CHAPTER 2

FINANCIAL INSTITUTIONS AND OPERATIONS

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2.1 Depository Institutions

 include commercial banks, savings and loan
associations, and credit unions
 income derived from interest on loans, interest and
dividend on securities, and fees income are highly
regulated because
(1) they mobilize a significant amount of household and
business deposits
(2) they are used as vehicles for executing
monetary policy
Inst. Dr. Dagnu L. Capital Market
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2.1 Depository Institutions

Asset/Liability Problem of DIs
DIs are exposed to
Credit risk- default by borrower or by issuer
of security
Regulatory risk-adverse impact of regulations
on earnings
Funding (interest rate) risk-caused by interest
rate changes when DIs borrow long(short)
and lend short(long) Inst. Dr. Dagnu L. Capital Market
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2.1 Depository Institutions

Liquidity concerns
arises due to short-term maturity nature of deposits
DIs should always be ready to satisfy withdrawals
and meet loan demand
Sources of funds include
 attract additional deposit
 borrow using securities as a collateral
 sell securities it owns
 raise short-term funds in the money market
Inst. Dr. Dagnu L. Capital Market
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2.1 Depository Institutions

COMMERCIAL BANKS
 Services include
• Individual banking- saving
• Institutional banking- paying of pention
• Global banking - transfer of money
• Universal banking- in Europe
Traditional banking
Investment Banking
Inst. Dr. Dagnu L. Capital Market
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2.1 Depository Institutions

Sources of funds
• Deposits-savings, demand, time
• Reserve requirement-portion of deposit
kept as a caution against possible bank
illiquidity
• Non-deposit borrowings
• Common stock and Retained earnings
Inst. Dr. Dagnu L. Capital Market
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2.1 Depository Institutions

Regulation
• by the central bank
• areas of regulation include,
 Ceilings on deposit interest
 Permissible activities for CBs
 Capital requirements

Inst. Dr. Dagnu L. Capital Market

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2.1 Depository Institutions

Capital requirements
• aimed at preventing insolvency
• banks have high debt to equity ratio
• Risk based capital requirements
It has two components
(1) Classifying bank capital into Tier 1
and Tier 2 capital
(2) Establishing credit risk wieght for
bank assets Inst. Dr. Dagnu L. Capital Market
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2.1 Depository Institutions

Classes of capital
(a) Tier 1 (core) capital includes Common
Stockholders‘ equity, certain types of preferred
stock, minority interest in consolidated
subsidiaries
(b) Tier 2 (supplementary) capital includes
loan-loss reserves, perpetual debt, certain
types of preferred stock, and subordinated debt
Inst. Dr. Dagnu L. Capital Market
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2.1 Depository Institutions

(2) Credit weights of assets

Risk Weights Examples of Assets included

0% - Treasury securities
- Mortgage backed securities issued by government mortgage
institutions

20% - Municipal general obligation bonds

- Mortgage backed securities issued by government sponsored
mortgage institutions

50% - Municipal revenue bonds

- Residential mortgages
100% - Commercial loans and commercial mortgages
- Corporate bonds Inst. Dr. Dagnu L. Capital Market
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3.1 Depository Institutions

 the
minimum Tier 1 capital (core capital)
requirement is 4% of book value of assets,
and minimum total capital is 8% of the risk-
weighted assets.

