CHAPTER-3

FINANCIAL INSTITUTIONS IN THE FINANCIAL SYSTEM

This chapter contains the following sub topics

 Classification of financial institutions

 Depository financial institutions
 Non-depository institutions
 Investment banking firms

Introduction

Financial system of a country consists of the four important components such as:
• Financial Institutions
• Financial Markets
• Financial Instruments
• Financial Services.

Financial Institutions
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
market. 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 are required by the government to operate within established regulatory
guidelines.
Financial institutions are the major part of a financial system. Hence, it is more importance than
other component of the financial system because all the components of financial system are
directly or indirectly related with the financial institutions. Financial institutions are providing
various services to the economic development with the help of issuing of the financial
instruments.

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Classification of Financial Institutions
In financial market there are many types of financial institutions or intermediaries exist for the
flow of funds. Some of them involve in depositary type of transactions whereas other involve in
non-depositary type of transactions. The type of financial institutions can be divided into two
types as follows:
1. Depository Financial Institutions
The depository types of financial institutions include banks, credit unions, saving and loan
associations and mutual saving banks
2. Non-depository Institutions
Non-depository institutions are not banks in real sense. They make contractual arrangement and
investment in securities to satisfy the needs and preferences of investors. The non-depository
institutions include insurance companies, pension funds, finance companies and mutual funds.
(1) Depository financial institutions or Banking Institutions: It includes the following:
(A) Banks
(B) Credit unions
(C)Saving and loan associations
(D)Mutual saving banks

(A) BANKS
It is very difficult to give a precise definition of a bank due to the fact that a modem bank
performs a variety of functions. Ordinarily a 'Bank' is an institution which deals with the
money and credit in such a manner that it accepts deposits from the public and makes the surplus
funds available to those who need them, and helps in remitting money from one place to another
safely.

Types of Banks
Banks are of various types and can be classified as under
1. On the basis of ownership.
2. On the basis of domicile.
3. On the basis of functions.

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A. On the basis of Ownership
Banks can be classified on the basis of ownership in the following categories:
(i) Public Sector Banks
(ii) Private Sector Banks
(iii) Cooperative Banks

(i) Public Sector Banks

The banks which are owned or controlled by the Government are called "Public Sector Banks".
(ii) Private Sector Banks
On the contrary Private Sector Banks are those banks which are owned and controlled by the
private sector i.e. private individuals and corporations.
(iii) Co-operative Banks
The word 'cooperative' stands for working together. Therefore cooperative banking means an
institution which is established on the principle of cooperation dealing in ordinary banking
business. Cooperative banks are special type of banks doing ordinary banking business in which
the members cooperate with each other for the promotion of their common economic interests.

Features of Cooperative Banking

Following are the distinguishing main features of a cooperative bank:-
(a) Membership of Cooperative Banks is voluntary.
(b) Functions of a Cooperative Bank are common banking functions.
(c) Organization and management of a Cooperative Bank is based on democratic principles.
(d) Main objectives of a Cooperative bank are to promote economic, social and moral
development of its members.
(e) Basic principle of Cooperative Bank is equality.

(B) On the basis of domicile

The banks can be classified into the following two categories on the basis of domicile:
(i) Domestic Banks
(ii) Foreign Banks

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(i) Domestic Banks
Those banks which are incorporated and registered in Ethiopia are called domestic banks.
(ii) Foreign Banks
Foreign Banks are those banks which are set up in a foreign country with their control and
management in the hands of head office in their country of origin but having business branches
in Ethiopia. Foreign Banks are also known as Foreign Exchange Banks or Exchange Banks.

