Chapter Two

Financial Institutions in the Financial System

2.1. Introduction
Business entities include nonfinancial and financial enterprises. Nonfinancial enterprises
manufacture products (e.g., cars, steel, computers) and/or provide nonfinancial services (e.g.,
transportation, utilities, computer programming). On the other hand, financial enterprises, more
popularly referred to as financial institutions, provide services related to one or more of the
following:
A. 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 institution.
B. Exchanging of financial assets on behalf of customers.
C. Exchanging of financial assets for their own accounts.
D. Assisting in the creation of financial assets for their customers, and then selling those
financial assets to other market participants.
E. Providing investment advice to other market participants.
F. Managing the portfolios of other market participants.
From the various services listed above, the services indicated in “B” and “C” is the broker and
dealer functions and the service indicated in “D” is referred to as underwriting. As we have
explained earlier, typically a financial intermediary that provides an underwriting service also
provides a brokerage and/or dealer service.
2.2. Classification and Role of Financial Intermediaries
2.2.1. Classification of Financial Intermediaries
Financial intermediaries may be classified in a variety of ways. One of the most important
distinctions is between Depository and Non-Depository Intermediaries. Below is their basic
distinction:
1. Depository Intermediaries: include commercial banks and nonbank thrift institutions
(like savings & loan associations, savings banks, credit unions, and money market).
 Depository intermediaries derive the bulk of their loanable funds from deposit
accounts sold to the public.
 In other words, it means that these institutions acquire the bulk of their funds by
offering their liabilities to the public mostly in the form of deposits.
2. Non-Depository Intermediaries: include contractual institutions (like insurance
companies and pension funds) and investment institutions (like investment companies or
mutual funds, finance companies, and real estate investment trusts).
 Contractual institutions attract funds by offering legal contracts to the public in
order to protect the savers against potential risks.
 Investment institutions sell shares to the public and invest the proceeds in stocks,
bonds, and other securities.
2.2.2. Role of Financial Intermediaries
As we have seen, financial intermediaries obtain funds by issuing financial claims against
themselves to market participants, and then investing those funds.
 The investments made by financial intermediaries-their assets- can be in loans and/or
securities. These investments are referred to as direct investments.
 Market participants who hold the financial claims issued by financial intermediaries are
said to have made indirect investments.
We have stressed that financial intermediaries play the basic role of transforming financial assets
that are less desirable for a large part of the public into other financial assets–their own
liabilities–which are more widely preferred by the public. This transformation involves at least
one of four economic functions:
1. Providing maturity intermediation;
2. Reducing risk via diversification;
3. Reducing the costs of contracting and information processing; and
4. Providing payments mechanism.
1. Maturity Intermediation
The maturity of at least a portion of the deposits accepted is typically short term.
 For example, certain types of deposits are payable upon demand.
 Others have a specific maturity date, but most are less than two years.
The maturity of the loans made by financial intermediaries may be considerably longer than two
years.
Maturity intermediation has two implications for financial markets.
 First, it provides investors with more choices concerning maturity for their investments;
borrowers have more choices for the length of their debt obligations.
 Second, because investors are naturally reluctant to commit funds for a long period of
time, they will require that long-term borrowers pay a higher interest rate than short-term
borrowers.
A financial intermediary is willing to make longer-term loans, and at a lower cost to the
borrower than an individual investor would, by counting on successive deposits providing the
funds until maturity although at some risk. Thus, the second implication is that the cost of
longer-term borrowing is likely to be reduced.
2. Reducing Risk via Diversification
Consider the example of the investor who places funds in an investment company.
 Suppose that the investment company invests the funds received in the stock of a large
number of companies.
 By doing so, the investment company has diversified and reduced its risk.
 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.
  Yet by investing in the investment company for the same sum of money, investors can
accomplish this diversification, thereby reducing risk.
This economic function of financial intermediaries transforming riskier assets into less risky ones
is called diversification.
 Although individual investors can do it on their own, they may not be able to do it as cost
effectively as a financial intermediary, depending on the amount of funds they have to
invest.
