Chapter Two

Financial Institutions
2.1. Introduction
The economic development of a nation is reflected by the progress of the various economic units,
broadly classified into corporate sector, government and household sector. While performing their
activities these unit will be placed in a surplus/deficit /balanced budgetary situations. There are areas or
people with surplus funds and there are those with a deficit unit. A financial system or financial sector
functions as an intermediary and facilitates the flow of funds from the area of surplus to the area of
deficit. A financial system is a composition is various institutions, markets, regulations, and laws,
practices, money manager, analyst, transactions, and claims and liabilities.
The word system in the term financial system implies a set of complex and closely connected or
interlined institutions, agents, practices, markets, transactions, claims, and liabilities in the
economy. The financial system is concerned about money, credit and finance the three terns are
intimately related yet are somewhat different from each other. A typical system consists of financial
market, financial instruments and financial intermediation.
Meaning of Financial System
A financial system is a system that allows the transfer of money between savers and borrowers. it
comprises of a set of complex and closely interconnected financial institutions, markets, instruments,
services, practices, and transactions. Financial systems are crucial to the allocation of resources in a
modern economy. They channel household savings to the corporate sector and allocate investment
funds among firms,
A financial system consists of institutional unit and markets that interact, typically in a complex
manner, for the purpose of mobilizing funds for investment, and providing facilities, including
payment systems for the financing of commercial activity.

A financial system may be discussed at a global, regional, and firm specific level. The firm’s
financial system is the set of implemented procedures that track the financial activities of the
company. On a regional scale, the financial system is the system that enables lenders and borrowers
to exchange funds. The global financial system is basically a broader regional system that
encompasses all financial institutions, borrowers and lenders within the global economy.
There are multiple components making up the financial system of different level: within a firm, the
financial system encompasses all aspects of finances. For example, it would include accounting
measures, revenues and expense schedules, wages and balance sheet verification. Regional financial
systems would include banks and other financial institutions, financial markets, and financial services.
In a global view, financial systems would include the International Monetary Fund, Central Banks,
World Banks, and major banks that practice overseas lending.

Functions of Financial System

A financial system is a network of financial institutions, financial markets, financial instruments and
financial services to facilitate the transfer of funds. The system consists of savers, intermediaries,
instruments, and ultimate user of funds. The function of financial system can be enumerated as
follows:
1. Financial system works as an effective conduit for optimum allocation of financial resources in an
economy.

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2. It helps in establishing a link between the savers and investors
3. It allows asset – liability transformation
4. Economic resources are transferred from one party to another through financial system
5. It ensures the efficient functioning of the payment mechanism in an economy
6. All transactions between the buyers and sellers of goods and services are effected smoothly
because of financial system
7. It helps in risk transformation by diversification as in case of mutual fund.
8. Financial system enhances liquidity of financial claims
9. Financial system helps price discovery of financial assets resulting from the interaction of buyers
and sellers.
10. It helps reducing the cost of transactions
The Basic Features of a Financial System are:
1. Financial system provides an ideal linkage between depositors and investors, thus encouraging
both savings and investments
2. It facilitates the expansion of financial markets over space and time
3. It promotes efficient allocation of financial resources for socially desirable and economically
productive purposes.
4. It influences both quality and the pace of the economic development.
Constituents of Financial System
There are three basic constituents of a financial system. These are:
1. Financial Instruments or assets
2. Financial markets and
3. Financial intermediaries
Financial Intermediaries (Institutions) and Their Roles
Financial institutions provide various types of financial services in an economy. Financial
intermediaries are a special group of financial institutions that obtain funds by issuing claims to market
participants and use these funds to purchase financial assets.
Financial Institutions & Capital Transfers.
Financial institutions are firms and their behavior can be analyzed in much the same way that
economists analyze any other type of firm. Thus we can think of them as producing various forms of
loans out of money which people are willing to lend. Furthermore, we can assume that they are profit
maximizes and that the profit arises from charging interest to borrowers at a rate which exceeds that
paid to lenders.

Like any other firm, profits will be maximized at the point where total revenue minus total costs is at
its greatest, that is where the marginal revenue accruing from an extra unit of output is just matched by
the marginal cost of producing it. Also, quite conventionally, we can assume that the marginal cost of
production is rising in the short term. Imagine, for simplicity, that a firm’s output consists of loans and
that the major variable input is the deposits which it can attract from members of the public who can
save. Other things being equal, it will attract more deposits (than at present) with which to increase its
production of loans only if it offers a higher rate of interest or better service (than at present).

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Whatever it does to get the extra deposit is likely to cost more than was involved in getting the
previous marginal business.

