FINANCIAL INSTITUTIONS

The role of the Financial Sector in mobilizing and making loanable funds available from
savers to spenders for consumption and investment purposes

 Financial intermediaries provide access to capital.

 Banks convert short-term liabilities (demand deposits) into long-term assets by providing
loans; thereby transforming maturities.
 Through diversification of loan risk, financial intermediaries are able to mitigate risk
through pooling of a variety of risk profiles.

Commercial banks – This is a financial institution which is engaged in every day banking
activities or money transaction services. They are privately owned by shareholders. They are
involved in the business of buying and selling money. A commercial bank buys money when it
accepts deposits and sells money by making loans. Commercial banks pay out a lower interest
rate on deposits than what it collects on loans

Commercial banks are important for the safe and efficient transaction of business activities as
they offer services which are essential to all business organizations. They are also called joint
stock companies because a common stock of money from shareholders is pooled together to
form the capital.

Functions of commercial banks

i) It provides a safe place for one’s spare cash. Money can be lodged in either a
current/chequing account or a savings account.

ii) Collects payment on the customer’s behalf from those instructed to lodge money to
the account

iii) Makes payment on customers’ behalf when instructed by them to do so (standing

order arrangement)

iv) It makes loans to customers by short term overdrafts or long term loans

v) Allows people to make payments using cheques, debit and credit card and
electronically which is safer than cash

vi) Distributes notes and coins in the country

 vii) Buys and sells shares on behalf of customers

viii) Additional activities and services are:

- Night safe facilities

- Safety deposit facilities
- Automated teller machines or cash dispensers
- Travelers’ cheques
- foreign exchange purchases and sales
- bankers draft or managers cheque
- credit references and letters of credit
- financial advice
- executor and trustee work
- insurance and life assurance (OMNI and Scotia Mint)
- credit cards
- drive in tellers and electronic, telegraphic or wire transfers
- collects dividends payments for customers

Credit Creation by commercial Banks

Commercial banks play an important role in sustaining and increasing the money supply of a
country. This is called the credit creation process. There is a difference between the interest
rate on loans and the interest rate on savings.

It must be noted that the central bank requires that commercial banks keep a portion of their
deposit money with the central bank.

Commercial banks are at times limited in their credit creation by the following:

 Reserve requirement- the portion of the deposits that commercial banks must keep with
the central banks

 Cash leakages – money is taken from the bank, example in case of emergencies

 Special deposits –in some countries, commercial banks are expected to keep an amount
in excess of the legal reserve requirement. An interest rate is usually paid for this to the
commercial banks
 The commercial banks own ability to attract deposits and the habits of the public –
some banks are not able to compete in very competitive loan environment and so are not
able to make many loans.

 Government’s monetary policies –The government is able to restrict the commercial

banks’ ability to make loans by requiring the commercial banks meet certain criteria in
granting loans. They may also restrict the category of loans that may be granted.

 Open Market Operation - Open market operations (OMO) refers to the buying and
selling of government securities in the open market in order to expand or contract the
amount of money in the banking system

 Moral Suasion. - refers to a method adopted by the central bank to persuade or

convince the commercial banks to advance credit in accordance with the directives of the
central bank in the economic interest of the country. Simply, the process in which the
central bank requests or persuade the commercial banks to comply with the general
monetary policy of the central bank is called a moral suasion.

STOCK EXCHANGES
a) Stock exchange –organizations established to make the transfer, purchase and sale of
stocks/shares in public companies easier, which give firms the ability to raise capital.
Many stock exchanges bring buyers and sellers together through the internet or through
specialist who operate from trading houses. Example of specialist and trading houses are
Mayberry Investment and Jamaica Money market Brokers

Role of stock exchanges or markets

Stock exchanges are important in the economy as they allow for the smooth operation of
government and commercial financial activities. Stock exchanges have the following
roles:

 Public companies can raise new capital on the stock exchange

 Public companies already on the stock exchange can raise additional capital
through a ‘rights issue’. A rights issue is where existing shareholders are given the
preference or the right to purchase new shares in proportion to the shares they
already have. They normally paid a favourable price.
  They act as a link between the primary and the secondary market

 They contribute directly to economic progress and prospects. A healthy stock

market is a sigh of economic progress in a country. It is assumed that people
improving their profits and this leads to the increased of the overall earnings of
the country.

 They provide certain level of protection for investors same companies listed on
the stock exchange are expected to have a high reputation and are stable.

