTC (Over the Center) (Stock
exchanges vs. Dealer markets or Stock exchanges vs. private
placements(OTC))

Although the existence of a financial market is not a necessary condition for the creation and
exchange of a financial asset, in most economies financial assets are created and subsequently
traded in some type of organized financial market structure.

A financial market can be classified by its organizational structure. These organizational

structures can be classified as auction markets and over-the-counter markets.
6. Based on globalization
From the perspective of a given country, financial markets can be classified as either internal or
external. The internal market is also called the national market and it is composed of the
domestic market and the foreign market. The domestic market is where securities are issued by
firms and governments in the issuer’s home country. In other words, the domestic market is
where issuers domiciled in a country issue securities and where those securities are subsequently
traded. The foreign market in any country is where the securities of issuers not domiciled in the
country are sold and traded.
The external market, also called the international market, offshore market, and Euromarkets,
allows trading of securities with two distinguishing features:
▪ at issuance securities are offered simultaneously to investors in a number of countries,
and
▪ they are issued outside the jurisdiction of any single country.

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 7. Intermediated vs. Non-Intermediated (Direct securities vs. indirect securities
markets)
A market in which direct securities such as bonds issued by a corporation directly sold to
lenders without any intermediation, that brings direct transfer of capital called Non-
Intermediated financial market.
A market in which indirect securities such as deposits accounts issued by financial institutions
such as banks or investment firms (financial intermediary) sold to lenders with intermediation
called intermediated financial market.

Major participants and players in financial markets

In the financial markets, there is a flow of funds from one group of parties (funds-surplus units)
known as investors to another group (funds-deficit units) which require funds. However, often
these groups do not have direct link. The link is provided by market intermediaries such as
brokers, mutual funds, leasing and finance companies, etc. In all, there is a very large number of
players and participants in the financial market.

The individuals or Households:

These are net savers and purchase the securities issued by corporate. Individuals provide funds
by subscribing to these securities or by making other investments.
The Firms or Corporate
✓ Often have surplus funds from operations
✓ Invest funds on money market, commercial bills and sometimes buy shares in businesses
The corporate are net borrowers. They require funds for different projects from time to time.
They offer different types of securities to suit the risk preferences of investors’ Sometimes; the
corporate invest excess funds, as individuals do.
The funds raised by issue of securities are invested in real assets like plant and machinery. The
income generated by these real assets is distributed as interest or dividends to the investors who
own the securities.
Government and its agencies
Acts for the government to ensure gaps in the supply of funds are filled and Works through the
authorized dealers
Government may borrow funds to take care of the budget deficit or as a measure of controlling
the liquidity, etc. Government may require funds for long terms (which are raised by issue of
Government loans) or for short-terms (for maintaining liquidity) in the money market.
Government makes initial investments in public sector enterprises by subscribing to the shares,
however, these investments (shares) may be sold to public through the process of disinvestments.
Supranational
Such as the World Bank (WB), IMF, African development bank Asian development bank,
European development bank etc)
These Supranational financial institutions have been participating in international and national
financial markets in channeling funds.

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Regulators:
Financial system is regulated by different government agencies. The relationships among other
participants, the trading mechanism and the overall flow of funds are managed, supervised and
controlled by these statutory agencies.
In India, two basic agencies regulating the financial market are the Reserve Bank of India (RBI)
and Securities and Exchange Board of India (SEBI).
Reserve Bank of India, being the Central Bank, has the primary responsibility of maintaining
liquidity in the money market’ It undertakes the sale and purchase of T-Bills on behalf of the
Government of India.

SEBI has a primary responsibility of regulating and supervising the capital market. It has issued
a number of Guidelines and Rules for the control and supervision of capital market and
investors’ protection. Besides, there is an array of legislations and government departments also
to regulate the operations in the financial system.
Think of about financial system regulation in our country Ethiopia
Market Intermediaries:
There are a number of market intermediaries known as financial intermediaries or merchant
bankers, operating in financial system. These are also known as investment managers or
investment bankers.

The objective of these intermediaries is to smoothen the process of investment and to establish a
link between the investors and the users of funds.
Corporations and Governments do not market their securities directly to the investors. Instead,
they hire the services of the market intermediaries to represent them to the investors. Investors,
particularly small investors, find it difficult to make direct investment. A small investor desiring
to invest may not find a willing and desirable borrower. He may not be able to diversify across
borrowers to reduce risk. He may not be equipped to assess and monitor the credit risk of
borrowers. Market intermediaries help investors to select investments by providing investment
consultancy, market analysis and credit rating of investment instruments.
In order to operate in secondary market, the investors have to transact through share brokers.
Mutual funds and investment companies pool the funds (savings) of investors and invest the
corpus in different investment alternatives.
Some of the market intermediaries are:-
Banks
They are the largest providers of funds to business and get most of their funds from deposits and
also provide a wide range of debt securities to business.
Insurance Companies
They Issue contracts to provide a future payment if a certain event happens and use the fees from
these contracts to invest in equities, debt and property.
Finance Companies
They get funds by issuing debentures and borrowing from the general public and provide short-
to-medium-term funds to business, particularly leasing finance.

