Financial Markets and Institutions Handout

FINANCIAL MARKETS COMPLET HANDOUT 4 ACFN 2ND YEAR
& INSTITUTIONS STUDENTS
FINANCIAL MARKETS & INSTITUTIONS

CONTENTS
1. An overview of the Financial System 11. Thrift Institutions
2. Financial Assets: Meaning, 12. Insurance Companies
Characteristics, and Types 13. Pension Funds
3. Money Market 14. Investment Companies
4. Money Market Instruments 15. Real Estate Investment Trusts
5. Capital Market 16. Finance Companies
6. Capital Market Instruments 17. Mortgage Companies
7. Financial Institutions and Intermediaries 18. Other Financial Institutions
8. Understanding Bank, Banking and 19. Regulations of Financial Markets and
Banking Business Financial Institutions
10. Commercial Banks 20. Nature of Financial System Regulations
Financial Markets and Institutions:

An overview of the Financial System
The objective of all economic activity is to promote the well-being and standard of living of the
people, which depends on the income and distribution of income in terms of real goods and
services in the economy. The production of output, which is vital to the growth process in the
economy, is a function of the many inputs used in the productive process. These inputs are
material inputs (in the form of physical materials, viz., raw materials, plant, machinery, etc.),
human inputs (in the form of labor and enterprise) and financial inputs (in the form of capital,
cash and credit). The easy availability of financial inputs promotes the growth process through
proper coordination between human and material inputs.
MATERIAL INPUTS+HUMAN INPUTS +FINANCIAL INPUTS = PRODUCTION
OUTPUTS
The financial inputs emanate from the financial system, while real goods and services are part of
the real system. The interaction between the real system (goods and services) and the financial
system (money and capital) is necessary for the productive process. Trading in money and
monetary assets constitute the activity in the financial markets and are referred to as the financial
system.
1 DU CBE ACFN COMPLIED BY: KANBIRO O. JUNE ,

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Finance at the micro and macro levels:

At the micro level, Finance is the study of the financial or monetary aspects of the production,
spending, borrowing, and lending decisions. Finance deals with the raising and using of money
by individuals, firms, governments, and foreign investors. In this context, finance deals with how
individuals manage money.
At the macro level, Finance is concerned with how the financial system coordinates and channels
the flow of funds from lenders to borrowers and vice versa, and how new funds may be created
by financial intermediaries during the borrowing process. The production and sale of goods and
services within the economic system are intimately related to the deposits, stocks and bonds, and
other financial instruments that are bought and sold in the financial system.
Financial system is vital to a healthy economy. That is why the government regulates and
supervises the operations of a financial system. The aim of such regulations is to promote and
ensure a smooth-running, efficient financial system. By establishing and enforcing operating
regulations for financial markets and institutions, Government (as a regulator) tries to promote
competition and efficiency while preserving the safety and soundness of the system.
Concept of ‘Saving’:
Our expenditure is continuous and ongoing, while our income is received only periodically
(usually monthly). This lack of synchronization between the receipt of income and expenditures
(one is periodical and the other is persistent) calls for a better management of our resources, i.e.
money. Whatever we spend (out of earnings) towards the purchase of goods and services for our
personal and family use is called consumption spending. Income that is not spent on
consumption is called ‘saving’. Such savings will either be invested in Real Assets or
Investment Goods (such as the house we buy or build), and in Financial Assets (such as Bank
Deposits, Stocks and Bonds, and money).
Meaning of SSUs and DSUs:

We know that not every household will have excess of income over expenditure, viz., saving.
The other can also be the reality, that is, some households would have their expenditure
exceeding their income. In the case of the latter, they have to find the means of ‘financing’ their
deficit. Thus, ‘Surplus Spending Units (SSUs)’ are those households (and firms) whose
income exceeds their spending. That means, SSUs spend (towards consuming goods and
services) less than their current income and they have surplus funds to buy investment goods
(which may be real or financial assets). On the other hand, ‘Deficit Spending Units (DSUs)’ are
those households (and firms) whose spending exceeds their income. Obviously, the DSUs have
deficit and they need to find means to finance their deficit.

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Financial System:
“The Financial System provides a mechanism whereby an individual unit (which may be a
household or a firm) that is an SSU may conveniently make funds available to DSUs who
intend to spend more than their current income”. Financial System is comprised of Financial
Markets and Financial Institutions.
Financial Markets:
Financial Markets are the markets where SSUs can lend their funds directly to DSUs. In other
words, Financial Markets are the markets in which spending units trade financial claims (SSUs
by lending their surplus funds and DSUs by borrowing for their deficit). This activity of SSUs
lending their funds directly to DSUs is called ‘Direct Finance’. For example, the Ethiopian
Telecommunications Corporation may issue corporate bonds (may be to finance plant expansion
all over the country), and one Admasu from Dilla can purchase some these bonds out of his
surplus income (which is not spent on consuming goods and services for his household). So, in
this case, there is direct financing provided by the SSU (here Mr.Admasu, an household) to the
DSUs (here the ETC). Another example of Direct Finance is the buying of shares and stocks of
a corporation in the financial market.
Financial Institutions and Financial Intermediaries:

Financial Institutions are those firms that provide financial services to SSUs and DSUs. The
most important Financial Institutions are the Financial Intermediaries. Financial Intermediaries
are those financial institutions (such as Banks) which borrow from SSUs for the purpose of
lending to DSUs. The Surplus Spending Units park their surplus funds (in the form of Bank
Deposits) out of which the Financial Intermediaries lend the Deficit Spending Units to meet their
deficit (excess of expenditures over their income). Thus, the Financial Intermediaries serve a
connecting link between SSUs and DSUs. This activity of SSUs lending their surplus funds
through financial intermediaries to DSUs to meet their deficit is called ‘Indirect Finance’. For
example, Mr.Admasu may choose to park his surplus funds in Commercial Bank of Ethiopia at
Dilla and the CBE may use these funds to lend to one its business customer. So, in this case,
there is indirect financing through the Financial Intermediary (Commercial Bank of Ethiopia)
who acts as the connecting link between the SSU (Admasu) and the DSU (Business Customer
who needs finance). Here, an important point to observe is though it is the funds of Admasu
(SSU) which is lent by CBE to the Business Customer (DSU), the DSU owes repayment to the
Financial Intermediary (CBE) and not to the SSU.

