Chapter Three: Financial Institutions and Operations

Chapter Three
Financial Institutions and Operations

Contents in Chapter Three
– Introduction
– Functions of Financial Institutions
– Deposit Taking Financial Institutions
– Non Deposit Taking Institutions
Introduction
• The term financial institutions and financial
intermediaries are often used interchangeably.
• The financial institutions or intermediaries are
engaged in the business of channeling money from
savers to borrowers.
• This channeling process, which is known as
financial intermediation, is crucial to a well
functioning of modern economy.
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• Since current economic activity depends heavily
on credit (most of which goes through financial
intermediaries, as with bank credit cards) and
future economic growth depends heavily on
business investment.
• For example, a student loan for college which increases
the level of education and human capital will promote
future economic growth of a country.
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Functions of financial institutions
• With in the main functions of channeling funds from savers
to borrowers, financial institutions perform five important
functions.
1. Pooling the savings of individuals: Small savers may not
have enough money individually to make large loans or
buy bonds, but through the bank they can indirectly invest
in loans, bonds, and earn better rates of interest.
• Therefore, every small depositor indirectly owns a small

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piece of the financial institution’s portfolio.
2.
Providing safekeeping, accounting and access to payments system:
•Financial institutions (e.g. banks) are safe places to deposit money,
because bank deposits are insured up to a certain level of money.
•The periodic bank statement that banks send to the depositor keep
the depositor about his/her income, expenditures and cash flows.
•Finally, since the payments system involves more than just cash, a
bank account is basically necessary to access the payment system,
e.g., to pay your bills with checks or online payment.
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3. Providing liquidity: Liquidity refers to the ability
of the financial assets to be converted in to cash.
• Money is a good store of value in that it is highly
liquid. Checking deposits are practically as liquid
as cash; saving deposits can be converted in to cash
with a quick visit to the ATM (Automatic Teller
Machine).
• Therefore, financial institutions facilitate liquidity.
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4. Reducing risk by diversifying: When financial institutions pool
the savings of individuals, they invest them in a wide variety of
loans, bonds, and other assets.
• Diversifying, which is known as “not keeping all your eggs in

one basket”, is a proven way to reduce risk.
• For example, a typical stock mutual fund invests in about 200 stocks;
where as individual small saver might only be able to invest in one
stock by her/his own. Buying shares of mutual fund and indirectly
owning a small piece of 200 stocks is a lot less risky than owning just
one stock. That one company could easily lose almost all of its value;
but it is unlikely that 200 companies would lose their value.
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5. Collecting and processing information:
• Financial institutions have a much easier time than
individuals do, when it comes to screening out bad
credit risks and monitoring loans for complains.
• This is because financial institutions have a wealth
of information about current and past applicants,
as well as standardized procedures for evaluating
creditworthiness.
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Information Asymmetries
• Information is the basis for decisions as a result participants in
the financial sector thrive on information.
• For example, when a person goes to a bank to get a loan, the bank will
look up that person's credit history, have the person fill out numerous
forms, and have the person document that her/his income and wealth
are enough for her/his to have an easy time repaying.
• As long as both the borrower and the bank can obtain that
information quickly, the loan will either be approved or
rejected quickly.
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• But getting the necessary information to make an
informed decision is not always easy.
• This is a big reason why direct finance is so uncommon.
• It is very hard the average person to judge the
creditworthiness of another person, or of a company, so
most people sensibly avoid loaning money directly.
• A potential borrower knows more about his own
trustworthiness and ability to repay than a potential
lender does.
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• Asymmetric information is the unequal knowledge that
each party to a transaction has about the other party.
• Thus, because of the lack of information about the
trustworthiness and other characteristics of the other
party, many mutual beneficial transactions never take
place.
• For example, people routinely pay several thousands of birr extra for
new car instead of buying used cars in excellent condition is because
of the problem of getting information about the car’s true condition or
about the reliability of the person selling it.
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• Thus, having unequal knowledge about each other
the following two problems will result in.
1. Adverse selection
2. Moral hazard
• Adverse Selection: It is the problem created by
asymmetric information before a transaction occurs
or a loan is made in case of banks.
• It is a pre-contractual asymmetries of information.
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• In the above used car, for example, the owner of the car
is the most likely to resell a recently purchased car by
hiding the car’s defect.
• As a result, prospective used car buyers will decide not
buying used cars at all.
• Therefore, since the adverse selection problem stems
from a lack of information, financial institutions can
help to solve this problem by gathering information
about the party who is interested to enter a financial
contract.
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• Moral Hazard: is the risk that one party to a transaction will
engage in behavior that is undesirable from the other
party’s point of view, after a transaction has taken place.
• It results from post-contractual asymmetries of information.
• For example, if your car is fully insured, why you bother for
locking it?
• If your laundry machine is fully insured and no longer of