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Mutual funds
They get funds from the savings of people preparing for retirement and Invest funds on money
market, commercial bills and sometimes buy shares in businesses
➢ Investment Companies
➢ Share brokers
➢ Credit Rating Agencies
➢ Underwriters (security firms) etc
To summarize, these market intermediaries provide different types of financial services to the
investors. They provide expertise to the securities issuers. They are constantly operating in the
financial market. Small investors in particular and other investors too, rely on them. It is in their
(market intermediaries) own interest to behave rationally, maintain integrity and to protect and
maintain reputation, otherwise the investors would not trust them next time. In principle, these
intermediaries bring efficiency to corporate fund raising by developing expertise in pricing new
issues and marketing them to the investors.
1.4. Lending and Borrowing in the Financial System.
The financial system is one of the most important inventions of modern society. Its primary task
is to move scarce loanable funds from those who save to those who borrow for consumption and
investment.
Business firms, households, and governments play a wide variety of roles in modern financial
systems. It is quite common for an individual or institution to be a lender of funds in one period
and a borrower in the next, or to do both simultaneously. In this section we will discuss the
lending and borrowing activities in the financial system and explain why such activities are a
prerequisite for the existence of money and capital markets.
Financial assets exist in an economy because the savings of various individuals, corporations,
and governments during a period of time differ from their investment in real assets. Saving is the
difference between income (revenue) and consumption (expense). By real assets, we mean thing
such as houses, buildings, equipment, inventories and durable goods. If savings equaled
investment in real assets for all economic units in an economy over all periods of time, there
would be no external financing, no financial assets and no money and capital markets.
Each economic unit would be self sufficient, current expenditures and investment in real assets
would be paid for out of current income. A financial asset is created only when the investment of
an economic unit in real assets exceeds its savings, and it finances this excess by borrowing or
issuing equity securities. Of course, another economic unit must be willing to lend. In the
economy as a whole, savings-surplus economic unit (those whose savings exceed their
investment in real assets) provide funds to savings deficit units (those whose investment in real
assets exceeds their savings). This exchange of funds is evidenced by pieces of paper
representing a financial asset to the holder and a financial liability to the issuer.
If our investment in real assets exceeds our savings, we usually make up the difference by:
Liquidating some (all) of our financial assets (eg. Drawing money out of our savings
account);
issuing debt or equity securities or
Using some combination of both.

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On the other hand, if our savings exceed our investment in real assets, we can:
Build up our holdings of financial assets (eg. by placing money in a savings account or
buying a few shares of stocks);
pay off some outstanding debt or retire stock previously issued by our business firm; or
Do some combination of both.
To sum up: Savings-surplus economic units are net lenders of funds and are really a net supplier
of funds to the financial system. He or she accomplishes this function by purchasing financial
assets, paying off debt, or retiring equity (stock). In contrast, savings deficit economic units are
net borrowers of funds and are really net demanders of funds from the financial system. Such
units sell financial assets, issue new debt or sell new stock. The business and government sectors
of the economy tend to be net borrowers (demanders) of funds, while the household sector,
composed of all families and individuals, tends to be a net lender (supplier) of funds.

Chapter two
Financial Institutions in the Financial System
Chapter contents
2.1 Financial Institutions
2.2 Services of Financial Institutions
2.3 Functions/roles of Financial Intermediaries
2.4 Classifications of financial institutions

Chapter Objectives:
After completing this chapter, you will be able to:
➢ Define financial institutions
➢ Identify the key customers of financial institutions
➢ Describe the Capital Transfers
➢ Identify and explain the services of financial institutions
➢ Describe the role of financial intermediaries
➢ Analyze impact of financial intermediaries in an economy
➢ Describe the basis of classification of financial institutions
➢ Identify and describe the activities of depository institutions
➢ Identify and describe the activities of non-depository institutions
➢ Explain the differences and similarities among different financial institutions.
Introduction
Financial institutions are business organizations that act as mobilizers and depositories of
savings, and as purveyors of credit or finance.
They also provide various financial services to the community. They differ from non-financial
business organizations in respect of their products i.e., while the former deal in financial assets
such as deposits, loans, securities, and so on, the latter deal in real assets such as machinery,
equipment, stocks of goods, real estate, and so on.

12
The activities of different financial institutions may be either specialized or they may overlap;
quite often they overlap. Yet, we need to classify the financial institutions and this is done on
such basis as their primary activity or the degree of their specialization with relation to savers or
borrowers with whom they customarily deal or the manner of their creation. Thus, this chapter
will discuss the services of financial institutions and the differences and similarities among
different financial institutions.
2.1 Financial Institutions
Financial institutions are business organizations that act as mobilisers and depositories of
savings, and as purveyors of credit or finance.
They also provide various financial services to the community. They differ from non-financial
business organizations in respect of their products i.e., while the former deal in financial assets
such as deposits, loans, securities, and so on, the latter deal in real assets such as machinery,
equipment, stocks of goods, real estate, and so on.
Financial institutions serve as intermediaries by channeling the savings of individuals,
businesses, and governments into loans or investments.
They are major players in the financial marketplace that they often serve as the main
source of funds for businesses and individuals.
Some financial institutions accept customers’ savings deposits and lend this money to
other customers or to firms. In fact, many firms rely heavily on loans from institutions for
their financial support.
Financial institutions permit the flow of funds between borrowers and lenders by facilitating
financial transactions.
Key Customers of Financial Institutions
The key suppliers of funds to financial institutions and the key demanders of funds from
financial institutions are:
1. Individuals,
2. Businesses, and
3. Governments.
Individuals
The savings that individual consumers place in financial institutions provide these
institutions with a large portion of their funds. Individuals not only supply funds to
financial institutions but also demand funds from them in the form of loans. However,
individuals as a group are the net suppliers for financial institutions: They save more
money than they borrow.
Businesses
Firms also deposit some of their funds in financial institutions, primarily in checking
accounts with various commercial banks. Like individuals, firms also borrow funds from
these institutions, but firms are net demanders of funds. They borrow more money than
they save.
Governments.
Governments maintain deposits of temporarily idle funds, certain tax payments, and
Social Security payments in commercial banks. They do not borrow funds directly from
financial institutions, although by selling their debt securities to various institutions,

