CHAPTER –TWO

Financial Institutions and

operations
 Chapter outline
 Introduction
 Role of Financial Institutions
 Functions of Financial Institutions
 Types of financial institutions
 Central banks and Its role
 Deposit taking institutions
 Non deposit taking institutions
 Risk management and financial institutions
Introduction

 Financial system is composed of Financial

institutions, Financial markets, Financial
Instruments and Financial services.
 The first constituents of the financial system
comprises of financial institutions or financial
intermediaries.
 They act as a link between the savers and the
investors which results in institutionalization of
personal savings.
 Introduction
 The term financial institutions and financial
intermediaries are often used interchangeably.
 The financial institutions or intermediaries are
engaged in the business of channeling money from
savers to borrowers.
 This channeling process, which is known as financial
intermediation, is crucial to a well functioning of
modern economy
Roles of financial institutions
 Mobilize savings in a financial form by offering instruments
with attractive yields and appropriate maturities that people
want to acquire.
 It can increase the efficiency of investment by screening
project proposals and by monitoring the behaviour of
borrowers and issuers of equity.
 Provision of finance for medium or long term projects
 Promotion of investment of public and private capital for
development the projects in line with the national
development objectives
Roles of financial institutions
 Provision of technical assistance to help prepare,
finance and carryout development projects and
programmes
 It can provide ways of pooling and pricing risks that
enable large and high risk activities to be undertaken.
Hence it affects risk sharing between households
and firms.
 It also reduces the transaction costs of market
economy by providing a convenient and cheap
medium of exchange-making it easier for both
buyers and sellers to engage in business.
Roles of financial institutions
 Financial services allow the poor to convert flows of savings
overtime into lump sums that can be used not only for
investment to generate income but also to reduce
vulnerability to shocks, cover lifecycle needs and acquire
useful consumer durables.
 Promotion of national saving
 Promotion of capital investment and others.
 In general they provide both financial and non financial
services like appraisal, implementation, monitoring of
projects and training entrepreneurs and the like.
 Functions of Financial Institutions

 Within the main functions of channeling funds from

savers to borrowers, financial institutions perform
five important functions.
1. Pooling the savings of individuals
2. Providing safekeeping and payments system
3. Providing liquidity
4. Reducing risk by diversifying
5. Collecting , processing and providing information
 Functions of Financial Institutions
1. Pooling the savings of individuals
 Small savers may not have enough money
individually to make large loans or buy bonds, but
through the bank they can indirectly invest in loans,
bonds, and other assets and earn better rates of
interest than they could on their own.
2. Providing safekeeping and payments system
 Financial institutions (e.g. banks) are safe places to
deposit money and other valuables and facilitate the
transfer and payment of money.
Functions of Financial Institutions
3. Providing liquidity
 Liquidity refers to the ability of the financial assets
to be converted in to cash.
 Therefore, financial institutions facilitate liquidity.
4. Reducing risk by diversifying
 When financial institutions pool the savings of
individuals, they invest them in a wide variety of
loans, bonds, and other assets.
 Functions of Financial Institutions
5. Collecting , processing and providing information
 Financial institutions have a much easier time than individuals
do when it comes to screening out bad credit risks and
monitoring loans for complains.
 This is because financial institutions have a wealth of
information about current and past applicants, as well as
standardized procedures for evaluating creditworthiness.
 In the subsequent sections we will discuss the types of financial
institutions.
Types of Financial Institutions

Financial institutions can be classified in different ways . For

Instance they can be classified as:

1. Central banks
2. Depository Institutions
3. Non-depository Institutions
1. Central Banks
 Nature of Central Banks:
 A central bank, reserve bank, or monetary authority is a
banking institution granted with the exclusive privilege to
lend a government its currency.
 A central bank is the apex bank in a country. It is called by
different names in different countries:
 The bank of England
 Reserve bank of India,
 The Federal Reserve System in America
 The Bank of France in France
 National Bank of Ethiopia in Ethiopia
 State Bank of Pakistan
Functions of Central Bank

1. Regulator of currency
2. Banker, Fiscal Agent and Advisor to the Government
3. Custodian of Cash reserve of Commercial Banks
4. Custody and Management of Foreign Exchange
Reserves
5. Lender of Last resort
6. Clearing House for transfer and settlement
7. Controller of Credit
1. Regulator of currency
 It is the bank of issue. It has monopoly power to
issue currency notes (legal tender money)
 This monopoly of issuing notes has the following
benefits:
 Uniformity in the notes issued which helps in facilitating
exchange and trade.
 Enhances stability in the monetary system and creates
confidence among the public
 The central bank can restrict or expand the supply of cash
according to the requirement of the economy
 2.Banker, Fiscal Agent and Advisor to the
Government