Attaining cost effective diversification in order to reduce risk by purchasing the financial assets
of a financial intermediary is an important economic benefit for financial markets.
3. Reducing the Costs of Contracting and Information Processing
Investors purchasing financial assets should take the time to develop skills necessary to
understand how to evaluate an investment. Although there are some people who enjoy devoting
leisure time to this task, most prefer to use that time for just that – leisure.
In addition to the opportunity cost of the time to process the information about the financial asset
and its issuer, there is the cost of acquiring that information.
 All these costs are called information processing costs.
 The costs of writing loan contracts are referred to as contracting costs.
 There is also another dimension to contracting costs, the cost of enforcing the terms of
the loan agreement.
In other words, there are economies of scale in contracting and processing information about
financial assets because of the amount of funds managed by financial intermediaries. The lower
costs accrue to the benefit of the investor who purchases a financial claim of the financial
intermediary and to the issuers of financial assets, who benefit from a lower borrowing cost.
4. Providing a Payments Mechanism
Although the previous three economic functions may not have been immediately obvious, this
last function should be.
 Most transactions made today are not done with cash.
 Instead, payments are made using checks, credit cards, debit cards, and electronic
transfers 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.
2.3. The Role of Commercial Banks and Nonbank Thrift Institutions
2.3.1. General
There are several types of depository intermediaries: commercial banks and nonbank thrift
institutions or simply “thrifts” that comprises savings and loan associations, credit unions, and
mutual savings banks. In addition to accepting deposits, these institutions make loans and
provide other financial services. These types of institutions are distinguished by their type of
ownership (investor or depositor owned) and the type of loans (business or personal).
Commercial banks, among others, are the largest and most widely spread depository corporations
that are owned by investors. These banks lend primarily to businesses.
 In this regard, commercial banks may be independent corporations or may be subsidiaries
of bank holding companies.
The second largest types of depository institutions, following commercial banks, are savings and
loan associations. Savings and loan associations, in this regard, are owned by their depositors
and specialize in making home mortgage loans.
 The mission of savings and loan associations is to serve the thrift (that is, savings) and
home ownership needs of consumers.
The other types of depository institutions are mutual savings banks and credit unions. Mutual
savings banks are also owned by their depositors and focus primarily on loans to the local
community. Credit unions are non-profit associations that are owned by their members, the
depositors, and their primary focus is making personal loans to their members.
Exhibit 3.3.1: Features of Depository Intermediaries: Summary

Type Ownership Primary Mission

Commercial Banks Corporations; owned by investors Lend to businesses
Saving and Loans Either corporations or owned by Offer savings accounts for
(S & L) depositors individuals and make loans for
home ownership
Mutual Savings Owned by depositors Lend to the local community
Banks
Credit Unions Non-profit; owned by depositors or Lend and provide other financial
members services to members
Generally speaking, the depository intermediaries are highly regulated financial intermediaries
and their day-to-day operations and financial services are closely supervised by various
government agencies and authoritative bodies. The various regulations pertaining to the
structure, portfolio characteristics, financial services, in theory, are designed at least to promote
competition and ensure the safety of the public’s funds. Along with this, governments and
concerned agencies exercise close supervision and monitor the operations of such intermediaries.
2.4. Commercial Banks and Money Creation
2.4.1. Importance of Commercial Banks
Commercial banks are one of the most important depository financial intermediaries that offer
the public both deposit and credit services. In addition to their traditional services, commercial
banks have started to provide fewer and more innovative services such as investment advice &
execution and tax & travel planning to their customers.
 The name commercial implies the fact that these banks devote a substantial portion of
their resources to meeting the financial needs of business firms.
The following are major indicators of the role and/or importance of commercial banks:
 They are principal means of making payments through the checking accounts (demand
deposits) they offer;
 They are able to create money from excess reserves made available from the public’s
deposits;
 They receive deposits (excess cash of savers) and provide loans & make investments and,
thus, generate a multiple amount of credit in the economy; and
 They are most important sources of consumer credit as well as one of the major sources
of loans to small and medium sized businesses.
Moreover, commercial banks are principal purchasers of debt securities issued by state, local,
and federal governments.
