CHAPTER TWO: FINANCIAL INSTITUTIONS

Introduction
The term financial institutions and financial intermediaries are often used interchangeably.
Financial institutions deal with various financial activities associated with financial systems,
such as securities, loans, risk diversification, insurance, hedging, retirement planning,
investment, portfolio management, and many other types of related functions. With the help of
their functions, financial institutions transfer money or funds to various tiers of economy and
thus play a significant role in acting upon the domestic and the international economic scenario.

Overview of 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
marketplace, with large amount of financial assets under their control. 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/intermediaries are institutions engaged in the business of channeling

money from savers to borrowers. i.e., channel funds between borrowers and lenders.
Intermediation improves social welfare by channeling resources to their most effective use. The
channeling process which is known as financial intermediation is crucial to the well-functioning
of modern economy, since current economic activity depends heavily on credit and future
economic growth depends heavily on business investment. For example, a student loan for
college which increases the level of education and human capital, will promote future economic
growth of a country.

Key Customers of Financial Institutions

The key suppliers of funds to financial institutions and the key demanders of funds from
financial institutions are individuals, businesses, and governments.

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
1|Page
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.

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

Functions of Financial Institutions

The following are the major functions of financial institutions:

1. Pooling the savings of individuals

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

Types of Financial Institutions

The services provided by financial institutions depend on its type. Services provided by the
various types of financial institutions may vary from one institution to another. For example, the
services offered by the commercial banks are different from insurance companies. The most
important financial institutions that facilitate the flow of funds from investors to firms are
commercial banks, mutual funds, security firms, insurance companies, and pension funds.

Generally financial institutions are classified into two as depository and non-depository financial
institutions. The different types of financial institutions are discussed as follows:

2|Page
Depository institutions are a financial institution (such as commercial bank, savings bank, and
credit union) that is legally allowed to accept monetary deposits from consumers. It contributes
to the economy by lending much of the money saved by depositors.

Non-depository institutions are financial intermediaries that do not accept deposits but do pool
the payments of many people in the form of premiums or contributions and either invest it or
provide credit to others. Hence, non-depository institutions form an important part of the
economy. These institutions receive the public's money because they offer other services than
just the payment of interest. They can spread the financial risk of individuals over a large group,
or provide investment services for greater returns or for a future income.
Non depository institutions include: Insurance companies, Pension Funds, mutual funds, etc.

Depository Institutions

Depository institutions are financial firms that take deposits from households and businesses
and manage, and make loans to other households and businesses. In other words depository
institutions are those institutions which accept deposits from economic agents (liability to them)
and then lend these funds to make direct loans or invest in securities (assets). They include:
commercial banks, savings and loan associations, andcredit unions.

Deposits are money placed in an account at a depository institution & constituting a claim on the
depository institutions.

Loans are the borrowing of a sum of money by households or businesses from the depository
institutions.

The deposits accepted by these institutions represent their liabilities (debts). With the fund raised
through deposits and other funding sources depository institutions make direct loans to various
entities and also invest in securities.

Depository institutions drive their income from:

 Interest on loans,
 interest and dividend on securities, and
 fees income

3|Page
Assets and Liability Problem of DIs

A depository institution seeks to earn a positive spread between the assets it invests in (loans and
securities) and the cost of its funds (deposits and other sources). The spread is referred to as
spread income or margin. The spread income should allow the institution to meet operating
expenses and earn a fair profit on its capital.

Depository institution makes a profit by borrowing from depositors at a low interest rate and
lending at a higher interest rate. The depository institution earns no interest on reserves, but it
must hold enough reserves to meet withdrawals. So the depository institution must perform a
balancing act to balance the risk of loans (profits for stockholders) against the safety of reserves
(the security for depositors).

Depository Institutions Risks

In the process of generating spread income depository institutions are exposed to the following
risks:
◦ Credit or default risk: refers to the risk that a borrower will default on a loan
obligation to the depository institution. i.e., default by borrower or by issuer of
security

◦ Regulatory risk: refers to the risk that regulators will change the rules so as to
impact the earnings of the institution unfavorably. i.e., adverse impact of
regulations on earnings

◦ Funding /Interest rate/ risk: refers to the risk associated with the amount of
interest paid for depositors and received from borrowers. In other words it is a
risk caused by interest rate changes when DIs borrow long(short) and lend
short(long).