Making the assumption that financial firms are profit maximizers, however, does not mean that we
have to think of financial firms operating according to the model of perfect competition. Financial
firms tend to be large and that this is because economies of scale are very common in the production of
financial products. This has inevitably led, and continues to lead, to situations where some financial
business is dominated by a few, large organizations. In such cases we can observe many of the
characteristics which oligopolistic theories of the firm would lead us to expect, for example, little
apparent competition over prices but a great deal of effort going into marketing and product
differentiation. We can move even further away from the model of perfect competition and still stay on
fairly familiar ground. We can drop the assumption of profit maximization. There have been occasions
in the recent past, particularly involving the major retail banks, when it has looked to outsiders as if
decisions have been made to pursue other objectives, at least in the short run. These other objectives
might have been to increase market share at the expense of competitors, or to achieve a rate of growth
(measured by the number of account holders) greater than that of their rivals. Obviously, this sort of
behavior is possible only if a certain level of profit has already been achieved and is reasonably secure,
but it is quite different from rigorous profit maximization. Even so, this still leaves the behavior of
financial firms looking very much like that of many other types of firm.

While it is important to bear in mind these similarities between financial and other types of firm, there
is of course much that is distinctive about the business of financial firms: their products, and people’s
reasons for buying the products, are different from those of manufacturing and retail firms. For
example, the decision to buy a financial ‘product’ often involves making a judgement about events
which might develop quite a long way into the future. This is not necessary when buying goods for
everyday consumption.

Furthermore, there are also significant differences between the products offered by financial firms. One
distinction which is very commonly made, for example, lies between ‘deposit-taking institutions’
(DTIs) and ‘non-deposit-taking institutions’ (NDTIs). Deposit-taking institutions are organizations
such as banks and building societies, whose liabilities (assets to lenders) are primarily deposits. These
can be withdrawn at short (sometimes zero) notice and usually form part of the national money supply.
Non-deposit-taking institutions are organizations such as life insurance companies whose liabilities are
promises to pay funds to savers only in response to a specified event. Unless the specified event
occurs, it is very difficult to withdraw these funds and there is usually a considerable financial penalty
for savers who do so. Similarly, contributions to a pension fund cannot be easily withdrawn until the
pension falls due for payment.
Financial system provides for efficient flow of funds from saving to investment by bringing savers and
borrowers together via financial markets and financial institutions. Financial institutions (also called
financial intermediaries) facilitate flows of funds from savers to borrowers. This can be depicted in the
following exhibit.

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1. Direct transfers of money and securities, as shown in the top section, occur when a business sells
its stocks or bonds directly to savers, without going through any type of financial institution. The
business delivers its securities to savers, who in turn give the firm the money it needs.

2. As shown in the middle section, transfers may also go through an investment bank (one type of
financial institution) which serves as a middleman and facilitates the issuance of securities. The
company sells its stocks or bonds to the investment bank, which in turn sells these same securities
to savers.
The businesses’ securities and the savers’ money merely “pass through ’’the investment bankers.
However, the investment bank does buy and hold the securities for a period of time, so it is taking a
risk- it may not be able to resell them to savers for as much as it paid.
3. Transfers can also be made through financial intermediaries such as a bank or mutual fund. Here
the intermediary obtains funds from savers in exchange for its own securities, and it then uses this
money to purchase and then hold a business’s securities. For example, a saver might deposit money
in a bank, receiving from it a certificate of deposit, and then the bank might lend the money to a
business in the form of a mortgage loan.

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 1.2. Functions (Services) of Financial Institutions
Business entities include nonfinancial and financial enterprises. Nonfinancial enterprises manufacture
products (e.g., cars, steel, computers) and/or provide nonfinancial services (e.g., transportation,
utilities, computer programming). Financial enterprises, more popularly referred to as financial
institutions, provide services related to one or more of the following:
Financial institutions provide services related to one or more of the following:
1. Transforming financial assets acquired through the market and constituting them into a different and
more widely preferable type of asset-which becomes their liability. This is the function performed by
financial intermediaries, the most important type of financial institutions.
2. Exchanging of financial assets on behalf of customers. In other words, financial institutions also
provide brokerage services.
3. Exchanging of financial assets for their own accounts. Some financial institutions purchase financial
assets (or securities) from different parties and then resell to savers. In such a circumstance, the
securities that are not yet sold will be held as inventories. This is the dealer function and such services
involve assistance in the trading of securities in the secondary markets (market making).
4. Assisting in the creation of financial assets for their customers, and then selling those financial
assets to other market participants. Financial institutions, particularly investment banks, (1) help
corporations design securities with features that are currently attractive to investors, (2) buy these
securities from the corporation, and (3) resell them to savers. Although the securities are sold twice,
this process is really one primary market transaction, with the investment banker acting as a broker to
help transfer of capital from savers to businesses. This service is referred to as underwriting.
5. Providing investment advice to other market participants.
6. Managing the portfolios of other market participants.
Role of Financial Intermediaries
The following are some of the activities or role of financial intermediaries
 Financial intermediaries come between ultimate borrowers and lenders by transforming direct
claims in to indirect ones.
 They purchase primary security and, in turn, issue their own (called, secondary clams) securities.
 The primary security that a bank might purchase is a mortgage, a commercial loan, or a consumer
loan.
 The indirect (secondary) claim issued is a demand deposit, a savings account, or a certificate of
deposit.
 A life insurance company, on the other hand, purchases corporate bonds, among other things, and
issues life insurance policies.
 Financial intermediaries transform funds in such a way as to make them more attractive.
 On one hand, the indirect securities issued to ultimate lenders are more attractive than is a direct or
primary security. In particular, these indirect claims are well suited to the small savers.
 On the other hand, the ultimate borrower is able to sell its primary securities to financial
intermediaries on more attractive terms than it could if the securities were sold directly to ultimate
lenders.
 Financial intermediaries provide variety of services and economies that make the transformation of
claims attractive. In doing this, the financial intermediaries obtain compensation by an interest rate
spread.