 In this regard, they are major buyers of government treasury bills.
 They play a dominant role in the money and capital markets.
2.4.2. Commercial Bank Services
1. Individual Banking;
2. Institutional Banking; and
3. Global Banking.
1. Individual Banking Services
 Consumer lending,  Automobile and boat financing,
 Residential mortgage lending,  Brokerage services, and
 Consumer installment loans,  Student loans,
 Credit card financing,
From their individual banking services, commercial banks derive interest income or fee income.
2. Institutional Banking
Encompasses loans to nonfinancial corporations, financial corporation’s (such as life insurance
companies), and government entities (for instance, state and local governments).
 Also included in this category are commercial real estate financing and other activities,
leasing and factoring.
3. Global Banking
That bank began to compete head-to-head with investment banking (or securities) firms. Global
banking covers a broad range of activities involving the following:
 Corporate Financing, and
 Capital Market and Foreign-Exchange Products and Services.
Corporate Financing involves two components.
The first is the procuring of funds for a bank’s customers.
  This can go beyond traditional bank loans to involve the underwriting of securities.
 In assisting customers in obtaining funds, banks also provide bankers’ acceptances,
letters of credit, and other types of guarantees for their customers.
The second area of corporate financing involves advice on such matters as strategies for
obtaining funds, corporate restructuring, divestitures, and acquisitions.
Capital Market and Foreign Exchange Products and Services involve transactions where;
 The bank may act as a dealer or broker in a service.
 Similarly, some banks maintain a foreign-exchange operation, where foreign currency is
bought and sold.
2.4.3. Portfolio Characteristics of Commercial Banks
A. Assets of Commercial Banks
1. 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 bank’s first line of defense
against:
 Withdrawal by depositors,
 Customer demand for loans, and
 Immediate cash needs to cover expenses.
Commercial banks often hold an amount of cash that is just sufficient to meet short run
contingencies.
 Commercial banks hold no more in cash than is absolutely required since the yield on
cash asset is minimal or nonexistent.
Deposits held with other banks are also considered primary reserves. Such deposits are a means
of paying for “correspondent banking services”, i.e. for the services of other banks or for “Bank
to Bank” transactions, and hence, provide an implicit return.
Primary reserves also include reserves held behind deposits as required by Federal Reserve
System (or deposits held in the “National Bank” in the case of Ethiopia).
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. The securities held by commercial
banks are varied as discussed below:
Municipal Securities:
Municipal securities are the most important group of securities acquired by commercial banks in
the open market. These are bonds and notes issued by state, city, and local governments, which
constitute the largest portion of their security investments.
 Such securities provide tax-exempt interest income.
Treasury Bills and Short-Term Treasury Notes & Bonds:
Banks favor Treasury Bills and short-term Treasury Notes & Bonds because of the following two
reasons:
 Such securities are readily marketable; and
 Such securities are freed from default risk.
3. Loans and Equipment Leasing Schemes
The principal business of commercial banks is to make loans to qualified borrowers. In this
regard, loans are among the highest yielding assets a bank can hold in its portfolio that provide
the largest portion of their operating revenue. Commercial banks also make loans of reserves to
other banks through the Federal Funds market and to securities dealers through repurchase
agreements.
Moreover, long-term loans to business firms have been supplanted (or replaced) to some extent
in recent years by equipment leasing plans available from larger banks and the subsidiaries of
bank holding companies.
 In general, equipment leasing plan or lease financing is the functional equivalent of a
loan.
 Lease financing, in this regard, carries significant tax advantage for a bank as well as cost
& tax advantage for the customer too.
Commercial banks are important lenders in the real estate field supporting construction of
residential and commercial structures.
 They provide longer maturities on installment loans in order to finance purchases of
homes (residential buildings) by households.
B. Liabilities (or Financial Claims) of Commercial Banks
1. Deposits
The bulk of commercial bank funds come from deposits. In spite of this, commercial banks also
raise funds from other, non-deposit sources as well. With regard to the deposit sources, there are
three common types of deposits made with commercial banks. These are:
Demand Deposits (also called transaction accounts) are checking accounts.