 As banker to the government the central bank:

 keeps the deposits of the government and makes payment
on behalf of the government (state and/or central)
 It buys and sells foreign currency on behalf of the
government
 It keeps the stock of gold of the government
 Thus, it is the custodian of government money and wealth.
2. Banker, Fiscal Agent and Advisor to the
Gov’t ….Cont’d

 As fiscal agent of the gov’t, Central bank:

 Makes short term loans to the gov’t
 It floats loans, pays interest on them, and finally
repays them on behalf of the gov’t
 Thus, it manages the entire public debt
2. Central Bank as Banker, Fiscal Agent and
Advisor to the Gov’t ….Cont’d

 As Advisor of the gov’t the central bank

 Advises the gov’t on such issues as
 economic and monetary matters as controlling inflation or
deflation,
 devaluation or revaluation of the currency,
 Deficit financing
 Balance of payment etc
 3. Custodian of Cash Reserve
Requirement of Comm. Banks
 Commercial banks are required to keep reserve
equal to a certain percentage of deposits with the
Central bank.
 It is on the basis of these reserves that central bank
transfers funds from one bank to another to
facilitate clearing of checks.
 The central bank acts as the custodian of the cash
reserve requirement of commercial banks and helps
in facilitating their transactions.
4.Custody and Mgt of Foreign
Exchange
 It keeps and manages the foreign exchange reserve of the
country
 It sells gold at fixed price to the monetary authority of other
countries
 It buys and sells foreign currencies at international prices
 It fixes the exchange rates within narrow limits in keeping its
obligation as a member of IMF
 It manages exchange control operations by supplying foreign
currencies to importers and persons visiting foreign countries
on business, studies, etc in keeping with the rules laid down
by the gov’t
5.Central Bank
Lender of Last resort

 As lender of last resort, the central bank grants

accommodations in the form of re-discounts and
collateral advances to commercial banks, bill
brokers, dealers, or other financial institutions
 This facilities help such institutions in order to help
them in times of stress so as to save financial
structure of the country from collapse.
 6. Clearing House for transfer and
settlement

 It acts as a clearing house for transfer and

settlement of mutual claims of commercial banks
7. Controller of Credit
 This is the most important function of central bank
in order to control inflation and deflation.
 It adopts quantitative and qualitative methods
 Quantitative methods aim at controlling the cost
and quantity of credit by adopting:
 Bank rate policy
 Open market operation and
 By variation in reserve ratio of commercial banks
7. Controller Of Credit…. Cont’d

 Qualitative methods control the use and direction

of credit.
 These involve:
 Selective credit control
 Direct action
7. Controller of Credit…. Cont’d

 Additional controlling functions of Central banks

include the supervising and controlling of
commercial banks:
 Issue of licences
 The regulation of branch expansion
 To see that every bank maintains the minimum paid
up capital and reserve as provided by law
 Inspection or auditing the accounts of banks
7.Controller of Credit…. Cont’d
 To approve the appointment of chairpersons and directors
of such banks in accordance with the rules and
qualifications
 To control and recommend merger of weak banks in order
to avoid their failures and to protect interest of depositors
 To recommend nationalization or privatization of certain
banks to the government in public interest
 To publish periodical reports relating to different aspects
of monetary and economic policies
Central Bank and objectives of Credit
Control
 The credit control is the means to control the
lending policy of Commercial banks by the central
bank to achieve the following objectives
 To stabilize the internal price level
 To stabilize the rate of foreign exchange
 To protect the outflow of gold
 To control business cycles
 To meet business needs
 To have growth with stability.
Monetary Policy (MP)
 Definition of Monetary policy (MP):
 MP refers to credit control measures adopted by
central banks of a country
 MP refers to a policy employed by central bank to
control the supply of money as an instrument for
achieving the objective of general economic policy.
 MP is any conscious action undertaken by the
monetary authorities to change the quantity,
availability, or cost of money
Objectives of MP

 The following are the Principal objectives of

Monetary Policy:
 1. Price Stability
 2. Economic Growth
 3. Balance of Payment
 4. Full Employment
1. Price Stability objective of Central
Banks
 Price Stability means relative controlling of inflation
or deflation.
 Deflationary price level raises increasing
unemployment and falling level of out put and
income. It ultimately leads to depression.
 Inflation is unjust and ruins the general economic
welfare of the community.
 Hence both deflation and inflation are not good for
the economy, price stability is very much important.
Price Stability objective of Central
Banks (cont’d)