(C) On the basis of functions

The banks can be classified on the basis of functions in the following categories:
(i) Commercial Banks
(ii) Industrial Banks
(iii) Agricultural Banks
(iv) Exchange Banks
(v) Central Bank

(i) Commercial Banks

Commercial Banks are those banks which perform all kinds of banking business and functions
like accepting deposits, advancing loans, credit creation, and agency functions for their
customers. Since their major portion of the deposits are for the short period, they advance only
short term and medium term loans for business, trade and commerce. Majority of the commercial
banks are in the public sector.
(ii) Industrial Banks
The Industrial banks are those banks which provide medium term and long term finance to the
industries for the purchase of land and building, plant and machinery and other industrial
equipment. They also underwrite the shares and debentures of the industries and also subscribe
to them.
(iii) Agriculture Banks
The needs of agricultural credit are different from that of industry, business, trade and
commerce. Commercial banks and industrial banks do not deal with agriculture credit financing.
An agriculturist has both types of needs:
(i) He requires short term credit to purchase seeds, fertilizers and other inputs and

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(ii) He also requires long term credit to purchase land, to make permanent improvement on land,
to purchase agricultural machinery and equipment such as tractors etc.Agricultural credit is
generally provided by the Cooperative institutions.
(iv)Exchange Banks
The exchange banks are those banks which deal in foreign exchange and specialized in financing
the foreign trade. Therefore, they are also called foreign exchange banks. Foreign Exchange
Banks are those banks which are set up in a foreign country with then control and management
in the hands of head office in their country of origin but having business branches in Ethiopia.
(v) Central Bank
The Central Bank is the apex bank of a country which controls, regulates and supervises the
banking, monetary and credit system of the country. The Central Bank is owned and controlled
by the Government of the country. The Reserve Bank of India is the Central Bank in India. The
important function of central bank is as follows:-
(i) It acts as banker to the Government of the country.
(ii) It also acts as agent and financial advisor to the Government of the country.
(iii) It has the monopoly to issue currency of the country.
(iv) It serves as the lender of the last resort.
(v) It acts as the clearing house and keeps cash reserves of commercial banks.

FUNCTIONS OF COMMERCIAL BANKS

The Commercial Banks perform a variety of functions which can be divided in the following
three categories:
1. Basic Functions
2. Agency Functions
3. General Utility Functions
1. Basic Functions
The basic functions of bank are those functions without performing which an institution cannot
be called a banking institution at all. That is why these functions are also called primary or acid
test function of a bank. The basic/primary/acid test function of a bank is:-
(a) Accepting Deposits,
(b) Advancing of Loans and

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(c) Credit Creation

(a) Accepting Deposits

The first and the most important function of a bank is to accept deposits from those people who
can save and spare for the safe custody with the bankers.. For this purpose the banks have
different kinds of deposit accounts to attract the people which are as under;-
(i) Saving Deposit Account
(ii) Fixed Deposit Account
(iii) Current Deposit Account
(iv) Recurring Deposit Account
(v) Home Loan Account
(b) Advancing of Loans
Advancing of loans is the second acid test function of the commercial banks. After keeping
certain cash reserves, the banks lend their deposits to the needy borrowers. It is one of the
primary functions without which an institution cannot be called a bank. The bank lends a certain
percentage of the cash lying in the deposits on a higher rate of interest than it pays on such
deposits. The longer the period for which the loan is required the higher is the rate of interest.
Similarly higher the amount of loan, the higher shall be the rate of interest. Before advancing the
loans the bank satisfy themselves about the credit worthiness of the borrowers. This is how a
bank earns profits and carries on its banking business. There are various types of loans which are
provided by the banks to the borrowers. Some of the important ways of advancing loans are as
under:-

(i) Call Money Advances

(ii) Cash Credits
(iii) Overdrafts
(iv) Discounting Bills of Exchange
(v) Term Loans
(vi) Credit Creation

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(i) Call Money Advances
The Call Money Market which is also known as inter-bank call money market deals with very
short period loans called call loans.
(ii) Cash Credits
This is a type of loan which is provided to the businessmen against their current assets such as
shares, stocks, bonds etc. These loans are not based on credit worthiness or personal security of
the customers.
(iii) Overdrafts
The facility of Over Drafts is provided to the traders and businessmen through current accounts
for which the banks charge interest on the outstanding balance of the customers. A limit is fixed
by the bankers for withdrawal of over drafts and the customer is not allowed to withdraw more
than that limit from his Over Draft Current Account.
(iv) Discounting Bills of Exchange
A holder of a bill of exchange can get it discounted with a commercial bank. Bills of Exchange
are also called the Commercial Bills and the market dealing with these bills is also called
commercial bill market. Bills of exchange are those bills which are issued by the businessmen or
firms in exchange of goods sold or purchased. The bill of exchange is a written unconditional
order signed by the drawer (seller) requiring the drawee (buyer) to pay on demand or at a fixed
future date, (usually three months after date written on the bill of exchange), a definite sum of
money. After the bill has been drawn by the drawer (seller), it is accepted by the drawee (buyer)
by countersigning the bill. Once the buyer puts his acceptance on the bill by signing it, it
becomes a legal document. They are like post dated cheques issued by the buyers of goods for
the goods received.