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 Importance of Financial Intermediaries
The considerations underlying the attractiveness of indirect securities is that the pooling of funds by
financial intermediaries lead to a number of benefits or importance to the investors. These are:
A. Convenience
Intermediaries convert direct (primary) securities in to a more convenient vehicle of investment
(indirect or secondary claims).
 They divide primary securities of higher denomination in to indirect securities of lower
denomination.
 They also transform a primary security of a certain maturity in to an indirect security of a different
maturity.
 This would often conform more to the desires of diverse (small-saving) investors than those on
primary securities.
B. Lower Risk
Lower risk associated with indirect securities results from the benefits of diversification of
investments.
 In effect, financial intermediaries transform the individual investors in matters of diversification in
to large institutional investors as the former share proportionate beneficiary interest in the total
portfolio of the latter.
C. Expertise Management
Indirect securities give to the investors the benefits of trained, experienced, and specialized
management services together with continues supervision.
 In effect, financial intermediaries place the individual investors in the same position in the matter
of expert management as large institutional investors.
D. Low Cost
The benefits of investment through financial intermediaries are available to the individual investors at
relatively lower cost due to “economies of scale.”
 The major financial intermediaries are banks, insurances - both life & non–life (general) insurance
companies, mutual funds, non-bank financial companies, and so on, which provide their services at
relatively low cost.

2.2. Classification and their Portfolio of Financial Institutions

Financial institutions may be grouped in a variety of ways. One of the most important distinctions is
between depository institutions and non-depository institutions.
A. Depository institutions
Depository institutions include commercial banks (or simply banks), savings and loan associations,
saving banks, and credit unions. All are financial intermediaries that acquire the bulk of their funds by
offering their liabilities to the public mostly in the form of deposits. Once they raise funds through
deposits and other funding sources, depository institutions both make direct loans to various entities
and invest in securities. In this section we will discuss the activities of each depository institutions,
funding sources, asset /liability problem of all depository institutions and other aspects of it.

All depository institutions accept deposit. The major differences among these types of institutions lie
in that how they are owned and in the sources and uses of funds. The income of depository institutions
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is derived from two sources: (1) the income generated from the loans they make and the securities they
purchase and (2) fee income. Depository institutions are highly regulated because of the vital role that
they play in the country’s financial system. Demand deposit accounts are the principal means that
individuals and business entities use for making payments, and government monetary policy is
implemented through the banking system.
2.3 Commercial Banks:
The dominant privately owned financial institution in the economies of most major countries is the
commercial bank. This institution offers the public both deposit and credit services, as well as a
growing list of newer and more innovative services, such as investment advice. The name commercial
implies that banks devote a substantial portion of their resources to meeting the financial needs of
business firms. In recent years, however, commercial banks have significantly expanded their offerings
of financial services to consumers and units of government. Thus, because commercial banks satisfy a
broad range of financial service needs in the economy, they are called department stores of finance.
Commercial banks are the principal means of making payments through the checking accounts
(demand deposits) they offer.
Banks are important because of their ability to create money from excess reserves made available from
the public’s deposits. The banking system creates money simply by extending credit (i.e. making loans
and purchasing securities). Banks are also the principal channel for government monetary policy. Most
countries carry out policies to affect interest rates and the availability of credit mainly through altering
the level and growth of reserves held by banks and other depository institutions.
Commercial banks are owned by private investors, called stockholders, or by companies called bank
holding companies. The vast majority of commercial banks are owned by bank holding companies. A
bank holding company is a corporation that exists only to hold shares in one or more banks. The
company may also hold stock in certain non-bank business ventures.
Importance of Commercial Banks
 They are principal means of making payments through the checking accounts (demand
deposits) they offer
 Are able to create money from excess reserves made available from the public’s deposits
 Receive (deposit) excess cash of savers and provide loans and make investments; thus,
generate a multiple amount of credit
 Most important source of consumer credit
 One of the major sources of loans to small and medium sized businesses
 Principal purchasers of debt securities issued by state, local, and federal government
 Major buyers of government treasury bills
 Play a dominant role in the money and capital markets
Commercial banks play an important role in the country’s money supply. These services can be
broadly classified as follows: (1) individual banking; (2) institutional banking; and (3) global banking.
Of course, different banks are more active in certain of these activities than others.
Individual banking encompasses consumer lending, residential mortgage lending, consumer
installment loans, credit card financing, automobile and boat financing, brokerage services, student
loans, and individual oriented financial investment services such as personal trust and investment