Illustrative example for funding /interest rate/ risk: Assume Awash bank raises birr 100
million by issuing a deposit account that has a maturity period of one year at the interest rate of
5%. Then the bank has invested all its birr 100 million in government security for 10 years at the
interest rate of 8%.

4|Page
In this case the income spread of the bank is known only for the first year and it is unknown for
the next 9 years. The income spread for year one is 3% (8%-5%) and the spread for the future
(for 9 years) will depend on the interest rate that Awash bank will have to pay to depositors in
order to raise birr 100 million after one year. Thus, if interest rates decline, the spread will
increase and if the interest rates rise the spread will decline because the ceiling (the upper limit)
was locked to 8%. But if Awash bank must pay more than 8% to depositors. The spread will be
negative. This is because it will cost the bank more to finance the government securities than it
will earn on the funds invested in those securities.

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

Liquidity concerns

Liquidity concerns for commercial banks arises due to short-term maturity nature of deposits.
Besides facing credit risk & interest rate risk, Depository institutions should always be ready to
satisfy withdrawal needs of depositors and meet loan demand of borrowers.

Depository institutions use the following ways to accommodate withdrawal and loan demands:

 attract additional deposit;

 borrow using existing securities as a collateral (from a federal agency or financial
institutions);
 sell securities it owns;
 raise short-term funds in the money market.

Regulations of Financial Institutions

Financial institutions have historically been heavily regulated, with the primary purpose of this
regulation being to ensure the safety of the institutions and thus to protect investors. These
regulations have taken the form of prohibitions on nationwide branch banking, restrictions on the
types of assets the institutions can buy, ceilings on the interest rates they can pay, and limitations
on the types of services they can provide.

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

Types of depository institutions

Depository financial Institutions include:

 commercial banks,
 savings and loan associations, and
 credit unions
 microfinance institutions

A. Commercial Banks
Commercial banks are the largest and most diversified intermediaries on the basis of range of
assets held and liabilities issued. Commercial banks provide numerous services in the financial
system. 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. Commercial banks Collect funds from different sources, & Put them in to different uses. In
addition they have also concerns in foreign exchange products and services and agency services
(such as collection of cheques, draft, and bill for their customers, etc).

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
percent 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.

6|Page
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.”

Sources and Uses of Funds at Commercial Banks

Bank Funding (sources of funds)

Commercial banks obtain most of their funds by accepting different types of deposits (savings,
demand, and time 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 and a
particular maturity period. 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. In addition to attracting deposits commercial banks use non-deposit
borrowings (borrowings from money market), common stock and retained earnings as source of
fund.
Note: Reserve requirements
Reserve is portion of deposit kept as a caution against possible bank illiquidity. All
banks must maintain a specified percentage of their deposits in non-interest bearing
account of a central bank. i.e., a bank cannot invest one birr for every one birr obtained
in deposit. The central bank is banker’s bank or the last resort. Banks with temporarily
short of funds can borrow from the central bank

Uses of Funds

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.

7|Page
Some of the more popular means by which commercial banks extend credit to firms are term
loans, lines of credit, and investment in debt securities issued by firms. Term loans are provided
by banks for a medium-term period to finance a firm’s investment in machinery or buildings. For
example, consider a manufacturer of toys that plans to produce toys and sell them to retail stores.
It will need funds to purchase the machinery for producing toys, to make lease payments on the
manufacturing facilities, and to pay its employees. As time passes, it will generate cash flows
that can be used to cover these expenses. However, there is a time lag between when it must
cover these expenses (cash outflows) and when it receives revenue (cash inflows). The term loan
can enable the firm to cover its expenses until a sufficient amount of revenue is generated.

Commercial banks can also provide credit to a firm by offering a line of credit,which allows the
firm access to a specified amount of bank funds over a specified period of time. This form of
bank credit is especially useful when the firm is not certain how much it will need to borrow over
the period. For example, if the toy manufacturer in the previous example was not sure of what its
expenses would be in the near future, it could obtain a line of credit and borrow only the amount
that it needed. Once a line of credit is granted, it enables the firm to obtain funds quickly.
Commercial banks also invest in debt securities (bonds) that are issued by firms.
Sample Balance sheet of Commercial Banks

Assets Liabilities
Reserves & cash xxx Checkable deposits xxx
Loans xxx Saving deposits xxx
Liquidity assets xxx Time deposits xxx
Gov’t Securities xxx Borrowing xxx
Own Capital xxx
Total xxx Total xxx
Reserves (reserve requirement): are an obligation on a bank or other depository institutions to
maintain a specified proportion of total assets in liquid form.
◦ Depository institutions are required to hold a minimum percentage of deposits as
reserves, which is known as a required reserve ratio (rrr).
Loans: are commitments of fixed amounts of money for agreed-upon credit terms (periods of
time and interest rate).
Liquidity assets: are government Treasury bills and commercial bills.

