Chapter 3

Financial Institutions

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 FINANCIAL INSTITUTIONS /INTERMEDIARIES
• The financial system is a complex structure including
many different financial institutions: banks,
insurance companies, mutual funds, stock and bonds
markets, etc.
• Financial intermediaries include commercial banks,
mutual savings banks, credit unions, life insurance
companies, and pension funds.
• These and other financial intermediaries emerged
because of inefficiencies found in direct financing.
• Financial intermediaries intervene between the
borrower (DSU) and the ultimate lender (SSU).
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 Transaction Costs
• Transactions costs influence financial structure
─E.g., a $5,000 investment only allowsyou to
purchase 100 shares @ $50 / share (equity)
─ No diversification
─Bonds even worse—most have a $1,000 size
• In sum, transactions costs can hinder flow of funds to people
with productive investment opportunities

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 Transaction Costs
• Financial intermediaries make profits by
reducing transactions costs
1. Take advantage of economies of
scale (example: mutual funds)
2. Develop expertise to lower transactions costs.

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Asymmetric information causes one group with
better information to use this the less-advantage
at the expense of informed group.

If not controlled, asymmetric information can cause

markets to function very inefficiently or even
break down completely.
• Adverse selection
• Moral hazard

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Role of Financial Intermediaries in Reducing
Information Costs

How do intermediaries reduce adverse

selection and moral hazard? There are several
ways.

• Screening. Prior to a loan being given, a bank

investigates a firm's or individual's credit
history and financial status.
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• Credit rationing. Riskier borrowers will be expected
to pay higher interest rates to compensate for this
risk. However, ONLY the riskiest borrowers are
willing to pay the highest rates. This is an extreme
case of adverse selection. In this case, banks may be
unwilling to assume the high risk levels and simply
refuse to lend to these types of borrowers.

• Creating long-term customer relationships. Repeat

customers will not require the same effort for
screening and monitoring that new customers. Also,
customers have an incentive to establish a good
repayment record in order to get loans from the
same bank in the future.
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• Monitoring. Once the loan is made, the bank
must ensure that the borrower does not
engage in risky activities that could lead to
default. One way to prevent this is for banks
to place "restrictive covenants" into the loan
contract to prohibit certain activities, and then
to check compliance and enforce the
agreement when necessary

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• Collateral. Requiring a potential borrower to
pledge assets to be turned over in case of
default reduces credit risk in several ways.
Obviously, it protects the bank from total
financial loss in the event of a default. But it
also screens out questionable borrowers
(who will not have sufficient collateral) and
reduces moral hazard problems since the
borrower risks losing his/her property if a
default occurs.
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 DEPOSITORY INSTITUTIONS

 include commercial banks, savingsand 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

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 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 rate) risk-caused by interest
(interest DIs
rateborrow long(short) and lend
short(long)
changes when

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 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

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Types of Depository Institutions
COMMERCIAL BANKS
• A commercial bank is a profit-seeking business firm,
dealing in money and credit. It is a financial institution
dealing in money in the sense that it accepts deposits
of money from the public to keep them in its custody
for safety. So also, it deals in credit, i.e., it creates
credit by making advances out of the funds received as
deposits to needy people.
• Wide variety of services and products
• Operate under state and federal laws
• Usually the largest financial institutions

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Types of Depository Institutions
• Banks have influenced economies & politics
for centuries. Historically, the primary
purpose of a bank was to provide loans to
trading companies. Banks provided funds to
allow businesses to purchase inventory, and
collected those funds back with interest when
the goods were sold.

