CHAPTER ONE

INTRODUCTION TO FINANCIAL INSTITUTIONS

? What is financial institution?

Introduction
Financial institutions are a business organization that provides savings and
financing opportunities. They are business organizations that act as mobilizes
and depositories of savings and as purveyors of credit or finance. They also
provide various financial services to the community. They differ from non-
financial (industrial and commercial) business organizations in respect of their
wares, i.e., while the former deals in financial assets such as deposits, loans,
securities, financial services and so on, the latter deal in real assets such as
machinery, equipment, real estate and so on.

BY:Geleta L.(BA) MFI for 4th Year Department 04/04/2024

of MGMT
 financial institution……….

Financial institutions are the key players in the financial markets

as they perform the function of intermediation and thus determine
the flow of funds. The activities of different financial institutions
may be either specialized or they may overlap; quite often they
overlap. Yet, we need to classify the financial institutions and this is
done on such basis as their primary activity or degree of their
specializations with relations to savers or borrowers with whom
they customarily deal or the manner of their creations. In other
word, the functional, geographical, sectoral scope of activity or the
type of ownership are some of the criteria large number and variety
of financial institutions which exist in the economy.

BY:Geleta L.(BA) MFI for 4th Year Department 04/04/2024

of MGMT
 Role of Financial Institutions

The most important function of financial institutions is to

assist in the transfer of funds from surplus agents to deficit
agents to deficit agents. In assisting this process a financial
intermediary undertakes several economic roles.
I. The provision of a payment mechanism
II.Maturity transformations
III.Risk transformations
IV.Liquidity provision
V. Reduction of transactions, information and search costs.
BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024
Role of Financial Institutions

I. Provision of payment mechanism

Financial intermediaries, especially commercial banks, facilitate the payments of funds by non cash
measures such as; cheques, credit cards, electronic transfer, letter of credit—etc. An effective payment
system is essential to the health of a modern economy among domestic agents and between domestic and
foreign agents.
II. Maturity transformation role.
 Surplus agents typically wish to have their surplus funds redeemable at short notice, and deficit
agents ( investors) wish to borrow funds over long term horizon.
 Thus, financial intermediaries such as commercial banks, accepts investors fund on a short term basis
and channel these funds to long-term borrowers. The process of converting short term liabilities
(deposits) into long-term assets (loan) is known as maturity transformations.
III. Risk diversification role
 Surplus agents needs complete protection for their capital. On the other hand , borrowers needs
capital to finance in risky investment projects. Thus the demand of these two agents contradict each
other. If a surplus agent lends directly to a deficit agent, this would leave them heavily exposed to the
risk of default by the deficit agent.

BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024

Financial intermediaries can play an important part in
transforming the low risk requirement of savers into meeting the
risk finance requirement of firms {borrowers}. Thus, a financial
intermediaries that receives funds from many surplus agents can
pool these funds lend to a large number of deficit agents
(diversification).
Financial intermediaries mitigate several types of risk. First,
bank take deposits from many people and make thousands of loans
with these deposits. Thus, each depositor faces only a small amount
of the risk associated with loans that would go default. No one
depositor losses all there assets when a bank loan goes unpaid.
Banks also provide a low-cost way for depositors to diversify their
investments. Mutual fund companies of small investors a way to
purchase a diversified portfolio of several different stocks.
BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024
 IV. Liquidity role
Liquidity refers to the ease with which an asset can be converted into
cash. Surplus agents would not be willing to hold the financial assets
(bonds or shares) unless they have the ability to sell them at short notice
at fair market place. Thus, deposit taking institutions are therefore able to
ensure liquidity provision without maintaining large balances in relation
to total deposits.
V. Reduction of contracting, search and information costs role
The cost of acquiring and processing the information about the borrower
(known as information processing costs) must be considered when you
lend money. The cost of loan contracts are referred to as contracting cost.
In addition cost of contracting, the ability, and cost of enforcing the terms
of loan agreements should also be considered by lenders. Most surplus
agents lack the time, skill and resources to find and analysis prospective
deficit agents and draw up and enforce the necessary legal contracts.

BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024

Financial institutions such as banks, provides cost effective intermediations;
financial intermediations benefits from considerable economies o scale, because
they are looking for many prospective investment opportunities, they can
devote resources to recruiting and training high quality staff to assist in the
process of finding suitable deficit agents.
They draw up more standardized contract or they can recruit legal counsel as
part of professional staff to write contract involving more complex transactions.
The two potential credit cost necessarily incurred by the lenders (surplus
agent) and which is eliminated by financial intermediations is cost of analyzing
credit worthiness of borrowers and cost of developing contract (stationary,
witness per-diem, etc)

BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024

 Classification of financial institutions
Financial institutions act as a channel through which scattered
savings are collected and then invested in business firms. These
institutions can broadly be divided in to three categories: namely;
depository institutions, non-depository institutions, and investment
intermediaries.
A. Depository financial institutions
Depository institutions are financial intermediaries that accept
deposits from individuals and institutions and make loans. These
institutions include commercial banks, savings and loan
associations, and credit unions. They are unique from the other
intermediaries in that they are directly engaged in accepting
deposit and channeling it to others.
BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024
  Examples of Depository Financial Institution

 Commercial banks: They serve a variety of savers and borrowers. Historically,

commercial banks were the major institutions that handled checking accounts and
through which the central bank expanded or contracted the money supply.
Today, however, several other institutions also provide checking services and
significantly influence the money supply. Conversely, commercial banks are providing
an ever-widening range of services, including stock brokerage services, agency services
and so on.
 Savings and credit associations (S&Ls): traditionally served individual savers and
residential and commercial mortgage borrowers, taking the funds of many small
savers and then lending this money to home buyers and other types of borrowers.
 Credit unions: are cooperative associations whose members are supposed to have a
common bond, such as being employees of the same firm. Members’ savings are
loaned only to other members, generally for auto purchases, home improvement
loans, and home mortgages. Credit unions are often the cheapest source of funds
available to individual borrowers.
BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024
 B. Non-depository financial institutions

Non-depository institutions are financial intermediaries

that acquire funds at periodic intervals on a contractual
basis. Their main purpose is giving different financial
services (sharing of loss and pension services). But, they
are also important financial intermediaries because they
raise huge fund which they channel to investors in
different ways.

BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024

 Major types of non-depository financial institutions


This group of financial intermediaries includes insurance companies and pension
funds.
 Insurance companies
Insurance companies provide (sell and service) insurance policies, which are legally
binding contracts. Insurance company is a company that offers insurance policies to
the public. The primary functions of insurance company is to compensate the
individual and companies (policy holders) if perceived adverse event occur, in
exchange for premium paid to the insurer (insurance company) by policy holder.

It provides social security and promotes individual welfare. Insurance companies
promises to pay specified sum contingent on the occurrence of future unforeseen
events, such as death, or an automobile accidents. They distribute or spreading risks
to a number of individuals. They function as risk bearers. They accept or underwrite
the risk for an insurance premium paid by the policy maker or owner of the policy.

BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024

  Pension funds
After people retire from their employment, most people can expect to receive some
form of pension. This comes in one of three forms: a flat-rate pension paid by the
state to everyone above a certain age; an occupational pension provided from a fund
to which the employer and employee have contributed; and a personal pension paid
from a fund to which the individual has made contributions. As we shall see, only the
second and third forms strictly involve financial intermediation. This is because the
first of these operates on ‘pay as you go’ principles, while payments under the latter
are made from an accumulated fund of savings.
A pension fund is a fund that is established for the eventual
payment of retirement benefits. The entities that establish
pension plans, called the plan sponsors, are:-
 Private business entities acting for their employees.
 Federal, state & local entities on behalf of their employees
 Unions on behalf of their employee.

BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024

 Types of pension funds

Unfunded pension schemes: Schemes where payments to pensioners are financed by
simultaneous contributions from those in work. Such schemes are often called ‘pay as you go’ or
PAYG schemes.

Funded pension schemes: This scheme is where payments to pensioners are made out of the
income earned by a fund of savings which has been built up in earlier years by (usually regular)
savings contributions. There are two types of funded scheme:
i) Defined benefit plan
ii) Defined contribution plan

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 plan 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.
BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024
 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 contributed is either a percentage of the employee's
salary or a percentage of profit.
 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.
 The plan sponsor gives the participants various options as to the
investment vehicles in which they may invest.
 Therefore, in a defined contribution plan the employee bears all
the investment risks.
BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024
 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. This
group of financial intermediaries includes investment banks and mutual
funds which are involved in the purchase and sale of different securities
such as bonds and stocks.
Their primary function is to help individuals/firms to buy and
issue/sell the securities. They advise investors about their portfolio
choice and pricing of different securities. They also serve as security
traders by arranging traders among borrowers and lenders. Besides,
they acquire funds by issuing and selling different securities and use
the funds so raised to purchase diversified portfolio of securities.
BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024
 Types of investment companies
There are two major types of investment companies.
These are:
a) Mutual funds
b) Investment banking
A) Mutual Funds
A mutual funds (in US) or unit trust (in UK and India)
raise funds from the public and invest the fund in a variety
of financial assets. Mutual funds are investment companies
that pool money from investors at large and offer to sell
and buy back its shares on a continuous basis and use the
capital raised to invest in securities of different companies.
BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024
  Nature of mutual funds
Mutual funds possess shares of several companies and receive
dividends in lieu of them and the earnings are distributed among the
units/shares holders. Mutual funds sell shares (units) to investors and
redeem outstanding shares on demand at their fair market value. Thus,
they provide opportunity of small investors to invest in a diversified
portfolio of financial securities. They also enjoy economies of scale
by incurring lower transactions costs and commissions.
Mutual fund is a trust that pools the savings of a number of
investors who share a common financial goal. This pool of money is
invested in accordance with a stated objective. The joint ownership of
the fund is thus “Mutual”, i.e. the fund belongs to all investors. The
money collected is then invested in financial market instruments on
different securities; such as shares, debentures and other securities.

BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024

 The income earned through these investments and the capital
appreciations realized are shared by its unit holders in proportion
the number of units owned by them. Thus, a mutual Fund is the
most suitable investment for the common man as it offers an
opportunity to invest in a diversified, professionally managed
basket of securities at a relatively low cost. A Mutual Fund is an
investment tool that allows small investors access to a well-
diversified portfolio of equities, bonds and other securities. Each
shareholder participates in the gain or loss of the fund. Units are
issued and can be redeemed as needed. The fund’s Net Asset
value (NAV) is determined each day.

BY:Geleta L.(BA) MFI for 4th Year Department of Management

04/04/2024
 Investments in securities are spread across a wide cross-section of industries
and sectors and thus the risk is reduced. Diversification reduces the risk because
all stocks may not move in the same direction in the same proportion at the same
time. Mutual fund issues units to the investors in accordance with quantum of
money invested by them. Investors of mutual funds are known as unit holders.
When an investor subscribes for the units of a mutual fund, he becomes part
owner of the assets of the fund in the same proportion as his contribution
amount put up with the corpus (the total amount of the fund). Mutual Fund
investor is also known as a mutual fund shareholder or a unit holder.
Any change in the value of the investments made into capital market
instruments (such as shares, debentures etc) is reflected in the Net Asset Value
(NAV) of the scheme.
NAV is defined as the market value of the Mutual Fund scheme's assets net of
its liabilities. NAV of a scheme is calculated by dividing the net market value of
scheme's assets by the total number of units issued to the investors.

BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024

 Based on their structure:
a) Open- Ended Mutual Funds, and
b) Close-Ended Mutual Funds.
Based on their investment objectives:
a) Equity funds: These funds invest in equities and equity
related instruments.
b) Debt funds: They invest only in debt instruments.
c) Balanced funds: They invest on both equity and debt
instruments.

BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024

 1. Open-End Funds
 Open-End Funds are mutual funds those 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.
 Investors can buy and sell the units from the fund, at any point of time.
 A mutual fund's share price is based on its net asset value (NAV) per
shares.
 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 or unit
BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024
 2. Closed-end fund:

 In contrast to open-end mutual funds, closed-end funds sell shares like any other
corporation and usually do not redeem their shares.
 These funds raise money from investors only once. Therefore, after the offer period,
fresh investments can not be made into the fund.
 Units/shares of close-end funds sell on either an organized exchange (e.g. NYSE) or
OTC market.
 Investors who wish to purchase closed-end funds must pay a brokerage commission
at the time of purchase and again at the time of sale.
 Recently, most of the New Fund Offers of close-ended funds provided liquidity
window on a periodic basis such as monthly or weekly. Redemption of units can be
made during specified intervals. Therefore, such funds have relatively low liquidity.
 The price of the share is determined by supply and demand, so the price can fall
below or rise above the NAV per shares.
 Shares selling below NAV are said to be trading at discount.
 Shares selling above NAV are said to be trading at premium.

BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024

 Difference between Open-Ended and Close-Ended Mutual
Funds
i) The number of shares of an open-ended fund varies
because the fund sponsor sells new shares to investors
and buys existing shares from shareholders. By doing so
the share price is always the NAV of the fund.
ii) In contrast, closed-end fund have a constant number of
shares outstanding because the fund sponsor does not
redeem shares and sells new shares to investors, except
at the time of new a underwriting.

BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024

Functions of Mutual Funds
The following are some of the benefit associated with mutual
funds:
i) .Mobilizing small saving
ii) .Professional management
iii).Diversified investment/reduced risk
iv).Better liquidity
v) .Investment protections
vi).Low transaction costs (economy of scale)
vii).Economic development

BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024

 I. Mobilizing small saving: Direct participations in securities is
not attractive to small investors because of some requirements
which is difficult for them. Mutual fund mobilize funds by selling
their own shares, known as units, this funds are invested in shares
of different institutions ( private and public institutions).
II. Professional Management: Mutual funds employ professional
experts who manage the investment portfolio efficiently and
profitability. Thus, investors are relieved from the emotional
stress in buying and selling securities since mutual funds take
care of this functions.
 The professional managers act scientifically with :
 The right timing to buy and sell for their clients
 Automatic reinvestment of dividends and capital gains….etc.
BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024
 III. Diversified Investment/Reduced Risk: Funds mobilized from
investors are invested in various industries spread across the
country/globe. This is advantage to the small investors, because they
cannot afford to assess the profitability and viability of different
investment opportunities. Mutual funds provide small investors the access
to a reduced investment risk resulting from diversifications, economies of
scale in transactions cost and professional financial management.
IV. Better Liquidity: There is always a ready market for the mutual funds
units -it is possible for the investors to divest holding at any time during
the year at the Net Asset Value (NAV). Securities held by the fund could be
converted into cash at any time.
V. Investment Protections: Mutual funds are legally regulated by
guidelines and legislative provisions of regulatory bodies (such as, SEC in
US, SEBI in India---etc.).

BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024

 vi. Low Transactions Cost (Economy of Scale): The cost of purchase
and sell of mutual funds is relatively lower because of the large volume
of money being handled by mutual funds in the capital market.
Brokerage fees, trading commissions, etc. are lower. This enhances the
quantum of distributable income available for investors.
vii. Economic Development: Mutual funds mobilize more savings and
channel them to the most productive sector of the economy. The
efficient functioning of mutual funds contributes to an efficient
financial system. It creates ways for the efficient allocations of the
financial resources of the country which in turn contributes to the
economic development. Diversions of resources from consumptions
into saving and investment.
BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024
 B) 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.
Investment banking, or I-banking, as it is often called, is the term used to
describe the business of raising capital for companies and advising them on
financing and merger alternatives. Capital essentially means money.
Investment banking includes a wide variety of activities, including
underwriting, selling, and trading securities, providing financial advisory
services, and managing assets. Investment banks cater to a diverse group of
stakeholders – companies, governments, non-profit institutions, and
individuals – and help them raise funds on the capital market.

BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024

 They perform the following major functions for their customers:
 Serve as trading intermediaries for clients
 Lend and invest banks’ assets

Provide advice on mergers, acquisitions , and other financial

transactions: Advise on mergers, acquisitions, and divestitures to help
companies become more competitive.
 Research and develop opinions on securities, markets, and economies :
Maintenance of large databases that allows them to produce research
reports on economies, markets, companies, stocks, and bonds.
 Issue, buy, sell, and trade stocks and bonds : They help companies and
governments raise capital by issuing different types of securities such as,
equity, debt, private placements, commercial paper, medium-term notes
 Manage investment portfolios :

BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024

 Investment banks once contrasted sharply with
commercial banks, where people mainly deposited their
money and sought commercial and retail loans. In recent
years, though, the two types of structures have become
increasingly similar; commercial banks now offer more
investment banking services as they attempt to corner the
market by presenting themselves as one-stop shops. They
mainly involve in primary markets, the market in which
new issues are sold and bought for the first time.

BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024

 On the basis Of their legal formality,

 Classification of financial institutions can be made as formal financial

institutions, semi-formal financial institutions and informal financial
institutions.
Formal financial institutions :-are those that are subject not only to
general laws and regulations, but also to specific regulations and
supervisions. Their operations are under a direct supervision of central
bank. It includes:
 Development banks ( both private and public)
 Commercial banks ( both public and private)
 Saving banks
 Non- bank financial intermediaries (insurance companies,
investment companies, etc)
BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024
 Semi-formal institutions:- are those that are formal in the sense of being registered
entities subject to all relevant laws, including the commercial laws, but informal insofar as they
are, with few exceptions, not under the bank regulations and supervisions:
 free to set their own interest rate;
 unlike banks, free from minimum capital requirement.
 It includes:
 Credit unions
 Multipurpose cooperatives
 Self help associations (such as: Idir)

Informal Financial providers :(generally not referred to as institutions) are those to

which neither special bank law, nor general commercial law applies, and whose operations
are also so informal that disputes arising from contract with them often cannot be settled by
recourse to the legal system. An informal fund provider consists of:
 Individual money lenders
 Traders, land lords,
 Rotating and saving credit associations {like equb in Ethiopia}
 Families and friends
BY:Geleta L.(BA) MFI for 4th Year Department of Management 04/04/2024