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Financial Intermediation:
Remember that a financial intermediary is one which intermediates funds transfer between the
SSUs and the DSUs, by creating secondary securities. The financial intermediaries obtain the
funds from the SSUs and offer their own securities (such as Deposit Certificates, Insurance
Contracts, Pension Contracts, which are commonly known as Secondary Securities) as financial
claims to the SSUs. They then provide the funds to the DSUs (in the form of advances) and
accept the securities issued by DSUs (such as Stocks and Shares, Bonds and Debentures,
Treasury Bills, which are widely known as Primary Securities) as financial claims on the
DSUs. Thus they carry out ‘financial intermediation’.
There are Financial Institutions which do not act as Financial Intermediaries. They are financial
institutions which facilitates funds transfers from SSUs to DSUs without creating securities on
their own. They simply act as conduit pipe between the SSUs and DSUs. For example, a
security broker in Addis Ababa may provide the services of procuring shares offered by a newly
formed Share Company to an investor situated in Mekelle, for a commission or service charge.
In this context, the security broker does not create a secondary security (like the one created by
financial intermediaries), but simply transfers the security of the DSU (the share company) to the
SSU (the investor in Mekelle). This kind of financial transaction is known as ‘Semi-Direct
Finance’, which is facilitated by ‘Financial Institutions which are not financial intermediaries’.
Financial Markets in the Financial System:

Financial Markets perform the vital function of channeling savings to those individuals and
institutions needing more funds for spending. The financial markets are the heart of the global
financial system. They attract and allocate savings and set interest rates and the prices of
financial assets (which are predominantly the financial claims such as stocks, bonds, etc).
By selling financial claims (such as stocks and bonds) in the financial markets, large amounts of
funds can be raised quickly from the pool of savings accumulated by households, businesses, and
governments. The business firm or government carrying out the investment then hopes to repay
its loans from the financial marketplace by drawing on future income.
The Money and Capital Markets operating within the financial system make possible the
exchange of current income for future income and the transformation of savings into investment
so that production, employment, income, and living standards can grow.
Those who supply funds to the financial markets receive only promises in return for the loan of
their money. These promises are packaged in the form of financial claims and financial services,
attractively such as stocks, bonds, deposits, and insurance policies. Financial claims promise the
supplier of funds a future flow of income in the form of dividends, interest, or other returns.

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Though there is no guarantee for these returns, the suppliers of funds to the financial system
expect not only to recover their original funds but also to earn additional income as a reward for
waiting and for assuming risk.
Functions performed by Financial System & Financial Markets:

The Financial System and its major component (Financial Markets) perform the following
functions:
(1) Savings function: The global system of Financial Markets and Institutions provides a
connecting link for the savings of the public. Bonds, stocks and other financial claims sold in
money and capital markets provide a profitable outlet for the public savings. These savings flow
through the financial markets into investment so that more goods and services can be produced.
(2) Wealth function: The financial instruments sold in the money and capital markets provide
an excellent way to store wealth (i.e. to preserve the value of assets held) until they are needed
for spending. Though there is a general preference to store the value of wealth in the form of
real assets (such as buildings, automobiles), yet they are subject to depreciation and loss in value.
Contrarily, the financial instruments do not have wear and tear, and they have the chance of
generating regular income and appreciate in value over time.
(3) Liquidity function: Financial Markets in the financial system provide a convenient means
of converting the financial instruments into cash, with ease and without loss of time. Money
possessed in the form of bank deposits are the most liquid form of assets. For other financial
instruments, the financial markets provide a ready market for who wish convert them back into
cash.
(4) Credit function: Financial markets furnish credit to finance consumption and investment
spending. Credit consists of a loan of funds in return for a promise of future payment.
Consumers need credit to buy home, groceries, other services, and to pay outstanding debts.
Business houses need credit to stock the goods, construct new shops, meet payrolls, and pay
dividend to their stockholders. Similarly, governments need credit provide public facilities.
(5) Payments function: The financial system provides a mechanism for making payments for
goods and services. Certain financial assets serve as a medium of exchange in making payments.
(6) Risk Protection function: By selling insurance policies, the financial markets offer
protection against life, health, property, and income risks of businesses, consumers and the

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governments. The money and capital markets are used by businesses and consumers to “self-
insure” against risk, by building up wealth as protection against future losses.
(7) Policy function: In the recent times, the financial markets have been the principal channel
though which government has carried out its policy of attempting to stabilize the economy.
Governments can influence the borrowing and spending plans of the public, by altering the
interest rates and the availability of credit. This in turn influences the growth of jobs,
production, and prices.
Types of Financial Markets:
The major categories of Financial Markets are the Money Market and the Capital Market.
A. Money Market:
Money market is the market for short-term loans. It is the institution through which individuals
and institutions (with temporary surpluses of funds) meet the needs of borrowers (who have
temporary funds shortages). By convention, a security or loan maturing within one year or less
is considered to be a money market instrument. Money market has its own components – such
as Treasury Bill Market, Market for Certificates of Deposit, Federal Funds Market, and
Eurocurrency Market.
B. Capital Market:
Capital Market is designed to finance long-term investments by businesses, governments, and
households. Construction of factories, highways, schools, and homes are possible through funds
traded in the capital market. Financial instruments in the capital market have original maturities
of more than one year, as against money market instruments which are for less than a year.
Components of Capital Market include the Stock Market, the Bond Market the Mortgages
Market, and the Futures Market.
Financial Assets:
Meaning, Characteristics, and Kinds
What is a Financial Asset?

A Financial Asset is a “claim against the income or wealth of a business firm, household, or unit
of government, represented usually by a certificate, receipt, or other legal document, and usually
created by the lending of money”.
Characteristics of Financial Assets:
 Financial Assets do not provide a continuing stream of services to the owner as does a home
or a machinery or an automobile.
 Financial Assets are wanted because they promise future returns to their owners.
 Financial Assets serve as a store of value (purchasing power).

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 There is no question of ‘depreciation’ for financial assets, since they do not wear out like
physical goods.
 Their physical condition or form is generally not relevant in determining their market value
(price).
 They have little or no value as a commodity (for they are generally represented by a piece of
paper, i.e. certificate or contract, or by information stored in a computer file).
 The cost of transport and storage of financial assets is low.
 Financial Assets are fungible, i.e. they can be easily changed in form and interchanged (or
substituted) for other assets.
Kinds of Financial Assets:

Though there are thousands of different financial assets, they can broadly be categorized into:
(1) Money,
(2) Equity,
(3) Debt Securities, and
(4) Derivative Securities.
1. Money - is the legal currency of any country, ETB in Ethiopia, USD in America, INR in
India.
2. Equity - (also known as Stock) is in the form of Common Stock and Preferred Stock.
3. Debt Securities - may be classified as Bonds, Notes, and Accounts Payable. Another
classification may be Negotiable debt securities, and Non-negotiable debt securities. Those
debt securities which can be converted into another debt or equity are known as Negotiable
debt securities, e.g. Convertible Bonds. Those which cannot be so converted are Non-
Negotiable debt securities, e.g. Passbook Savings Accounts in Banks.
4. Derivative Securities - form the fourth category of Financial Assets. By the very
name, one can understand that Derivative securities are those whose formation is dependent on
the original securities. They have a market value that is tied to or influenced by the value or
return on a financial asset. Examples include futures contracts, options, and swaps.
Money as a Financial Asset

What is Money?
Any financial asset that is generally accepted in payment for purchase of goods and services is
money. That’s why it is BIRR as money in Ethiopia, RUPEE in India, and YEN in Japan. Thus,
currency issued by NBE in Ethiopia, by the FED-Reserve in US, are different forms of Money.
Checking accounts in US are considered to be money, for they are freely accepted in payment for
purchase of any good or service in the US.