A person’s ability to make a profit on the stock exchange will depend on:

- The economic state of the country

- The prospects for other companies in the industry. One must know other company’s
prospect, whether they are performing badly or not. One company performing badly can
mean significant growth for another company in the industry.
- Supply and demand factors

- An individuals’ ability to speculate- A person’s ability to speculate is dependent on a

person’s ability to forecast the trend of share prices of other companies trading on the
stock exchange.
Note animals are used to refer to the different types of investors on the stock exchange.
The animals used are:

Bull- A bull buys stock when the price is low, expecting it to rise. It will then resell stock
when the price is at the highest. Bull buys when prices are rising

Bear-A bear expecting prices to fall will sell stock. Then he will buy stock when the
price is at rock bottom expecting it to rise again. They sell when prices are falling

Stag- Buys shares and sells then almost immediately for a profit. These persons enter the
stock exchange for quick profits and expect to spend a short trading time on the stock
exchange. Buys new shares before they are issue, hoping to make profit from a rise in
price

Jobbers– Deals with particular types of securities. The broker approaches the jobbers who
quotes a higher selling price and a lower buying price
 b) Shares market – A shares market is where the dealers trade with each other. There is no
middle man or the stock exchange brokers. The shares market is therefore called a
dealers’ market. There is the direct exchange of shares.

Note, a shares market is different from a stock exchange. The stock exchange is also called an
auction market. This is a hi-tech market that uses technology, brokers or middle man. Transfer
of shares is done indirectly.

c) Credit union – can be defined as a group of people who pool their savings and lend to
each other at low interest. They are governed by the basic principles:
i) Democratic control
ii) All members must have a bond of interest
iii) One vote for each member regardless of the number of shares held.
iv) All members are borrowers
v) Dividends are given on share held

Advantages of cooperatives

i) Loyalty from members

ii) There is democracy- one member- one vote
iii) There are lower financial, operating, administrative and merchandise costs
iv) Lower rate of interest is paid on members’ shares (Loans)
v) Members ‘loyalty reduce the cost of advertising

d) Development banks – these are used to finance capital development projects in

agriculture, tourism, student loan, housing etc. there are several international
development banks

- The International bank for Reconstruction and Development (IBRD) also known as
the World Bank. This bank offers financial and technical assistance to developing
countries. This is to assist the improvement of the living standards and reduce poverty of
countries.

e) Mutual fund – This is a collective investment scheme. Many investors come together
and combine their funds and invest in stocks, bonds and other financial instruments.
Mutual funds are managed by professionals.
It allows individuals to pool their money and place it under professional management. It
provides the advantage of:
  Professional investment management
 Liquidity
 Investment record keeping
 Diversification

Dividends or interest is paid to investors.

There are basically three types of mutual funds:

- Income funds – This is for people who need money as a source of income or to live on

- Growth funds- These pay low dividends to those persons who can afford to leave their
money in the fund and allow it to grow over a longer time period

- Balanced funds- This consist of both stocks and bonds

f) Building society –They normally offer long term loan and bypass the main capital
market by lending directly to individuals. They borrow on a short term basis and lend on
a long term basis. Their main aim is to provide housing but know they are able to provide
loans for purchasing cars, and offering educational loans amount others.

g) Investment Trust Company- The investors are normally shareholders of the company.
The objective of this company is to buy shares in other companies. They do portfolio
investment. The company uses its profit to the shareholders who are the owners of the
trust.

h) Insurance company – Insurance came about due to unexpected events happening and
individuals not being able to restore the losses themselves e.g. fire and flood. Insurance is
the transferring of immediate risk facing an individual or group by them pooling the risk
of loss of all individuals in the group together. It is actually putting aside some money in
case some unfortunate event happens. It provides compensation for loss or damages in
these events. Insurance is for inanimate items e.g. cars, houses goods etc.

Assurance provides for an event that will happen such as death. This will always result
in payment because an investment element is combined with an insured amount. The
correct term for insuring people is Assurance.

The concept of pooling risks:

 Risks are either insurable or non-insurable. Companies will insure against risk that they
can calculate. There must be a large number of persons requiring insurance for the same
type of risks otherwise the pooling of risks is not functional. Pooling risks is the main
principle upon which insurance is based. Pooling means that the loss suffered by a small
number of insured individuals is spread over the total group of people insured.

A premium is paid by a number of persons facing similar risks in the pool. This is used
for compensation against any incontinency.

Risk transfer means shifting the responsibility of bearing the risk from one party to
another. A premium is paid per month into a pool for compensation against any
unfortunate event.
Risks are either insurable or non-insurable. Insured risks are those that the insurance
company can calculate such as the insuring goods against theft or fire. Non insurable
risks are loss of income due to a fall in sale.