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services. Interest income and fee income are generated from mortgage lending and credit card
financing.
Loans to nonfinancial corporations, financial corporations (such as life insurance companies), and
government entities fall into the category of institutional banking. Also included in this category are
commercial real estate financing and leasing.
It is in the area of global banking that banks began to compete head to- head with investment banking
(or securities) firms. Global banking covers a broad range of activities involving corporate financing
and capital market and foreign-exchange products and services.
Corporate financing involves two components. First is the procuring of funds for a bank’s customers.
This can go beyond traditional bank loans to involve the underwriting of securities. In assisting
customers in obtaining funds, banks also provide bankers acceptances, letters of credit, and other types
of guarantees for their customers. That is, if a customer has borrowed funds backed by a letter of credit
or other guarantee, its lenders can look to the customer’s bank to fulfil the obligation. The second area
of corporate financing involves advice on such matters as strategies for obtaining funds, corporate
restructuring, divestitures, and acquisitions.
2.3.1. Portfolio Characteristics Commercial Banks
1. Assets
Commercial banks are the financial department stores of the financial system. They offer a wider array
of financial services than any other form of institution, meeting the credit, payments, and savings needs
of individuals, businesses, and governments. This characteristic of financial diversity is reflected in its
uses of funds and sources of funds. Here, we will discuss the uses of funds first and in what
immediately follows the sources of funds.
a. Cash and Due from Banks (Primary Reserves)
All commercial banks hold a substantial part of their assets in primary reserves, consisting of cash and
deposits due from other banks. These reserves are the banker’s first line of defense against withdrawals
by depositors, customer demand for loans, and immediate cash needs to cover expenses. Banks
generally hold no more in cash than is absolutely required to meet short-run contingencies since the
yield on cash assets is nonexistent. Primary reserves also include reserves held behind deposits as
required by the Federal Reserve System.
b. Security Holdings and Secondary Reserves
Commercial banks hold securities acquired in the open market as a long-term investment and also as
a secondary reserve to help meet short-run cash needs. For many banks, municipal securities (bonds
and notes issued by state, city and other local governments) represent the largest portion of security
investments. In addition to municipal securities, investment in treasury obligations (including bills,
notes and bonds) are also assets of banks. Commercial banks also hold small amounts of corporate
bonds and notes, though they generally prefer to make direct loans to businesses as opposed to
purchasing their securities in the open market. Under existing regulations, commercial banks are
forbidden to purchase corporate stock. However, banks do hold small amounts of corporate stock as
collateral for loans.
c. Loans
The principal business of commercial banks is to make loans to qualified borrowers. Loans are among
the highest-yielding assets a bank can add to its portfolio, and they provide the largest portion of

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operating revenue. Banks make loans of reserves to other banks through the federal funds market and
to securities dealers through repurchase agreements. Far more important in dollar volume, however,
are direct loans to both businesses and individuals. These loans arise from negotiation between the
bank and its customer and result in a written agreement designed to meet the specific credit needs of
the customer and the requirements of the bank for adequate security and income. Commercial banks
make loans to nonfinancial corporations, financial corporations (such as life insurance companies), and
government entities. Banks also make consumer loans, residential mortgage loans, consumer
installment loans, credit card financing, automobile and boat financing, student loans, etc.
2. Bank Funding
So far we have focused on the uses of funds. Now let’s take a look at how a bank raises funds. The
sources of funds for banks include: (1) deposits; (2) non deposit borrowing; and (3) common stock and
retained earnings. Banks are highly leveraged financial institutions, which mean that most of their
funds come from borrowing (sources 1&2 above). The bulk of commercial bank funds (80 percent or
more) come from deposits. Equity capital (or net worth) supplied by a bank’s stockholders provides
only a minor portion (about 6 percent, on average) of total funds for most banks today.
i. Deposits
There are several types of deposit accounts. Some of these include:
a. Demand deposits, also called checking accounts, are the principal means of making payments
because they are safer than cash and widely accepted. Demand deposits pay no interest and can
be withdrawn upon demand.
b. Savings deposits pay interest, typically below market interest rates, do not have a specific
maturity, and usually can be withdrawn up on demand.
c. Time deposits, also called certificates of deposit, have a fixed maturity date and offer the
highest interest rates a bank can pay.
In addition to the above three main deposit accounts new forms of checkable (demand) deposits have
also appeared, combining the essential features of both demand and savings accounts. These
transaction accounts include negotiable orders of withdrawal (NOW) and automatic transfer services
(ATS). NOW accounts may be drafted to pay bills but also earn interest, while ATS is a preauthorized
payments service in which the bank transfers funds from an interest- bearing savings account to a
checking account as necessary to cover checks written by the customer.
• Revenues
 Interest and fees on loans
 Interest and dividends on securities held (for instance, interests on bonds held and dividends
on stocks held as a collateral)
 Earnings from trust (fiduciary) activities
 Service charges on checking accounts
• Expenses
 Interest on deposits
 Salaries and wages
 Interest cost on non-deposit sources of funds