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Functions/Services performed by Money:

 It serves as a Standard of Value for all goods and services.
 It serves as a medium of exchange. It is usually the only financial asset which virtually
every business, household, and government will accept in payment for goods and
services.
 It serves as a Store of Value – a reserve of future purchasing power. Purchasing power
can be stored in currency or in checking account until the time is right to buy.
 It functions as the only perfectly liquid asset in the financial system. (An asset is considered
to be liquid, if it possesses three characteristics: price stability, ready marketability, and
reversibility.)
Importance of Money as a Financial Asset:
 Acceptability of money for all transactions (Legal Tender)
 Negotiability (it can be converted for any other financial asset or real asset)
 Measure of Wealth (it serves as a measure of one’s wealth)
 Non-perish ability (even stored for long time, it does not perish – may be there could be
value fluctuations due to market conditions).
MONEY MARKET
MONEY MARKET: Meaning

 Financial markets that facilitate the flow of short-term funds (with maturities of 1 year or
less) are referred to as money markets.
 The securities that are traded in money markets are called money market securities.
 The money market is a market for financial assets that are close substitutes for money.
 It is a market for overnight short-term funds and instruments having a maturity period of one
or less than one year.
 It is not a place (like the Stock market), but an activity conducted by telephone.
 It can also be explained as a market place where financial instruments whose remaining
maturity of less than 1 year is traded, e.g., T-bills, commercial papers, CDs, a 30-year T-bond
issued 29½ years ago.
Objectives of Money Market:
 First, the money market should provide an equilibrating mechanism for evening out short-
term surpluses and deficits.
 Secondly, it should provide a focal point for Central Bank intervention influencing liquidity
in the economy.
 Thirdly, it should provide reasonable access to users of short-term money to meet their
requirements at a realistic price.

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Characteristics of the money market:

 It is not a single market but a collection of markets for several instruments.
 It is wholesale market of short term debt instruments.
 Its principal feature is to honor where the creditworthiness of the participants is important.
 The main players are: Government, financial institutions, banks, and corporate dominate the
money market. Individual investors participate in the money market directly.
 It is a need based market wherein the demand and supply of money shape the market.
Lenders and borrowers in the money market:

• Financial and non-financial institutions flip-flop their positions as lender and borrowers
frequently in money market.
Why is the need for money market?
• Money Market provides the channel through which suppliers of temporary cash surpluses
meet demanders of temporary cash deficits.
• Money is the most perishable of all commodities, i.e., holding of idle cash is expensive.
E.g., interest on $10m at 10% annual rate for one day = 10m x 0.10 x (1/360) = $2,777.78.
• Demand for short-term, say overnight, of cash does exist, e.g., banks to meet their reserve
requirement.
Functions of the Money Market:
The most important function of a money market is to provide a means whereby economic units
can quickly adjust through cash positions. For all economic units (business, household’s
financial institutions or governments) the timing of cash inflows is rarely perfectly synchronized
or predictable in the short run.
The following are the other important functions of Money Market:

 Provide a balancing mechanism to even out the demand for and supply of short term funds
 Provide a focal point for central bank intervention for influencing liquidity and general level
of interest rates in the economy.
 Provide reasonable access to suppliers and users of short term funds to fulfill their
borrowings and investment requirements at an efficient market clearing price. Besides the above
functions, a well functioning money market facilitates the development of a market for longer
term securities. The interest rates for extremely short term use of money serve as a benchmark
for longer term financial instruments.

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MONEY MARKET INSTRUMENTS
• Debt instruments, which have a maturity of less than one year at the time of issue, are called
money market instruments.
• These instruments are highly liquid and have less risk.
• The major money market instruments are Treasury bills, Certificates of deposit, commercial
paper, and repos.
Common money market instruments:

1. Bankers' acceptance - A draft issued by a bank that will be accepted for payment,
effectively the same as a cashier's check.
2. Certificate of deposit - A time deposit at a bank with a specific maturity date; large-
denomination certificates of deposits can be sold before maturity.
3. Repurchase agreements - Short-term loans—normally for less than two weeks and
frequently for one day—arranged by selling securities to an investor with an agreement to
repurchase them at a fixed price on a fixed date.
4. Commercial paper - Unsecured promissory notes with a fixed maturity of one to 270
days; usually sold at a discount from face value.
5. Treasury bills - Short-term debt obligations of a national government that are issued to
mature in three to twelve months. For the U.S., see Treasury bills.
CAPITAL MARKET: Meaning

• Financial markets that facilitate the flow of long-term funds (with maturities of more than 1
year) are referred to as Capital Markets.
• The securities that are traded in capital markets are called capital market securities.
• The capital market is the market for securities, where companies and governments can raise
long-term funds. It is a market in which money is lent for periods longer than a year.
• The capital market includes
 the stock market (which provide financing through the issuance of shares or
common stock, and enable the subsequent trading thereof), and
 the bond market (which provide financing through the issuance of bonds, and
enable the subsequent trading thereof).
 The capital markets consist of the primary market and the secondary market. The primary
markets are where new stock and bonds issues are sold (underwriting) to investors. The
secondary markets are where existing securities are sold and bought from one investor or
speculator to another, usually on an exchange (e.g. the New York Stock Exchange).

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STOCK MARKET (or EQUITY MARKET):

• A stock market is a public market for the trading of company stock and derivatives at an
agreed price; these are securities listed on a stock exchange as well as those only traded
privately.
• The size of the world stock market was estimated at about $36.6 trillion US at the beginning
of October 2008.
• The stocks are listed and traded on stock exchanges which are entities a corporation or
mutual organization specialized in the business of bringing buyers and sellers of the
organizations to a listing of stocks and securities together.
• The stock market in the United States includes the trading of all securities listed on the
NYSE, the NASDAQ, the Amex, as well as on the many regional exchanges, e.g. OTCBB
and Pink Sheets.
• European examples of stock exchanges include the London Stock Exchange, the Deutsche
Börse and the Paris Bourse, now part of Euronext.
Function and purpose

• The stock market is one of the most important sources for companies to raise money.
• This allows businesses to be publicly traded, or raise additional capital for expansion by
selling shares of ownership of the company in a public market.
BOND MARKET:
 The bond market (also known as the debt, credit, or fixed income market) is a financial
market where participants buy and sell debt securities, usually in the form of bonds.
 Bond markets in most countries remain decentralized and lack common exchanges like stock,
future and commodity markets. This has occurred, in part, because no two bond issues are
exactly alike, and the number of different securities outstanding is far larger.
 The Securities Industry and Financial Markets Association classified the broader bond
market into five specific bond markets:
 Corporate
 Government & agency
 Municipal
 Mortgage backed, asset backed, and collateralized debt obligation
 Funding
 Bond market participants are similar to participants in most financial markets and are
essentially either buyers (debt issuer) of funds or sellers (institution) of funds and often both.
Participants include:
 Institutional investors
 Governments
 Traders