8|Page
 ◦ Liquidity assets can be sold and instantly converted into reserve (cash) with
virtually no risk of loss. Because they have a low risk, they also earn a low
interest rate.

Securities: are government bonds and other bonds such as mortgage-backed securities. Because
their prices fluctuate, these assets are riskier than liquidity assets, but they also
have a higher interest rate.

Deposits: include Checkable deposits, saving deposits and time deposits.

 Demand Deposits: are funds held in an account from which deposited funds can be
withdrawn at any time without any advance notice to the depository institution. Demand
deposits can be "demanded" by an account holder at any time. Many checking and
savings accounts today are demand deposits and are accessible by the account holder
through a variety of banking options, including teller, ATM and online banking.
 Saving deposits: are savings accounts are accounts maintained by financial
institutions that pay interest but cannot be used directly as money in the narrow sense of
a medium of exchange (for example, by writing a check). These accounts let customers
set aside a portion of their liquid assets while earning a monetary return
 Time deposits: A time deposit (also known as a certificate of deposits (CDs) is a money
deposit at a banking institution that cannot be withdrawn for a certain "term" or period of
time (unless a penalty is paid). When the term is over it can be withdrawn or it can be
held for another term. Generally speaking, the longer the term the better the yield on the
money

Borrowing: depository institution borrows reserves (cash) from the federal funds market. It is
called inter-bank loan. The interest rate in this market is the federal funds
rate.

Own capital: is a depository institution's equity or net worth.

Regulation of Commercial Banks

The banking system is regulated by the central bank of a country. The central bank is responsible
for controlling the amount of money in the financial system. It also imposes regulations on

9|Page
activities of banks, thereby influencing the operations that banks conduct. The general
philosophy of regulators who monitor the banking system is to promote competition among
banks so that customers will be charged reasonable prices for the services that they obtain from
banks. Regulators also attempt to limit the risk of banks in order to maintain the stability of the
financial system. Areas of regulation include:
 Ceiling imposed on the interest rate that can be paid on deposit accounts

 Permissible activities for commercial banks: for example banks can neither
underwrite securities and stock not act as dealers in the secondary market for
securities and stocks.

 Geographical restriction on branch banking.

 Capital requirements:Capital requirements for CBs is aimed atpreventing

insolvency due the nature of the business. This is because banks’:

 Capital structure of CBs consists of equity & debt.

 have high debt to equity ratio (i.e., highly financial levered

institutions because of deposits).

B. Savings and loan associations

Savings and loan associations (S&Ls) are old institutions established to provide finance for
acquisitions of homes. They can be mutually owned or have corporate stock ownerships. NB:
Mutually owned means depositors are the owners. They have traditionally served individual
savers, residential and commercial mortgage borrowers, take the funds of many small savers and
then lend this money to home buyers and other types of borrowers. The collateral for the loan
would be the home being financed.

These institutions were to aggregate depositors’ funds and use the money to make long term
mortgage loans. The institutions were not to take in demand deposits but instead were authorized
to offer savings accounts that paid slightly higher interest than offered by commercial banks
(they issue NOW (Negotiable Order of Withdrawal–pays interest) account to commercial
customers. Which are traditionally reserved for commercial banks).

10 | P a g e
In function, Savings and loan associations are similar to commercial banks, and in recent years
the distinction between commercial banks and savings and loan institutions has become blurred
as the financial services industry has become more homogeneous. In the past, savings institutions
were legally required to engage primarily in home mortgage finance, and even though they now
may hold other types of assets, their traditional emphasis continues to be a major difference
between savings institutions and commercial banks.
C. Credit unions

Credit unions are the smallest and the newest of the depository institutions owned by a social or
economic group that accepts saving deposits and makes mostly consumer loans. Theyestablished
by people with a common bond. They are mutually owned established to satisfy saving and
borrowing needs of their members. Credit unions, called by various names around the world, are
member-owned, not-for-profit financial cooperatives that provide savings, credit and other
financial services to their members.

