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CHAPTER TWO

FINANCIAL INSTITUTIONS IN FINANCIAL SYSTEM

? What is financial institution?

Introduction

Financial institutions are a business organization that provides savings and financing opportunities. They are
business organizations that act as mobilizes and depositories of savings and as purveyors of credit or finance. They
also provide various financial services to the community. They differ from non-financial (industrial and
commercial) business organizations in respect of their wares, i.e., while the former deals in financial assets such as
deposits, loans, securities, financial services and so on, the latter deal in real assets such as machinery, equipment,
real estate and so on.

Financial institutions are the key players in the financial markets as they perform the function of intermediation and
thus determine the flow of funds. The activities of different financial institutions may be either specialized or they
may overlap; quite often they overlap. Yet, we need to classify the financial institutions and this is done on such
basis as their primary activity or degree of their specializations with relations to savers or borrowers with whom
they customarily deal or the manner of their creations. In other word, the functional, geographical, sectoral scope
of activity or the type of ownership are some of the criteria large number and variety of financial institutions which
exist in the economy.

Role of financial institutions

The most important function of financial institutions is to assist in the transfer of funds from surplus agents to
deficit agents to deficit agents. In assisting this process a financial intermediary undertakes several economic
roles.
I.The provision of a payment mechanism
II.Maturity transformations
III.Risk transformations
IV.Liquidity provision
V.Reduction of transactions, information and search costs.
I. Provision of payment mechanism
Financial intermediaries, especially commercial banks, facilitate the payments of funds by non cash measures
such as; cheques, credit cards, electronic transfer, letter of credit—etc. An effective payment system is essential
to the health of a modern economy among domestic agents and between domestic and foreign agents.

II. Maturity transformation role.

Surplus agents typically wish to have their surplus funds redeemable at short notice, and deficit agents (
investors) wish to borrow funds over long term horizon.

Thus, financial intermediaries such as commercial banks, accepts investors fund on a short term basis and
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channel these funds to long-term borrowers. The process of converting short term liabilities (deposits) into long-
term assets (loan) is known as maturity transformations.

III. Risk diversification role

Surplus agents needs complete protection for their capital. On the other hand , borrowers needs capital to finance
in risky investment projects. Thus the demand of these two agents contradict each other. If a surplus agent lends
directly to a deficit agent, this would leave them heavily exposed to the risk of default by the deficit agent.

Financial intermediaries can play an important part in transforming the low risk requirement of savers into
meeting the risk finance requirement of firms {borrowers}. Thus, a financial intermediaries that receives funds
from many surplus agents can pool these funds lend to a large number of deficit agents (diversification).

Financial intermediaries mitigate several types of risk. First, bank take deposits from many people and make
thousands of loans with these deposits. Thus, each depositor faces only a small amount of the risk associated with
loans that would go default. No one depositor losses all there assets when a bank loan goes unpaid. Banks also
provide a low-cost way for depositors to diversify their investments. Mutual fund companies of small investors a
way to purchase a diversified portfolio of several different stocks.

IV. Liquidity role

Liquidity refers to the ease with which an asset can be converted into cash. Surplus agents would not be willing
to hold the financial assets (bonds or shares) unless they have the ability to sell them at short notice at fair market
place. Thus, deposit taking institutions are therefore able to ensure liquidity provision without maintaining large
balances in relation to total deposits.

V. Reduction of contracting, search and information costs role

The cost of acquiring and processing the information about the borrower (known as information processing
costs) must be considered when you lend money. The cost of loan contracts are referred to as contracting cost. In
addition cost of contracting, the ability, and cost of enforcing the terms of loan agreements should also be
considered by lenders. Most surplus agents lack the time, skill and resources to find and analysis prospective
deficit agents and draw up and enforce the necessary legal contracts.

Financial institutions such as banks, provides cost effective intermediations; financial intermediations benefits
from considerable economies o scale, because they are looking for many prospective investment opportunities,
they can devote resources to recruiting and training high quality staff to assist in the process of finding suitable
deficit agents.

They draw up more standardized contract or they can recruit legal counsel as part of professional staff to write
contract involving more complex transactions.
The two potential credit cost necessarily incurred by the lenders (surplus agent) and which is eliminated by
financial intermediations is cost of analyzing credit worthiness of borrowers and cost of developing contract
(stationary, witness per-diem, etc)

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Classification of financial institutions

Financial institutions act as a channel through which scattered savings are collected and then invested in business
firms. These institutions can broadly be divided in to three categories: namely; depository institutions, non-
depository institutions, and investment intermediaries.

A. Depository financial institutions

Depository institutions are financial intermediaries that accept deposits from individuals and institutions and
make loans. These institutions include commercial banks, savings and loan associations, and credit unions.
They are unique from the other intermediaries in that they are directly engaged in accepting deposit and
channeling it to others.