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 Individuals
Because of the specificity of individual bond issues, and the lack of liquidity in many smaller
issues, the majority of outstanding bonds are held by institutions like pension funds, banks
and mutual funds. In the United States, approximately 10% of the market is currently held by
private individuals.
PRIMARY MARKET:
 The primary market is that part of the capital markets that deals with the issuance of new
securities.
 Companies, governments or public sector institutions can obtain funding through the sale of a
new stock or bond issue.
 This is typically done through a syndicate of securities dealers.
 The process of selling new issues to investors is called underwriting.
 In the case of a new stock issue, this sale is an initial public offering (IPO).
 Dealers earn a commission that is built into the price of the security offering, though it can be
found in the prospectus.
Features of primary markets are:

• This is the market for new long term capital.
• The primary market is the market where the securities are sold for the first time. Therefore,
it is also called the new issue market (NIM).
• In a primary issue, the securities are issued by the company directly to investors.
• The company receives the money and issues new security certificates to the investors.
• Primary issues are used by companies for the purpose of setting up new business or for
expanding or modernizing the existing business.
• The primary market performs the crucial function of facilitating capital formation in the
economy.
• The Borrowers in the new issue market may be raising capital for converting private capital
into public capital; this is known as "going public."
• The financial assets sold can only be redeemed by the original holder.
• Methods of issuing securities in the primary market are:
• 1. Initial public offering;
• 2. Rights issue (for existing companies);
• 3. Preferential issue.

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SECONDARY MARKET:
 The secondary market, also known as the aftermarket, is the financial market where
previously issued securities and financial instruments such as stock, bonds, options, and
futures are bought and sold.
 The term "secondary market" is also used refer to the market for any used goods or assets, or
an alternative use for an existing product or asset where the customer base is the second
market (for example, corn has been traditionally used primarily for food production and
feedstock, but a second- or third- market has developed for use in ethanol production).
 With primary issuances of securities or financial instruments, or the primary market,
investors purchase these securities directly from issuers such as corporations issuing shares in
an IPO or private placement, or directly from the federal government in the case of
treasuries. After the initial issuance, investors can purchase from other investors in the
secondary market.
 The secondary market for a variety of assets can vary from fragmented to centralized, and
from illiquid to very liquid.
 The major stock exchanges are the most visible example of liquid secondary markets - in this
case, for stocks of publicly traded companies.
 Exchanges such as the New York Stock Exchange, Nasdaq and the American Stock
Exchange provide a centralized, liquid secondary market for the investors who own stocks
that trade on those exchanges.
 Most bonds and structured products trade “over the counter,” or by phoning the bond desk of
one’s broker-dealer.
Functioning of Secondary Markets:

 Secondary marketing is vital to an efficient and modern capital market.
 In the secondary market, securities are sold by and transferred from one investor or
speculator to another.
 Fundamentally, secondary markets meets the investor's preference for liquidity (i.e., the
investor's desire not to tie up his or her money for a long period of time, in case the investor
needs it to deal with unforeseen circumstances) with the capital user's preference to be able to
use the capital for an extended period of time.
 Accurate share price allocates scarce capital more efficiently when new projects are financed
through a new primary market offering, but accuracy may also matters in the secondary
market because: (1) price accuracy can reduce the agency costs of management, and make
hostile takeover a less risky proposition and thus move capital into the hands of better
managers, and (2) accurate share price aids the efficient allocation of debt finance whether
debt offerings or institutional borrowing.


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CAPITAL MARKET SECURITIES
 The key capital market securities are bonds and stocks.

 The capital market securities offer more potential for higher returns, but their expected
returns are subject to a higher degree of uncertainty (risk).
 Because the capital markets facilitate the exchange of long-term securities, they help to
finance the long-term growth of government agencies and firms.
.
BONDS:
• Bonds are long-term debt securities issued by firms and governments to raise large amounts
of long-term funds.
• Bonds are differentiated by the issuer and can be classified as Treasury bonds, municipal
bonds, or corporate bonds.
1. Treasury Bonds:
• Treasury bonds are issued by the U.S. Treasury as a means of obtaining funds for a long-term
period. They normally have maturities from 10 years to 30 years.
• The Treasury issues short-term debt securities in the form of Treasury bills. It also issues
medium-term debt securities in the form of Treasury notes, which have maturities between 1
and 10 years.
• The minimum denomination of Treasury bonds is $1,000, but much larger denominations are
more common.
• The federal government borrows most of its funds by issuing Treasury securities.
• An active secondary market for Treasury bonds exists, so investors can sell Treasury bonds
at any time.
• Treasury bonds pay interest (in the form of coupon payments) on a semiannual basis (every 6
months) to the investors who hold them.
• Investors earn a return from investing in Treasury bonds in the form of these coupon
payments and
2. Municipal Bonds:
• Municipal bonds are bonds issued by municipalities to support their expenditures. They are
typically classified into one of two categories: (1) General Obligation Bonds, and (2)
Revenue Bonds.
General obligation bonds provide investors with interest and principal payments that are backed
by the municipality’s ability to tax.
• Conversely, revenue bonds provide interest and principal payments to investors using funds
generated from the project financed with the proceeds of the bond issue.
• For example, revenue bonds may be issued by a municipality to build a toll way. The
proceeds received in the form of tolls would be used to make interest and principal payments
to the investors who purchased these bonds.

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• The minimum denomination is $5,000, but larger denominations are more common.
• Municipal bonds pay interest on a semiannual basis. The interest paid on municipal bonds is
normally exempt from federal income taxes and may even be exempt from state and local
income taxes. This very attractive feature of municipal bonds enables municipalities to obtain
funds at a lower cost.
3. Corporate Bonds:
• Corporate bonds are bonds issued by corporations to finance their investment in long-term
assets, such as buildings and machinery. Their standard denomination is $1,000, but other
denominations are sometimes issued.
• The secondary market for corporate bonds is more active for those bonds that were issued in
high volume. Because there is less secondary market activity for corporate bonds than there
is for Treasury bonds, corporate bonds are less liquid than Treasury bonds with a similar term
to maturity.
• Maturities of corporate bonds typically range between 10 and 30 years, but some recent
corporate bond issues have maturities of 50 years or more.
• For example, both the Coca-Cola Company and Disney recently issued bonds with maturities
of 100 years.
4. International Bonds:
• Firms commonly issue bonds in the Eurobond market, which serves issuers and investors in
bonds denominated in a variety of currencies.
• For example, General Motors may consider issuing a dollar-denominated bond to investors in
the Eurobond market. Or it may consider issuing a bond denominated in Japanese yen to
support its operations in Japan.
• U.S. investors may use the Eurobond market to purchase bonds denominated in other
currencies that are paying higher coupon rates than dollar-denominated bonds. However, they
will be subject to exchange rate risk if they plan to convert the coupon and principal payments
into dollars in the future.
STOCKS:
 Stock is an equity security which represents ownership interest in the issuing firm.
 Whereas bonds are issued by both governments and businesses, stock is issued only by
business firms.
 The two forms of stock are common and preferred.
Common and Preferred Stock:
 Shares of common stock are units of ownership interest, or equity, in a corporation. Common
stockholders expect to earn a return by receiving dividends, by realizing gains through
increases in share price, or both.