Credit union membership is based on a common bond, a linkage shared by savers and borrowers
who belong to a specific community, organization, religion or place of employment such as
employees of a given firm or union. Credit unions pool their members' savings deposits and
shares to finance their own loan portfolios rather than rely on outside capital. Members benefit
from higher returns on savings, lower rates on loans and fewer fees on average.

Credit unions worldwide offer members from all walks of life much more than financial
services. Their investment is primarily devoted to short term installment consumer loans. They
provide members the chance to own their own financial institution and help them create
opportunities such as starting small businesses, growing farms, building family homes and
educating their children.

Regardless of account size in the credit union, each member may run for the volunteer board of
directors and cast a vote in elections. In some countries, members encounter their first taste of
democratic decision making through their credit unions.

The major regulatory differences between credit unions and other depository institutions are:

◦ the common bond requirement,

11 | P a g e
 ◦ the restriction that most loans are to consumers,
◦ their exemption from federal income tax because of their cooperative nature.
Savings and loan associations and credit unions are collectively known as thrift institutions. As
they obtain funds primarily by tapping the savings of households

D. Microfinance institutions (MFIs)

The active poor require a full set of micro finance services mainly in the form of saving and
credit facilities.

These services help the poor:

 Start new business or expand existing ones
 Improve productivity of farmers and micro enterprises.
 Improve human and social capital throughout their life
 Deal with vulnerabilities and poverty reduction

However, the active poor, both in the urban and rural areas, are neglected by formal bank and
non bank financial institutions because of different reasons. Such as:

 Collateral requirement of formal bank.

 High transactions cost(mini transaction) and High perceived risk (such as difficulty
in contract enforcement and harvest failure)

Therefore, the microfinance institutions can play invaluable contributions to narrow the gap
between the demand for and supply of financial products. Micro finance is the provision of a
broad range of financial services to the poor and low income households, for their micro
enterprises and small business.

Activities of MFI

 Small loans, typically, for working capital

 informal appraisal of borrowers and investments
 collateral substitutes, such as a group guarantee or compulsory savings
 access to repeated and large loans, based on repayment performance

In addition to the above activities MFIs have the following objectives

12 | P a g e
  to reduce poverty
 to empower women and other disadvantaged population group
 to create employment
 to help existing business grow or diversity their activities
 to encourage the development of new business

Non-depository institutions

Non-depository financial institutions are defined as those institutions that serve as an

intermediary between savers and borrowers, but do not accept deposits. They receive the
public’s money because they offer other services than just the payment of interest. They spread
the financial risk of individuals over a large group, or provide investment services for greater
returns or for a future income. Non depository institutions include:

 Insurance companies
 Pension funds
 Mutual funds
 Investment Banking Firms
 Brokers and dealers
A. Insurance Companies
Insurance companies provide various types of insurance for their customers, including life
insurance, property and casualty insurance, and health insurance. They offer insurance policies to
the public and make payments, for a price, when a certain event occurs. They provides social
security and promotes individual welfare. Insurance companies distribute/spread risks to
individuals, through the “Rule of large number” and they act as risk bearers.

Insurance companies periodically receive payments (premiums) from their policyholders, pool
the payments, and invest the proceeds until these funds are needed to pay off claims of
policyholders. They commonly use the funds to invest in debt securities issued by firms or by
government agencies. They also invest heavily in stocks issued by firms. Thus they help finance
corporate expansion.

13 | P a g e
Insurance companies employ portfolio managers who invest the funds that result from pooling
the premiums of their customers. An insurance company may have one or more bond portfolio
managers to determine which bonds to purchase, and one or more stock portfolio managers to
determine which stocks to purchase. The objective of the portfolio managers is to earn a
relatively high return on the portfolios for a given level of risk. In this way, the return on the
investments not only should cover future insurance payments to policyholders but also should
generate a sufficient profit, which provides a return to the owners of insurance companies. The
performance of insurance companies depends on the performance of their bond and stock
portfolios.

Like mutual funds, insurance companies tend to purchase securities in large blocks, and they
typically have a large stake in several firms. Thus they closely monitor the performance of these
firms. They may attempt to influence the management of a firm to improve the firm’s
performance and therefore enhance the performance of the securities in which they have
invested.
Like banks, insurance companies are also challenged by the information asymmetry problems of
adverse selection and moral hazard. Insurance companies can solve an adverse selection by
screening applicants. That is,

◦ verifying information in the application,

◦ checking the applicant’s history and
◦ by applying restrictive covenant in the insurance contract.
However, the solution of moral hazard is depending on the type of insurance offered.