 Commercial banks: They serve a variety of savers and borrowers. Historically, commercial banks were the
major institutions that handled checking accounts and through which the central bank expanded or contracted
the money supply.
Today, however, several other institutions also provide checking services and significantly influence the money
supply. Conversely, commercial banks are providing an ever-widening range of services, including stock
brokerage services, agency services and so on.
 Savings and loan associations (S&Ls): traditionally served individual savers and residential and
commercial mortgage borrowers, taking the funds of many small savers and then lending this money to
home buyers and other types of borrowers.
 Credit unions: are cooperative associations whose members are supposed to have a common bond, such as
being employees of the same firm. Members’ savings are loaned only to other members, generally for auto
purchases, home improvement loans, and home mortgages. Credit unions are often the cheapest source of
funds available to individual borrowers.

B. Non-depository financial institutions

Non-depository institutions are financial intermediaries that acquire funds at periodic intervals on a contractual
basis. Their main purpose is giving different financial services (sharing of loss and pension services). But, they
are also important financial intermediaries because they raise huge fund which they channel to investors in
different ways.

Major types of non-depository financial institutions

This group of financial intermediaries includes insurance companies and pension funds.

 Insurance companies
Insurance companies provide (sell and service) insurance policies, which are legally binding contracts. Insurance
company is a company that offers insurance policies to the public. The primary functions of insurance company is
to compensate the individual and companies (policy holders) if perceived adverse event occur, in exchange for
premium paid to the insurer (insurance company) by policy holder.

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It provides social security and promotes individual welfare. Insurance companies promises to pay specified sum
contingent on the occurrence of future unforeseen events, such as death, or an automobile accidents. They
distribute or spreading risks to a number of individuals. They function as risk bearers. They accept or underwrite
the risk for an insurance premium paid by the policy maker or owner of the policy.

 Pension funds
After people retire from their employment, most people can expect to receive some form of pension. This comes in
one of three forms: a flat-rate pension paid by the state to everyone above a certain age; an occupational pension
provided from a fund to which the employer and employee have contributed; and a personal pension paid from a
fund to which the individual has made contributions. As we shall see, only the second and third forms strictly
involve financial intermediation. This is because the first of these operates on ‘pay as you go’ principles, while
payments under the latter are made from an accumulated fund of savings.

A pension fund is a fund that is established for the eventual payment of retirement benefits. The entities that
establish pension plans, called the plan sponsors, are:-

 Private business entities acting for their employees.

 Federal, state & local entities on behalf of their employees
 Unions on behalf of their employee.

Types of pension funds

Unfunded pension schemes: Schemes where payments to pensioners are financed by simultaneous contributions
from those in work. Such schemes are often called ‘pay as you go’ or PAYG schemes.

Funded pension schemes: This scheme is where payments to pensioners are made out of the income earned by a
fund of savings which has been built up in earlier years by (usually regular) savings contributions. There are two
types of funded scheme:
i) Defined benefit plan
ii) Defined contribution plan

Defined benefit plan

 In defined benefit plan, the plan sponsor agrees to make specified dollar payment to qualifying employees at
retirement (and some payments to beneficiaries in case of death before retirement).
 The retirement payments are determined by a formula that usually takes in to account the length of service of
the employee and the earning of the employee.
 The pension obligations are effectively the debt obligation of the plan sponsor, who assumes the risk of having
insufficient funds in the plan to satisfy the contractual payments that must be made to retired employees. Thus,
unlike a defined contribution plan, in a defined benefit plan, all the investment risks are born by the plan
sponsor.

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Defined contribution plans

 In a defined contribution plan, the plan sponsor is responsible only for making specified contribution in to the
plan on behalf of qualifying participants.
 The amount contributed is either a percentage of the employee's salary or a percentage of profit.
 The payment that will be made to qualifying participants up on retirement will depend on the growth of the
plan assets, that is, payment is determined by the investment performance of the asset in which the pension
fund is invested.
 The plan sponsor gives the participants various options as to the investment vehicles in which they may invest.
 Therefore, in a defined contribution plan the employee bears all the investment risks.

C. Investment Companies

Investment companies are financial intermediaries that sell share to the public and invest the proceeds in a
diversified portfolio of securities. Each share that they sell represents a proportionate interest in the portfolio of
securities owned by the investment company. This group of financial intermediaries includes investment banks and
mutual funds which are involved in the purchase and sale of different securities such as bonds and stocks.

Their primary function is to help individuals/firms to buy and issue/sell the securities. They advise investors about
their portfolio choice and pricing of different securities. They also serve as security traders by arranging traders
among borrowers and lenders. Besides, they acquire funds by issuing and selling different securities and use the
funds so raised to purchase diversified portfolio of securities.