2016
 Preferred stock is a special form of ownership that has features of both a bond and common
stock. Preferred stockholders are promised a fixed periodic dividend that must be paid prior to
payment of any dividends to the owners of common stock. In other words, preferred stock has
priority over common stock when the firms dividends are disbursed.
International Stocks:
 Many large U.S. firms issue stock in international equity markets.
 They may be able to sell all of their stock offering more easily by placing some of the stock
in foreign markets, if there is not sufficient demand in the United States.
 In addition, they may be able to increase their global name recognition in countries where
they conduct business by selling some of their newly issued stock in those foreign markets.
 Investors commonly invest in stocks issued by foreign firms.
 They may believe that a particular foreign stock’s price is undervalued in the foreign market.
Derivative Securities Markets
• Financial instruments the value of which is derived from the prices of securities,
commodities, money or other external variables.
• Are created to manage price volatility
• Used to reduce inhert risk in portflio management
• although many, they fall into two basic categories:
(1) Forwards: are contracts that set a price for something to be delivered in the future or
agrement to buy or sell at certaine in the future at certain price.
(2) Options: are contracts that allow, but do not require, one or both parties to obtain
certain benefits under certain conditions or gives right to owner but not
obligation to buy or sell at fixed price.
.
Forward contract: Agreement between buyer and seller to trade securities for cash on a
specific date
Future contract: similar to forward contract, except that it is traded in an organized exchange
• asset standardized and indemnity is available in case of default
Swaps: Agreement to exchange specified periodic cash flows in the future based on some
underlying instrument or price
Example: interest rate swaps
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Financial Institutions and Intermediaries
We have earlier studied about Financial Institutions and Financial Intermediaries. The major
distinction between a Financial Institution and a Financial Intermediary is in its participation in a
financial transaction. We have also studied about different types of Financial Transactions (viz.,
Direct Finance, Semi-Direct Finance, and Indirect Finance).
While Financial Intermediaries involve in Indirect Finance, the other financial institutions
involve in semi-direct finance. For example, when you deposit your funds in a commercial bank
for a longer duration, you are tendered a Fixed Deposit Receipt (which is a Secondary Security
created by the commercial bank). The said bank pools all such funds from various fixed deposits
and invests in, say, Government Bonds (which is a primary security), this is a transaction of
‘Indirect Finance’. So, in Indirect Finance, the SSUs are given secondary securities by the
financial intermediary (in this example, a commercial bank) and the financial intermediary is in
possession of the primary security issued by DSUs (in this example, the Government who is
issuing the Bonds).
On the other hand, other financial institutions involve in semi-direct finance and not in indirect
finance. For example, a security broker acts as a connecting link between a SSU and a DSU in
transfer of stocks from the DSU to the SSU. The broker will get a commission, but he will never
issue a security of his own – that means, there is no creation of a secondary security by a non-
financial-intermediary. They merely involve in the transfer of security from one hand to another,
so to say, act as a connecting link between the ‘saver’ and the ‘borrower’ of funds.
Thus, all Financial Intermediaries are Financial Institutions, but not all Financial
Institutions are Financial Intermediaries.
 The following list is an example for Financial Intermediaries (which means they are
financial institutions also):
• Commercial Banks
• Saving Banks
• Saving and Loan Associations
• Credit Unions
• Insurance Companies (Life and Property)
• Pension Funds
• Real Estate Investment Trusts
 The Following are examples for Financial Institutions which are not Financial
Intermediaries:
• Security Dealers
• Security Brokers

2016
• Investment Bankers
1. Depository Institutions:
Depository Institutions (such as Commercial Banks, Savings and Loan associations, Savings
Banks, and Credit Unions) derive the bulk of the loanable funds from deposit accounts, sold to
the public.
2. Contractual Institutions:
Contractual Institutions (such as insurance companies and pension funds) attract funds by
offering legal contracts to protect the saver against risk, in the form of an insurance policy and a
retirement savings account.
3. Investment Institutions:
Investment Institutions (such as investment companies, and real estate investment trusts) sell
shares to the public and invest the proceeds in stocks, bonds, and other assets.
Understanding Bank, Banking/Banking Business
Bank: Word Origin

The word ‘Bank’ is of Germanic origin, and is linked to French word ‘Banqui’ and the Italian
word ‘Banca’. These words mean a bench for keeping, lending, and exchanging of money or
coins in the market place by money lenders and money changers. The term is so derived
because in the primitive days, the persons who carried out banking business used to sit on
benches to carry out the banking activities, and thus the term assumed the name ‘bank’. Quite
interestingly, in Amharic ‘bankoni’ refers to “the box or storage space in which the money is
kept by businessmen as well by home-savers”.
Bank/Banking: Meaning
By our common sense, we know that Bank is a place where people safe-keep their money and
earn interest on the same, and obtain money for their various requirements for interest. Yet we
know banks do more than simply safe-keeping our money, and lending loans to the needy.
Banking refers to the activities carried out by a bank in the course of its business. It is time to
know what a Bank means, or what a Bank does. In order to better understand the meaning of the
terms ‘bank’ and ‘banking’, let us have a look at certain definitions of the terms.
Bank/Banking: Definitions
“A bank is an institution for the keeping, lending, and exchanging, etc. of money”.
A bank is a deposit-taking institution which is licensed by the monetary authorities of a country
to act as a repository for money deposits by persons, companies and institutions, and which
undertakes to repay such deposits either immediately on demand or subject to due notice being

2016
given. Banks perform various services for their customers (money transmission, investment
advice, etc.) and lend out money deposited with them in the form of loans and overdrafts or use
their funds to purchase financial securities, in order to operate at a profit.
Commercial Banks are profit-making businesses that accept deposits and use these funds to
make loans. As long as the return on loans exceeds expenses and the interest banks pay on
deposits, they make a profit. From the banks’ standpoint, the key to success is to lend out as
much money as possible to creditworthy customers, to maximize the interest received from loans,
and to minimize the interest paid on deposits.
“A banker is a person or company carrying on the business of receiving moneys, and collecting
drafts, or customers subject to the obligation of honoring checks drawn upon them from time to
time by the customers to the extent of the amounts available on their current accounts”.
“No person or body corporate or otherwise can be a banker who does not (i) take deposit
accounts, (ii) take current accounts, (iii) issue and pay checks, and (iv) collect checks crossed
and uncrossed for customers”.
“The banking business is the business of receiving money on current or deposit account, paying
and collecting checks drawn by or paid in by customers, the making of advances to customers,
and includes such other business as the Authority (meaning the Monetary Authority of
Singapore) may prescribe for the purpose of the Act”.
“Banking refers to accepting for the purpose of lending or investment, of deposits of money from
the public, repayable on demand or otherwise, and withdraw able by check, draft, order or
otherwise”.
Banking Business: What is included?