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Types of Depository Institutions
Sources of funds
• Deposits-savings, demand, time
 Reserve requirement-portion of kept as a
deposit caution against possible bank
illiquidity
• Non-deposit borrowings
• Common stock and Retained earnings

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Types of Depository Institutions
Regulation
• by the central bank
• areas of regulation include,
 Ceilings on deposit interest
 Permissible activities for CBs-(Glass-Steagall Act)
repealed by (Grahm Blealy act)
 Capital requirements

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Types of Depository Institutions
Capital requirements
• aimed at preventing insolvency
• banks have high debt to equity ratio
• Riks based capital requirements(Basel I)
• Basel I has two components
(1) Classifying bank capital into Tier 1 and
Tier 2 capital
(2) Establishing credit risk wieght for bank
assets

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Types of 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

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TYPES OF DEPOSITORY INSTITUTIONS
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
(2) Credit weights of assets
mortgage institutions

50% - Municipal revenue bonds

- Residential mortgages
100% - Commercial loans and commercial mortgages
- Corporate bonds
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Types of Depository Institutions
the minimum Tier 1 capital requirement is 4% of book value
of assets, and minimum total capital is 8% of the risk-weighted
assets.

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Types of Depository Institutions

– Example: Consider the following assets of Addis Bank

– Asset BV in millions
– FGE treasury bill Br 240
– Bonds issued by AACA(General Obl) 120
– Residential mortgages 450
– Commercial loans 780
– Total book value Br
1,590
– Determine total risk weighted assets, tier 1 & total required
capital

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FUNCTIONS OF COMMERCIAL BANKS

1. Accepting deposits
• Accepting deposits is the primary functions of a
bank. The bank accepts deposits from those that
can save but cannot profitably utilize them. To
attract savings from all sorts of individuals, the
banks maintain different types of accounts:
I. Fixed deposit account
II. Current deposit account
III. Saving deposit account

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 Fixed deposit Accounts

• They are deposited for a specific

money of time. They are also known as time
period
liabilities. Interest is calculated for the whole
amount for the same period. If the depositor
withdraws the deposit before the expiry date,
the depositor will pay penalty rate plus the
banker should be willing to pay before the
expiry date.

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Current deposit accounts
• Current accounts are checkable accounts or
demand deposit accounts. Current accounts
are operated through cheques.

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Saving Deposit Accounts
• Saving deposit accounts are opened by
individual savers and small business owners. It
is opened for saving purpose- to keep the
money away from oneself and form thieves.

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 2. Advancing Loans
• After keeping certain cash reserves the bank lend
their deposits to the needy borrowers. Before
advancing loans, the banks satisfy themselves
about the credit worthiness of the borrowers.
The various types of loans granted by the bank
are:
a) Money at call
b) Cash credit
c) Overdraft facility
d) Term loan

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A. Call loan
• This type of loan is granted for a period of an overnight to a maximum of fourteen days. It is
an interest-bearing loan. Interest is calculated on daily basis. It usually granted without
collateral
B. Cash Credit
• A certain amount of money is granted for a customer. The customer can use any part of it and
pay interest only for that amount. The agreed interest rate is not applied on the unused
amount of loan.
C. Overdraft Facility
• This is also a type of loan granted to business owners whenever they face temporary financial
shortage. This loan is granted against collaterals. Interest is calculated on daily basis on the
debit balance of the customers’ account. It is a permission granted to over draw his current
account.
D. Term loans
• They are loans granted for a fixed period of time. The time period may be short-term,
intermediate and long-term loans. Short-term loan is usually a loan granted up to one year,
and intermediate loans are from one to five years and long term loan is a loan granted for
above five years. The purpose of the loan may be for commercial, industrial, merchandise,
consumer, educational medical, etc.

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3. Credit Creation
• It is a unique function of the bank. Credit creation is the
natural outcome of the process of advancing loans as
adopted by the banks. When a bank advances a loan to its
customer, it does not lend cash but opens an account in the
borrower's name and credits the amount of loan to this
account. Thus, whenever a bank grants a loan, it creates an
equal amount of bank deposit.
4. Promoting Cheque System
• In the modern business transaction, cheques have become
much more convenient method of settling debts than the
use of cash.