much use to you, why not you burn it down and collect the
insurance money?
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• Since bank deposits are insured by the federal government, moral
hazard is quite common in banking industry, the bank’s
managers can afford to take more risks with the banks assets.
• Financial institution can solve this problem by:
 Monitoring,
 Paying attractive salary and incentives to their managers to

avoid corruption and
 Putting some restrictive measures like require the borrower to

keep a tangible assets as a collateral or to abstain the
borrowers from purchasing certain goods and services or to
abstain the borrowers from certain risky activities
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• Financial institutions are commonly classified
as:
1. Depository institutions &
2. Non-depository institutions
1. Depository Institutions
• Depository institutions are financial intermediaries
that accept deposits.
• These deposits represent the liabilities (debts) of the
deposit accepting financial institutions.
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• With the fund raised through deposits and other
funding sources, depository institutions make
direct loans to various entities and also invest in
securities.
• Thus, their income is derived from:
 income generated from loans they make and
 income generated from the securities they
purchased
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• There are some financial institutions which are
highly specialized types of depository institutions
(these are called thrifts). Example, Saving banks, credit
unions etc.
• They have not been permitted to accept deposits
transferable by check or any negotiable instrument.
• They have obtained funds primarily by tapping the
savings of households.
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• Depository institutions are highly regulated
because of the important role that they play in
the financial system.
• Because of their important role, depository
institutions are affording special privileges such
as access to federal deposit insurance and access
to a government entity that provides funds for
liquidity of emergency needs.
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• Assets and Liability Problem of Depository
Institutions
• A depository institution seeks to earn a positive spread

between the assets it invests in (loans and securities)
and the cost of its funds (deposits and other sources).
• The spread is referred to as spread income or margin.
• The spread income should allow the institution to meet

operating expenses and earn a fair profit on its capital.
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• But, in generating spread income a depository
institution faces the following risks:
 Credit or default risk: refers to the risk that a borrower
will default on a loan obligation to the depository
institution.
 Regulatory risk: refers to the risk that regulators will
change the rules so as to impact the earnings of the
institution unfavorably.
 Funding or interest rate risk: refers to the risk associated
with the amount of interest paid for depositors and
received from borrowers.
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• Example: Awash bank raises Birr 100 million by
issuing a deposit account that has a maturity period
of one year at the interest rate of 5%. Then the bank
has invested all its Birr 100 million in government
security for 10 years at the interest rate of 8%.
• In this case:
I. The income spread of a bank is known only for the first
year and it is unknown for the next 9 years.

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II. The income spread for year one is 3% (8% - 5%) and the
spread for the future (for 9 years) will depend on the
interest rate that Awash bank will have to pay to
depositors in order to raise Birr 100 million after one year.
III. Thus, if interest rates decline, the spread will increase and
if interest rates rise, the spread will decline because the
ceiling (upper interest rate) has locked to 8%.
IV. But if Awash Bank must pay more than 8% to depositors,

the spread will be negative. This is because it will cost the
bank more to finance the government securities than it
will earn on the funds invested in those securities.
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• Think about the opposite situation. A short term
loan (1 year) financed by a 5 year deposit.
• After 1 year the loan needs to be reinvested. Find
a new borrower for the next four years (i.e., from
year two up to year five).
• The interest rate might have changed. If it goes
down there will be a loss. If it goes up there will
be a profit.
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Liquidity concern
• Besides facing credit risk & interest rate
risk, a depository institution must be
prepared to satisfy:
1. withdrawals of funds by depositors &
2. to provide loans to customers.
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• Depositary institutions uses the following ways to
accommodate withdrawal & loan demands:
1. Attract additional deposits
2. Use existing securities as collateral for borrowing from a

federal agency or other financial institution.
 Banks have a privilege to borrow funds from central
bank at discount, when they have got shortage of
liquidity.
3) Sell securities that they own
4) Raise short term funds in the money market.
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• Depository institutions are further subcategorized
depending on the market they serve, their primary source
of funding, type of ownership, how they are regulated and the
geographic extent of their market.
• Thus, depository institution includes:
a. Commercial Banks
b. Savings and Loan Associations
c. Saving Banks
d. Credit Unions
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a. Commercial Banks
• The primary business of commercial banks is to serve
businesses.
• They provide the widest variety of banking services.
• In addition to savings accounts, checking service,

consumer loans, industrial and commercial loans, and
credit cards, commercial banks may also offer trade
financing, investment banking and safe keeping of
valuables
.
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• Commercial banks are the largest bank, both in
assets and in geographic extent.
• They take deposit from people who want to save
and use the deposits to make loans to people who
want to borrow.
Bank Services
• Commercial banks provide numerous services in
the financial system; individual services,
institutional services and global services
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• Individual banking: It encompasses consumer lending,
residential mortgage lending, consumer installment loans,
credit card financing, student loan & individual oriented
financial investment service.
• They generate:
 Interest from loans
 Fee income from credit card financing