(v) Term Loan

Earlier the commercial banks were advancing only short term loans. The commercial banks have
also started advancing medium term and long term loans. Now the maturity period of term loans
is more than one year.

(vi) Credit Creation

Credit Creation is one of the basic functions of a commercial bank. A bank differs from the other
financial institutions because it can create credit. Like other financial institutions the commercial

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banks also aim at earning profits. For this purpose they accept deposits and advance loans by
keeping small cash in reserve for day-to-day transactions. In the layman's language when a bank
advances a loan, the bank creates credit or deposit. Every bank loan creates an equivalent deposit
in the bank. Therefore the credit creation means multiple expansions of bank deposits. The word
creation refers to the ability of the bank to expand deposits as a multiple of its reserves.

2. Agency Functions
The commercial banks also perform certain agency functions for and on behalf of their
customers. The bank acts as the agent of the customer while performing these functions. These
functions are:
(i) Remittance of funds
(ii) Collection and Payment of Credit Instruments
(iii) Execution of Standing Orders
(iv) Purchase and Sale of Securities
(v) Collection of dividends on shares and interest on debentures
(vi) Trustees and Executors of wills
(vii) Representation and Correspondence

(i)Remittance of Funds
Commercial banks provide a safe remittance of funds of their customers from one place to
another through cheques, bank drafts, telephone and electronic transfers etc.
(ii) Collection and Payment of Credit Instruments
The commercial banks used to collect and pay various negotiable instruments like cheques, bills
of exchange, promissory notes, and hundis etc.
(iii) Execution of Standing Orders
The commercial banks also execute the standing orders and instruments of their customers for
making various periodic payments like subscriptions, rents, insurance premiums and fees on
behalf of the customers out of the accounts of their customers.
(iv) Purchase and Sale of Securities
The commercial banks also undertake the sale and purchase of securities like shares, stocks,
bonds, debentures etc., on behalf of their customers performing the function as a broker agent.

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(v) Collection of dividends on shares and interest on debentures
Commercial banks also make collection of dividends announces by the companies of which the
customer of the bank is a shareholder, and also collects the interest on the debentures which
becomes due on particular dates generally half yearly or annually.
(vi) Trustees and Executors of wills
The commercial banks preserves the wills of their customers as their trustees and execute the
wills after the death of the customer as per the will as the executors.
(vii) Representation and Correspondence
The commercial banks also act as the representative and correspondents of their customers and
get passports, traveler's tickets, book vehicles and plots for their customers on the directions of
the customers.

3. General Utility Functions

In addition to basic functions and agency functions the commercial banks also provide general
utility services for their customers which are needed in the various walks of life. These functions
are as follows:
(i) Locker Facility
(ii) Traveler's Cheque Facility
(iii) Gift Cheque Facility
(iv) Letter of Credit
(v) Underwriting Contract
(vi) Provides Statistical Data
(vii) Foreign Exchange Facilities
(viii) Merchant Banking Services
(ix) Acting as Referee

(B) CREDIT UNIONS

Credit unions (CUs) are not-for-profit depository institutions mutually organized and owned by
their members (depositors). They were established in the United States in the early 1900s as self-
help organizations. Members paid an entrance fee and put up funds to purchase at least one

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deposit share. Members were expected to deposit their savings in the CU, and these funds were
lent only to other members.