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 ii. Non-deposit borrowing.
Non-deposit borrowing includes borrowing reserves in the federal funds market, borrowing from the
Federal Reserve Bank, and borrowing by the issuance of instruments in the money and bond markets.
Let’s see them one by one.
1. Reserve requirements and borrowing in the federal funds Market.
A bank cannot invest Br.1 for every Br.1 it obtains in deposit. All banks must maintain a specified
percentage of their deposits in a non-interest bearing account at the federal reserve bank or as cash in
the bank’s vault ( that is, currency on hand ). As a practical matter, banks hold most of their reserves in
the form of deposits with the Federal Reserve Banks. Vault cash holdings are kept to a minimum
because insurance rates increase significantly when large amounts of vault cash are held on bank
premises and no interest is earned on these cash holdings.
Each bank’s legal reserves may be divided into two categories -required reserves and excess reserves.
Required reserves are equal to the legal reserve requirement ratio times the volume of deposits subject
to reserve requirements. Excess reserves equal the difference between the total legal reserves actually
held by a bank (actual reserves) and the amount of its required reserves. For example, if a bank holds
Br.20 million in transaction accounts and Br.30 million in short-term time deposits and the law
requires it to hold 3 percent of its transaction accounts and 3 percent of its short term time deposits in
legal reserves, the required reserve for this bank is Br.1.5 million (or Br.20 million x3% + Br. 30
millionx3% ). If this bank has actual reserves of Br. 400,000 in cash on the premises and Br.1.6 million
on deposit with the Federal Reserve bank, this bank clearly holds Br. 500,000 in excess reserves (i.e.
Br. 400,000+Br.1.6 million – 1.5 million= Br 500,000).

Because reserves are placed in non-interest bearing accounts, there is an opportunity cost associated
with excess reserves. At the same time, there are penalties imposed on banks that do not satisfy the
reserve requirements. Thus, banks have an incentive to manage their reserves so as to satisfy reserve
requirements as precisely as possible. Banks temporarily short of their required reserves can borrow
reserves from banks that have excess reserves. The market where banks can borrow or lend reserves
(federal funds) is called the federal funds market.
2. Borrowing from the Federal Reserve Bank.
The Federal Reserve Bank is the banker’s bank –or to put it another way, the bank of last resort. Banks
temporarily short of funds can borrow from the Federal Reserve Bank (Fed). Collateral is necessary to
borrow and the Fed establishes (and periodically changes) the type of collateral that is eligible.
iii. Other non-deposit borrowing
Bank borrowing in the federal funds market and from Fed is short term. Other non-deposit borrowing
can also be short term in the form of issuing obligations in the money market. This includes security
repurchase agreements or repo market (where securities are sold temporarily by a bank and then
bought back later). Other non-deposit borrowing also includes issuance of securities (intermediate to
long term) in the bond market.
iv. Equity capital
Banks can raise funds by issuing common stock. They can also use their retained profits. However,
banks highly rely on borrowings rather than equity capital.

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Commercial banks do have a vital role in the financial system of a country and hence they are highly
regulated and supervised. The regulations cover the following areas.
1) Ceilings imposed on the interest rates that can be paid on deposit accounts.
2) Geographical restrictions on branch banking
3) Permissible activities for commercial banks.
4) Capital requirements for commercial banks.
2.4. Non-Bank Thrift Institutions
For many years, financial experts did not consider the liabilities of non-bank financial institutions as
really close substitutions for bank deposits. The non-bank thrift institutions are depository institutions
that accept deposits from the public as commercial banks do. The common non-bank thrift institutions
comprise savings and loan associations, savings banks, credit unions, and money market mutual funds.
Nowadays, it is recognized that these institutions play a vital role in the flow of money and credit
within the financial system and are particularly important in selected markets, such as the mortgage
market, and in the market for personal savings. This new awareness of the critical importance of non-
bank financial institutions in the economy and financial system stems from a number of sources:
The rapid growth of selected non-bank financial intermediaries in recent years. The increasing
penetration of traditional financial service markets by non-bank institutions. The thrift institutions
started to provide competitive services like banks do. Governments started to authorize savings and
loan associations to provide services provided by commercial banks. Greatly expanded the powers of
non -bank thrifts to loans comparable to many forms of bank credit.
Non-bank financial institutions are becoming increasingly like commercial banks and competing for
many of the same customers. Moreover, banks themselves are offering many of the services
traditionally offered by non-bank financial firms, such as security brokerage and insurance services.
This is why financial analysts today stress the importance of studying the whole financial institutions
sector in order to understand how the financial system works.
4.4.1. Types of Non-Bank Thrift Institutions
The well-known non-bank thrift institutions are four. This are:
 Savings & Loan Associations (S & Ls),
 Savings Banks,
 Credit Unions, and
 Money Market Mutual Funds
The sections that follow discuss in detail the growth, organization, and portfolio characteristics of each
of the aforementioned non-bank thrifts.
1. Credit Unions
Growth of Credit Unions
The characteristics & operations of credit unions have been neglected. Recently, however, there has
been a strong revival of interest in researching credit union behavior and growth.
Reasons
Credit unions are rapidly growing as financial intermediary
Their assets have more than doubled in few years
They are becoming significant institutional supplier of consumer installment credit.