•
• Institutional banking: loans to non-financial corporations

& financial corporations (like insurance companies),
government, leasing companies etc.
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• They generate:
 Interest from loan to corporation & leasing
 Fees from management of private assets pension

funds, custodial services.
• Global banking: It concerns a broad range of activities
involving corporate financing & capital market &
foreign exchange products & services.
• Most global banking generates fee income rather than
interest income.
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Bank Balance Sheet
• A balance sheet is a financial report that shows
the value of a company’s assets, liabilities, and
owner’s equity at a specific period of time,
usually at the end of the accounting period.
Bank Assets = Bank Liabilities + Bank Capital
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Bank Assets
 Assets earn revenue for the bank and includes cash,
securities, loans, and property and equipment that
allows it to operate.
a. Cash
• One of the major services of a bank is to supply cash on
demand, whether it is a depositor withdrawing money
or writing a check or a bank customer drawing a credit.
• Hence, a bank must maintain a certain level of cash
compared to its liabilities to maintain solvency.
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b. Securities
• The primary securities that banks own are
Treasury Bills and Government Bonds.
• These securities can be sold quickly in the
secondary market when a bank needs more
cash.
• Therefore, they are often referred to as
secondary reserves.
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c. Loans
• Loans are the major assets for most banks. They earn
more interest than banks have to pay on deposits, and,
thus, are a major source of revenue for a bank.
• Loans include the following major types :

• Business loans, usually called commercial and industrial
loans.
• Real estate loans, e.g., residential mortgages
• Consumer loans, e.g., credit cards
• Inter-bank loans, i.e., the loan given to other banks.
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Bank Liabilities
• Liabilities are either the deposits of customers or

money that banks borrow from other sources to use to
fund assets that earn revenue.
a. Checkable/Demand deposits
• Checkable or demand deposits are deposits where

depositors can withdraw the money at will.
• Most checkable or demand accounts pay very little

interest or no interest.
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b. Saving deposits
• Since saving accounts are not used as a payment system,

banks are forced to pay more interest for it.
• Saving deposits are mostly passbook saving accounts,

where all transactions were recorded in a passbook.
c. Fixed Deposit
• It is a deposit where the depositor agrees to keep the

money in the account until the certificate of deposit expires.
• The bank compensates the depositor with a higher interest

rate.
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d. Borrowing
I. Banks usually borrow money from other banks in what

is called the central/federal funds market.
II. Banks also borrow funds from non-depository

institutions, such as insurance companies, pension fund.
• However, most of these loans are collateralized in the

form of repurchase agreement, where the bank gives the
lender securities, usually Treasury bills, as collateral for
a short-term loan.
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III. As a last resort, banks can also borrow funds from
the central bank.
• But since borrowing from the central bank shows

that banks are under financial stress and unable to
get funding elsewhere, they do this rarely.
Bank Capital
• Banks can also get more funds either from the

bank’s owners if it is a corporation or by issuing
more stocks
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b. Saving & loan Association
• Saving and Loans Association represent a fairly
old institution.
• The basic purpose of establishing saving and
loans associations was pooling the savings of
local residents for financing the construction
and purchase of a homes.
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• The collateral for the loan would be the home
being financed.
• Saving and loans are either mutually owned
(means there is no stock outstanding) or have
corporate stock ownership, so technically the
depositors are the owners.
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• Traditionally, the only assets in which saving and
loans associations were allowed to invest have
been:
• Mortgages (Loans secured by a property).
• Mortgage – backed securities
• Government securities
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• But, because of the mismatch of lending and borrowing
(i.e., lending long and borrowing short), they have
expanded the type of assets in which they could invest.
• Thus, the acceptable list of investment now includes:
 Consumer loans (loans for home improvements,

automobile, education, credit cards etc)
 Non-consumer loans (loans for commercial, corporate

