Accounting for Financial Institutions

Chapter 1: Overview of Banks and other Financial Institutions

1.1. Introduction
The banking sector is the heart and soul of any economy. It is the most important
financial pillar of any financial sector that plays a vital role in the economic
development of the country. A bank can be defined in terms of (1) the economic
functions it serves, (2) the services it offers to its customers, (3) the legal basis for
its existence. Certainly, banks can be identified by:

(1) Functions: they perform in the economy as institutions involved in

transferring funds from savers to borrowers and in paying for goods and
services.
(2) Services: institutions that provide wide range of financial services.
(3) Legal basis: according to the U.S government a bank is “any business offering
deposits subject to withdrawal on demand and making loans of commercial
or business nature”, this definition developed by the U.S government many
times.

So, banks are financial intermediary institutions that offer financial services,
such as accepting deposits and granting loans, in addition to offering the widest
menu of services of any financial institution, either directly to the people who need
funds or through the capital markets.

1.2. Categories and Types of Banks

1. Central Banks
Oversee & manage all the banks in the
respective country & set monetary
policy.
2. Retail Banks
Provide products & services to
individuals consumers include:
payments & deposites, mortgage, cr
& dr cards.....etc.

3. Commercial Banks 4. Invetmnent Banks

Work with businesses to serve their Operate in the capital market to help
financial needs. clients raise capital through
underwritting & issuance of security.

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1.3. Competitive Challenge for Banks

Among the leading competitors with banks in wrestling for the loyalty of financial
service customers and a greater share of today’s dynamic financial marketplace are
such non-bank financial service institutions as these:

1) Insurance companies and pension plans: The companies that are

specialized in providing insurance services to its customers in the form
of insurance policies and annuities to protect them from risks in the
future, such as health, property, persons, automobiles, etc. These
companies also provide long-term investment plans for their customers.
In Egypt, there are many insurance companies such as Misr insurance
company, El Mohandes etc.

2) Mutual Funds: They are companies that are specialized in purchase and
sale of shares in the benefit of their customers. In other words, these
mutual funds are professionally managed investment fund that pools
money from many investors to purchase & sell securities.

3) Real Estate developers: Supply building and construction expertise and

construction financing to their customers. Undertake an entrepreneurial
role in creating the built environment in response to the needs of the
community and the market. Developers can be government entities, non-
profit organization, or other institutions that create/renew built
environment.

4) Credit unions and thrift instructions: Credit unions is a type of financial

cooperative that provides traditional banking services. Ranging in size
from small to large entities with thousands of members. They are created,
owned, and operated by their members. They offer credit payments and
saving deposit services often fully comparable to what banks offer.

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5) Security Brokers and Dealers: They provide their customers investment

and savings planning, and executing security purchases and sales, and
providing credit cards. In Egypt, we have "financial securities exchange
companies."

6) Finance Companies: They provide customers short-term and small

loans, such as for individuals and small businesses. They also provide the
cash for the daily household and operating costs to acquire goods and
services (e.g., mortgage finance, equity finance).

7) Finance Conglomerate companies: They are finance companies, but

they are larger than them and provide their customers widest range of
services (diversification of services). In Egypt, we don't have this type.

1.4. Banking Services

A) Traditional Services
1. Carrying out currency exchanges: means exchanging one form of currency for
another currency, in return of a service fee.
2. Discounting commercial notes and making business loans: making loans to
merchants who sold the debts (accounts receivable) they held against their
customers to a bank to raise cash quickly.
3. Offering Savings Deposits: Banks accept deposits as a source of funds that
enable it to raise loanable funds. These funds are interest- bearing by banks.
4. Safekeeping of valuables and certification of value: Means holding gold,
securities and other valuables owned by their customers in secure vaults.
5. Supporting government activities with credit: Banks purchase government
bonds with a portion of any deposits they receive.
6. Offering Checking accounts (Demand deposits): The service permits the
depositor to draft in payment for goods and services. Nowadays, the checking
account concept has been extended to the internet and smart cards.

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7. Offering thrift services: means managing customer’s property and investing

their funds for a fee. There are personal trust services to individuals and families,
and commercial trust services to corporations and other businesses.
8. Granting consumer loans
B) Modern Services
1. Offering different Financial advising services
2. Providing Cash management services
4. Offering Equipment leasing: this service is considered an alternative to lending
in which a bank buys equipment and rents it to its customers. This management
benefits banks and customers because as the real owner of the leased equipment, the
bank can depreciate it for additional tax benefits.
5. Making venture capital loans: the bank helps in financing many small projects
with high risks and long-term growth perspective. Therefore, they seek other
investors to share it in bearing risks. In this case, banks usually get equity in the
company and involved in its decisions.
6. Selling insurance services: some banks sold credit life insurance to their
customers receiving loans, thus guaranteeing loan repayment if borrowers die or
become disabled.
This service appeared as a competition between banks and non-bank institutions
(insurance companies). However, selling insurance would increase bank risk,
threaten depositors with losses, and lend to conflicts of interest in which banks
asking for one service were compelled to buy other services as well.
7. Selling Retirement plans: banks sell deposits retirement plans to individuals
holding these deposits until the funds are needed for income (save money) after
retirement.
8. Offering security brokerage executing buy and sell customer's orders for
securities.