CUs are prohibited from serving the general public. Rather, in organizing a credit union,
members are required to have a common bond of occupation (e.g., police CUs), association (e.g.,
university-affiliated CUs), or cover a well-defined neighborhood, community, or rural district.
CUs may, however, have multiple groups with more than one type of membership. Each credit
union decides the common bond requirements (i.e., which groups it will serve) with the approval
of the appropriate regulator

The primary objective of credit unions is to satisfy the depository and borrowing needs of their
members. CU member deposits (called shares, representing ownership stakes in the CU) are used
to provide loans to other members in need of funds. Earnings from these loans are used to pay
interest on member deposits. Because credit unions are not-for-profit organizations, their
earnings are not taxed.

(C) SAVING INSTITUTIONS

Savings institutions comprise two groups of depository institutions: savings associations and
savings banks. Historically, the industry consisted of only savings associations (referred to as
savings and loan (S&L) associations).

Like commercial banks, the main financial service provided by savings institutions, credit
unions, and finance companies is lending. Savings institutions (SIs) were created in the early
1800s in response to commercial banks' concentration on serving the needs of business
(commercial) enterprises rather than the needs of individuals requiring borrowed funds to
purchase homes. Thus, the first SIs pooled individual savings and invested them mainly in
mortgages and other securities. While today's SIs generally perform services similar to com-
mercial banks, they are still grouped separately because they provide important residential
mortgage lending and other financial services to households. That is savings institutions con-
centrate primarily on residential mortgage lending. However, these institutions have recently
operated in a slightly more diversified way, with a large concentration of residential mortgage
assets but holding commercial loans, corporate bonds, and corporate stock as well.

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(D) MUTUAL SAVING BANKS
Mutual saving banks are more or less similar to saving and loan associations. They primarily
accept savings of individuals and they are lent to the home users and consumers on a long-term
basis.
(2)Non-Depository Institutions or Non-Banking Institutions

Non-banking Financial Institutions are providing fund based services such as investment,
insurance, mutual funds etc. It includes the following institutions:
(A) Insurance Companies
(B) Pension/Provident Funds
(C) Finance Companies
 (D) Mutual Funds

(A)Insurance Companies
Insurance services offered by financial institutions (FIs) compensate individuals and corporations
(policyholders) if a pre-specified adverse event occurs, in exchange for premiums paid to the
insurer by the policyholder. The insurance provider can act either as an insurance underwriter or
an insurance broker. An insurance underwriter assesses the risk of an applicant for cover age or
for a policy. An insurance broker simply sells insurance contracts for coverage or for a policy.
Thus, a broker acts more as a middleman between the insurance underwriter and the applicant.
Insurance services are classified into two major groups: (1) life and (2) property-casualty. Life
insurance provides protection in the event of untimely death, illnesses, and retirement. Property-
casualty insurance protects against personal injury and liability due to accidents, theft, fire, and
other catastrophes. Many FIs offer both life and property-casualty services. Further, many FIs
that offer insurance services also sell a variety of investment products in a similar fashion to
other financial service firms, such as mutual funds.

A. LIFE INSURANCE
Life insurance allows individuals and (heir beneficiaries to protect against losses in income
through premature death or retirement. By pooling risks, life insurance transfers income-related
uncertainties from the insured individual to a group.

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The four basic classes or lines of life insurance are distinguished by the manner in which they are
sold or marketed to purchasers. These classes are (I) ordinary life (2) group life, (3) credit life,
and (4) other activities.
Generally life insurance companies offer the following type of life insurance policies:

1. Ordinary Life
Ordinary life insurance policies are marketed on an individual basis. It include the following
type of policies.
i. Term Life
This policy is the closest to pure life insurance; it has no savings element attached. Company will
pay only if the individual will die during the coverage period. If the insured individual lives
beyond the term of the contract, the contract expires and policy holder will get nothing.

ii. Whole Life

This policy protects the individual over an entire lifetime rather than for a specified coverage
period. In the early years of the contract, premiums are larger than those for term life contracts
and in the later years they are smaller. The overpayment in the early years creates a cash value
for whole life contracts that insured individuals can borrow against (at a stated rate paid to the
insurance company).

iii. Endowment Life

This type of policy combines a risk cum investment element. It guarantees a payout to the
beneficiaries of the policy if death occurs during some endowment period (e.g., prior to reaching
maturity). An insured person who lives to the endowment date (maturity date) receives the face
amount of the policy.

iv. Variable Life

Unlike traditional policies, usually, policyholders can choose mutual fund investments to reflect
their risk preferences. Thus, variable life provides an alternative way to build savings compared
to the more traditional policies such as whole life because the value of the policy increases (or
decreases) with the asset returns of the mutual fund in which premiums are invested.