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Credit unions
Are institutions, exclusively household oriented intermediaries
Offer deposit plans & credit resources only to individual & families.
provide low loan rates and high deposit interest rates to individual and families
They are really cooperatives, self-help associations of individuals, rather than profit motivated
financial institutions.
Savings deposits and loans are offered only to members of each association, and the members are
technically the owners, receiving dividends and sharing in any losses that occur. Credit unions had
begun providing financial services early in the 20th century to serve low income individual and
families by providing inexpensive credit and an outlet for their savings. Later, these institutions
broadened their appeal to middle income individuals by offering many new financial services and
engaging in aggressive advertising campaigns. For both savings deposits and consumer installment
loans, the credit union has become an aggressive competitor of commercial banks and savings
associations.
Many credit unions offer payroll savings plans where employees can conveniently set aside a portion
of their salary in a savings account. Credit unions frequently grant their borrowing members interest
refunds up to a certain percentage of the amount of the loan. Thus, credit unions often accept a smaller
spread between their loan and deposit interest rates; this is made possible because their operating costs
are usually so low.
Organization of Credit Unions
They are organized around a common affiliation or common bond among their members.
Most credit union members work for the same employer or for one of a group of related
Employers. Family members may also be eligible members of a credit union
Areas of Organization
Occupation related credit unions
Around a nonprofit association (Labor union, church, fraternal, or social organization)
Common areas of residence – such as Kebele, towns, etc.
2. Savings and Loan Associations
They are similar to credit unions because they extend financial services to households. They differ
from credit unions, however, in their heavy emphasis on long-term rather than short-term lending.
They are major sources of mortgage loans to finance purchase of homes by households.
Growth of S & L Associations
The first S & Ls were started early in the 19th C as building and loan associations. Money was
solicited from individuals and families so that certain members of the group could finance the building
of new homes. The same individuals and families who provide the funds were also borrowers from the
association. Today, however, savers and borrowers are frequently different individuals. Apart from
only providing a single product (i.e., lending funds to home buyers), more recently, competition from
commercial banks & credit unions have forced the S& Ls associations to diversify their operations.
Chartering & Regulation
Currently, S & Ls receive their charters from the states (regions) or from the federal government.
Authorities supervise their activities & regularly examine their books. Most S & Ls are mutual and,
therefore, have no stockholders. Technically, they are owned by their depositors

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However, a growing number of S & Ls associations are converting to stock form Stockholder-owned S
& Ls can issue capital stock to increase their net worth. Such forms are much larger in size than the
mutual associations.
3. Money Market Mutual Funds
Money Market Mutual Funds are also among the non-bank thrift institutions that appeared most
recently as compared to credit unions, S & Ls, and saving banks. The first money market mutual fund
– A financial intermediary pooling the savings of thousands of individuals and businesses and
investing those moneys in short terms high quality money market instruments – opened for businesses
in the U.S. in the year 1972. Taking advantage of the fact that interest rate on the most deposit offered
by commercial and saving banks were then restrained by federal ceilings, the money market mutual
fund offered share accounts whose yield reflected prevailing interest rate in the nation’s money market.
Thus, the money market mutual funds represent the classic case of profit seeking entrepreneurs finding
a loophole around ill-conceived government regulations. By now, there is no such interest rate ceiling
limit on deposited funds in the U.S. financial system.
In Ethiopia there is a government fixed ceiling on interest rate paid on deposits by all banks which is a
maximum of 5 % per year on deposits. However, the loan rate is competitive; there is no restriction on
the number of compounding; and there no as such minimum rate to be paid on deposits. Ideally, the
minimum rate for deposit could fall even to zero but cannot exceed the maximum ceiling set. To
conclude, in light of the discussions made from the U.S. perspective, it is important to further explore
the role of the existing non-bank thrifts in the financial system of Ethiopia.
Summary of Types of Depository Financial Institutions
Type Ownership Primary Mission
Commercial bank Corporations; owned by investors Lend to businesses
Savings and loan (S&L) Either corporations or owned by Offer savings accounts for individuals
depositors and make loans for home ownership
Mutual savings bank Owned by depositors Lend to the local community
Credit union Non-profit; owned by depositors Lend and provide other financial
services to members
Non-Depository Institutions
Non-Depository Institutions: include contractual institutions (like insurance companies and pension
funds) and investment institutions (like investment companies or mutual funds and real estate
investment trusts). Contractual institutions attract funds by offering legal contracts to protect the savers
against risk. Investment companies sell shares to individuals and use these funds to invest in a pool of
assets. These assets may be stocks, bonds, or some other investment. Investment companies that buy
and sell shares in the pool at any time the customer wishes are referred to as open-end investment
companies, which are also referred to as mutual funds. Investment companies that sell only a specific
number of shares in the pool are referred to as closed-end investment companies. Pools invested in
short term assets are referred to as money market funds. Pools invested in real estate investments are
referred to as real estate investment trusts.