Types of Insurance Companies

Mainly there are two types of insurance companies. These are Property and casualty insurance
company, and Life Insurance Company.
i. Property and Causality Insurance
They provide financial protection against:

◦ loss,damage, or distruction of property caused by accidents

◦ natural disasters or from the action of others

14 | P a g e
 ◦ loss from injury or death due to occupational accidents
The most common type of this insurance is auto insurance. Property and causality insurers use
the principles of indemnity, which is to pay for financial losses suffered by the insured, but no
more. If people made profit from insurance, it would motivate them to cause losses for profits.
For the same reason, insurance companies will not pay for losses that are covered by other
insurance or other forms of compensation. The claim of property and causality insurance is
uncertain, i.e., the amount and the timing of liability ascertainable only after the event.
ii. Life Insurance
Though the death of a single individual is an uncertain event, the number of deaths in a large
group is very predictable. Furthermore, the amount of the claim for any single death is certain
since it is specified in the contract. The Life insurance claim is fixed and certain.

There is no as such moral hazard problem in life insurance because most people want to live. The
only real moral hazard in life insurance is the possibility of suicide commit for providing a
benefit for his beneficiaries after he commits suicide. This moral hazard is reduced by a suicide
clause – not paying for suicides.

Characteristics of insurance companies

1. Insurance policy and premium: Insurance policy is a legally binding contract for which
the policy holder (owner) pays premium in exchange for the insurance company’s
promise to pay a price contingent of future events.The company is said to underwrite the
owner’s risk and act as a buffer against the uncertainties of future. When the policy is
accepted by an insurance company, it becomes an asset for the owner and a liability for
the insurance company.
2. Surplus & reserves: The surplus of an insurance company is the difference between its
assets and liabilities. Reserve is the amount of cash set aside by insurance company as a
contingent liability.
3. Determination of profits: An insurance company’s revenue for a fiscal year is generated
from two sources:
 premium earned (underwriting income)during the fiscal period
 investment income earned from invested assets

15 | P a g e
 4. Government guarantees: unlike the liabilities of depository institutions insurance
policies are not guaranteed by any federal entity.
B. Pension Funds

A pension fund is a fund that is established for the payment of retirement benefits. Most
pension fund assets are in employer-sponsored plans. The entities that establish pension plans
are called the plan sponsors. pension plans can be established by both governmental & private
organizationson behalf of their employees.

Pension funds receive payments (called contributions) from employees, and/or their employers
on behalf of the employees, and then invest the proceeds for the benefit of the employees. They
typically invest in debt securities issued by firms or government agencies and in equity securities
issued by firms.

Pension funds employ portfolio managers to invest funds that result from pooling the
employee/employer contributions. They have bond portfolio managers who purchase bonds and
stock portfolio managers who purchase stocks. Because of their large investments in debt
securities or in stocks issued by firms, pension funds closely monitor the firms in which they
invest. Like mutual funds and insurance companies, they may periodically attempt to influence
the management of those firms to improve performance.

Types of Pension Plans

There are three types of pension Plans:

i. Defined contribution plan

ii. Defined benefit plan
iii. Hybrid pension plan

i. Defined contribution plan

In defined contribution plan, contribution is defined by the plan. With this plan, the plan sponsor
is responsible only for making specified contribution in the planon behalf of qualifying
participants. The amount contributed is either a percentage of employee’s salary or a percentage
of profit. The payments that will be made to qualifying participants up on retirement will depend

16 | P a g e
on the growth of the plan assets.i.e., payment is determined by the investment performance of
asset in which the pension fund is invested. The plan sponsor gives the participants various
options as to the investment vehicles in which they may invest. Therefore, in a defined
contribution plan the employee bears all the investment risks.

ii. Defined benefit plan

In defined benefit plan retirement benefits are defined by the plan. In this plan, the plan sponsor
agrees to make specified dollar payment to qualifying employees at retirement, and some
payments to beneficiaries in case of death before retirement. The retirement payments are
determined by a formula that usually takes into account the length of service of the employee,
and the earning of the employee

The pension obligations are effectively the debt obligation of the plan sponsor, who assumes the
risk of having insufficient funds in the plan to satisfy the contractual payments that must be made
to retired employees. Thus, unlike a defined contribution plan, in a defined benefit plan, all the
investment risks are born by the plan sponsor.

iii. Hybrid pension plans:

Hybrid pension plan combines features of the above basic types of pension. With this plan, the
employer contributes a certain amount of each year to a fund as in defined contribution approach.
The employer guarantees a certain minimum level of each benefit, depending on an employee’s
years of service, as in a defined benefit plan. In such plan, the employer and employees share the
risk of providing retirement benefits.