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v. Universal Life and Variable Universal Life
A universal life policy allows the insured to change both the premium amounts and the maturity
of the life insurance contract. In addition, for some contracts, insurers invest premiums in money,
equity, or bond mutual funds—as in variable life insurance—so that the savings or investment
component of the contract reflects market returns. In this case, the policy is called variable
universal life.
2. Group Life Insurance
Group life insurance covers a large number of insured persons under a single policy. Usually
issued to corporate employers, these policies may be either contributory (where both the
employer and employee cover a share of the employee's cost of the insurance) or non-
contributory (where the employee does not contribute to the cost of the insurance; rather the cost
is paid entirely by the employer) for the employees themselves.
3. Credit Life
Credit life insurance protects lenders against a borrower's death prior to the repayment of a debt
contract such as a mortgage or car loan. Usually, the face amount of the insurance policy reflects
the outstanding principal and interest on the loan.

4. Other Life Insurer Activities

Three other major activities of life insurance companies are the sale of annuities, private
pension plans, and accident and health insurance.

i. Annuities
Individuals can purchase annuities with a single payment or payments spread over a number of
years. Payments may be structured to begin immediately, or they can be deferred (for example,
to start at retirement). These payments may cease at death or continue to be paid to beneficiaries
for a number of years after death.

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Example

ii. Private Pension Funds

Insurance companies offer many alternative pension plans to private employers in an effort to
attract this business away from other financial service companies such as commercial banks and
securities firms. Some of their innovative pension plans are based on guaranteed investment
contracts (GICs).

iii. Accident and Health Insurance

While life insurance protects against mortality risk, accident and health insurance protects
against ill-health risk. The rising cost of medical care has made accident and health insurance a
top priority for those wanting to have health expenses covered at a reasonable cost.'

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 2. PROPERTY-CASUALTY INSURANCE COMPANIES
These companies cover the following areas
i. Fire Insurance and Allied Lines
ii. Homeowners Multiple Peril (MP) insurance
iii. Commercial Multiple Peril insurance
iv. Automobile Liability and Physical Damage (PD) insurance
v. Liability Insurance (other than auto)

B. Pension Funds

Pension funds are similar to life insurance companies and mutual funds in that all three attract
small savers' funds and invest them in the financial markets to be liquidated at a later date.
Insurance companies and mutual funds are the main providers of pension funds. Pension funds
are unique, however, in that they offer savings plans through which fund participants accumulate
tax deferred savings during their working years before withdrawing them during their retirement
years. Pension funds provide the defined benefit pension funds and defined contribution
pension fund

Under defined benefit pension funds, the employer should set aside sufficient funds to ensure
that it can meet the promised payments. When sufficient funds are available, the pension fund is
said to be fully funded.
Under defined contribution pension fund in which the employer agrees to make a specified
contribution to the pension fund during the employee's working years.
The pension fund industry comprises two distinct sectors.

i. Private Pension Funds

Private pension funds are created by private entities (e.g. manufacturing, mining, or trans-
portation firms) and are administered by private corporations (financial institutions). Private fund
contributions come from fund participants and/or their employers. Defined contribution funds are
increasingly dominating the private pension fund market. Indeed, many defined benefit funds are

15
converting to defined contribution funds. Amount of pension depends on contribution and return
on investment by insurance companies.

ii. Public pension funds

Public pension funds are those funds administered by a federal, state, or local government (e.g.
Social Security).

Defined Benefit versus Defined Contribution Pension Funds

A pension plan governs the operations of a pension fund. Pension funds can be distinguished by
the way contributions are made and benefits are paid. A pension fund is either a defined benefit
fund or a defined contribution fund. In a defined benefit pension fund, the corporate employer
(or fund sponsor) agrees to provide the employee a specific cash benefit upon retirement, based
on a formula that considers such factors as years of employment and salary during employment.
The formula is generally one of three types: flat benefit, career average, or final pay formula. It is
used by government sector only.