business etc).
 Municipal securities.
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• The principal source of funds for Saving and
Loans Associations consisted of passbook savings
accounts and time deposits.
• Then it was expanded to negotiable order of
withdrawal (NOW) account, which is similar with
demand account.
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c. Saving banks:
• Saving banks are institutions similar to saving and
loans associations even though they are much older
than S & Ls.
• Originally, they were established to provide a means for
small depositors and earn a return on their deposits.
• They can be either mutually owned (i.e., mutually
saving banks) or stockholder owned. But most saving
banks are of the mutual form.
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• Asset structure of saving banks and S & Ls are
almost similar.
• The principal assets of saving banks are
residential mortgages.
• The principal source of funds for saving banks is
deposits which is very similar with S & Ls.
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• They have obtained funds primarily by tapping the
savings of households.
• They induce people to save and impose certain
restrictions on the withdrawal of the funds to save.
• Thus, they are highly specialized types of financial
institutions, called thrifts.
• They provide loans to individuals and corporations
for commercial purpose.
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d. Credit Unions
• They are the smallest & nonprofit depository
institution. They can obtain either a state or federal
charter.
• Their unique aspect is the “common bond”
requirement for credit union membership, such as
the employees of a particular company, unions,
religious affiliations or who live in a specific area
etc and they are governed by a board of volunteers.
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• Credit Unions are either cooperatives or mutually
owned.
• There is no corporate stock ownership. Since they
are nonprofit and owned by their customers, they
charge lower loan rates and pay higher interest
rates on savings.
• Therefore, the dual purpose of credit unions is to
serve their members saving and borrowing needs.
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Non-depository institutions
Wednesday, July 21, 2021 51

– These Non-depository institutions are financial
institutions that do not mobilize deposits:
– These include:
• Insurance companies
• Pension funds
• Investment companies
• Investment Banking Firms

A. Insurance companies
• Insurance company is a company that offers insurance

policies to the public.
• It provides social security and promotes individual welfare.
• They distribute or spreading risks to a number of individuals.
• The primary function of insurance companies is to

compensate individuals and corporations (policyholders) if
perceived adverse event occur, in exchange for premium paid
to the insurer by policyholder.

• Insurance companies provide (sell and service)
insurance policies, which are legally binding
contracts.
• Insurance companies promise to pay specified sum
contingent on the occurrence of future events, such
as death or an automobile accident.

• Therefore, they are risk bearer. That is, they accept
or underwrite the risk for an insurance premium
paid by the policyholder or owner of the policy.
Features of Insurance companies:
1. Insurance policy & premium: Insurance policy is a legally
binding contract for which the policy holder (owner) pays
premium in exchange for the insurance company's
promise to pay specified sum contingent of future events.

– The company is said to underwrite the owner's risk and act as a
safeguard against the uncertainties of life.
– When the policy is accepted by an insurance company, it becomes an
asset for the owner & a liability for the insurance company.

2. Surplus & reserves: The surplus of an insurance
company is the difference b/n its assets & liabilities.
And reserve is the amount of cash set aside by
insurance company as a contingent liability.
3. Determination of profits: An insurance company's
revenue for a fiscal year is generated from two
sources:
– Premium earned during the fiscal period.
– Investment income earned from invested assets.

4. Government guarantees: unlike the
liabilities of depositary institutions
insurance policies are not guaranteed by
any federal entity.

Types of Insurance Business
• There are two types of insurance
companies:
1. Life insurance companies. (The claim is fixed
and certain).
2. Property & causality insurance company.
(The claim is variable and uncertain).

B. Pension funds
• Pension funds are major institutional

investors and participants in the financial
markets.
• A pension fund is a fund that is established

for the payment of retirement benefits

• The entities that establish pension plans-called plan
sponsors- may be:
 private business entities acting for their employees,
 federal, state, and local entities on behalf of their

employees,
 unions on behalf of their employee and
 individuals for themselves.
• Thus, pension funds are financed by contribution from

employer and/or employees
Types of pension funds:
• There are two types of pension funds:
 Defined contribution plan
 Defined benefit plans
1. 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 contribute is either a percentage of the
employee's salary or a percentage of profit.
– The plan sponsor gives the participants various
options as to the investment vehicles in which they
may invest.
– 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.
– Therefore, in a defined contribution plan the
employee bears all the investment risks.
2. 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 pan 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.

3. Hybrid pension plans: It is a new phenomenon in pension
planning.
– This plan combines features of both basic types of pension.
– With this plan, the employer contributes a certain amount of

each year to a fund, as in a defined contribution approach.
– The employer guarantees a certain minimum level of cash

benefits, depending on an employee's years of service, as in
a defined benefit plan.
– In such plan, the employer and employees share the risk of

providing retirement benefits.
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.