 In this regard, significant portion of bank funds are generated through demand deposits.
 Demand deposits are principal means of making payments.
 They are safer than cash & widely accepted as a means for paying on various transactions
and expenditures.
Savings Deposits are deposits accepted through customers’ saving accounts.
 Saving deposits are small in Birr amount.
 Saving deposits bear relatively low-interest rate and the funds can be withdrawn by
customers with little or no notice.
Time Deposits are deposits of customers that carry a fixed maturity.
 Time deposits offer the highest interest rates a bank can pay to its customers.
  Time deposits can be divided into two forms:
 Negotiable Certificate of Deposits (Negotiable CDs), and
 Non-Negotiable Certificate of Deposits (Non-Negotiable CDs).
 Negotiable CDs are a form of time deposit (CDs) that can be traded in the open market
and purchased mainly by corporations.
 Non-Negotiable CDs are contracts negotiated between two parties and hence, the liability
cannot be transferred to a third party.
 Non-Negotiable CDs usually are small in amount and consumer type accounts.
2. Non-Deposit Sources of Funds
The non-deposit sources of bank funds refers to borrowed funds in order to meet bank cash needs
(at times competition increases for deposit funds). The following are some of the non-deposit
sources of funds for commercial banks:
 Purchases of reserves (federal funds from other banks);
 Security repurchase agreement (where securities are sold temporarily by a bank and then
bought back later); and
3. Equity Capital
Equity capital represents the net worth supplied by a bank’s shareholders.
 Equity capital constitutes only a minor portion of the total funds of most firms.
 The most important functions of equity capital is to keep a bank open even in the face of
operating losses until management can correct its problems.
C. Revenues and Expenses
1. Revenues
The revenues of commercial banks comprise the following:
 Interest and fees on loans;
 Interest and dividends on securities held (for instance, interests on bonds held and
dividends on stocks held as a collateral);
 Earnings from trust (fiduciary) roles; and
 Service charges on checking accounts;
2. Expenses
The expenses of commercial banks, on the other hand, constitute the following:
 Interest on deposits;
 Salaries and wages; and
 Interest cost on non-deposit sources of funds.
2.5. Nonbank Thrift Institutions
A. General
For many years, financial experts did not consider the liabilities of nonbank financial institutions
as really close substitutes for bank deposits.
 The nonbank thrift institutions are depository institutions that accept deposits from the
public as commercial banks do.
 The common nonbank thrift institutions comprise savings and loan associations, savings
banks, credit unions, and money market mutual funds.
Nowadays, it is recognized that these institutions play a vital role in the flow of money and credit
within the financial system and are particularly important in selected markets, such as the
mortgage market and in the market for personal savings. This new awareness of the critical
importance of nonbank financial institutions in the economy and as well in the financial system
stems from a number of sources:
 The rapid growth of selected nonbank financial intermediaries in recent years;
 The increasing penetration of traditional financial service markets by nonbank
institutions;
 Nonbank financial institutions are becoming increasingly like commercial banks and
competing for many of the same customers; and
 Moreover, banks themselves are offering many of the services traditionally offered by
nonbank financial firms, such as security brokerage and insurance services.
This is why financial analysts today stress the importance of studying the whole financial
institutions sector in order to understand how the financial system works.
B. Types of Nonbank Thrift Institutions
The well known nonbank thrift institutions are four. These are:
 Savings & Loan Associations (S & Ls),
 Savings Banks,
 Credit Unions, and
 Money Market Mutual Funds.
2.5.1. Credit Unions
A. Characteristics and Growth of Credit Unions
The reasons for the revival of interest in researching the roles, operations, and characteristics of
credit unions these days are the following:
 Credit unions are rapidly growing as financial intermediary;
 Their assets have more than doubled in few years; and
 They are becoming significant institutional suppliers of consumer installment credit.
Credit unions are institutions that are exclusively household oriented intermediaries. In this
regard, credit unions:
 Offer deposit plans & credit resources only to individual & families.
 Provide low loan rates and high deposit interest rates to individual and families.
 They are really cooperatives, self-help associations of individuals rather than
profit-motivated financial institutions.