The term ‘banking business’ includes all the following:
• The borrowing, raising, or taking of deposits of money;
• The lending, or advancing of money either upon or without security;
• The drawing, making, accepting, discounting, buying, selling, collecting and dealing in
bills of exchange, hundis, promissory notes, coupons, drafts, bills of lading, railway
receipts, warrants, debentures, certificates, scrips, and other instruments, and securities
whether transferable or negotiable or not;
• The granting and issuing of letters of credit, travellers’ checks, and circular notes;
• The buying, selling and dealing in bullion and spices;
• The buying and selling of foreign exchange, including foreign bank notes;

2016
• The acquiring, holding, issuing on commission, underwriting and dealing in stock, funds,
share, debentures, debenture stock, bonds, obligations, securities, and investments of all
kinds;
• The purchasing and selling of bonds, scrips or other forms of securities on behalf of
constituents or others;
• The negotiating of loans and advances;
• The receiving of all kinds of bonds, scrips or valuables on deposit or for safe custody or
otherwise;
• The providing of safe deposit vaults for custody of valuables of customers; and
• The collecting and transmitting of money and securities.
“Banking Business” means including the following:

• Receiving funds from the public as deposit through means that the National Bank has
declared to be an authorized manner of receiving funds;
• Under the account and risk of the person undertaking banking business to use the funds
referred to under paragraph (a), in whole or in part, for loans, investments and for purposes
that the National Bank has declared to be appropriate;
• The buying and selling of gold and silver bullion and foreign exchange;
• The transfer of funds to other domestic and foreign persons in the name of the banks
themselves or their customers;
• The discounting and negotiation of promissory notes, drafts, bills of exchange and other
evidences of debt;
• Any other activity recognized as customary banking business, which a bank engaging in the
activities described from paragraphs (a) to (e) is authorized to undertake by the National Bank.
COMMERCIAL BANKS
Meaning:
Commercial Banks are by far the most numerous of all financial institutions in any country,
particularly in U.S. Commercial Banks are the financial intermediaries that attract funds
with deposits and invest in money in consumer and business loans, state and local
government bonds, in domestic and international markets.
The primary business of banking is one of collecting funds from the community and extending
credit (making loans) to people for useful purposes. Banking organizations are also involved in
non-banking financial services.

2016
Today banks are the most important and most complex institution in the financial system of any
country. The banker is the custodian whom we trust to invest our funds safely. Furthermore, the
bank is responsible to its stockholders. Of course, in a country like Ethiopia, most of the banks
are nationalized and owned by the Government. But, as far as the private banking is concerned,
it is a profit-seeking business, which attempts to maximize the wealth of shareholders.
Sources of Commercial Bank Funds:

The three major sources of Commercial Banks Funds are: (i) Checkable Deposits, (ii) Time and
Savings Deposits, and (iii) Federal Funds.
Checkable Deposits:
Checkable deposits are checking account balances maintained at commercial banks. We write
checks ordering the bank to pay a third party from our demand deposit. Commercial Banks and
other Depository Institutions are empowered by law to issue demand deposit accounts.
The checking accounts facilitate easy payments, by eliminating the hardship for carrying a large
amount of cash. Payment is easily made for telephone, electric and other bills. Our cancelled
check serves as a proof of payment.
Banks do not pay interest on checkable deposits, but charge a nominal amount for various
services. Those service charges cover only a small proportion of the processing costs. Banks
provide ‘implicit interest’ on checkable deposits, in the form of calculators, balloons, and other
gifts and services such as check clearing, financial advice, and 24-hour teller machines.
Time and Savings Deposits:

Time and savings deposits are interest-bearing liabilities payable at some future date or after
notice. Legally banks have a right to claim 30-days notice for withdrawals of money from time
and savings deposits, but it is invariably waived by them. There are three types of consumer,
time and savings deposits (though varying with names in different regions):
• Savings deposits, also called passbook savings, fulfill the short-term savings needs for
demand deposit customers.
• Time Deposits, also called non-negotiable Certificates of Deposit (CDs), provide higher
rates of interest to interest-conscious savers. These deposits are with varying flexibility,
suited to the needs of the customers, such as, automatic renewal, interest payments by
check, and premature redemption.
• Money-Market Deposit Accounts (MMDAs) and Super NOW accounts (SNOWs) are
savings account exempt from rate ceilings as a $1,000 minimum or average balance is
maintained.

2016
Federal Funds:
Commercial banks lend one another funds through the Federal Reserve or through a
correspondent bank which is a member of the Federal Reserve. The leading bank notifies the
Federal Reserve of the transaction, and the Federal Reserve simultaneously debits the lending
bank’s account and credits the borrowing bank’s account. The transaction is usually a 1-day
loan, involves any amount specified, and costs very little. Federal Funds Loans are an excellent
way for a bank with excess funds to lend to a bank with insufficient funds for very short periods
of time.
Investments by Commercial Banks:

Commercial banks put their deposit money to work by making loans and buying bonds. Loans
are made to businesses and individuals for various reasons and uses. The three important
investments by commercial banks are: (i) Loans, (ii) State and Local Government Bonds, and
(iii) Money-Market Securities.
Loans:
Loans are an essential aspect of commercial banking. First, income from loans contributes to 80
percent of revenues of the average bank. Second, lending money to people in a confidential
manner is a valuable service. Third, lending money stimulates business development and
supports a growing economy. Whether loans are made to businesses or to consumers, business
activity increases.
Loans are negotiated directly between the bank (lender) and the customer (borrower). The loan
agreement is an understanding between two parties – the bank and the borrower. The terms are
tailor-made to suit the needs of both the parties. Bank loans can normally be categorized into the
following three types: (i) Commercial Loans, (ii) Consumer Loans, and (iii) Mortgage (Real
Estate) Loans.
Commercial Loans:
The traditional mainstay of bank lending is the commercial loan. These loans meet many diverse
credit needs of business enterprises. Commercial loans can broadly be grouped thus: (a)
Seasonal loans, (b) Permanent working capital loans, and (c) Term loans.
Seasonal Loans:
Seasonal loans are granted for periods less than one year, usually for 90 to 180 days. Borrowers
use seasonal loans to buy inventory and to finance accounts receivable during their peak sales
season. The loan is repaid when inventory and receivables are converted into cash. Seasonal
loans are called “self-liquidating loans”, since repayment follows from the normal liquidation of
inventory and receivables.