The insurance Guiding principles are:

1) Utmost good faith- The inured party must reveal all the relevant and important
information about the thing or the person that is insured. If a person does not reveal all
the necessary facts, then they are in breach and cannot claim on the insurance company.
Example a person buying life insurance is asked to disclose if they have any chronic
illness.

2) Insurable interest- The insurance company will only insure against a risk if one is going
to suffer if the thing it is insured against occurs e.g. fire. A person cannot take out
insurance on a friend causing an accident

3) Proximate cause – This ensures that the claim on the insurance company will only be
paid if the loss that is suffered is a direct result for what it was insured against. Example,
if house was destroyed by fire and it was insured against flooding, the insurance cannot
be claimed for loss due to fire.

4) Indemnity- The person will be compensated for the actual amount lost. The insured will
not be able to make a profit in any way. Example, if your car was destroyed in an
accident, you will not receive a new car but only the value or worth of the car. This does
not apply to a person losing his life because no money can compensate against loss of
life.

5) Subrogation- This ensures that the indemnity principle actually works. If there was an
accident and a car was wrecked, the insurance company will replace the car to its value
 and salvage the wreckage. The car is salvage because the person might get a different car
and then sell the wrecked car. The insured person will not in any way benefit or profit
from the loss.

6) Contribution- This term is relevant if the same property is insured by two or more
companies. Example if a house is valued at 4 million and insured with two insurance
companies A for 3 million and B for 1 million, then in case of a loss the insured will not
benefit. Company A will only pay 3/4 of the value of the loss and company B pays only
a ¼.

7) Average clause- this allows the insurance company to compensate the insured in the
same percentage or ratio that he is insured against at current value. Example, a man
insures his house two years ago for $4 000 000 and it is now valued at $8 000 000. If the
damages to his house is calculated at $200 000, he will only receive compensation of
$100 000. This was because the business was worth half the value two years ago when it
was insured.
The role of insurance
 It is a means of investment
 Provides coverage against personal risks
 Provides a source of capital since they are institutional investors
 They take on many of the risks of firms, therefore, industry is encouraged
 It allows for an improved standard of living. This is because insurance companies
facilitate trade enabling persons to enjoy a wide range of goods and services.
 It transfers risk as it is very risky for traders to send goods over long distance and
different climates.
 It provides contributions to the balance of payments due to earnings on the
invisible trade services account

Types of insurance policies

There are two types- Life assurance and non-life insurance.

Life Assurance- The insured persons cannot be compensated.

 Whole life policies – policies are payable on the death of the insured. However,
the person stops paying the premium at age sixty.

 Term policies- an example is mortgage policies. Persons who need mortgages on

their houses will subscribe. In the event of death, the policies are used to pay off
the mortgage.
  Endowment policies _ these policies allow for a specific sum of money to be paid
on a specified date or on the death of the policy holder, whichever comes first.
They allow persons to share in the profits of the company, but higher premium is
paid.

 Special policies- These are developed to meet the need of specific groups or
employees e.g. Blue Cross/Sagicor

 Home purchase policies – These link the proceed of an investment policy to the
purchase of a house

 Unit linked policies – These provide ordinary life coverage as well as investment
in a unit trust e.g. OMNI or SCOTIA MINT

Non -Life Insurance/Business Insurance

Marine Insurance

 Hull insurance – provides coverage for a vessel and its fixtures

 Cargo insurance- coverage for loss or damage to cargo (indemnity to the purchaser of
goods being shipped)
 Freight insurance – Charge for carrying cargo is given to the ship owner. The insurance
company provides indemnity to the ship owner if he has to repay the charge if he fails to
deliver.
 Ship owner’s liability insurance – Gives the sip owner coverage for a number of events
which may be his fault or cause by his employees e.g. damage to another vessel through
collision or injury to crew.

HOW DOES INSURANCE FACILITATE TRADE?

Transfer the risk from the company/person transporting the goods to the insurance company.
That is coverage is provided for vessel and goods. In case of any events, the owner and the
transporting companies is compensated for loss or damage of goods.

Fire, Motor or Aviation Insurance

Motor insurance has four categories and is compulsory for all drivers.

