FINANCIAL INSTITUTIONS AND

INVESTMENT MANAGEMENT

(MBA 662)
 CHAPTER ONE
INTRODUCTION TO FINANCIAL
INSTITUTIONS
 1.1. Meaning and Nature of Financial Institutions
 Financial Institutions deals with financial transactions, such as investments,
loans and deposits.
 If financial markets were perfect,
 all information about investors on security and any securities for sale would be
available.
 all securities for sale could be broken down into any size desired by investors
 transaction costs would be nonexistent.
 However, financial markets are imperfect.
 That is why financial institutions are needed to resolve the problems caused by
market imperfection.
 1.2. Importance of financial institutions
 FIs are very important factors that contribute to the growth or failure of the
economy of a nation.
Contributions of FIs for Economic Growth
 It can raise the proportion of savings channeled to investment, thereby reducing the
costs of financial intermediation;
 It may improve the allocation of resources across investment projects, thus increasing
the social marginal productivity of capital; and
 It can influence the savings rates of households, for example, if it induces a higher
degree of risk sharing and specialization, which as a result stimulates higher growth.
 Cont…
Important factors for stable financial system
 A stable financial system can be described as a financial system that is able to
withstand shocks without giving way to cumulative processes which could
o Impair the allocation of savings to investments and
o the processing of payments in the economy.
 Financial system architecture should be carefully planned.
 A solid micro supervision of the financial sector should be in place.
 Close co-operation & exchange of information between the central bank &
supervisory authorities is warranted at all times & especially in periods of
financial stress.
 Cont…
 There are several, complementary public policies that are typically needed to
sustain or build up confidence in financial institutions.
 Fiscal policy. If fiscal authorities are restricted in their ability to run deficits or
accumulate large debts, an important source of financial market stress and financial
instability is removed.
 Monetary policy. Monetary authorities should in the first place try to guarantee price
stability,
Indirectly, this should also be conducive to supporting financial
stability, as the economy will have less macro uncertainties to deal with,
when allocating resources.
 1.3. Functions of financial institutions
 Directing the Payment System
 Assisting With Resources and Capital: by extending credit
 Moving Financial Resources
 Risk Management: eg. insurance
 Informing Financial Decisions
 Maintaining the Market: active participant
 1.4. Financial Intermediaries and their Roles
 A financial intermediary channels savings into investments.
 Financial intermediaries exist for profit in the financial system
 There is a need to regulate their activities.
 Recent trends suggest that their role in savings and investment functions can be
used for an efficient market system or like the sub-prime crisis shows,
 they can be a cause for concern as well.
 Role of the Financial Intermediaries
 Help the Household Sector  Creation of New Assets and Liabilities
 Help the Business Sector  Provide Liquidity
 Help the State and Local  Help in Lowering Interest Rates
Government  Bring Stability in the Capital Market
 Help the Central Government
 Benefit to the Economy
 Lenders and FIs both Earn
 Spread of Risks
 1.5. Types of Financial Institutions
Depository Institutions
 It is one that specializes in depository lending.
 The primary functions of these institutions are to accept deposits from surplus units
and provide credit to deficit units through loans and purchases of securities.
 Eg. savings bank, commercial bank, savings and loan association, or credit union.
 The major assets of depository institutions are loans (financial assets) and the major
liabilities (sources of funds) are deposits.
 Depository institutions can also be generally categorized into
 commercial banks and
 other depository institutions (such as saving and loan institutions, credit unions, and
microfinance institutions).
 Cont…
Commercial Banks: are institutions that offer deposit and credit services as well as a
growing list of newer services as:
 investment advice, security underwriting, selling insurance and financial
planning.
 Unlike the name “commercial”, commercial banks expanded their services to
consumers and Government units.
 Commercial Banks manage
 the customers' current and savings accounts,
 pay out checks that have been drawn on the bank by account holders, and
 perform the collection of checks deposited in their customers' accounts.
 Banks implement a number of other procedures for payments to customers, such as:
 ATM's (Automated Teller Machines), telegraphic transfer, and EFTPOS
(Electronic Funds Transfer at the Point of Sale), or Debit Cards.
 Cont…
Other Depository Institutions:
Savings and Loans Associations: Also known as a thrift, is a financial
institution that specializes in accepting savings deposits and making mortgage
and other loans.
 They are often mutually held.

 It is possible for a savings and loan to be stock-based and even publicly

traded.
 The distinction between S&Ls and commercial banks is minimal.

 However, S &Ls continue to hold a less diversified set of assets than

commercial banks do.