3. Mutual Funds
Mutual funds are financial institutions that pool the financial resources of individuals and
companies and invest those resources in (diversified) portfolios of assets. Open-end mutual funds
(the majority of mutual funds) sell new shares to investors and redeem outstanding shares on
demand at their fair market values. They provide opportunities for small investors to invest in a
liquid and diversified portfolio of financial securities. Thus, mutual funds can be viewed both as
a financial institution and as a type of security investment. For small investors, mutual funds are
also able to enjoy economies of scale by incurring lower transaction costs and commissions.

Different Types of Mutual Funds

The mutual fund industry is usually considered to have two sectors: short-term funds and long-
term funds. Long-term funds comprise the following
i. Equity Funds
These funds are consisting of common and preferred stock securities.

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ii. Bond Funds
These funds are consisting of fixed income capital market debt securities.

iii. Hybrid Funds

Hybrid funds are consisting of both stock and bond securities.
iv. Index Funds
A growing number of the long-term mutual funds are index funds in which fund managers buy
securities in proportions similar to those included in a specified major stock index (such as the
S&P 500 index).

Short-term funds is as follows:

i. Money Market Mutual Funds (MMMFs)

Another Classification of Mutual Funds

Mutual funds can be classified in the following categories.

1. Open-end Mutual Fund

A fund for which the supply of shares is not fixed but can increase or decrease daily with pur-
chases and redemptions of shares.

2. Closed-end Mutual Fund

It has a lock in period and mutual fund holders can redeem within lock in period. Lock in period
may be three years or more

Investor Returns from Mutual Fund Ownership

The return for the investor from investing in mutual fund shares (Units) reflects two aspects of
the underlying portfolio of mutual fund assets. First, the portfolio earns income and dividends on
those assets. Second, capital gains occur when the mutual fund sells an asset at prices higher than
the original purchase price of the asset. With respect to capital appreciation, mutual fund assets
are normally marked to market daily. This means that the managers of the fund calculate the
current value of each mutual fund share (Units) by computing the daily market value of the

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fund's total asset portfolio less any liabilities and then dividing this amount by the number of
mutual fund shares outstanding. The resulting value is called the net asset value (NAV) of the
fund. This is the price that investors obtain when they sell shares back to the fund that day or the
price they pay to buy new shares in the fund on that day.

4. Finance Companies

Finance companies issue debt securities and lend the proceeds to individuals or firms in need of
funds. The three major types of finance companies are (1) sales finance institutions, (2) personal
credit institutions, and (3) business credit institutions.

1. Sales Finance Institutions

These Finance companies are specialized in loans to customers of a particular retailer or
manufacturer. For example, Ford Motor Credit and Sears Roebuck Acceptance Corporation are
specialized in making loans to customers of a specific retailer or manufacturer.

2. Personal Credit Institutions

These Finance companies are specialized in installment and other loans to consumers. Household
Finance Corp. and American General Financial Services, a subsidiary of AIG Corp.are
specialized in making installment and other loans to consumers.

3. Business Credit Institutions

These Finance companies are specialized in business loans. For example CIT Group and U.S.
Bank Equipment Finance provide financing to corporations, especially through equipment
leasing and factoring.

Finance companies generally charge higher rates for consumer loans because they generally
attract riskier customers 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. It is, in fact, possible for individuals to obtain a mortgage from a subprime lender
finance company (a finance company that lends to high-risk customers) even with a bankruptcy
in their credit records. However, this sector of the finance company industry significantly hurt

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overall industry profitability in the 2000s. Banks rarely make such loans. Most finance
companies that offer these mortgages, however, charge rates commensurate with the higher risk,
and a few loan shark finance companies prey on desperate consumers, charging exorbitant rates
as high as 30 percent or more per year.

INVESTMENT BANKING FIRMS

INTRODUCTION

An investment bank is a financial institution that assists individuals, Corporations and

governments in raising capital by underwriting or acting as the client's agent in the issuance of
securities (or both). An investment bank may also assist companies involved in merger; and
acquisitions and provide ancillary services such as market making, trading of derivatives and
equity securities, and FICC services (fixed income instruments, currencies, and
commodities).Unlike commercial banks and retail banks, investment banks do not take deposits.