Inst. Dr. Dagnu L. Capital Market

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2.1 Depository Institutions

Example: Consider the following assets of Addis Bank
Asset BV in millions
FGE treasury bill Br 240
Bonds issued by AACA(General
(General Obl)
Obl) 120
Residential mortgages 450
Commercial loans 780
Total book value Br 1,590
Determine total risk weighted assets, tier 1 & total
required capital
Inst. Dr. Dagnu L. Capital Market
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2.1 Depository Institutions

Savings and Loan associations(S&Ls)
• established to provide finance for
acquisitions of Assets
• can be mutually owned(by depositors) or have
corporate stock ownerships
• ASSETS include:
mortgages, mortgage-backed securities, and
government securities,consumer loans, non-consumer
loans and municipal securities
Inst. Dr. Dagnu L. Capital Market
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2.1 Depository Institutions

FUNDING
• Saving and time deposits
• NOW (Negotiable Order of Withdrawal)
–pays interest
• Borrow from the federal home loan
banks

Inst. Dr. Dagnu L. Capital Market

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• 2.1 Depository Institutions

CREDIT UNIONS
• established by people with a common
bond/interset
• can be cooperatives or mutually owned
• established to satisfy saving and
borrowing needs of their members

Inst. Dr. Dagnu L. Capital Market

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2.1 Depository Institutions

Sources of funds
• deposit by members called shares
Assets
• consumer loans extended to members

Inst. Dr. Dagnu L. Capital Market

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2.2 Non-depository Institutions

INSURANCE COMPANIES
• make payments, for a price, when a certain event
occurs
• Life and non-life insurance companies
Characteristics
• Insurance policy and premium
• Surplus and reserves
• Components of profits: Underwriting income and
investment income
Inst. Dr. Dagnu L. Capital Market
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2.2 Non-depository Institutions

Life insurance companies
 Insurance against death or retirement
 Liabilities and liability risk: a liability risk
arises when an insured desires to let the
policy lapse due to policy rate falling
below market rate
 Investments in equity and debt securities

Inst. Dr. Dagnu L. Capital Market

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2.2 Non-depository Institutions

Types of life insurance policies
 Protection against risk of death(term life)
 Life insurance with investment component(whole life
policy/Universal life/variable life)
 Insurance against risk of life designed for pension
programs(annuity)
 Pure investment oriented vehicles/guaranteed
investment contract

Inst. Dr. Dagnu L. Capital Market

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2.2 Non-depository Institutions

Non-life insurance companies
• a.k.a property and casuality insurance
• they provide protection against
loss,damage, or distruction of property
loss or impairment of income producing
ability
claims for damages by third parties
loss from injury or death due to occupational
accidents Inst. Dr. Dagnu L. Capital Market
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2.2 Non-depository Institutions

Non-life insurance companies
• liabilities are of short-term maturity compared with
life insurance companies
• the amount and timing of liabilities is uncertain

Inst. Dr. Dagnu L. Capital Market

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2.2 Non-depository Institutions

PENSION FUNDS
• a fund established for payment of retirement benefit
• pension plans can be established by both
governmental and private organizations
• they can be defined contribution plan or defined
benefit plan or combination of the two

Inst. Dr. Dagnu L. Capital Market

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2.2 Non-depository Institutions

(1) defined contribution plans
 contributions are defined, but not the
benefits.
 sponsors do not guarantee any certain
amount upon retirement
 payment depends on investment
performance of the asset
 employee bears risk of investment
Inst. Dr. Dagnu L. Capital Market
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2.2 Non-depository Institutions

(2) defined benefit plans

 benefits are defined
 amount of benefit is determined based on
length of service and earnings of the
employee
 all investment risks are borne by plan
sponsors
Inst. Dr. Dagnu L. Capital Market
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2.2 Non-depository Institutions

(3) Hybrid pension plans

 contributions are defined with a guaranteed
minimum benefit
 in case the fund does not generate sufficient
growth to attain pre-set level of benefit then
the employee is obliged to add amount of the
deficit
 investment risk is shared
Inst. Dr. Dagnu L. Capital Market
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2.2 Non-depository Institutions

INVESTMENT COMPANIES
 sellshares to the public and invest the proceed
in diversified portfolio of securities
 securities may include common stock,
government bonds, corporate bonds, or money
market instruments
 reduce risk through diversification
 lower cost of contracting and information
processing Inst. Dr. Dagnu L. Capital Market
End of Chapter 2