 Credit Unions are offered only to members of each association, and the members
are technically the owners, receiving dividends and sharing in any losses that
occur.
Many credit unions offer payroll savings plans where employees can conveniently set aside a
portion of their salary in a savings account.
 Credit unions frequently grant their borrowing members interest refunds up to a certain
percentage of the amount of the loan.
 Thus, credit unions often accept a smaller spread between their loans and deposit interest
rates; this is made possible because their operating costs are usually so low.
B. Organization of Credit Unions
They are organized around a common affiliation or common bond among their members.
 Most credit union members work for the same employer or for one of a group of related
employers.
 Family members may also be eligible members of a credit union.
Areas of Organization include the following:
 Occupation related credit unions;
 Around a non-profit association (labor union, church, fraternal, or social organization);
and
 Common areas of residence (for instance, residents in a given Kebele, Sub-Kebele, Sub-
Town, and/or Town).
C. Regulations of Loans, Investments, and Dividends (case of U.S.)
Like commercial banks, credit unions are heavily regulated with respect to the following aspects:
 The services they are permitted to offer;
 The rates charged for credit; and
 Dividends paid on members’ deposits.
2.5.2. Savings and Loan Associations
Savings and Loan Associations are similar to credit unions because they extend financial
services to households.
 They differ from credit unions, however, in their heavy emphasis on long-term rather
than short-term lending.
  They are major sources of mortgage loans to finance purchase of homes by households.
A. Growth of S & L Associations
The first S & Ls in the U.S. were started early in the 19th C as “Building and Loan Associations”.
 Money was solicited from individuals and families so that certain members of the group
could finance the building of new homes.
 The same individuals and families who provide the funds were also borrowers from the
association.
Today, however, savers and borrowers often are different individuals.
 Apart from only providing a single product (i.e. lending funds to home buyers), more
recently, competition from commercial banks & credit unions have forced the S & Ls to
diversify their operations.
B. Chartering & Regulation
Currently, S & Ls receive their charters from the states (regions) or from the federal government.
 Authorities supervise their activities & regularly examine their books.
Most S & Ls are mutual and, therefore, have no stockholders.
 Technically, they are owned by their depositors.
However, a growing number of S & Ls are converting to stock form.
 Stockholder-owned S & Ls can issue capital stock to increase their net worth.
 Such forms are much larger in size than the mutual associations.
C. How Funds are Raised and Allocated?
S & Ls are broadening their role many choosing to offer a full line of financial services for
individuals & families.
 Other S & Ls are branching out into business credit and commercial real estate lending.
1. Asset Portfolios
Residential mortgage loans still are the dominant assets of S & Ls. In addition to this, the
following are also assets included in their portfolio:
 Mortgaged backed securities issued by governments,
 Consumer loans,
 Commercial paper,
 Corporate debt securities, and
 Mutual funds and municipal revenue bonds.
2. Liabilities of S & Ls
Savings deposits constitute the bulk of funds available to the savings & loan industry.
Particularly important among the newly developed savings deposit plans offered by the industry
are the following:
  Money market deposit accounts,
 CDs, and
3. Trends in Industry Structure
The pressure of rising costs and the resulting squeeze on earnings have caused many savings &
loans to merge or be absorbed by larger associations.
 They were unable to take advantages of economies of scale (as they are small in size to
access wider group of customers) and scope (in order to provide broad range of financial
services).
 Although, the number of S & Ls has been declining, the average size of the S & Ls has
increased in recent years.
4. Possible Remedies for S & Ls Industry’s Problems
The following are believed to provide the remedies for the S & Ls industry’s problems:
 The first is ensuring a sound decision making process by management to diversify
operations and identifying innovative (or new) services to offer to the public.
 The second remedy is reasonable control of misappropriations of S & Ls assets and
significantly reducing operating costs.
 Moreover, further relaxation of government regulations to permit the offering of new
services and the merging of smaller associations into larger ones.
5. Savings & Loan Associations: Ethiopian Perspective
The underlying objective of Savings & Loan Associations, among other microfinance
institutions, in Ethiopia is to reach and/or provide credit services to the poor, who do not as well
as cannot get access to funds or loans from bigger financial institutions such as banks.