Types of investment:
1. Open-end funds
• More popularly open-end funds are referred to as a
mutual fund.
• It 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.
• A mutual fund's share price is based on its net asset value
(NAV) per share.
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

2. Closed-end fund:
• In contrast to mutual funds, closed-end funds
sell shares like any other corporation and usually
do not redeem their shares.
• 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.
• The price of the share is determined by supply and
demand, so the price can fall below or rise above
the NAV per share.
– Shares selling below NAV are said to be trading at
discount.
– Shares selling above NAV are said to be trading at
premium.
3. Unit trust
• It is similar to closed-end fund in that it issues a
fixed number of ownership shares called unit
certificates.
• They are sold and redeemed only by the issuing
company, like open-end funds.
• Unit trusts typically invest in bonds and differ in
several ways from open and closed end funds that
specialize in investing in bonds.
i. There is no active trading of bonds in the portfolio of the
unit trust. That is, usually the only time the trustee can
sell an issue in the portfolio is if there is a dramatic
decline in the issuer's credit quality.
ii. Unit trust has a fixed termination date unlike open-end

and closed –end funds.
iii. Unlike open-end and close-end fund investors, the

unit trust investor knows that the portfolio consists of
a specific collection of bonds and has no concern that
the trustee will alter the portfolio.
2.3. 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.

• They mainly involve in primary markets, the
market in which new issues are sold and bought
for the first time.
• They advice issuers on how best to raise funds, and
then they help to sell the securities.
• They are also involved in planning and executing
other types of financial transactions such as
merger, acquisition and restructuring.

Thus, they perform two general functions:
i. They assist both government and nongovernmental
companies in obtaining funds by selling securities,
i.e., raise funds for clients.
ii. They act as brokers or dealers in the buying and
selling of securities in secondary markets, i.e.,
assisting clients in the sale or purchase of
securities.

• Activities of investment banking firms
 Public offering (underwriting of securities)
 Private placement of securities
 Securitization of assets
 Merger and acquisition
 Merchant banking trading
 Money management

1. Public offering (underwriting) of securities
• Investment bankers performing one or more of the
following three functions:
A) Advising the issuer on the terms and the
timing of the offering.
B) Buying the securities from the issuers.
C) Distributing the issue to the public.

• The advisory role may require investment bankers
to:
i. Design a security structure that is more pleasant to
investors than a particular traditional structure.
ii. Design securities with characteristics that were
more attractive to investors in order to reduce the
cost of borrowing.
iii. Design securities structure for low quality bond
issues, so called high yield or junk bond structure.
• When investment banking firm buys the security from the
issuer and accept the risk of selling the securities to investors at
a lower price, it is referred to as an underwriter.
• The function of buying the securities from the issuer is called
underwriting.
• Thus, the fee earned from underwriting the security is the
difference between the price paid to the issuer and the price at
which the investment bank re-offers the security to the public.
• This difference is called gross spread or the underwriter
discount.
2. Private placement of securities
• In addition to underwriting securities for distribution
to the public, investment banking firms place
securities with a limited number of institutional
investors like insurance companies, pension fund etc.
• Investment banking firms assist in the private
placement of securities in several ways, for example,
they work with the issuer on the design and pricing
of securities.
3. Securitization of Assets
• Securitization of assets refers to the issuance of

securities that have a pool of assets as collateral.
• Assets securitization generates revenue in the

following ways:
i. When an investment banking firm securitizes assets

on behalf of a client and then underwrites the issues,
it receives the gross spread, just as in any other
underwriting.
ii. If the investment banking firm buys the underlying
assets, creates the securities, and then sells the
securities, it realizes a profit on the difference
between what it sells the entire issue for and the
price it paid for the assets.
4. Merger and Acquisition

• Investment banking firms are active in merger
and acquisition.

• They may participate in merger and acquisition
activity in one of the following ways:
i. Finding merger and acquisition candidates.
ii. Adjusting acquiring companies or target companies with
respect to price and non-price terms of exchanges or
helping companies fend-off / discourage an unfriendly
takeover.
iii. Assisting acquiring companies in obtaining the necessary
funds to finance a purchase.

5. Merchant Banking
• When an investment banking firm commits its own

fund by either taking an equity interest or credit
position in companies, this activity referred to as
merchant banking.
• The interest rate charged on debt funding provided

to a client, particularly for bridging financing, is high,
reflecting the high risk associated with such lending.

6. Money Management
• Investment banking firms have created
subsidiaries that manage fund for either individual
investors or institutional investors such as pension
funds.