13
 governments indirectly borrow from them. The government, like business firms, is
typically a net demander of funds. It typically borrows more than it saves.

Financial institutions provide various types of financial services in an economy. Financial

intermediaries are a special group of financial institutions that obtain funds by issuing claims to
market participants and use these funds to purchase financial assets. In this section we will
discuss the different services of financial institutions. We will also discuss the role of financial
intermediaries, which is the most important type of financial institutions
Financial Institutions & Capital Transfers
Transfers of capital between savers and those who need capital will be direct financial flow and
/or indirect/intermediated financial flow.
Direct funds transfers are more common among individuals and small businesses and in
economies where financial markets and institutions are less developed.
While businesses in more developed economies do occasionally rely on direct transfers, they
generally find it more efficient to enlist the services of one or more financial institutions when it
comes time to raise capital. Before you see the capital transfer it is better looking the financial
markets and flow of funds relationship in the following figure
Figure 2.1. Financial markets and flow of funds relationship

Suppliers of funds: Demanders of funds:

• Surplus(savings) units • Deficit units

Lenders: Brrowers:
• Househooders • Householders
• companies • Companies
• Governments • Governments
• Rest of world • Rest of world

Receive financial Who supply

instruments Issue financial instruments Who receive funds?
fundfunds
Financial markets

Direct transfers of money and securities (direct financial flows):

When a business sells its stocks or bonds directly to savers, without going through any type of
financial institution, it is referred as direct financial flows. The business delivers its securities to
savers, who in turn give the firm the money it needs.
Figure 2.2 direct financial flow
Supplies of funds Provide funds Users of funds
(surplus units) Financial assets (deficit units)
Indirect/intermediated financial

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flow.
Transfers may also go through an investment bank (one type of financial institution) which
serves as a middleman and facilitates the issuance of securities and /or transfers can also be made
through financial intermediaries such as a bank or mutual fund.
The company sells its stocks or bonds to the investment bank, which in turn sells these same
securities to savers.
The businesses’ securities and the savers’ money merely “pass through ’’the investment bankers.
However, the investment bank does buy and hold the securities for a period of time, so it is
taking a risk- it may not be able to resell them to savers for as much as it paid.
Transfers can also be made through financial intermediaries such as a bank or mutual fund. Here
the intermediary obtains funds from savers in exchange for its own securities, and it then uses
this money to purchase and then hold a business’s securities. For example, a saver might deposit
money in a bank, receiving from it a certificate of deposit, and then the bank might lend the
money to a business in the form of a mortgage loan.
Therefore in the indirect financial flows there are two ways of capital transfer: first by using
same securities (businesses’ securities) and second using different securities (business securities
and intermediary securities) by investment banks and financial intermediaries respectively. See
figure 2.3 below.
Figure 2.3 indirect financial flow

Supplies of funds
Funds Funds Intermediaries
(surplus units) Users of funds
Financial
Asstes financial assets (deficit units)

2.2 Services of Financial Institutions

Financial institutions provide services related to one or more of the following:
1. Transforming financial assets acquired through the market and constituting them into a
different and more widely preferable type of asset-which becomes their liability. This is the
function performed by financial intermediaries, the most important type of financial
institutions.
2. Exchanging of financial assets on behalf of customers. In other words, financial institutions
also provide brokerage services.
3. Exchanging of financial assets for their own accounts. Some financial institutions purchase
financial assets (or securities) from different parties and then resell to savers. In such a
circumstance, the securities that are not yet sold will be held as inventories. This is the dealer
function and such services involve assistance in the trading of securities in the secondary
markets (market making).
4. Assisting in the creation of financial assets for their customers, and then selling those
financial assets to other market participants. Financial institutions, particularly investment
banks, (1) help corporations design securities with features that are currently attractive to
investors, (2) buy these securities from the corporation, and (3) resell them to savers.
Although the securities are sold twice, this process is really one primary market transaction,