 Apparently, banks require collaterals and set stringent requirements to extend credit.
 That is, banks often require sound investment proposals as well as strictly evaluate the
business standing of borrowers before extending credits.
 Therefore, the operations of the S & Ls in Ethiopia were aimed at providing loans in
small denominations to the low income groups in the society, who cannot fulfill the
requirements of banks and similar institutions for obtaining loanable funds.
Practically speaking, most of the Savings & Loan Associations in Ethiopia obtain their funds
from the financially strong and highly liquid government enterprises like the Ethiopian Air
Lines, the Ethiopian Telecommunication Corporation (ETC), and the Ethiopian Electric Power
Corporation (EEPCO), and the like. While the suppliers of funds are those financially strong and
highly liquid government enterprises, the borrowers largely are low income groups & households
whose credit standing is generally weak/poor.
As a result, the risk of default on the loans of these S & Ls in Ethiopia has remained to be the
highest as experience reveals. The cost of credit (as reflected in the rate charged) on the funds
provided by the S & Ls in the context is one of the highest, which, on average, is 18% per annum
according to available sources. The major reasons for this being:
  High risk of default on outstanding loans (i.e. significant portion of their loans are
frequently non-performing),
 Smaller size of the S & Ls themselves (and hence, they are unable to obtain economies of
scale in their services), and
 High operating costs.
In spite of the aforementioned drawbacks and/or problems, the S & Ls in the context of Ethiopia
has been playing incredible role in extending credit facilities to the majority, but economically
weak groups in the society and, thus, enhancing the saving & investment practice in the economy
at large.
2.5.3. Savings Banks
Savings banks initially started to provide financial services in order to meet the financial needs
of small savers.
 Savings banks play active role in the residential mortgage market as do S & Ls but are
more diversified in their investments.
 Savings banks purchase corporate bonds and common stocks, make consumer loans, and
invest in commercial mortgage.
Savings banks designated their financial services to appeal to individuals and families. The
savings banks investments are limited (as required by law) for:
 First mortgage loans,
 U.S. government and federal agency securities,
 High grade corporate bonds and stocks, and
 Municipal bonds.
Technically speaking, savings banks are owned by their depositors.
 The principal sources of funds for savings banks are deposits.
All net earnings available after funds are set aside to provide adequate reserves must be paid to
the depositors as owner’s dividends. Regulations exercised primarily by the states are designed
to ensure maximum safety of deposits.
2.5.4. Money Market Mutual Funds
Money Market Mutual Funds are also among the nonbank thrift institutions that appeared most
recently as compared to Credit Unions, S & Ls, and Saving Banks.
 The first money market mutual fund – a financial intermediary pooling the savings of
thousands of individuals & businesses and investing those moneys in short-term, high
quality money market instruments – opened for business in the U.S. in the year 1972.
Taking advantage of the fact that interest rates on most deposits offered by commercial and
savings banks were then restrained by federal ceilings, the money market mutual funds offered
share accounts whose yield reflected prevailing interest rate in the nation’s money market.
 Thus, the money market mutual funds represent the classic case of profit seeking
entrepreneurs finding a loophole around ill-conceived government regulations.
  By now, there is no such interest rate ceiling (upper/maximum limit) on deposited funds
in the U.S. financial system.
In Ethiopia, however, there is still government fixed interest rate ceiling on deposit funds
available with commercial banks, which was 7% over years. However, the interest rate on loans
remains to be competitive, i.e. there is no ceiling or floor limit on loanable funds extended by
banks. Moreover, there is no restriction on the number of compounding interests and there
nothing called minimum interest rate payable (floor limit) on deposits. The minimum rate for
deposit could fall even to zero; but the interest rate on deposits cannot exceed the ceiling set.
As a concluding remark, it is worthwhile to emphasize on the fact that contextualizing the entire
discussions in this chapter to the domestic situation is required from readers of the material. In
particular, it is extremely beneficial to further explore the role of the existing nonbank thrift
institutions in the context of Ethiopia in light of the discussions, which is, by and large, made
from the U.S. perspective.