Central Bank
86
Evolution of Central Banking:
 A central bank is the term used to describe the authority
responsible for policies that affect a country’s supply of
money and credit.
 More specifically, a central bank uses its tools of monetary
policy—open market operations, discount window
lending, changes in reserve requirements—to affect
short-term interest rates and the monetary base (currency
held by the public plus bank reserves) and to achieve
important policy goals.
• Central banking is mostly a recent development being essentially a
product of the nineteenth century. The following cases can be
considered here:
1. Riks bank of Sweden – established in 1664
2. Bank of England – established in 1694 – serve as a central bank in

1844
3. Bank of France – established in 1800
4. Reichs bank of Germany – established in 1876
5. Bank of Netherlands – established in 1814 – on the ruins of old bank

of Amsterdam (1609)
6. The bank of Norway – established in 1817

7. The national bank of Denmark - established in 1818
8. The national bank of Belgium - established in 1850
9. The bank of Spain - established in 1856
10.The bank of Russia - established in 1860
11.The bank of Japan - established in 1882
12.The bank of Italy - established in 1893
13.The Swiss national bank - established in 1907
14.The Federal Reserve system in America - established in

1913
15. The bank of Canada - established in 1934
16. Reserve bank of India – established as its central bank in

1934
17. National bank of Ethiopia - established in 1942 –

National & Commercial Bank proclamation, August 1942
• Establishment of IMF after second world war gave a

further stimulus to the establishment of central banks as
it became necessary to establish such financial
institution to deal with IMF.
• In the nineteenth century Central Banks of many other
countries were established.
• They were empowered to issue notes with special
principles and powers.
• They became bankers and advisers of their respective
governments.
• Today, central bank is the central arch of the monetary and
fiscal framework in every country of the world and its
activities are essential for the proper functioning of the
economy
Definition of a Central Bank
• A Central Bank may be defined as that central monetary
institution which is charged with performing the duties
of bankers’ bank, fiscal agent for the government and
managing the monetary system of the country.
• A central bank is an entity responsible for the monetary
policy of its country or group of member states.

• It is responsible:
 To maintain the stability of the national currency and
monetary supply
 Controlling loan interest rates
 Acting as ‘’bailout’’ lender of last resort to the banking
sector during times of financial crises
 Thus, a central bank is a national financial institution created
to operate, not for profit, but for the public purpose of
influencing the economy in desirable direction through
monetary means
Difference between a central bank & a commercial bank
1. A central bank aims at maximizing the public welfare

through monetary means. It has no profit motive.
Where as commercial banks have profit motive.
2. A central does not deal with the public directly but a

commercial bank can exist only by dealing directly
with the public
3. Modern central banks have the monopoly over notes

issue but commercial banks does not have.
4. The central bank is a state owned institution but
commercial banks can be private & state owned banks
5. The central bank does not compete with commercial
banks, rather it comes to their rescue as the lender of the
last resort
6. The central bank is the custodian of the foreign exchange
of a country where as commercial banks are only the
authorized dealers
7. The central bank controls the entire banking system, thus
commercial banks function under its control
Functions of the Central Bank
1. Bank of issue: The modern central bank enjoys monopoly
over printing or issuing of currency notes. No other bank is
permitted to issue notes.
• The main reasons for granting monopoly right of note issue
to the central bank are:
i. The central bank brings uniformity in its notes, which is
essential for proper regulation
ii. It is easier to supervise the note issue. Any practices or
irregularities are easily detected.
iii. Monopoly over note issue by the central bank adds a
distinctive prestige and advantage. People value it more
because it has only one source, i.e., the central bank.

Prestige gets with the backing of the government.
iv. Money is a good servant but a bad master. The supply of
money in the economy must be under control to protect
inflation. Credit control function has been assigned to the
central bank, and it can exercise better control if it is the
sole authority in the matter of issue of note
v. The political interference in the matter of note issue
can be avoided. That is, if the government itself has
the right of note-issue, political considerations or
interest of government rather than sound monetary
economy become the determining factors.

2. Banker, agent and advisor to the government: the
central bank acts as a banker to the government, i.e., it
accepts the deposit from the central or state
government(s), make collections and payments on
their behalf, grant the short–term loans, especially
loans in the nature of ‘bridge loans’.
 The central bank also act as an agent to the
government. On behalf of the government, it manages
national debt and issue securities and loans.
 The purchase-sale of treasury bills and other securities as
to maintain adequate money supply with the public is
also under the control of the central bank.
 As an agent, it collects the taxes and makes
disbursements on its behalf.
 The central bank is a financial advisor to the government.
It advises the government on all policy matters relating to
the economy, i.e., deficit financing, monetary policy, trade
policy etc
3. Custodian of the cash reserve of commercial banks
 The central bank is the banker’s bank. It keeps the reserves of the
banks with it and acts as the custodian of these cash reserves.
 These reserves provide an effective support to the country’s
credit and banking system.
4. Custodian of nation’s foreign exchange reserve
 As custodian of foreign exchange reserves, the central bank tries
to manage it carefully to overcome the difficulties of balance of
payment and to maintain reasonable stability in the exchange
rate.