Types of investment companies

There are two major types of investment companies. These are:
a) Mutual funds
b) Investment banking

 A) Mutual Funds
A mutual funds (in US) or unit trust (in UK and India) raise funds from the public and invest the fund in a variety
of financial assets. Mutual funds are investment companies that pool money from investors at large and offer to
sell and buy back its shares on a continuous basis and use the capital raised to invest in securities of different
companies.

Nature of mutual funds

Mutual funds posses shares of several companies and receive dividends in lieu of them and the earnings are
distributed among the units/shares holders. Mutual funds sell shares (units) to investors and redeem outstanding
shares on demand at their fair market value. Thus, they provide opportunity of small investors to invest in a
diversified portfolio of financial securities. They also enjoy economies of scale by incurring lower transactions
costs and commissions.

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Mutual fund is a trust that pools the savings of a number of investors who share a common financial goal. This
pool of money is invested in accordance with a stated objective. The joint ownership of the fund is thus “Mutual”,
i.e. the fund belongs to all investors. The money collected is then invested in financial market instruments on
different securities; such as shares, debentures and other securities. The income earned through these investments
and the capital appreciations realized are shared by its unit holders in proportion the number of units owned by
them. Thus, a mutual Fund is the most suitable investment for the common man as it offers an opportunity to invest
in a diversified, professionally managed basket of securities at a relatively low cost. A Mutual Fund is an
investment tool that allows small investors access to a well-diversified portfolio of equities, bonds and other
securities. Each shareholder participates in the gain or loss of the fund. Units are issued and can be redeemed as
needed. The fund’s Net Asset value (NAV) is determined each day.

Investments in securities are spread across a wide cross-section of industries and sectors and thus the risk is
reduced. Diversification reduces the risk because all stocks may not move in the same direction in the same
proportion at the same time. Mutual fund issues units to the investors in accordance with quantum of money
invested by them. Investors of mutual funds are known as unit holders.

When an investor subscribes for the units of a mutual fund, he becomes part owner of the assets of the fund in the
same proportion as his contribution amount put up with the corpus (the total amount of the fund). Mutual Fund
investor is also known as a mutual fund shareholder or a unit holder.

Any change in the value of the investments made into capital market instruments (such as shares, debentures etc) is
reflected in the Net Asset Value (NAV) of the scheme.

NAV is defined as the market value of the Mutual Fund scheme's assets net of its liabilities. NAV of a scheme is
calculated by dividing the net market value of scheme's assets by the total number of units issued to the investors.

Types of Mutual Funds

Based on their structure:
a) Open- Ended Mutual Funds, and
b) Close-Ended Mutual Funds.

Based on their investment objectives:

a) Equity funds: These funds invest in equities and equity related instruments.
b) Debt funds: They invest only in debt instruments.
c) Balanced funds: They invest on both equity and debt instruments.

Open-End Funds
 Open-End Funds are mutual funds those continually stands ready to sell new shares to the public and to
redeem its outstanding shares on demand at a price equal to an appropriate share of the value of its portfolio,
which is computed daily at the close of the market.
 Investors can buy and sell the units from the fund, at any point of time.
 A mutual fund's share price is based on its net asset value (NAV) per shares.
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NAV = Market Value – Mutual fund liability

Number of mutual fund shares outstanding

Example: Suppose that a mutual fund with 10 million shares outstanding has a portfolio with a market value of
Birr 215 million and liabilities of Birr 15 million. What would be the NAV per share?

NAV = 215,000,000 – 15,000,000

10,000,000
= Birr 20 per share or unit

2. Closed-end fund:

 In contrast to open-end mutual funds, closed-end funds sell shares like any other corporation and usually do
not redeem their shares.
 These funds raise money from investors only once. Therefore, after the offer period, fresh investments can not
be made into the fund.
 Units/shares of close-end funds sell on either an organized exchange (e.g. NYSE) or OTC market.
 Investor's who wish to purchase closed-end funds must pay a brokerage commission at the time of purchase
and again at the time of sale.
 Recently, most of the New Fund Offers of close-ended funds provided liquidity window on a periodic basis
such as monthly or weekly. Redemption of units can be made during specified intervals. Therefore, such funds
have relatively low liquidity.
 The price of the share is determined by supply and demand, so the price can fall below or rise above the NAV
per shares.
 Shares selling below NAV are said to be trading at discount.
 Shares selling above NAV are said to be trading at premium.

Difference between Open-Ended and Close-Ended Mutual Funds

i) The number of shares of an open-ended fund varies because the fund sponsor sells new shares to investors
and buys existing shares from shareholders. By doing so the share price is always the NAV of the fund.
ii) In contrast, closed-end fund have a constant number of shares outstanding because the fund sponsor does
not redeem shares and sells new shares to investors, except at the time of new a underwriting.