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5. Agency Service
• Banks perform certain agency functions for and on behalf of their
customers besides their main functions such as:
– Collection and payment of credit instruments like cheques, bills of
exchange, promissory notes, etc.
– Execution of standing orders: - banks execute the standing instructions
of their customers for making various periodic payments against his
account.
– Remittance of funds by bank is simple, convenient, safe and
inexpensive. This service is available to both customers as well as non-
- customers of the bank.
a. Bank draft
b. Telegraphic transfers and
c. Mail transfer

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6. General Utility Function
A. Traveler's cheques
• Banks to avoid the risk of loss or inconvenience in to carrying large amount of cash while
traveling issue Traveler’s cheques. These cheques are issued in variable denominations and
are encashable on any office of the issuing bank or corresponding bank. They are usually
used foreign purposes.
B. Safe custody of valuable and securities
• Banks accept valuables for safe custody purpose. Valuables such as: negotiable securities,
jewelers and documents of the title to property, etc. The modern bank being equipped with
safe and strong rooms is naturally a very safe and convenient depository of valuables.
C. Foreign trade service
• Letters of credit
• CAD ( Cash against document )
• Advance payment
D. Foreign exchange
• In assisting foreign trade by discounting foreign bills of exchange and facilitating foreign
currency, a bank has sometimes arrange for the payment of costs to the transport, insurance
and warehousing of goods.

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Micro-Financing Institutions

• A micro finance institution (MFI) is an organization that

offers financial services to the very poor.
• micro finance as making small loans available to the
poor through schemes specially designed to meet the
Poor’s particular needs and circumstances.
• Micro-finance clients are typically self-employed,
entrepreneurs. In rural areas, they are usually small
farmers and others who are engaged in small income
generating activities such as food processing and petty
trade. In urban areas, micro-finance activities are more
diverse and include shopkeepers, service providers,
artisans, street vendors, etc.

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Services Provided by Micro-Financing
Institutions
• Credit provision & saving mobilization are the core financial products
/services provided by MFIs. But there are other services provided by MFI.
Micro financial Institutions provide the following types of services:
• Credit provision
– Small size credit (loans)
– Rural and urban poor households
– Petty traders
– Handcraft producers
– Unemployed youth and women ...etc.
• Saving mobilization
• - One of the objectives of MFIs is to encourage the saving habit of the
poor society.
• Other services
– Now a day in addition to credit provision and saving mobilization, some MFIS
provide other financial services like local money transfer, pension fund
administration and short-term training to clients.

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Objectives of the Micro finance
Institutions
• The goal of MFIs as development organizations is to service the
financial needs of un-served or underserved markets (the poor) as a
means of meeting development objectives. The development
objectives generally include one or more of the following:
 To reduce poverty.
 To help existing businesses grow or diversify their activities and
to encourage the development of new businesses.
 To create employment and income opportunities through the
creation and expansion of micro enterprise and ,
 To increase the productivity and income of vulnerable group,
especially women and the poor.

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Types of Depository Institutions

Savings and Loan associations(S&Ls)

• established to provide finance for acquisitions of homes
• 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
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Types of Depository Institutions

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

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 Mutual Savings Banks

• They are similar to savings and loans

association. To the customers the difference is
simply technical.
• They issue checking and savings accounts to
collect funds from households and they invest
primarily in residential mortgages. They are
owned cooperatively by members with
common interest such as company employees
and union members.

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Types of Depository Institutions

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

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

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Types of 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

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GENERAL PRINCIPLE OF INSURANCE

1. Principle of Insurable Interest

• Insurable interest refers to the existence of a financial
relationship to the subject-matter insured. The subject-
matters insured may be property having intrinsic value, life
of a person, bodily injury, or an event that may cause a
legal liability causing payment for the damages created.
2. Principles of Indemnity
• Indemnity means to pay and put back the policy holder in
the same financial position as just prior to the loss. The
policy owner receives from the insurer financial
compensation equal to the amount of the loss or the face
value of the policy, whichever is lower.