5. Lender of the last resort
 It performs this function by extending the
rediscounting facility to the banks, which enhances the
elasticity and liquidity of the entire banking system.
 This function of a central bank emerged because of:
a. Its monopoly power over note issue

b. Centralization of metallic and cash reserve
c. Its greater capacity to create credit,

6. Bank of central clearance, settlement and transfer
 A central bank is banker’s bank and custodian of
cash reserve.
 As all the banks in a country have accounts with its
central bank, it can easily settle their mutual claims
through mere book keeping entries.
7. Controller of money supply & credit
 Uncontrolled credit can play havoc with the
economy.
 It can cause wide fluctuations in the purchasing power of
value of money- which in turn has the potential of creating
economic and social unrest.
 A central bank has controlled money supply and credit to
ensure the reasonable achievement on price stability, full
employment, economic growth, balanced BOP.
8. Supervision of banks: For the development of an adequate
& sound banking system for catering to the needs of trade,
industry & agriculture, the central bank has been vested
with extensive power of supervision over banks.
Credit Control
 The most important function of the central bank is to control the
credit creation power of the commercial banks operating in the
country in order to control:
1. Inflation and
2. Deflation in the economy
The capacity of the banks to provide credit depends upon the
cash resources, i.e.,
 Cash balance on hand
 Cash balance in the central bank

• The cash resources increase through:
Rise in the deposit resources of banks
Borrowing from the central bank
Sale of their investments
• Banks usually make loans up to the point where they

can no longer do so because of the reserve
requirement restriction (or up to the point where
their excess reserves are zero).

e x c e s s re s e rv e s  a c tu a l re s e rv e s  re q u ire d re s e rv e s
• When someone deposits $100 in a bank, and the bank

deposits the $100 with the central bank, the bank has
$100 in total reserves.
• If the required reserve ratio is 20%, the bank has
excess reserves of $80. With $80 of excess reserves,
the bank can have up to $400 of additional deposits.
The $100 in reserves plus $400 in loans equal $500 in
deposits.
ASSETS LIABILITIES
Reserves 100 500 Deposits
Loans 400
Summary: Deposits
Bank 1 100
Bank 2 80
Bank 3 64
Bank 4 51.20
. .
. .
. .
Total 500.00
• Thus, their credit creation power should be controlled.
Wednesday, Jul 108
Credit Control Measures
 The measures/techniques of credit control used by
the central bank can be divided in to two types:
1. Quantitative credit control
2. Qualitative credit control
Quantitative credit control methods
They can also be called as general methods of credit
control.
• These instruments are designed to regulate the lending
ability of the financial sector of the economy.
• The use of these methods does not discriminate among
the various segments of the economy.
• The quantitative techniques are:
1. Bank rate: The bank rate or discount rate is the rate at

which a central bank is prepared to discount bills of
specified type.
 It is the minimum rate/price charged by the central bank
for discounting approved bills of exchange.
• The increase bank rate will make the credit costlier.
• The higher cost of credit will ultimately reduce the

volume of credit = lower inflation.
• Lower bank rate leads to borrowing from central bank
more cheaper funds and in turn the commercial banks
will provide loan to the public at lower rate of interest.
• Example; assume that the bank rate is increased from 10%
to 11%, the commercial bank will now receive Br 89
instead of Br 90 from the discounting of a bill of Br 100.

• Thus, the capacity of a commercial bank to create
credit will decline.
• Because of the increase in the bank rate commercial
banks will increase their lending rates.
• This will discourage the borrowers from borrowing and
reduce the volume of credit.
2. Open Market Operation: It refers to direct sale and
purchase of securities and bills in the open market by
the central bank. The aim is to control volume of credit.
• In order to increase money supply in the market, the
central bank starts purchasing securities in the open
market.
• Then borrowing in the money market become
cheaper due to increased supply of money.
• On the other hand, in order to contract the credit,
the central bank starts selling securities in the open
market.

3. Variable reserve requirement: Through this technique,
the central bank can change the “excess cash reserve”
positions of the banks and hence their credit creation
capacity.
 It a more effective tool of monetary policy as
compared to bank rate and open market operation.
 This can be used through:
a. Cash reserve ratio &

b. Statutory liquidity ratio
Cash reserve ratio: All the commercial banks are required to
maintain a minimum percentage of its deposits with the
central bank.
 The reserves in excess of the minimum requirement can
be utilised by the commercial banks to extend credit to its
customers.
 Example; Assume that a commercial bank of Ethiopia has
a deposit of Br 200,000,000 and the cash reserve ratio
(CRR) is 20%.
• It will be required to deposit Br 40,000,000 with the
National Bank of Ethiopia as cash reserves.
• The excess money Br 160,000,000 can be utilised by CBE
to create credit.
Statutory Liquidity Ratio (SLR): It refers to that portion of
deposits with the banks which it has to keep with itself
as liquid assets (like Gold, approved govt. securities etc.)
 If the central bank wishes to control credit and
discourage credit it would increase CRR & SLR.
Qualitative Credit Control Methods
 They are also known as selective and direct credit
control methods.
 Qualitative credit is used by the central bank for
selective purposes. Some of them are:
1. Margin requirements: This refers to difference
between the market value of the security and its
maximum loan value.