15
 with the investment banker acting as a broker to help transfer of capital from savers to
businesses. This service is referred to as underwriting.
5. Providing investment advice to other market participants.
6. Managing the Portfolios of other market participants. The best example is the services of a
mutual fund (to be discussed in later sections).
2.3 Functions/roles of Financial Intermediaries
With financial intermediaries in an economy, the flow of savings from savers to users of funds
can be indirect.
Financial intermediaries include depository institutions (commercial banks, savings and loan
associations, savings banks, and credit unions) and none depository institutions (insurance
companies, investment companies, pension funds, and finance companies).
These intermediaries come between ultimate borrowers and lenders by transforming direct
claims into indirect ones. They purchase primary securities and, in turn, issue their own
securities. The primary security that a bank might purchase is a mortgage loan, a commercial
loan, or a consumer loan; the indirect claim issued is a demand deposit, a savings account, or a
certificate of deposit.
Financial intermediaries transform funds in such a way as to make them more attractive. On one
hand, the indirect security issued to ultimate lenders is more attractive than is a direct, or
primary, security. In particular, these indirect claims are well suited to the small saver. On the
other hand, the ultimate borrower is able to sell its primary securities to a financial intermediary
on more attractive terms than it could if the securities were sold directly to ultimate lenders.
Financial intermediaries provide a variety of economic functions that make the transformation of
claims attractive.
These economic functions include:
1. Maturity intermediation
The maturity of the indirect security is usually short term. For example, certain types of deposit
are payable upon demand. Others have a specific maturity date, but most are less than two years.
However, the maturity of the direct security may be considerably longer than two years. In the
absence of financial intermediary, the borrower would have to borrow for a shorter term or
savers would have to commit funds for a longer length of time than they want.
A financial intermediary is able to transform a primary security of a certain maturity into indirect
securities of different maturities. As a result, the maturities of the primary and the indirect
securities may be more attractive to the ultimate borrower and lender than they would be if the
loan were direct.
2. Reducing Risk via Diversification
Consider the example of the investor who places funds in an investment company, which in turn
invests the funds received in the stock of a large number of companies. By doing so, the financial
intermediary (or the investment company) is able to diversify risk. If these securities (stocks) are
less than perfectly correlated with each other, the intermediary is able to reduce the risk
associated with fluctuations in value of financial assets. Investors who have a small sum to invest
would find it difficult to achieve the same degree of diversification because they do not have
sufficient funds to buy shares of a large number of companies.
3. Reducing information processing costs

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 The financial intermediary is able to develop information on the ultimate borrower (and can
evaluate an investment) in a more efficient manner than the saver. Moreover, the intermediary
may be able to reduce the moral hazard problem of unreliable information
4. Divisibility and Flexibility
A financial intermediary is able to pool the savings of many individual savers to purchase
primary securities of varying sizes. In particular, the intermediary is able to tap small pockets of
savings for ultimate investment in real assets. The offering of indirect securities of varying
denomination makes financial intermediaries more attractive to the saver. Moreover, borrowers
have more flexibility in dealing with a financial intermediary than with a large number of lenders
and are able to obtain terms better suited to their needs.
5. Reducing other Transaction costs
Because financial intermediaries are continually in the business of purchasing primary securities
and selling indirect securities, economies of scale not available to the borrower or to the
individual saver are possible. As a result, transaction costs such as costs associated with locating
potential borrowers and savers, and other costs are lowered.
Investors who want to make a loan to a business will need to write the loan contract. However, to
write a loan contract they may not have the required knowledge and thus they have to hire an
attorney to do so. The employment of such professionals is not cost effective for individual
savers than it is for financial intermediaries.
In other words, there are economies of scale to a financial intermediary and the lower costs
accrue to the benefit of the individual saver (investor) who purchases a financial claim of the
financial intermediary and to the issuers of financial assets, who benefit from a lower borrowing
cost.
6. Providing a payments Mechanism
Most transactions made today are not done with cash. Instead, payments are made using checks,
credit cards, debit cards, and electronic transfer of funds. These methods for making payments,
called payment mechanisms, are provided by certain financial intermediaries. The ability to
make payments without the use of cash is critical for the functioning of a financial market. In
short, depository institutions transform assets that cannot be used to make payments into other
assets that offer that property.
7. Expertise and convenience
The financial intermediary is an expert in making purchases of primary securities and in so
doing eliminates the inconvenience to the saver of making direct purchases. The financial
intermediary is also an expert in dealing with ultimate savers- an expertise lacking in most
borrowers. Financial intermediaries must channel funds from the ultimate lender to the ultimate
borrower at a lower cost or with more convenience or both than is possible through a direct
purchase of primary securities by the ultimate lender. Otherwise, they have no reason to exist.
2.4 Classifications of financial institutions
1. Depository Financial Institutions
2. Non depository financial institutions

2.4.1 Depository Financial Institutions

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Financial institutions accept deposits from individuals, firms and government and provide loans
to individuals, firms and government.
All are financial intermediaries that acquire the bulk of their funds by offering their liabilities to
the public mostly in the form of deposits. Once they raise funds through deposits and other
funding sources, depository institutions both make direct loans to various entities and invest in
securities
Depository financial institutions include:
• Commercial banks (or simply banks),
• savings and loan associations,
• saving banks, and
• Credit unions.
In this section we will discuss the activities of each depository institutions, funding sources, asset
/liability problem of all depository institutions and other aspects of it.
Differences among depository financial institutions
The major differences among these types of institutions lie on:
1. Ownership (how they are owned)
2. Sources and
3. Uses of funds.
Income of depository financial institutions
The income of depository institutions is derived from two sources:
1. The income generated from the loans they make and the securities they purchase and
2. Fee income.
Depository institutions are highly regulated because of the vital role that they play in the
country’s financial system.
Demand deposit accounts are the principal means that individuals and business entities use for
making payments, and government monetary policy is implemented through the banking system.
Depository institutions seek to generate income by the spread between the return that they earn
on assets and the cost of their funds.
That is, they buy money and sell money. They buy money by borrowing from depositors or other
sources of funds. They sell money when they lend it to businesses or individuals. In essence,
they are spread businesses. Their objective is to sell money for more than it costs to buy money.
Consequently, the objective of a depository institution is to earn a positive spread between the
assets it invests in (what it has sold the money for) and the costs of its funds (what it has
purchased the money for). The spread income should be maximized to allow the institution to
meet operating expenses and earn a fair profit on its capital.
Risks
In generating spread income a depository institution faces several risks. Some of these risks
include:
1. Credit risk (default risk):
It refers to the risk that the issuer of a security that the depository institution holds will default on
its obligation or that the ultimate borrower will default on a loan obligation to the depository
institution.
2. Regulatory risk:

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 It refers to the risk that government will change the rules and regulations and these changes may
adversely affect the earnings of the institution.
3. Interest rate risk:
Let’s try to explain interest rate risk by using an illustration. Suppose that a depository
institution raises Br. 50 Million using deposit accounts that have a maturity of one year and
agrees to pay an interest rate of 5 percent. Let’s ignore the fact that the depository institution
cannot invest the entire Br. 50 million and suppose, for the time being, that Br. 50 million is
invested in a security that matures in 10 years paying an interest rate of 8 percent.
This depository institution has locked in a spread of 3 percent only for the first year because the
spread after the first year will depend on the interest rate this depository institution will have to
pay depositors in order to raise Br. 50 million after the one- year time deposit matures. If interest
rates decline, the spread will increase because the cost of borrowing will decline whereas the
lending rate is locked in an interest rate of 8 percent. If interest rates rise, however, the spread
income will decline and may even get negative. For example, if the borrowing interest rate rises
to 7 percent, the spread income will be 1 percent (8%-7%) which is less than 3 percent. Next
time, if interest rates on deposit accounts rise to 10 percent, the spread will be–2 percent (8%-
10%) because the lending rate is locked in the 8 percent rate.
In our example, the depository institution has borrowed short (borrowed for one year) and lent
long (invested for 10 Years). This policy will benefit from a decline in interest rates but be
disadvantaged if interest rates rise. The interest rate risk in our example is the risk that future
interest rates may rise.
Suppose that the depository institution follows a borrow long and lend short policy and that the
institution borrowed funds for 10 years at 5 percent and invested in a security maturing in one-
year earning 8 percent. A rise in interest rates will benefit the depository institution because it
can then reinvest the proceeds from the maturing one-year security in a new one-year security
offering a higher interest rate. In this case a decline in interest rates will reduce the spread and
may even make it negative if future lending rates decline below 5 percent. In this case, the
interest rate risk is the risk that future interest rates may decline.
Liquidity of depository financial institutions
Because of uncertainty about the timing and /or the amount of the cash outlays, a depository
institution must be prepared to have sufficient cash to satisfy withdrawals of funds by depositors
and to provide loans to customers.
A depository institution can accommodate withdrawals and loan demand in several ways. Some
of these include:
• Attracting additional deposits
• using existing securities as collateral for borrowing from a federal agency or other financial
institution such as an investment bank
• raise short – term funds in the money market; or
• Sell securities that it owns.
Depository institutions hold liquid assets not only for operational purposes, but also because of
the regulatory requirements.
Classification of Depository Financial Institutions

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 . Commercial banks and
A. Savings and loan associations
B. Saving banks, and
C. Credit unions
A. Commercial Banks
The dominant privately owned financial institution in the economies of most major countries is
the commercial bank. Commercial banks accumulate deposits from savers and use the
proceeds to provide credit to firms, individuals, and government agencies. Thus they
serve investors who wish to “invest” funds in the form of deposits.

Commercial banks use the deposited funds to provide commercial loans to firms and
personal loans to individuals and to purchase debt securities issued by firms or
government agencies. They serve as a key source of credit to support expansion by firms.
Historically, commercial banks were the dominant direct lender to firms. In recent years,
however, other types of financial institutions have begun to provide more loans to firms.
Like most other types of firms, commercial banks are created to generate earnings for
their owners.
In general, commercial banks generate earnings by receiving a higher return on their use
of funds than the cost they incur from obtaining deposited funds.
For example, a bank may pay an average annual interest rate of 4 percent on the deposits it
obtains and may earn a return of 9 % on the funds that it uses as loans or as investments in
securities. Such banks can charge a higher interest rate on riskier loans, but they are then
more exposed to the possibility that these loans will default.

Although the traditional function of accepting deposits and using funds for loans or to
purchase debt securities is still important, banks now perform many other functions as well.
In particular, banks generate fees by providing services such as travelers’ checks, foreign
exchange, personal financial advising, insurance, and brokerage services. Thus commercial
banks are able to offer customers “one-stop shopping.”
Therefore; commercial banks are called department stores of finance because commercial banks
satisfy a broad range of financial service needs in the economy. Commercial banks are the
principal means of making payments through the checking accounts (demand deposits) they
offer.
Banks are important because of their ability to create money from excess reserves made available
from the public’s deposits.
The banking system creates money simply by extending credit (i.e. making loans and purchasing
securities). Banks are also the principal channel for government monetary policy. Most countries
carry out policies to affect interest rates and the availability of credit mainly through altering the
level and growth of reserves held by banks and other depository institutions.
Ownership structure of commercial banks
Commercial banks are owned by:
❖ Private investors, called stockholders, or by
❖ Companies called bank holding companies.