 Minimum legal coverage – for injuries to third parties on public roads. A third party
includes all others except the insurer and the insured
  Third party coverage – The same as above but provides compensation for property
and equal fees of third party

 Third party fire and theft- For injuries to third parties on public roads. Compensation
of property and legal fees of third party; coverage for theft of car and for damage
caused by fire.
 Comprehensive coverage – For injuries to third parties on public roads.
Compensation of property and legal fees of third party; coverage for theft of car and
for damage caused by fire. Also provide for damages to insured vehicle, personal
injury to driver or damage to personal possessions in the car.

Aviation Insurance-Covers aircrafts against damages by accident and the operators against
claims from injury or the death of passengers.

Accident insurance – property – Covers a number of risks relating to any type of property. This
includes accidental damage to machinery, vehicles, deliberate damage caused by vandals,
burglary and loss of animals or stock.

Personal accident Insurance-Refers to accidents caused by a wide range of risks to persons or

groups of persons. Compensation is provided for losses due to total or partial disability arising
from accidental causes. This insurance is usually taken out by celebrities.

Liability insurance-coverage is provided for events which may be made against the insured e.g.
racers

Public liability –Coverage is provided by firms who may have to pay customers for injury to
their persons or property by their short comings or negligence e.g. slipping on a wet floor

Employer’s liability –Employers are required by law to insure their employees

Fidelity guarantee– Coverage is provided against theft by employees.

TYPES OF FINANCIAL MARKETS

They are two main types of financial markets- primary and secondary
 1) Primary markets –Used for the selling of NEW securities such as bonds and new
shares to investors. This includes companies that are issuing shares as startup capital and
to start up new operations.
This is usually the only time and market where then issuer of new shares will be directly
involved in the transaction. All financial claims are made in primary markets.

2) Secondary markets – Allows persons to exchange used or previously issued financial

claims at will. The secondary markets will provide liquidity for investors who own
primary claims. The stock exchange and used car dealers are example of secondary
market.

FINANCIAL INTERMEDIARIES

Deposit type institutions

- Commercial banks
- Credit unions
- Thrift institutions

Contractual Savings Institutions

- Life insurance companies

- Pension funds

Investment Funds

- Mutual funds
- Money market funds

Other types of Financial Intermediaries

- Finance companies
- Government agencies

TYPES OF FINANCIAL INSTRUMENTS

A financial instrument is any certificate that confirms that a debt has been brought into
existence. The sale or transfer of a debt will allow the seller to acquire finance.
Financial instruments are usually called securities- this is a broad name that includes bills,
bonds, stocks, certificates of deposits and other type of securities.

Bill- this is an IOU for a short term loan

Treasury bill- this is a loan to the government of the country and can be bought and sold on
financial markets. They are short term loans which becomes a part of the national debt.

The government borrows from the private sector if they need to fund a project or manipulate the
money supply. This debt is for a ninety-day period. The government allows financial institutions
to bid for them at a discount and will accept the best rate offered.

Treasury notes- These are medium term loans and issued by the government. They are
considered free of the risk of failure to repay. Unlike bills, they are coupon issue and issued at
face value. Is for a time period between one to ten years

Bond – this is a contractual commitment of the borrower to make cash payments to a lender for a
fixed number of years. When the bond matures or the date on the on the cover expires, the lender
is paid the face value of the security. The person who is the lender in the bond contract is known
as a bondholder.

Treasury bonds - These are medium to long term loans made to the government from the private
sector. This becomes a part of the national debt as the government borrows from the public by
issuing treasury bonds. The time period is from ten to thirty or more years.

NOTE: Treasury bills, notes and bonds are all loans made to the government by the private
sector. The main distinguishing factor is the time period for repayment. All loans to government
are considered to be free of default risks of failure to repay.

TREASURY BILLS TREASURY NOTES TREASURY BONDS

1. Short term(90 days) 1. Medium term (1 – 1. Medium to long term

10 years) loans ( 10 – 30 or
2. Issued by the more years)
government 2. Issued by the
government 2. 2. Made to
3. Part of the national government from the
debt 3. Coupon issue and private sector
Corporate bonds – these are long term IOU that represents a claim against the firm’s
assets. When large firms need money for capital expenditure, they issue bonds. In most
case, the bond holder’s return will be fixed. Payments of interest rates are fixed
regardless of profits. They have maturity dates from five to thirty years.

Municipal bonds _ the long term obligations of local government. They are used to
finance capital expenditure for local government projects e.g. schools, roads etc. They
have limited secondary markets and are not considered to be very liquid investments.

Equity securities – Equities are ordinary shares in the companies. They are also called
common stock and represent ownership claim on the firm’s assets. The higher a firms
profit the higher the return for shareholders. However, if a loss occurs, they must share in
the losses.