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9. Security Underwriting: marketing new securities to raise funds for corporations

and other institutions.
10. Offering mutual Funds and Annuities: these services offer higher yields than
are currently available on conventional bank deposits. Those products also carry
more risk. Recently, bank mutual funds sales have slowed due to the lack of strong
profitability, strict regulations and changing public attitudes.
11. Offering Merchant Banking Services: these services mean temporary
purchase of corporate stock to aid the launching of a new business venture or to
support the expansion of an existing company. This service means that banks (as a
temporary stockholder) bear considerable risk that the stock purchased may decline
in value. The risk also includes loss due to changing currency prices and interest
rates.
1.5 Main Factors Affecting Banks & other Financial Service Firms

1) Service Proliferation (Diversification)

This trend has accelerated in recent years because of:

A) Increasing pressure of competition from other banks and from non-

bank institutions.

B) More knowledge and demanding customers

C) Shifting Technology

This trend increased bank costs and posed greater risk of bank failure. The
position effect of this trend is opening new source of income to the bank (fees
and commissions).

2) Rising competition

The level of competition in financial services has grown as banks and their
competitors have expanded their services offerings. This competition is
represented in (1) competition between banks and other banks in attracting

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clients with the quality of services. (2) competition between banks and non-
banks organizations in the variety of services.

Customer convenience is the name of the game in the banking industry.

In Egypt, the competition pushed Egyptian banks to start widening the services
provided and be market and customer oriented. Moreover, attempts by banks to
face this competition by merger or escape from the market.

3) Deregulation

Although the banking industry was heavily regulated, now there is a trend to
deregulation. This trend is due to the unfair competition between banks and non-
banks organizations that provide the same services but without regulation.
Deregulation means the limitation of government regulation and giving the
banks freedom to provide services which will serve them to attract more
customers. In Egypt, although the control of the central bank, some regulations
are released such as currency exchange rate, now banks are free to set their
exchange rates for the different banks.

4) Rising Funding costs

Both the deregulation and the increases competition dramatically increase the
average cost of selling deposits. When banks provide high interest rates on
deposits to attract customers, this leads to an increase in the rates of loans. In
addition, banks use more of their capital, a highly expensive source of funds, to
support bank's assets. These expensive sources of funds encouraged banks to
look for the ways to cut other operating costs such as reducing the number of
employees and replacing aging equipment with modern electronic processing
systems.

In Egypt, this trend does not affect the banks because of the government
regulations.

5) An increasingly interest sensitive mix of funds.

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The banks now strive to be more competitive in the returns they offer on the
public's money and more sensitive to changing public preferences regarding how
savings are allocated. In other words, the interest increases by banks to attract
customers and customers are sensitive to the higher interest rates without loyalty
to their banks they deal with. Thus, the relations with banks are economic and
financial oriented rather than loyalty.

6) A technological Revolution

As a result of competition and higher operating costs faced by banks lead the
banks to turn toward automation and electronic networks to replace labor-based
production systems. The new technology includes internet-banking, ATM, ….
etc. In Egypt, The Egyptian banks entered the world of technology to facilitate
the services they provide. Also, this trend affects the customer's opinion to deal
with banks to the degree of technology provided by the bank.

7) Consolidation and Geographic expansion

The tendency to merge among small and medium banks can result in powerful
financial institutions. Each bank tries to move from cities to suburban
communities to be near of the customers everywhere by making many branches.
Also, some banks are merging to satisfy capital requirements. Many banks open
many branches to be near customers which lead to damage of small banks.

8) Globalization of Banking

The geographical expansion and consolidation of banking units have well

reached beyond the boundaries of a single nation to encompass the globe. Large
banks not only need to be in one nation but also try to enter new communities
and open branches all over the world to serve their customers an attract them. In
Egypt, since there are no constraints for competition, this trend makes the
competition more intensive and tougher. Because there is now an international
competition, the market is open for foreign banks to provide their services. There

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are a lot of international banks that enter the Egyptian market which will benefit
Egyptian banks from their experience. However, there is a debate around this
trend.

Some Advantages of Globalization:

1. Linking the local banks to the international banking network.

2. The Egyptian banks will gain experience from foreign banks.

3. The Egyptian banks will have access to foreign banks.

4. The competition is for the benefit of the customer.

Some disadvantages of globalization:

1. The competition is for foreign banks.

2. The local capital may move towards other countries that contain
profitable markets, i.e., pushing local limited resources to abroad
because of investment opportunities.

3. Attracting local skills personnel in banking industry to the foreign

banks with high salaries.

4. Decreasing the market share of local banks.

9) Increase risk of failure “the risk of bankruptcy.”

From the above trends, increasing competition between banks and non-banks
coupled with the problem of loans and volatile economy have led to bank failures
in nations over the world. In Egypt, a lot of banks are affected by the great
competition, so they were sold to other banks or merge to be stronger in financing
their customers.

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Questions
1. What is a bank? Defined by the functions it serves and the roles it plays.
2. Who are the principal competitors for a bank in the financial market?
3. In the Financial System and Competing Financial-Service institutions, define:
▪ Insurance companies and pension plans Credit Unions
▪ Credit unions & thrift instructions
▪ Mutual Funds
▪ Security Brokers and Dealers
▪ Investment Banks
▪ Finance Companies
▪ Real Estate developers
▪ Finance Conglomerate companies
4. What are the main factors affecting banks & other financial service firms?

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