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The vast majority of commercial banks are owned by bank holding companies. A bank holding
company is a corporation that exists only to hold shares in one or more banks. The company may
also hold stock in certain non-bank business ventures.
Sources of funds /liabilities (Bank funding) of commercial banks
The sources of funds for commercial banks include:
1. Deposits;
2. Non deposit borrowing; and
3. Capital stock(Common and preferred stocks and
4. Retained earnings.
Commercial banks obtain most of their funds by accepting deposits from investors. These
investors are usually individuals, but some are firms and government agencies that have
excess cash. Some deposits are held at banks for very short periods, such as a month or less.
Commercial banks also attract deposits for longer time periods by offering certificates of
deposit, which specify a minimum deposit level (such as $1,000) and a particular maturity
(such as 1 year) in United States of America. Because most commercial banks offer
certificates of deposit with many different maturities, they essentially diversify the times at
which the deposits are withdrawn by investors.
Therefore it can be said that Banks are highly leveraged financial institutions, which mean that
most of their funds come from borrowing (sources 1&2 above).
Equity capital (or net worth) supplied by a bank’s stockholders provides only a minor portion
(about 6 percent, on average) of total funds for most banks today.
Deposits
There are several types of deposit accounts. Some of these include:
▪ Demand deposits, also called checking accounts, are the principal means of making
payments because they are safer than cash and widely accepted. Demand deposits pay no
interest and can be withdrawn upon demand.
▪ Savings deposits pay interest, typically below market interest rates, do not have a
specific maturity, and usually can be withdrawn up on demand.
▪ Time deposits, also called certificates of deposit, have a fixed maturity date and offer the
highest interest rates a bank can pay.
▪ Nnegotiable orders of withdrawal (NOW) - NOW accounts may be drafted to pay bills
but also earn interest
▪ Automatic transfer services (ATS) and others that are nowadays created. ATS is a
preauthorized payments service in which the bank transfers funds from an interest-
bearing savings account to a checking account as necessary to cover checks written by
the customer.
The last two types of deposits combining the essential features of both demand and savings
accounts
Non-deposit borrowing
Non-deposit borrowing includes:
1. Borrowing reserves in the federal funds market,
2. Borrowing from the Federal Reserve Bank, and
3. Borrowing by the issuance of instruments in the money and bond markets.

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 Let’s see them one by one.
Reserve requirements and borrowing in the federal funds Market.
A bank cannot invest Br.1 for every Br.1 it obtains in deposit. All banks must maintain a
specified percentage of their deposits in a non-interest bearing account at the federal reserve
bank or as cash in the bank’s vault ( that is, currency on hand ).
Each bank’s legal reserves may be divided into two categories
❖ Required reserves and
❖ Excess reserves.
Required reserves are equal to the legal reserve requirement ratio times the volume of deposits
subject to reserve requirements.
Excess reserves equal the difference between the total legal reserves actually held by a bank
(actual reserves) and the amount of its required reserves.
For example, if a bank holds Br.20 million in transaction accounts and Br.30 million in short-
term time deposits and the law requires it to hold 3 percent of its transaction accounts and 3
percent of its short term time deposits in legal reserves, the required reserve for this bank is
Br.1.5 million (or Br.20 million x3% + Br. 30 millionx3% ). If this bank has actual reserves of
Br. 400,000 in cash on the premises and Br.1.6 million on deposit with the Federal Reserve bank,
this bank clearly holds Br. 500,000 in excess reserves (i.e. Br. 400,000+Br.1.6 million – 1.5
million= Br 500,000).
Because reserves are placed in non-interest-bearing accounts, there is an opportunity cost
associated with excess reserves. At the same time, there are penalties imposed on banks that do
not satisfy the reserve requirements. Thus, banks have an incentive to manage their reserves so
as to satisfy reserve requirements as precisely as possible. Banks temporarily short of their
required reserves can borrow reserves from banks that have excess reserves. The market where
banks can borrow or lend reserves (federal funds) is called the federal funds market.
Borrowing from the Federal Reserve Bank
The Federal Reserve Bank is the banker’s bank –or to put it another way, the bank of last resort.
Banks temporarily short of funds can borrow from the Federal Reserve Bank (Fed). Collateral is
necessary to borrow and the Fed establishes (and periodically changes) the type of collateral that
is eligible.
Other non-deposit borrowing
Bank borrowing in the federal funds market and from Fed is short term. Other non-deposit
borrowing can also be short term in the form of issuing obligations in the money market.
This includes:
❖ Security repurchase agreements or repo market- where securities are sold temporarily by a
bank and then bought back later.
❖ Other non-deposit borrowing also includes issuance of securities (intermediate to long term)
in the bond market.
Equity capital
Banks can raise funds by issuing common stock. They can also use their retained profits.
However, banks highly rely on borrowings rather than equity capital.
Uses of funds (Assets) for commercial banks