Functions of Mutual Funds

The following are some of the benefit associated with mutual funds:

i) Mobilizing small saving v) Investment protections

ii) Professional management vi) Low transaction costs (economy of scale)
iii) Diversified investment/reduced risk vii) Economic development.
iv) Better liquidity

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i. Mobilizing small saving: Direct participations in securities is not attractive to small investors because of some
requirements which is difficult for them. Mutual fund mobilize funds by selling their own shares, known as units,
this funds are invested in shares of different institutions ( private and public institutions).

ii. Professional Management: Mutual funds employ professional experts who manage the investment portfolio
efficiently and profitability. Thus, investors are relieved from the emotional stress in buying and selling securities
since mutual funds take care of this functions.
 The professional managers act scientifically with :
 The right timing to buy and sell for their clients
 Automatic reinvestment of dividends and capital gains….etc.

iii. Diversified Investment/Reduced Risk: Funds mobilized from investors are invested in various industries spread
across the country/globe. This is advantage to the small investors, because they cannot afford to assess the
profitability and viability of different investment opportunities. Mutual funds provide small investors the access to
a reduced investment risk resulting from diversifications, economies of scale in transactions cost and professional
financial management.

iv. Better Liquidity: There is always a ready market for the mutual funds units -it is possible for the investors to
divest holding at any time during the year at the Net Asset Value (NAV). Securities held by the fund could be
converted into cash at any time.

v. Investment Protections: Mutual funds are legally regulated by guidelines and legislative provisions of
regulatory bodies (such as, SEC in US, SEBI in India---etc).

vi. Low Transactions Cost (Economy of Scale): The cost of purchase and sell of mutual funds is relatively lower
because of the large volume of money being handled by mutual funds in the capital market. Brokerage fees, trading
commissions, etc are lower. This enhances the quantum of distributable income available for investors.

vii. Economic Development: Mutual funds mobilize more savings and channel them to the most productive sector
of the economy. The efficient functioning of mutual funds contributes to an efficient financial system. It creates
ways for the efficient allocations of the financial resources of the country which in turn contributes to the economic
development. Diversions of resources from consumptions into saving and investment.

 B) Investment Banking Firms

Investment bank is a financial institution engaged in securities business. Investment banking firms perform
activities related to the issuing of new securities and the arrangement of financial transactions.

Investment banking, or I-banking, as it is often called, is the term used to describe the business of raising capital
for companies and advising them on financing and merger alternatives. Capital essentially means money.

Investment banking includes a wide variety of activities, including underwriting, selling, and trading securities,
providing financial advisory services, and managing assets. Investment banks cater to a diverse group of

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stakeholders – companies, governments, non-profit institutions, and individuals – and help them raise funds on the
capital market. They perform the following major functions for their customers:

 Serve as trading intermediaries for clients

 Lend and invest banks’ assets
 Provide advice on mergers, acquisitions, and other financial transactions: Advise on mergers, acquisitions, and
divestitures to help companies become more competitive.
 Research and develop opinions on securities, markets, and economies : Maintenance of large databases that
allows them to produce research reports on economies, markets, companies, stocks, and bonds.
 Issue, buy, sell, and trade stocks and bonds : They help companies and governments raise capital by issuing
different types of securities such as, equity, debt, private placements, commercial paper, medium-term notes
 Manage investment portfolios :

Investment banks once contrasted sharply with commercial banks, where people mainly deposited their money and
sought commercial and retail loans. In recent years, though, the two types of structures have become increasingly
similar; commercial banks now offer more investment banking services as they attempt to corner the market by
presenting themselves as one-stop shops. They mainly involve in primary markets, the market in which new issues
are sold and bought for the first time.

Figure: How Financial institutions Provide Finance to Firms

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Furthermore, on the basis of their legal formality, classification of financial institutions can be made as formal
financial institutions, semi-formal financial institutions and informal financial institutions.

Formal financial institutions are those that are subject not only to general laws and regulations, but also to
specific regulations and supervisions. Their operations are under a direct supervision of central bank. It includes:
 Development banks ( both private and public)
 Commercial banks ( both public and private)
 Saving banks
 Non- bank financial intermediaries (insurance companies, investment companies, etc)
Semi-formal institutions are those that are formal in the sense of being registered entities subject to all relevant
laws, including the commercial laws, but informal insofar as they are, with few exceptions, not under the bank
regulations and supervisions:
 free to set their own interest rate;
 unlike banks, free from minimum capital requirement.

It includes:
 Credit unions
 Multipurpose cooperatives
 Self help associations (such as: Idir)

Informal Financial providers (generally not referred to as institutions) are those to which neither special bank
law, nor general commercial law applies, and whose operations are also so informal that disputes arising from
contract with them often cannot be settled by recourse to the legal system. An informal fund provider consists of:
 Individual money lenders
 Traders, land lords,
 Rotating and saving credit associations {like equb in Ethiopia}
 Families and friends

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