 S &Ls accept deposit and extend loans primarily to household customers.
 Cont…
Credit Unions: It is a member-owned financial cooperative
Operated for promoting thrift, providing credit, and providing other financial
services to its members.
They are offering deposit and credit services to individuals and families.
They are cooperative, self-help association of individuals rather than profit
motivated institutions
All of whom have a common bond, such as working for the same employer.
They offer low loan rates and high deposit interest rates and have relatively low
operating costs.
 Cont…
Credit Unions usually report low default and delinquency rates.
The major difference between the credit unions and banks is that
the credit unions are owned by the members unlike banks.
The policies of credit unions are governed by a volunteer Board of Directors that is
elected by and from the membership itself.
This board of directors also decides on the interest rates to be charged.
According to the regulation of credit unions, only the members of the credit union are
eligible to deposit money in the union or borrow money from the union.
 Cont…
Micro-Finance Institutions: It provides financial services to micro-entrepreneurs
and small businesses, which lack access to banking and related services due to
 the high transaction costs associated with serving these client categories.
Micro finance is defined as the provision of financial intermediation through
distribution of small loans acceptance of small savings and the provision of
other financial products and services to the poor.
 Cont…
Mutual Savings Banks: A mutual savings bank is a financial institution chartered
by a central or regional government, without capital stock, that is owned by its
members who subscribe to a common fund.
The institution is intended to provide a safe place for individual members to
save and to invest those savings in mortgages, loans, stocks, bonds and other
securities and to share in any profits or losses that result.
The members own the business.
Mutual savings banks are much like savings and loans, but are owned
cooperatively by members with a common interest, such as company
employees, union members, or congregation members.
 Cont…
Money Market Funds: A money market fund is a mutual fund that invests in
short-term, high-quality fixed income securities.
They are financial intermediaries pooling deposits of many individuals and
investing those in short-term, high quality, money market instruments.
They rank among the relatively safe investments.
These funds combine low risk securities investments with ready liquidity.
 Cont…
 Non-Depository Institutions
 Government or private organization that serves as an intermediary between savers
and borrowers, but does not accept time deposits.
 insurance company, investment trust, or mutual fund or unit trust
 Such institutions fund their lending activities either by selling securities (bonds,
notes, stock/shares) or insurance policies to the public.
 Unlike depository institutions, non-depository institutions do not accept checkable
deposits.
 With one exception that will be noted shortly, you cannot simply write a "check" to
withdraw funds from a non-depository institution.
 Types of non-depository financial institutions

Financial-Brokers: It is a financial institution that facilitates the buying and

selling of financial securities between a buyer and a seller.
 Brokerage firms serve a clientele of investors who trade public stocks and

other securities.
 Sometimes brokerage firm is entrusted with the responsibility of researching

the markets to provide appropriate recommendations and in so doing; they

direct the actions of pension fund managers and portfolio managers alike.
 Cont…
Investment Institutions:
1) Finance Companies: They grant credit to businesses and consumers for a
wide variety of purposes acquiring their funds mainly from debt.
 Like banks, they use people's savings to make loans to businesses, but instead of
holding deposits, they sell bonds and commercial papers.
2) Investment companies: provide an outlet for the savings of many individual
investors towards bonds, stocks, and money market securities.
 Cont…
3) Mutual funds: They pool funds of savers and make them available to
business and government demanders.
 They obtain funds through sale of shares and uses proceeds to acquire bonds &
stocks.
 Provides greater diversification, lower transaction cost, opportunities for capital gains
and indirect access to higher yielding securities that can be purchased only in large
blocks.
 Cont…
4) Pension Funds: A pension fund is an entity set up to collect monies from
employer(s) and workers, invest the proceeds in securities and other assets, and
pay benefits to retirees from the fund's accumulated resources.
 Pension funds are savings plan through which fund participants accumulate
savings during their working days so that they withdraw the fund during their
retirement years.
 It is a fund established by an employer to facilitate and organize the
investment of employees' retirement funds contributed by the employer and
employees.
 Cont…
5) Insurance Companies: most people are risk-averse.
 Most people are prepared to make a payment (or sacrifice some income) in
order to avoid any serious risk.
 Amongst the non-deposit taking institutions this service is carried out by
insurance companies.
 They allow people to choose the certainty of a slightly reduced current
income (reduced by the premiums they pay) in exchange for avoiding a
catastrophic loss of income (or wealth) if some accident should occur.
 Cont…
6) Investment Banking Firms: Itis a financial institution that assists individuals,
corporations and governments in raising capital by underwriting and/or acting as the
client's agent in the issuance of securities.
An investment bank may also assist companies involved in mergers and
acquisitions, and provide ancillary services such as
 market making, trading of derivatives, fixed income instruments, foreign exchange,
commodities, and equity securities.
Unlike commercial banks and retail banks, investment banks do not take deposits.
Investment banking firms provide their clients with the opportunity to generate
funds through different processes.
 1.6. Risk in financial institutions
 Systematic (undiversifiable) risk: caused by changes associated with
systemic factors.
 can only be hedged but cannot be diversified.
 For example, changes in interest rates and government policies.
 Credit risk: arises as a result of the debtor's non-performance.
 This may arise either from the debtor's inability or unwillingness to perform in
the pre-committed contract manner.
 This is because many people will be affected, that is, from the lender who
underwrote the contract to other lenders to the creditors as well as to the
debtor's shareholders.
 Credit risk is diversifiable but difficult to perfectly hedge.
 Cont…
 Counterparty risk: comes from the non-performance of a trading partner.
This may be as a result of the counterparty's refusal to perform due to adverse
price movement caused by some political constraint that was not anticipated by
the principals.
Diversification is the main tool for controlling counterparty risk.
 Operational risk: is the risk associated with the problems of accurately
processing, settling, taking and making delivery in exchange for cash.
It also arises in record keeping, computing correct payments, processing system failures
and complying with various regulations.
As such, individual operating problems are small but can easily expose an institution to
outcomes that may be very costly.
 Cont…
Legal risks are endemic in financial institutions.
 This is in the sense that financial contracting is separate from legal ramifications
of credit risk, counterparty risk as well as operational risk.
New statutes and regulations can put formerly well-established transactions into
contention.
End of the chapter!