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 Commercial banks use most of their funds either to provide loans or to purchase debt
securities. In both cases they serve as creditors, providing credit to those borrowers who need
funds. They provide commercial loans to firms, make personal loans to individuals, and
purchase debt securities issued by firms or government agencies. Most firms rely heavily on
commercial banks as a source of funds. They offer a wider array of financial services than any
other form of institution, meeting the credit, payments, and savings needs of individuals,
businesses, and governments.
Assets of commercial banks include the following
1. Cash and Due from Banks ( Primary reserves)
2. Security holdings and secondary reserves
3. Loans
1. Cash and Due from Banks ( Primary reserves)
All commercial banks hold a substantial part of their assets in primary reserves, consisting of
cash and deposits due from other banks. These reserves are the banker’s first line of defense
against withdrawals by depositors, customer demand for loans, and immediate cash needs to
cover expenses. Banks generally hold no more in cash than is absolutely required to meet short-
run contingencies since the yield on cash assets is nonexistent. Primary reserves also include
reserves held behind deposits as required by the Federal Reserve System.
2. Security holdings and secondary reserves
Commercial banks hold securities acquired in the open market as a long-term investment and
also as a secondary reserve to help meet short-run cash needs. For many banks, municipal
securities (bonds and notes issued by state, city and other local governments) represent the
largest portion of security investments. In addition to municipal securities, investment in treasury
obligations (including bills, notes and bonds) are also assets of banks.
Commercial banks also hold small amounts of corporate bonds and notes, though they generally
prefer to make direct loans to businesses as opposed to purchasing their securities in the open
market. Under existing regulations, commercial banks are forbidden to purchase corporate stock.
However, banks do hold small amounts of corporate stock as collateral for loans.
3. Loans
The principal business of commercial banks is to make loans to qualified borrowers. Loans are
among the highest-yielding assets a bank can add to its portfolio, and they provide the largest
portion of operating revenue. Banks make loans of reserves to other banks through the federal
funds market and to securities dealers through repurchase agreements. Far more important in
dollar volume, however, are direct loans to both businesses and individuals. These loans arise
from negotiation between the bank and its customer and result in a written agreement designed to
meet the specific credit needs of the customer and the requirements of the bank for adequate
security and income. Commercial banks make loans to nonfinancial corporations, financial
corporations (such as life insurance companies), and government entities. Banks also make
consumer loans, residential mortgage loans, consumer installment loans, credit card financing,
automobile and boat financing, student loans, etc.
Regulations of commercial banks
Commercial banks do have a vital role in the financial system of a country and hence they are
highly regulated and supervised. The regulations cover the following areas.

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 - Ceilings imposed on the interest rates that can be paid on deposit accounts
- Geographical restrictions on branch banking
- Permissible activities for commercial banks.
- Capital requirements for commercial banks.
So far we have discussed commercial banks. In the next section we will discuss on the
thrifts.
These include:
1. Savings and loan Associations (S&Ls)
2. Savings Banks
3. Credit Unions
B. Savings and loan Associations (S&Ls)
Saving and loan associations are the major source of mortgage loans to finance the purchase of
homes. The collateral for the loans would be the home being financed.
More recently, however, competition from commercial banks coupled with unstable interest rates
and many failures have forced savings and loans to diversify their operations.
The acceptable list of investments now includes consumer loans (loans for home improvement,
automobiles, education, and credit cards), non-consumer loans (commercial, corporate, business,
or agricultural loans), and municipal securities. S&Ls are not permitted to invest in junk bonds.
S&Ls invest in short term assets for operational (liquidity) and regulatory purposes. Liquidity
requirements are not imposed on banks because the majority of their assets are of less than five
years’ maturity.
Like banks, S&Ls are now subject to reserve requirement.
Ownership structure of S&Ls
In terms of ownership, S&Ls are either mutually owned or have corporate stock ownership.
In mutually owned ones stocks are not issued (thus, no stock outstanding) and therefore the
depositors themselves are the owners. Any profits of the institution will be distributed to
depositors instead of stockholders (because there are no stockholders).
Sources of funds
The sources of funds for S&Ls consist of passbook savings accounts, time deposits and
negotiable order of withdrawal (NOW) accounts. The S&Ls can also raise funds in the money
market (e.g. – they can use the repurchase agreement market, borrow in the federal funds market
and from the Fed) and the bond market.
Uses of funds
Mortgage loans to finance the purchase of homes.
C. Savings Banks
Savings banks are similar to, although much older than, S&Ls. These institutions play an active
role in the residential mortgage market, as do savings and loans, but are more diversified in their
investments, purchasing corporate bonds and common stock, treasury and government agency
securities, making consumer loans and investing in commercial mortgages. This is because more
portfolio diversification was allowed for savings banks than was permitted for S&Ls.
The principal source of funds for savings banks is deposits. Savings banks offer the same types
of deposit accounts as S&Ls. However, the ratio of deposits to total assets is greater for savings