Non-depository financial institutions (insurance companies, pension funds, mutual funds, finance
companies and investment banks) do not accept deposits. They raise funds by offering legal contracts,
selling shares to the public, borrowing in the money market and issuing long-term debt. This section
provides a general idea of each non-depository institution

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 A. Insurance Companies
Insurance companies provide insurance policies, which are legally binding contracts for which the
policy holder (or owner) pays insurance premiums. According to the insurance contract, insurance
companies promise to pay specific sums contingent on the occurrence of future events, such as death
or an automobile accident. Thus, insurance companies are risk bearers. Insurance companies can be
divided in to two life insurance and property and casualty insurance.

Life insurance companies today insure policy holders against three basic kinds of risk: premature
death, the danger of living too long and outlasting one’s accumulated assets, and serious illness or
accident. Life insurance companies invest the bulk of their funds in long-term securities-bonds,
stocks, and mortgages, thus helping to fund real capital investment by businesses and government.

In case of a property and casualty insurance, the policy involves the payment of periodic fee or
premium to the company in exchange for a promise to pay the insured if a damage to various types of
property that is being insured against occurs. The importance of insurance companies in the financial
system is based more on their ability to accumulate funds for investment than on their stated business
of providing insurance. They hold large amount of securities, and are a major source of business
financing.

B. Pension Funds
Pension funds are established to provide income to retired persons in the economy. The fund is raised
through the contribution of employees who are supposed to be the beneficiaries up on retirement. The
employers also contribute to this fund to undertake their social obligation and to ensure the welfare of
their ex-employees. Those funds are then invested in different securities.
The major roles of pension fund are:
2. It provides sustaining security to the society
3. It helps in maintaining consumer market
4. It becomes the source of finance for government-based investments.
5. It serves the role of national economy stabilization by investing on government bonds.
There are two basic and widely used types of pension plans: defined benefit plans and defined
contribution plans. In a defined benefit plan, the plan sponsor agrees to make specified dollar payments
annually to qualifying employees beginning at retirement (and some payments to beneficiaries in case
of death before retirement).These payments typically occur monthly. The pension obligations are
effectively a debt obligation of the plan sponsor. The plan sponsor, thereby, assumes the risk of having
insufficient funds in the plan to satisfy the regular contractual payments that must be made to retired
employees.

In a defined contribution plan, however, the plan sponsor is responsible only for making specified
contributions into the plan on behalf of qualifying participants, not specified payments to the employee
after retirement. The amount contributed is typically either a percentage of the employee’s salary and
/or a percentage of the employer’s profits. The plan sponsor does not guarantee any specific amount at
retirement. The payments that will be made to qualifying participants upon retirement depend on the
investment performance of the funds in which the assets are invested and are not guaranteed by the
plan sponsor.
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 C. Mutual Funds

Mutual funds (one type of investment companies) are financial intermediaries that sell shares to the
public and invest the proceeds in a diversified portfolio of securities. Mutual funds are a kind of
financial institution that combine the money of its shareholders and invest those funds in a wide variety
of stocks, bonds, and so-called money market instruments. These companies are especially attractive to
the small investor, to whom they offer continuous management services for a large and highly varied
security portfolio. By purchasing shares offered by an investment company, the small saver gains
greater price stability and reduced risk, opportunities for capital gains, and indirect access to higher
yielding securities that can only be purchased in large blocks.

The distinct feature of mutual funds is that persons owning shares in the fund have a right to sell them
back to the fund at their current asset value whenever they wish to do so. The fund is obligated to
redeem the shares it issues, and mutual shares are not traded in secondary markets. The importance of
these institutions in the financial system is that they provide an easy way for individuals to invest in a
diversified portfolio of financial assets. Thus, mutual funds provide the investor with professional
management of funds and diversification of investment risk.