FUNCTIONS OF INVESTMENT BANKS

Investment banks have many functions to perform. Some of the most important functions of
investment banking are as follows:

1. Investment Banking

Investment banking refers to activities related to underwriting and distributing new issues of debt
and equity securities. New issues can be either first-time issues of a company's debt or equity
securities or the new issues of a firm whose debt or equity is already trading— secondary
security offerings or seasoned issues. An investment bank will often bring in a number of other
investment banks (a so-called syndicate) to help sell and distribute a new issue. The lead bank in
the syndicate directly negotiates with the issuing company on behalf of the syndicate.

2. Venture Capital

A difficulty for new and small firms in obtaining debt financing from commercial banks is that
CBs are generally not willing or able to make loans to new companies with no assets and
business history. In this case, new and small firms often turn to investment banks (and other

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firms) that make venture capital investments to get capital financing as well as advice. Venture
capital is a professionally managed pool of money used to finance new and often high-risk
firms. Venture capital is generally provided to back an untried company and its managers in
return for an equity investment in the firm. Venture capital firms do not make outright loans.
Rather, they purchase an equity interest in the firm that gives them the same rights and privileges
associated with an equity investment made by the firm's other owners.

3. Market Making

Market making involves the creation of a secondary market in an asset by a securities firm or
investment bank. Thus, in addition to being primary dealers in government securities and
underwriters of corporate bonds and equities, investment bankers make a secondary market in
these instruments. Market making can involve either agency or principal transactions. Agency
transactions are two-way transactions made on behalf of customers— for example, acting as a
stockbroker or dealer for a fee or commission. On the NYSE, a market maker in a stock such as
IBM may, upon the placement of orders by its customers, buy the stock at $164 from one
customer and immediately resell it at $165 to another customer. The $ 1 difference between the
buy and sell price is usually called the bid-ask spread and represents a large proportion of the
market maker's profit. In principal transactions, the market maker seeks to profit on the price
movements of securities and takes either long or short inventory positions for its own account.

4. Trading

Trading is closely related to the market-making activities performed by investment banks just
described; a trader takes an active net position in an underlying instrument or asset. There are at
least six types of trading activities:

i. Position Trading
Position trading involves purchases of large blocks of securities on the expectation of a favorable
price move. Position traders maintain long or short positions for intervals of up to several weeks
or even months. Rather than attempting to profit from very short-term movements in prices, as
day traders do, position traders take relatively longer views of market trends. Such positions also
facilitate the smooth functioning of the secondary markets in such securities.

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ii. Pure Arbitrage

Pure arbitrage entails buying an asset in one market at one price and selling it immediately in
another market at a higher price. Pure arbitrageurs often attempt to profit from price
discrepancies that may exist between the spot, or cash, price of a security and its corresponding
futures price. Some important theoretical pricing relationships in futures markets should exist
with spot markets and prices. When these relationships get out of line, pure arbitrageurs enter the
market to exploit them.

iii. Risk Arbitrage

It involves buying securities in anticipation of some information release—such as a merger or
takeover announcement or a Federal Reserve interest rate announcement. It is termed risk
arbitrage because if the event does not actually occur— for example, if a merger does not take
place or the Federal Reserve does not change interest rates—the trader stands to lose money.
iv. Program Trading
It is defined by the NYSE as the simultaneous buying and selling of a portfolio of at least 15
different stocks valued at more than $1 million, using computer programs to initiate such trades.

v. Stock Brokerage
It involves the trading of securities on behalf of individuals who want to transact in the money or
capital markets. To conduct such transactions, individuals contact their broker (such as Merrill
Lynch), who then sends the orders to its representative at the exchange to conduct the trades.

vi. Electronic Brokerage

It offered by major brokers, involves direct access, via the Internet, to the trading floor, therefore
bypassing traditional brokers. Many securities firms and investment banks offer online trading
services to their customers as well as direct access to a client representative (stockbroker). Thus,
customers may now conduct trading activities from their homes and offices through their
accounts at securities firms.