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banks than for S&Ls. In terms of ownership, they can be either mutually owned (called mutual
savings banks) or stockholder owned. Most savings banks are of the mutual form.
D. Credit Unions
Credit unions are institutions established to provide credit to individuals who share some
common bond, such as working in the same organization, belonging to the same association, or
neighborhood. While they are the smallest of the depository institutions, they are many in
number. The members of credit union provide the funds primarily in the form of savings
accounts. Credit unions are exclusively household oriented intermediaries offering their deposit
plans and credit resources only to individuals and families. Their rapid growth stems mainly
from offering low loan rates and high deposit interest rates to individuals and families.
Credit unions are really cooperative, self-help associations of individuals, rather than profit
motivated financial institutions. The dual purpose of credit unions is to serve their members’
saving and borrowing needs and the members of credit unions are technically the owners,
receiving any distribution of profits and sharing in any losses that occur. There is no corporate
stock ownership. Credit unions began early in the twentieth century and are the newest of the
depository institutions.
2.4.2 Non-Depository Financial Institutions
Non-depository financial institutions do not accept deposits. They raise funds by offering legal
contracts, selling shares to the public, borrowing in the money market and issuing long-term
debt. This section provides a general idea of each non-depository institution.
. Insurance companies, C. finance companies and
A. pension funds, D. investment banks
B. mutual funds,
A. Insurance Companies
Insurance companies provide insurance policies, which are legally binding contracts for which
the policy holder (or owner) pays insurance premiums.
According to the insurance contract, insurance companies promise to pay specific sums
contingent on the occurrence of future events, such as death or an automobile accident. Thus,
insurance companies are risk bearers.
Insurance companies can be divided in to two-life insurance and property and casualty insurance.
Life insurance companies today insure policy holders against three basic kinds of risk: premature
death, the danger of living too long and outlasting one’s accumulated assets, and serious illness
or accident.
Life insurance companies invest the bulk of their funds in long-term securities-bonds, stocks, and
mortgages, thus helping to fund real capital investment by businesses and government. In case of
a property and casualty insurance, the policy involves the payment of periodic fee or premium to
the company in exchange for a promise to pay the insured if a damage to various types of
property that is being insured against occurs.
The importance of insurance companies in the financial system is based more on their ability to
accumulate funds for investment than on their stated business of providing insurance. They hold
large amount of securities, and are a major source of business financing.
B. Pension Funds

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Pension funds are established to provide income to retired persons in the economy. The fund is
raised through the contribution of employees who are supposed to be the beneficiaries up on
retirement. The employers also contribute to this fund to undertake their social obligation and to
ensure the welfare of their ex-employees. Those funds are then invested in different securities.
The major roles of pension fund are:
• It provides sustaining security to the society
• It helps in maintaining consumer market
• It becomes the source of finance for government-based investments.
• It serves the role of national economy stabilization by investing on government bonds.
There are two basic and widely used types of pension plans:
1. Defined benefit plans and
2. Defined contribution plans.
In a defined benefit plan, the plan sponsor agrees to make specified dollar payments annually to
qualifying employees beginning at retirement (and some payments to beneficiaries in case of
death before retirement).These payments typically occur monthly. The pension obligations are
effectively a debt obligation of the plan sponsor. The plan sponsor, thereby, assumes the risk of
having insufficient funds in the plan to satisfy the regular contractual payments that must be
made to retired employees.
In a defined contribution plan, however, the plan sponsor is responsible only for making
specified contributions into the plan on behalf of qualifying participants, not specified payments
to the employee after retirement. The amount contributed is typically either a percentage of the
employee’s salary and /or a percentage of the employer’s profits. The plan sponsor does not
guarantee any specific amount at retirement. The payments that will be made to qualifying
participants upon retirement depend on the investment performance of the funds in which the
assets are invested and are not guaranteed by the plan sponsor.
C. Mutual Funds
Mutual funds (one type of investment companies) are financial intermediaries that sell shares to
the public and invest the proceeds in a diversified portfolio of securities.
Mutual funds are a kind of financial institution that combine the money of its shareholders and
invest those funds in a wide variety of stocks, bonds, and so-called money market instruments.
These companies are especially attractive to the small investor, to whom they offer continuous
management services for a large and highly varied security portfolio. By purchasing shares
offered by an investment company, the small saver gains greater price stability and reduced risk,
opportunities for capital gains, and indirect access to higher yielding securities that can only be
purchased in large blocks.
The distinct feature of mutual funds is that persons owning shares in the fund have a right to sell
them back to the fund at their current asset value whenever they wish to do so. The fund is
obligated to redeem the shares it issues, and mutual shares are not traded in secondary markets.
The importance of these institutions in the financial system is that they provide an easy way for

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individuals to invest in a diversified portfolio of financial assets. Thus, mutual funds provide the
investor with professional management of funds and diversification of investment risk.
D. Finance Companies
Finance companies are financial intermediaries the function of which is to make loans to both
individuals and business. Finance companies provide such services as:
• Consumer lending,
• Business lending, and
• Mortgage financing.
Unlike banks, finance companies do not accept deposits; instead, they rely on short-and long-
term debt for funding. Finance companies charge higher rates for consumer loans than banks.
The higher rates that finance companies charge, for consumer loans is due to risks of consumer
loans than commercial banks. In fact, customers that seek individual (or business) loans from
finance companies are often those who have been refused loans at banks or thrifts.
E. Investment Banks
Investment banking involves the raising of debt and equity securities for corporations or
governments.
This includes the: Origination, Underwriting, and Distribution of issues of new securities.
Investment banking also includes corporate finance activities such as:
• Advising on mergers and acquisitions, and Advising on the restructuring of existing
corporations.
The major source of fund for investment banks is:
• The repurchase agreement (securities sold under agreement to repurchase).
• Securities sold short for future delivery

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