2016
Permanent Working Capital Loans:

When ‘inventory and accounts receivable needs’ continue throughout the year, the business firm
requires a permanent working capital loan. Many businesses carry a big stock of merchandise,
carry accounts receivable from past sales, and so are in need of permanent working capital. Such
loans are usually redeemed out of future profits and depreciation or from the sale of bonds or
common stock.
Term Loans:
Term loans are credits extending from 1 to 10 years in the future. Supposing a firm buys a new
machine, it requires many years of operation to earn sufficient profits to repay the loan.
Typically term loans mature in 3 to 10 years and are repaid in monthly or quarterly installments.
While granting such term loans, banks exercise abundant caution and study the credit-worthiness
of the borrower.
State and Local Government Bonds:

State and Local Government Bonds are issued by State and City governments. They are also
called Municipal Bonds. These bonds are exempt from income taxes. Banks benefit more by
investing in these bonds.
Money-Market Securities:
Money-market securities are sources of liquidity, since they can be sold at nearly full value
quickly – usually within a business day. Trading profits are also earned by banks by regularly
dealing in such securities. Banks commonly deal in the following money-market instruments:
• Treasury Bills, ,
• Repurchase agreements,
• Bankers’ acceptances,
• Commercial Paper, and
• Demand or Call money
THIRFT INSTITUTIONS
1. Saving & Loan Associations:

Savings and Loans Associations sell deposits and invest in mortgage, consumer, and commercial
loans. Savings and Loan Associations obtain funds in the form of savings from middle-income
savers and lend these funds to purchasers of real estate. They also collect funds by issuing
certificates of deposit. They primarily invest in mortgage loans. Mortgage interests are the
primary source of income of Savings and Loan Associations, and interest paid on savings is their
major disposition of income.

2016
2. Banks:
Savings banks raise funds with deposits and invest primarily in long-term securities, bonds,
residential mortgages, consumer loans, and commercial loans. Like Savings and Loan
Associations, Savings Banks attract funds from small investors. They do not make extensive use
of money-market borrowings for liquidity and have no capital stock.
3. Credit Unions:
Credit unions are a consumer savings and lending intermediary that pools savings to make
mostly installment-type loans to its members. In fact, Credit Unions are deposit intermediaries
that borrow and lend money to a group of consumers with a common association.
Three ingredients are needed to form a Credit Union: (1) a group of people with a common bond,
(2) a pool of savings from members, and (3) a portfolio of loans to members. Credit Union
members share a ‘common bond’ such as a labor union, church, employer, or neighborhoods.
Members buy “shares” in the credit union with their savings. They are extended the privilege of
borrowing from credit unions after becoming a savings member.
Credit Unions are Non-Profit-Oriented institutions. Ordinarily the treasurer is the only salaried
officer and other officials serve on a voluntary, part-time basis. The major part of credit unions
funds come from members’ savings in the form of shares and deposits. The major source of
revenue for the credit union is interest paid on loans. Most of the loans by credit unions are the
‘consumer loans’ to members. Credit unions are restricted in (i) the amounts that may be lent on
secured and unsecured loans, (ii) the term of loans, and (iii) the interest rates that may be
charged.
INSURANCE COMPANIES
Life insurance companies accumulate savings by individuals and inspire people against the
financial misfortune of untimely death. They function as financial intermediaries collecting
premiums from insured persons and investing the funds until needed for death benefits.
Premiums are the charges made by insurance companies for guaranteeing that benefits are paid
to the insured’s family, in the event of his or her death.
Life insurance policies are classified as: ordinary life insurance, group life insurance, and credit
life insurance. Ordinary life insurance is the one taken by individuals, usually from insurance
agents. They are broadly classified as: whole life policies, and term life policies. Group life
insurance covers many lives under one insurance policy. Each insured person is getting a
certificate stating that he/she is covered under the group policy. Premiums are generally paid by

2016
the employer-firm. Credit life insurance is used to repay a debt in the event that the borrower
dies. As the loan is repaid, the insurance decreases with the balance owed. The lender and the
borrower’s family are protected against unpaid debt left by the deceased borrower.
 Life insurance companies invest life and pension reserves in primary securities. They
grant loans against the cash value of whole life insurance policies. The policyholder has
the right to borrow from the insurance company any amount up to the cash value at a
specified rate of interest. Premiums for life and health policies account for a three-fourth
of total income of a life insurance company, while a fourth of total income is from the
asset portfolio of the company.
 Property and Casualty Insurance companies collect premiums from those subject to a
small chance of a large loss and pay benefits to the unfortunate few who suffer losses.
Five major divisions of property and casualty insurance are: Fire insurance, Marine
insurance, Theft insurance, Fidelity Bonds, and Surety Bonds.
 Fire insurance indemnifies the insured for losses and damage to buildings and personal
property caused by fire, lightning, windstorm, explosion, and a number of other perils.
Coverage may extend beyond the destruction of the actual asset to include loss of income
and additional expenses resulting from the loss of the destroyed asset.
 Marine insurance covers loss and damage during transportation. The two major types of
marine insurance are: ocean and inland. Ocean marine insurance covers perils at sea to
ships and their cargos. Inland marine insurance protects domestic shipments not only by
ships on inland waterways, but also by railroads, trucks, airplanes, mail, parcel post,
express, messenger and other forms of transportation.
 Theft insurance provides protection against the criminal acts of others. Burglary,
robbery, and theft by persons other than employees of the insured are covered under theft
insurance. Criminal acts of employees are separately protected under Fidelity Bonds.
 Fidelity bonds protect a business against dishonest employees. Surety Bonds insure that
a specific obligation of one party to another will be met. The insurance company (the
surety) agrees to pay a third party (the oblige) if the individual or business (the principal)
defaults on a debt or obligation.

2016
PENSION FUNDS
• Like Life insurance companies, Pension Funds also accumulate savings by individuals
and inspire people against the financial misfortune of untimely death.
• 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.
INVESTMENT COMPANIES
• Investment companies exist in several forms but are best known as Mutual Funds.
• Mutual Funds provide diversification by investing our money in many marketable stocks
and bonds selected by professional fund managers.
• Mutual funds sell shares to individuals, pool these funds, and use them to invest in
securities.
• Mutual funds are classified into three broad types, (1) Money Market Mutual Funds, (2)
Bond Mutual Funds, and (3) Stock Mutual Funds.
• 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.
• Stock mutual funds pool the proceeds received from investors to invest in stocks.
• 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.

2016
REAL ESTATE INVESTMENT TRUSTS
• Real Estate Investment Trusts are the real estate counterparts to investment companies.
They are now emerging as a dynamic and demanded type of financial intermediary.
• They are sponsored and managed by a trust manager, who provides investment and
management services to the REIT in exchange for a fee.
• REITs may have some of their activities financed through borrowing.
• Assets of REITs generally reflect four stages of real estate development: (1) Land in non-
housing use, (2) Land held for speculation, (3) Land in development stages, and (4) Land
improved with buildings.
FINANCE COMPANIES
• Finance companies issue debt securities and lend the proceeds to individuals or firms in
need of funds.
• Their lending to firms is focused on small businesses.
• When extending these loans, they incur a higher risk that borrowers will default on (will
not pay) their loans than is typical for loans provided by commercial banks. Thus they
charge a relatively high interest rate.
• The common element that generally separates Finance Companies from other Financial
Institutions is that they borrow funds from investors and bankers in large denominations
and lend directly to consumers and businesses.
• Thus, Finance Companies serve as financial intermediaries by purchasing wholesale
quantities of money and then reselling it to individual consumers and businesses in
retail quantities at retail prices.
• Three principal types of finance companies are: (1) Sales Finance Companies, (2)
Personal Finance Companies, and (3) Business Finance Companies.
• Sales Finance companies cater to the loan needs of retailers and their customers by
maintaining a close relationship with the dealer.
• In addition to providing financing to customers of the dealer, sales finance companies
sometimes provide financing of the dealer’s inventory or floor stock.
• Personal finance companies provide consumers with small, short-term, direct loans
which may be secured by collateral or unsecured.
• Business Finance companies serve commercial loan needs by providing secured loans
on inventory, receivables, and fixed assets or by factoring accounts receivables.
• Finance companies raise funds from bank loans, sales of commercial paper, and issuances
of long-term debt.