• By requiring higher margin while accepting a commodity
as a security it can decrease the flow of credit in to a
particular trade or vice versa.
• For example, if a security has a market value of Br 100
and if the margin requirement is 40%, then the maximum
that may be advanced for the purchase of security is Br
60.
• Thus, increasing the margin requirement will decrease the
amount that may be loaned for the purchase of security.

2. Credit rationing: under rationing, quota system is
adopted according to the needs of the economy. For
example, granting more loan to manufacturing sector.
3. Regulation of consumer credit: This refers to issuing
rules regarding down payments and maximum
maturities of instalment credit for purchase of goods.
• A higher cash down requirement will place the goods
beyond the reach of some customers.

• If the instalments period is reduced, the monthly
instalment will go up, and hence some consumers may
find it difficult to afford the goods.
4. Direct Action: This step is taken by the central bank
against banks that don't fulfil conditions and
requirements.
• The central bank may refuse to rediscount their papers
or charge a penal/punishing rate of interest over and
above the bank rate, for credit demanded beyond a
limit.
5. Moral Suasion: it is a general term describing a variety
of informal methods used by the central bank to
persuade commercial banks to behave in a particular
manner.
• The central bank may issue directives to commercial
banks to refrain from certain type of lending. For
example, not granting loan without a collateral.

End of Chapter Three

Chapter Three: Financial Institutions and Operations

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Chapter Three: Financial Institutions and Operations

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Chapter Three

Financial Institutions and Operations

to borrowers, financial institutions perform five important

1. Pooling the savings of individuals: Small savers may not

have enough money individually to make large loans or

in loans, bonds, and earn better rates of interest.

• Therefore, every small depositor indirectly owns a small

•Financial institutions (e.g. banks) are safe places to deposit money,

because bank deposits are insured up to a certain level of money.

the depositor about his/her income, expenditures and cash flows.

bank account is basically necessary to access the payment system,

e.g., to pay your bills with checks or online payment.

• Diversifying, which is known as “not keeping all your eggs in

• Information is the basis for decisions as a result participants in

the financial sector thrive on information.

are enough for her/his to have an easy time repaying.

information quickly, the loan will either be approved or

• A potential borrower knows more about his own

trustworthiness and ability to repay than a potential

• If your laundry machine is fully insured and no longer of

• Financial institution can solve this problem by:

 Paying attractive salary and incentives to their managers to

 Putting some restrictive measures like require the borrower to

• A depository institution seeks to earn a positive spread

• The spread is referred to as spread income or margin.

• The spread income should allow the institution to meet

issuing a deposit account that has a maturity period

of one year at the interest rate of 5%. Then the bank

has invested all its Birr 100 million in government

security for 10 years at the interest rate of 8%.

I. The income spread of a bank is known only for the first

year and it is unknown for the next 9 years.

IV. But if Awash Bank must pay more than 8% to depositors,

2. to provide loans to customers.

2. Use existing securities as collateral for borrowing from a

depending on the market they serve, their primary source

of funding, type of ownership, how they are regulated and the

geographic extent of their market.

• Thus, depository institution includes:

• In addition to savings accounts, checking service,

 Fee income from credit card financing

• Institutional banking: loans to non-financial corporations

 Interest from loan to corporation & leasing

 Fees from management of private assets pension

• Global banking: It concerns a broad range of activities

involving corporate financing & capital market &

foreign exchange products & services.

• Most global banking generates fee income rather than

• Loans include the following major types :

• Liabilities are either the deposits of customers or

• Checkable or demand deposits are deposits where

• Most checkable or demand accounts pay very little

• Since saving accounts are not used as a payment system,

• Saving deposits are mostly passbook saving accounts,

• It is a deposit where the depositor agrees to keep the

• The bank compensates the depositor with a higher interest

I. Banks usually borrow money from other banks in what

II. Banks also borrow funds from non-depository

• However, most of these loans are collateralized in the

• But since borrowing from the central bank shows

• Banks can also get more funds either from the

• Thus, the acceptable list of investment now includes:

 Consumer loans (loans for home improvements,