C. Mutual Funds

Mutual funds are corporations that accept money from savers and then use these funds to buy
stocks, long-term bonds, or short-term debt instruments issued by businesses or government
units. Mutual fundssell shares to individuals, pool these funds, and use them to invest in
securities. In other words a mutual fund pools the funds of many people and managers invest the
money in a diversified portfolio of securities to achieve some stated objective. These
organizations pool funds and thus reduce risks by diversification. They also achieve economies
of scale in analyzing securities, managing portfolios, and buying and selling securities. They
continually stands ready to sell new shares to the public and to redeem its outstanding shares on

17 | P a g e
demand at a price equal to an appropriate share of the value of its portfolio which is computed
daily at the close of the market.

Mutual funds are owned by investment companies. Many of these companies have created
several types of money market mutual funds, bond mutual funds, and stock mutual funds so that
they can satisfy many different preferences of investors.

Different funds are designed to meet the objectives of different types of savers. Hence, there are
bond funds for those who desire safety, stock funds for savers who are willing to accept
significant risks in the hope of higher returns, and still other funds that are used as interest-
bearing checking accounts (the money market funds). Thus, mutual funds are classified into three
broad types. These are:

 Money market mutual funds pool the proceeds received from individual investors to
invest in money market (short-term) securities issued by firms and other financial
institutions.
 Bond mutual funds pool the proceeds received from individual investors to invest in
bonds, and
 Stock mutual funds pool the proceeds received from investors to invest in stocks.
Mutual funds are regulated by the Securities and Exchange Commission (SEC). Primary
objective of regulation is the enforcement of reporting and disclosure requirements to protect the
investor. Such Institutional investors include mutual funds, pension funds, and insurance
companies—are a growing force in developed markets.

Investment Policies

Each mutual fund has a specified investment policy, which is described in the fund’s prospectus.
For example, money market mutual funds hold the short-term, low-risk instruments of the money
market, while bond funds hold fixed-income securities. Some funds have even more narrowly
defined mandates. For example, some bond funds will hold primarily Treasury bonds, others
primarily mortgage-backed securities.

Management companies manage a family, or “complex,” of mutual funds. They organize an

entire collection of funds and then collect a management fee for operating them. By managing a

18 | P a g e
collection of funds under one umbrella, these companies make it easy for investors to allocate
assets across market sectors and to switch assets across funds while still benefiting from
centralized record keeping. Some of the most well-known management companies are Fidelity,
Vanguard, Putnam, and Dreyfus.

Role of Mutual Funds as Financial Intermediaries

When mutual funds use money from investors to invest in newly issued debt or equity securities,
they finance new investment by firms. Conversely, when they invest in debt or equity securities
already held by investors, they are transferring ownership of the securities among investors.

By pooling individual investors’ small investments, mutual funds enable them to hold diversified
portfolios (combinations) of debt securities and equity securities. They are also beneficial to
individuals who prefer to let mutual funds make their investment decisions for them. The returns
to investors who invest in mutual funds are tied to the returns earned by the mutual funds on their
investments. Money market mutual funds and bond mutual funds determine which debt
securities to purchase after conducting a credit analysis of the firms that have issued or will be
issuing debt securities. Stock mutual funds invest in stocks that satisfy their specific investment
objective (such as growth in value or high dividend income) and have potential for a high return,
given the stock’s level of risk.
Because mutual funds typically have billions of dollars to invest in securities, they use
substantial resources to make their investment decisions. In particular, each mutual fund is
managed by one or more portfolio managers, who purchase and sell securities in the fund’s
portfolio. These managers are armed with information about the firms that issue the securities in
which they can invest.

After making an investment decision, mutual funds can always sell any securities that are not
expected to perform well. However, if a mutual fund has made a large investment in a particular
security, its portfolio managers may try to improve the performance of the security rather than
sell it. For example, a given mutual fund may hold more than a million shares of a particular
stock that has performed poorly. Rather than sell the stock, the mutual fund may attempt to
influence the management of the firm that issued the security in order to boost the performance
of the firm. These efforts should have a favorable effect on the firm’s stock price.