2016
MORTGAGE COMPANIES
• Mortgage companies, also known as Mortgage dealers or Mortgage bankers, are dealers
in residential, commercial, and special-purpose property mortgages.
• Mortgage companies are intermediaries among real estate purchasers using debt
financing and investors desiring mortgages or mortgage-backed securities.
• Mortgage companies act primarily as a conduit between real estate borrowers and long-
term lenders.
OTHER FINANCIAL INSTITUTIONS
 Securities firms include investment banks, investment companies, and brokerage firms. They
serve as financial intermediaries in various ways.
 First, they play an investment banking role by placing securities (stocks and debt securities)
issued by firms or government agencies. That is, they find investors who want to purchase
these securities.
 Second, securities firms serve as investment companies by creating, marketing, and
managing investment portfolios. A mutual fund is an example of an investment company.
 Finally, securities firms play a brokerage role by helping investors purchase securities or
sell securities that they previously purchased.
1. Investment Bankers
• Investment Bankers market new stock and bond offerings to individual and institutional
investors around the world. Investment bankers perform several important functions to bring
new securities to the investing public.
• Three major functions of investment bankers are: (1) Origination, (2) Underwriting, and (3)
Distribution. New securities are created during origination, bought by investment bankers
during underwriting and sold to investors during the distribution phase.
• Investment banking firms often purchase a new issue or guarantee its sale at a specified price.
The investment banking firm underwrites the new issue when it assumes the marketing risk.
If the security is not sold to investors at the offering price, then the underwriter incurs the
loss.
2. Security Dealers: Security Dealers trade existing securities among millions of investors,
both individual and institutional.
3. Security Brokers: Security Brokers act as middlemen providing connecting link between
security buyers and security sellers, for a commission.
• These intermediaries contribute their expertise and facilities toward helping individuals,
businesses, and Government bring new security issues to the money and capital market and
to exchange existing securities.

2016
REGULATIONS OF FINANCIAL MARKETS AND INSTITUTIONS
Reasons behind Regulations of Financial Institutions and Markets:

 Concern for the safety of the public’s funds.
 To promote public confidence in the system.
 To ensure equal opportunities and fairness in the public’s access to financial services.
 To prevent excessive money creation, and hence excessive inflation.
 To aid “disadvantaged” economic sectors.
 To ensure that important financial services are provided reliably and at a reasonable cost.
 Regulation seeks to promote the safety and stability of financial institutions in order
to preserve the confidence of the public and avoid institutional failures. However,
regulation can become a costly burden that significantly increases the operating costs
of financial institutions and limits the cleansing effects of failure and competition.
Regulations provide the following benefits to FIs & FMs:

• Regulations subsidize the growth of financial institutions and protect them from competition.
• Regulations tend to increase public confidence.
• Regulations spawn innovative escapes (regulatory dialectics) through loopholes in the
regulations.
NATURE OF FINANCIAL SYSTEM REGULATIONS
Regulation of Commercial Banks:

• Due to their importance in the financial system, commercial banks are typically the most
regulated of all financial institutions.
 Supervision of financial institutions in the future will rest primarily upon:
 Government examinations (of market data and the firms’ risk management
systems)
 Capital requirements, and
 Market discipline.

2016
Regulation of Non-Bank Thrift Institutions:

Non-bank Thrifts such as Savings & Loans Associations, Savings Banks, and Credit Unions face
regulations in respect of:
• Chartering
• New Branches
• Mergers & Acquisitions
• Deposit Insurance
• Supervision
Regulation of Insurance Companies:

While not quite as heavily regulated as commercial banks, insurance intermediaries face tough
regulatory rules that are imposed primarily by state insurance commissions.
Regulation of Pension Funds:

Because pension funds have risen rapidly to hold the bulk of the retirement savings of workers,
they are heavily regulated by the courts and government agencies today.
Regulation of Finance Companies:

The bulk of regulation of finance companies is at the state level and focuses principally upon the
making of consumer loans.
Regulation of Investment Companies and Mutual Funds:

Investment companies or mutual funds are regulated predominantly by the federal government in
the U.S., through the Securities Exchange Commission.
= THE END =

2016

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FINANCIAL MARKETS COMPLET HANDOUT 4 ACFN 2ND YEAR

& INSTITUTIONS STUDENTS

FINANCIAL MARKETS & INSTITUTIONS

Financial Markets and Institutions:

1 DU CBE ACFN COMPLIED BY: KANBIRO O. JUNE ,

Finance at the micro and macro levels:

Meaning of SSUs and DSUs:

2 DU CBE ACFN COMPLIED BY: KANBIRO O. JUNE ,

Financial Institutions and Financial Intermediaries:

3 DU CBE ACFN COMPLIED BY: KANBIRO O. JUNE ,

Financial Markets in the Financial System:

4 DU CBE ACFN COMPLIED BY: KANBIRO O. JUNE ,

Functions performed by Financial System & Financial Markets:

5 DU CBE ACFN COMPLIED BY: KANBIRO O. JUNE ,

What is a Financial Asset?

6 DU CBE ACFN COMPLIED BY: KANBIRO O. JUNE ,

Kinds of Financial Assets:

Money as a Financial Asset

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Functions/Services performed by Money:

MONEY MARKET: Meaning

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Characteristics of the money market:

Lenders and borrowers in the money market:

The following are the other important functions of Money Market:

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MONEY MARKET INSTRUMENTS

Common money market instruments:

CAPITAL MARKET: Meaning

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STOCK MARKET (or EQUITY MARKET):

Function and purpose

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Features of primary markets are:

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Functioning of Secondary Markets:

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CAPITAL MARKET SECURITIES

 The key capital market securities are bonds and stocks.

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Derivative Securities Markets

Financial Institutions and Intermediaries

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Understanding Bank, Banking/Banking Business

Bank: Word Origin

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Banking Business: What is included?

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“Banking Business” means including the following:

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Sources of Commercial Bank Funds:

Time and Savings Deposits:

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Investments by Commercial Banks:

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Permanent Working Capital Loans:

State and Local Government Bonds:

1. Saving & Loan Associations:

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