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GENERAL PRINCIPLE OF INSURANCE

3. Principle of Utmost Good-Faith

• Utmost Goods Faith refers to the duty to disclose all material facts relating to the
risk to be covered. A material fact is a fact, which would influence the mind of a
prudent underwriter in deciding whether to accept a risk for insurance and on
what terms.
4. Principle of Subrogation
• The doctrine of subrogation provides that if an insurer pays a loss to its insured due
to the wrongful act of another policy, the insurer is subrogated to the rights of the
insured and may prosecute a suit against the wrongdoer for recovery of its outlay.
5. Principle of Contribution
• This also supports the principle of indemnity. It takes effect when there is duplicate
coverage. It refers to the right of an Insurer who paid under a policy to call upon the
other insurers equally or otherwise liable for the same loss to contribute to
payment. In other words,when more than one insurance company insures the same
risk each company will only pay a proportion of any compensation.

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Types of Non-depository Institutions
Life insurance companies
 They obtain funds by selling insurance policies that protect
against loss of income from premature death or retirement. In
the event of death, the policyholder’s beneficiaries receive
the insurance benefits and with retirement the policyholder
receives the benefits.
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

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Types of 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

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Types of Non-depository Institutions
Non-life insurance companies
• They sell protection against loss of property from fire,
theft, accident, negligence, and other causes that can be
actuarially predicted.
• 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
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Types of 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

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Types of Non-depository Institutions

PENSION FUNDS
• They obtain their funds from employer and employee
contributions during the employees’ working years and
provide monthly payments upon retirement.
• 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

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Types of Non-depository Institutions
(1) defined contribution plans
contributions are defined, but not the benefits.
 sponsors do not guarantee anycertain amount upon
retirement
 payment depends on investment performance of the asset
 employee bears risk of investment

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Types of 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

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Types of 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

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Other Types of Financial Intermediaries

• Finance Companies:They make loans to consumers and

small businesses. Unlike commercial banks, they do not
accept savings deposits from consumers. They obtain the
majority of their funds by selling short-term IOUs, called
commercial paper, to investors.
• Mutual funds:They sell equity shares to investors and use
these funds to purchase stocks or bonds.
• Money market mutual funds (MMF): A MMF is a mutual
fund that invests in short-term securities with low default
risk.
• Investment companies: They raise money by selling stock
and earn income for the stockholders by investing the
proceeds in a diversified portfolio of assets.

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Types of Non-depository Institutions
INVESTMENT COMPANIES
sell shares to thepublic and invest theproceed 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

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Risks of Financial Intermediation
• Liquidity risk
• interest rate risk
• market risk
• credit risk
• off-balance-sheet risk
• foreign exchange risk
• country and sovereign risk
• actuarial risk
• operating, technological, and systematic risk

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 Liquidity Risk
• Because of the asset transformation function of FIs mismatches between
assets and liabilities can occur:
• maturity mismatches
• liquidity mismatches
• If runs (bankers’ risk), or unusually high demand for withdrawals of
demand deposits occur, this can cause a liquidity crisis for the FI, which
can begin a spiral down…asset sales at bargain prices…etc.

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 Interest Rate Risk
• The positive spread between borrowed funds and invested funds can be
threatened because of interest rate changes….if the maturity of the sources
of funds does not equal the maturity of uses:
• Two types:
1. source of funds is shorter term than the term the funds are invested..
(refinancing risk)

0 Liabilities 1 year

0 Assets 2 years
1 year

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 Interest Rate Risk
2. Reinvestment risk: The risk that the returns on funds to be reinvested will
fall below the originally anticipated returns. (the use of funds is shorter
term than the source of funds)

0 Liabilities 2 years

0 Assets 1 year

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 Maturity Matching
• Addresses both interest rate and liquidity risk…and therefore market value
risk, i.e., since interest rates help to determine the market value of assets
(inverse relationship)
• however, this works against the role of the FI providing true ACTIVE ASSET
TRANSFORMATION services
• maturity-matching
• doesn’t work with equity investments
• is only an approximation….duration matching is more accurate.