D. Finance Companies
Finance companies are financial intermediaries the function of which is to make loans to both
individuals and business. Finance companies provide such services as consumer lending, business
lending, and mortgage financing. Unlike banks, finance companies do not accept deposits; instead,
they rely on short-and long-term debt for funding. Finance companies charge higher rates for consumer
loans than banks.

The higher rate that finance companies generally charge for consumer loans is due to the fact that they
generally attract riskier customers than commercial banks. In fact, customers that seek individual (or
business) loans from finance companies are often those who have been refused loans at banks or
thrifts.

E. Investment Banks
Investment banking involves the raising of debt and equity securities for corporations or governments.
This includes the origination, underwriting, and distribution of issues of new securities. Investment
banking also includes corporate finance activities such as advising on mergers and acquisitions, as well
as advising on the restructuring of existing corporations.

The major source of fund for investment banks is the repurchase agreement (securities sold under
agreement to repurchase). The other major source of fund is securities sold short for future delivery.

Equity capital of investment banks is generally lower than that of commercial banks. One reason for
their lower equity capital levels is that investment bank balance sheets contain mostly tradable (liquid)
securities compared to the relatively illiquid loans that represent a significant portion of banks’ asset
portfolios. When we consider the asset side of the balance sheet, the major assets of investment banks
consists of long positions in securities and reverse repurchase agreements-securities purchased under
agreements to resell.
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 F. Trust Companies
A trust company is corporation formed to act as a trustee according to the terms of a contract (referred
to as a trust agreement). A trustee is a person or a business that has the responsibility of overseeing the
management of funds, making sure that they are managed in a way that is in the best interests of the
beneficiaries (the persons for whose benefit the trust is established). Though many banks have their
own trust departments to serve this function, independent trust companies exist to accept and manage
funds according to a trust agreement.
Management Decision of Financial Institution and Risks in Financial Institution
The management of a financial institution is called upon daily to make portfolio decisions; that is:
 What financial assets to buy or sell
 What the institutions sources and uses of funds should be
A number of factors affect these critical decisions concerning the portfolios of financial institutions
include:
A. The relative rate of return and risk attached to different financial assets
 Affects composition of the institution’s portfolio
 Management is interested in maximizing profits and that has minimal aversion to risk, pursue
highest yielding financial assets available especially corporate bonds and stock
 A more risk-avert institution is likely to surrender some yield in return for the greater safety
available in acquiring government bonds and high-quality money market instruments.
B. The cost, volatility, and maturity of incoming funds provided by surplus-budget units
 It has significant impact upon the financial assets acquired by a financial institution.
 Commercial banks derive a substantial proportion of their funds from checking accounts, which are
relatively inexpensive but highly volatile
 Concentrate lending activities in short and medium term loans, to avoid expensive shortage of cash
 Pension funds, which receive a stable and predictable inflow of savings, is largely freed from
concern over short-run liquidity needs
 Invest heavily in long-term financial assets
 Hedging principle – the approximate matching of the maturity of financial assets held with
liabilities is an important guide for choosing the financial assets to be held.
C. Size of the individual financial institution
 Larger institutions can take advantage of greater diversification in sources and uses of funds
 They can contact a broader range of savers and achieve greater stability in its incoming flows
of funds
 Through economies of scale (size), larger financial institutions can often sell financial services
to both ultimate borrowers and ultimate lenders at lower cost
D. External forces – regulations & competition
 Play major role in shaping both the sources & uses of funds
 Financial institutions are highly regulated because:
 They hold the bulk of the public’s savings
 They are crucial to economic growth and investment activity
 Commercial banks are prohibited from investing in corporate stock or in speculative debt securities

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 Insurance companies must restrict any security purchases (investment) to those a “prudent man”
would most likely choose. Such regulations, in theory, are designed to promote competition and
ensure the safety of the public’s funds

2.5 Risks in Financial Industry

In financial institutions there are enormous risks that they have to consider. Some of the risks are:
liquidity, interest rate, foreign exchange rate, security price, Damage to Company Reputation,
Cybercrime (as One of The Major Financial Institutions Risks), Economic Slowdown,
Regulatory/Legislative Changes, Increasing Competition, Failure to Innovate, Disruptive
Technologies, Failure to Attract/Retain Talent. etc.
Exchange rate risk is clearly important when we are discussing the movement of capital from one
country to another. This is the risk that the value of the currency of the country to which capital is
being exported will fall, resulting in a capital loss when the owner of the capital later converts the
funds back into his own currency. It follows that interest rates in countries with currencies thought
likely to lose value over time include an exchange risk premium.

In addition to facing exchange rate risk, an investor may well fear default risk much more in a foreign
country than in his own economy. This may simply reflect a lack of information about the degree of
risk in foreign countries. On the other hand, default risk may objectively be much higher in developing
countries that are constantly short of foreign currency and have a history of unstable governments.
Firms find it harder to plan under such circumstances and may have to deal with frequent changes in
regulations and taxes as well as rates of exchange.

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