19 | P a g e
D. Investment Banking Firms

Investment bank is a financial institution engaged in securities business. Investment banking

firms perform activities related to the issuing of new securities and the arrangement of financial
transactions. They mainly involved in primary markets, the market in which new issues are sold
and bought for the first time. They advise issuers on how best raise funds, and then they help sell
the securities.

Investment banking is a type of financial service that focuses on helping companies acquire
funds and grow their portfolios. Investment banking firms assist client companies in obtaining
funds by selling securities, i.e., raise funds for clients and act as brokers or dealers in the buying
and selling securities in secondary markets, i.e., assisting clients in the sale or purchase of
securities. Much of this comes in the form of stock and bonds transfer, but investment capital and
wholesale corporate acquisitions are also part of the equation.

Bankers within this sector are usually highly trained, and are widely recognized as some of the
most elite participants in the financial marketplace. They are often sought as much for their
consulting and advising services as they are for actually executing transactions. Modern
investment banks are made up of two parts: the corporate business and the sales and trading
business.

 The Corporate Business. The corporate side of investment banking is a fee-for service
business; that is, the firm sells its expertise. The main expertise banks have is in
underwriting securities, but they also sell other services. They provide merger and
acquisition advice in the form of prospecting for takeover targets, advising clients about
the price to be offered for these targets, finding financing for the takeover, and planning
takeover tactics or, on the other side, takeover defenses. The major investment banking
houses are also actively engaged in the design of new financial instruments.
 The Sales and Trading Business. Investment banks that underwrite securities sell them
on the sales and trading end of their business to the bank’s institutional investors.
These investors include mutual funds, pension funds, and insurance companies. Sales and
trading also consists of public market making, trading for clients, and trading on the
investment banking firm’s own account.

20 | P a g e
  Market making requires that the investment bank act as a dealer in securities, standing
ready to buy and sell, respectively, at wholesale (bid) and retail (ask) prices. The bank
makes money on the difference between the bid and ask price, or the bid-ask spread.
Banks do this not only for corporate debt and equity securities, but alsoas dealers in a
variety of government securities. In addition, investment banks tradesecurities using their
own fund, which is known as proprietary trading. Proprietarytrading is riskier for an
investment bank than being a dealer and earning the bid-askspread, but the rewards can
be commensurably larger.

Generally Investment banking firms are engaged in the following activities:

 Public offering- underwriting of securities
 Private placement of securities
 Merger and acquisition
 Merchant banking
 Trading and creation of derivative instruments

1. Public offering of securities

Investment bankers performing one or more of the following functions:

 Advising the issuer on the terms and the timing of the offering
 Buying the securities from the issuers
 selling the issue to the public
When investment banking firms buy the security from the issuer and accept the risk of selling the
securities to investors at a lower price, it is referred to an underwriter. The function of buying
the securities from the issuer is called underwriting. Thus, the fees earned from underwriting
the security is the difference between the price paid to the issuer and the price at which
investment bank re-offers the security to the public. This difference is called the spread or the
underwriter discount.
2. Private placement of securities

In addition to public offering of securities, investment banking firms place securities with a
limited number of institutional investors like insurance companies, pension funds, mutual funds,

21 | P a g e
etc. They assist in the private placement of securities in several ways, such as in he design and
pricing of securities.

3. Merger and acquisition

Investment banking firms may participate in merger and acquisition activity in one of the
following ways:

 Finding merger and acquisition candidates

 Adjusting acquiring companies or target companies with respect to price and non
price terms of exchanges or helping companies fend off unfriendly takeover.
 Assisting acquiring companies in obtaining the necessary funds to finance a
purchase.
4. Merchant banking

When an investment banking firm commits is own fund by either taking an equity interest or
credit position in companies, this activity referred to as merchant banking.

5. Trading and creation of derivative instrument

Future, option, swaps are examples of instruments that can be used to control the risk of an
investor’s portfolio, or in case of an issuer, the risk associated with the issuance of a security.

E. Brokers and Dealers

Dealers and brokers are involved in the secondary market, trading “used” or already outstanding
securities. Brokers match buyers and sellers and earn a commission but dealers commit their own
capital in the buying and selling of securities and hope to make profit on the spread of
transaction (i.e., the difference between the selling and the buying prices of securities).

22 | P a g e