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5. Investing

Investing involves managing pools of assets such as closed- and open-end mutual funds (in
competition with commercial banks, life insurance companies, and pension funds). Securities
firms can manage such funds either as agents for other investors or as principals for themselves
and their stockholders. The objective in funds management is to select asset portfolios to beat
some return-risk performance benchmark such as the S&P 500 index. Since this business
generates fees that are based on the size of the pool of assets managed, it tends to produce a more
stable flow of income than does either investment banking or trading.

6. Cash Management

Investment banks offer bank deposit-like cash management accounts (CMAs) to individual
investors. Most of these accounts allow customers the ability to write cheques against some type
of mutual fund account (e.g., money market mutual fund).

7. Mergers and Acquisitions

As noted earlier, investment banks frequently provide advice on, and assistance in, mergers and
acquisitions. For example, they assist in finding merger partners, underwrite any new securities
to be issued by the merged firms, assess the value of target firms, recommend terms of the
merger agreement, and even assist target firms in preventing a merger (for example, writing
restrictive provisions into a potential target firm's securities contracts).

8 Other Service Functions

Other service functions include custody and escrow services, clearance and settlement services,
and research and advisory services.

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THE WORLD'S TOP INVESTMENT BANKS
1. Goldman Sachs (GS): One of the oldest banking firms founded in 1869 and headquartered in
New York, GS offers a wide range of services spread across four divisions - investment banking,
institutional client services, investing and lending and investment management. Goldman
Sachs reported net revenues of $34.210 billion for 2013, of which investment banking division
contributed $6 billion.

2. JP Morgan Chase (JPM): One of the largest investment banks, JPM Chase reported net
revenues of $96,606 million, of which investment banking revenue contributed $1,700 million. · 

3. Barclays (BCS): Reports indicate total income of £28,444 million of which the investment
banking segment contributed to £10,733 million. Along with investment banking, it has a strong
presence in retail and commercial banking and card processing business.

4. Bank of America Merrill Lynch (BofA-ML): The large entity formed by erstwhile Merrill
Lynch being taken over by Bank of America following the 2008 financial crisis, offers a wide
array of banking services including investment banking, mortgage, trading, brokerage and card
services. Operating in 40 countries across the globe with total revenue of $89,801 million, the
investment banking division contributed $6,126 million (up from $5,299 of 2012).

5. Morgan Stanley (MS): Founded in 1935 and headquartered in New York USA, the global
firm employs 55,794 employees spread across multiple countries. It reported net revenue of
$32,417 million, of which the investment banking segment contributed $5,246 million.

6. Deutsche Bank (DB): Based in Germany and listed on XETRA stock exchange, Deutsche
Bank reported net revenue of EUR 31,915 million. One of the largest financial services firms of
Europe, DB specializes in the cross border payments, international trade financing, cash
management, card services, mortgage, insurance and the usual investment banking stream.
Deutsche has a global presence with operations in 71 countries.

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7. Citigroup: Tracing its roots back to the origin of Citibank in 1812, Citi today has 251,000
employees with business and operations in 160 countries. Of the total revenues of $76,366
million reported for 2013, contributions from investment banking rose 8% from the prior year to
$4,000 million.

8. Credit Suisse : With a net income of CHF 2,131 million in year 2013 (report), the Zurich
Switzerland based Credit Suisse group founded in 1856, today employs 46,000 members across
the globe in over 50 countries. Apart from the regular investment banking business, it also has
presence in taxation and advisory, structural lending, real estate leasing and investment research
services.

9.UBS(Union Bank of Switzerland): Another Swiss investment firm founded in 1862 and
headquartered in Zurich, UBS had a net income of CHF(Swiss Franc) 27,732 million in the year
2013 (report). The firm has a strong workforce of more than 60,000 employees across the globe
with majority of them in US and Switzerland.

10. HSBC(Hong Kong and Shanghai Banking Corporation): Another London based financial
powerhouse founded in 1865 with operation in 75 countries serving 54 million global customers
through 254,000 employees, HSBC offers a wide variety of services ranging from FOREX,
leasing, M&A, card processing, account services, investment banking and private banking.

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