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 Market Risk
• As traditional activities the banks decline in relative
of (deposit-taking and proportions other forms of
lending) importance. activitieshave grown in
• Especially trading …. Actively investing in stocks, bonds, and derivative
securities…as a profit-center.
• Market Risk is the risk that in active trading, the market value of the banks
asset(s) declines.
• Example: derivative trading on the Japanese Nikkei Stock Market Index

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 Credit Risk
• Is the likelihood that a borrower will default on a loan…or that the issuer of
a bond that the FI has invested in, default on interest or principal
repayment.
• Default risk
• obviously, FIs are ‘diversified’ investors…their portfolio of financial assets
and portfolio of loans must be widely diversified across industries,
geographical regions and income groups.
• Firm-specific credit risk is the risk of default of the borrowing firm
associated with the specific types of project risk undertaken by that firm.
• Systematic credit risk is the risk of default associated with the health of the
general economy.

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 Off-balance-sheet Risk
• Off-balance-sheet activity, by definition, does not appear on the current
balance sheet of the FI
• commercial letter of credit is an irrevocable obligation to make payment
to a beneficiary of documents evidencing shipment of goods.
• BAs - Bankers Acceptances
• as the guarantor…of such financial instruments, the Bank remains liable
for payment, and there is always a chance that the client may become
insolvent, leaving the Bank with obligation to pay…but without recourse.

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 Foreign Exchange Risk
• Mismatches between the amount of foreign currency denominated assets
and liabilities can lead to foreign exchange losses or gains depending on
the relative movement of the two currencies involved.

A Net Short Asset Position in Birr

0 Foreign Assets 80 million Birr

0 Foreign Liabilities 100 million Birr

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 Foreign Exchange Risk
• A FI that matches both the SIZE and MATURITIES of its exposures in assets
and liabilities of a given currency is hedged (immunized) against foreign
currency, liquidity, and interest rate risk.

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 Country and Sovereign Risk
• Is the risk of losses experienced by an FI due to
changing, social, economic, or political factors specific to one
country….
• Hong Kong reverting to Chinese control….
• Mexico, Argentina imposing restrictions on debt repayments
of domestic corporations…etc.
• Greece potentially defaulting on international
loan obligations.

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 Actuarial Risk
• Actuaries estimate future liabilities for insurance companies based on the
law of large numbers and using conservative financial forecasting
assumptions.
• Actuarial risk is the risk that those estimates turn out to be wrong.
• Of course, actuaries, continually review their estimates as time moves
on….they will identify “actuarial surpluses” and “actuarial deficits” in
funds that are accumulating for the purpose of meeting a future liability.
This way the fund sponsor can be informed about their progress toward
their target terminal value, and can take action in advance to avoid a crisis.
• Adverse selection is the tendency of those most at risk in a group to take
out insurance so that the insuring FI that priced the contract with respect
to the average in the group is faced with losses.
• Moral Hazard is the risk that the insured (or beneficiary) will alter his or
her behavior after contracting in order to benefit from the contract.

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 Operating/Technological/Systemic
Risk
• Efficient electronic communications/ data-base
/information/
payments/ processing systems form the back-bone of a modern
FI
• once in place, it is possible for the FI to add more services and serve
more clients with little or no impact on the systems infrastructure of
the FI
• Economies of scale is the degree to which a FI’s average unit costs of
producing financial services fall as its output of services increases.
• Economies of scope is the degree to which a FI can generate cost
synergies by producing multiple financial service products.
• Correspondent Banking is the provision of reciprocal banking
services between pairs of FIs, often in two separate jurisdictions.

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 END
CHAPTER 3
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