 The goal of price stabilization implies that in general

the average price level as measured by the whole
sale price index or consumers’ price index should not
be allowed to vary beyond narrow margins.
2. Economic Growth Objective
 Economic growth can be defined as the process
whereby the real per capita income of a country
increases over a long period of time.
 It is measured by the increase in the amount of
goods and services produced in a country.
2. Economic Growth Objective…
Cont’d

 How Monetary Policy contribute to Economic

Growth?
 Through:
 Management of Aggregate Demand
 Encouragement of saving and Investment
3. Balance of Payment objective

 A balance of payment deficit is defined an excess of import

over export; and outflow of foreign currency will be more
than the inflow of currency).
 In this case the monetary policy might be adjusted
to improve exports and restrict important and even
measures might be taken to the extent of adjusting
the exchange rate.
4. Full Employment Objective
 Full employment is a situation in which every body
who wants to work gets work.
 It should be noted that full employment is not an
end in itself. It is a precondition for maximum
social welfare.
 Along with the full employment of labor, other
economic resources must be used with maximum
efficiency and productivity.
Instruments of Monetary policy
 The monetary authority uses different instruments
to achieve the objectives of MP of the country. They
are divided in to two categories:
 1 Quantitative, general or indirect includes:
 Bank rate variations,

 Open market operations, and

 Changing reserve requirements.

 They are meant to regulate the overall level of credit

in the economy provided through commercial banks.
Instruments of MP…Cont’d
2. Qualitative, selective or direct mechanisms: These
include changing margin requirement, and
regulation of the direction of credit of flow).
 They aim at controlling specific types of credit.

 These controls are used to influence specific types

of credit for particular purpose.
 When there is brisk speculative activity in the
economy or in particular sector in certain
commodity, and prices are rising, the NB raises
margin loans against specified securities. The result
is that the borrowers are given less money in loans
against specific securities.
 1. Bank rate Policy
 The bank rate is the minimum lending rate of the
central bank at which it rediscounts the bill of
exchange and government securities held by
Commercial Banks (CBs).
 When there is inflation in the economy the central
bank raises the bank rate to restrict the borrowing
demand of commercial banks.
 Borrowing from the Central bank becomes costly and
commercial banks borrow less from it.
 The Commercial Banks in turn raise their lending rate to
the business communities and borrowers borrow less from
CBs.
 Thus this will lead to contraction of credit and prices are
checked from rising further
 1. Bank rate Policy

 When prices are depressed, the central bank lowers

the bank rate:
 It is cheap to borrow from national bank (NB) on the part
of the CBs.
 The latter also lower their lending rates.
 Business people are encouraged to borrow more.
 Investment is encouraged.
 Output, employment, income and demand start rising and
the downward movement of prices is checked.
2. Open Market Operation
 Open market operation refers to sale and purchase
of securities in the money market by central bank.
 With rising price (inflation), the National bank sells
securities. The reserve of Commercial banks are reduced
and they are not in a position to lend more to business
people. Further investment is discouraged and the rise in
prices is checked.
 When recessionary forces start in the economy, the
National bank buys securities. The reserves of Commercial
banks are raised. They lend more. Investment, output,
income and demand rise, and fall in price is checked.
3. Change in reserve ratio
 Every bank is required by law to keep a certain
percentage of its total deposits in the form of a
reserve fund with the central bank (NB).
 For instance, when prices are rising, the NB raises the
reserve ratio. Banks are required to keep more with the
central bank. Their reserves are reduced and they lend
less. The volume of investment, output, and employment
are adversely affected
 Types of financial institutions
 Financial institutions can be classified in many
different ways. The standard classification, however,
will be as follows:

Depository Institutions Non-Depository Institutions

Commercial Banks Insurance Companies
Savings and Loan Associations Pension Funds
Saving Banks Investment Companies
Credit Unions Investment Banking firms
2. Depository Institutions (DIs)
 Next to central banks ,the second category of
financial institutions are depository institutions.
 Depository financial institutions can be further
classified as follows: These are:
1. Commercial Banks
2. Savings and Loan Associations
3. Saving Banks
4. Credit Unions
2. Depository Institutions (DIs)
 DIs accept deposits from economic agents (liability
to them) and then lend these funds to make direct
loans or invest in securities (assets)
 Income of DIs:
 Income generated from loans
 Income generated from investment in securities, and
 Fee income
 2. Depository…
  Depository institutions, which are usually just called
banks, are categorized as such because their primary
source of funding is the deposits of savers.
 In other words, depository institutions are financial
intermediaries that accept deposits.
 These deposits are the liabilities (debts) of accepting
financial institutions.
 With the fund raised through deposits and other
funding sources, they make direct loans to various
entities and invest in securities.
 Depository …
 In U.S.A., the Federal Deposit Insurance Corporation
(FDCI) insures the savings accounts of such institutions
up to a certain limit.
 Depository institutions are further subcategorized
depending on the market they serve, their primary
source of funding, type of ownership, how they are
regulated and the geographic extent of their market.
 Thus, depository institution includes commercial
banks, saving and loan associations, saving banks and
credit union.
 Depository …
 Depository institutions are highly regulated because of
the important role that they play in the financial
system.
 Because of their important role, they are affording
special privileges such as:
 access to federal deposit insurance, and
 access to a government entity that provides funds
for liquidity of emergency needs.
Constituents of DIs
 DIs include:
 Commercial Banks
 Saving and loan associations
 Saving Banks
 Credit unions
Asset/ Liability Problems of DIs
 Spread Income (margined Income)=
 Income from loan and Investment Less cost of its
funds (deposit and other sources)
Asset/ Liability Problems of DIs
(Cont’d)
 DIs face the following risks:
 Credit (Default) risk
 Regulatory risk
 interest rate risk)
Risks of DI
 Credit risk (Default risk) refers to the risk that a borrower
will default on a loan obligation or that the issuer of the
security that the DIs holds will default
 Regulatory risk is the risk that regulators will change the
rules and affect the earnings of the institutions
unfavourably
 Interest rate risk is the risk that the interest rate
movement may move in such a manner that profits will be
adversely affected
Example of funding risk
 Suppose a DI raise $100 million by issuing a
deposit account with a 1 year maturity and
agreeing to pay interest rate of 7%. Ignoring the
reserve requirement, let’s assume that the DI can
invest the entire amount, in a government security
at 9% interest rate for 15 years
 Thus spread for the first year = 2%
Example (cont’d)
 Spread for the remaining 14 years depends on the
future interest rate that DI pays for its new
depositors in order to raise the $100 million:
 If interest rate increases, spread declines
 If interest rate decreases, spread increases
 If the DI must pay more than 9%, the spread will be
negative.
 DI benefit from decline in interest rate but suffers
from increases
Example (cont’d)
 Suppose the DI could borrow funds for 15 years at
7% and invest it in a government security maturing
in 1 year earning 9%:
 Spread income for Year 1= 2%.
 Note that the deposit interest rate is fixed in this
case, while the investment in gov’t securities could
vary.
 Spread after the first year:
 If interest rate on investment increases, DI benefit
 If interest rate on investment declines, spread reduces
Example (cont’d)
 Justification:
 A rise in interest rate benefits the DI b/s it can
reinvest the proceeds from the maturing 1-year
government security offering a higher interest rate.
 A. Commercial Banks
 Com. Banks are those FIs which accept deposit
from the public repayable on demand and lend
them for short periods
 Bank Services

 Commercial banks provide numerous services in the

financial system.
 The services can be broadly classified as:
1. Individual banking;
2. Institutional banking; and
3. Global banking.
 1. Individual banking:
 It encompasses consumer lending, residential
mortgage lending, consumer installment loans,
credit card financing, student loan & individual
oriented financial investment service.
 They generate income:
 Interestfrom loans
 Fee income from credit card financing
 2. Institutional banking:
 loans to non-financial corporations & financial
corporations (like insurance companies), government,
leasing companies etc.
They generate:
 Interest from loan to corporation & leasing
 Fees from management of private assets pension
funds, custodial services.
 3. Global banking:
 It concerns a broad range of activities involving
corporate financing & capital market & foreign
exchange products & services.
 Most global banking generates fee income rather than
interest income.
 Bank Balance Sheet
1. Bank Assets
 Assets earn revenue for the bank and includes cash,
securities, loans, and property and equipment that
allows it to operate.
A. Cash
 One of the major services of a bank is to supply cash on
demand, whether it is a depositor withdrawing money
or writing a check or a bank customer drawing a credit.
 Hence, a bank must maintain a certain level of cash
compared to its liabilities to maintain solvency.
 Bank Balance Sheet
B. Securities
 The primary securities that banks own are
Treasury Bills and Government Bonds.
 These securities can be sold quickly in the

secondary market when a bank needs more cash.

 Therefore, they are often referred to as

secondary reserves.
 Bank Balance Sheet
C. Loans
 Loans are the major assets for most banks. They
earn more interest than banks have to pay on
deposits, and, thus, are a major source of revenue
for a bank.
 Loans include the following major types:

 Business loans, usually called commercial and industrial

loans.
 Real estate loans, e.g., residential mortgages
 Consumer loans, e.g., credit cards
 Inter-bank loans, i.e., the loan given to other banks.
 Bank Balance Sheet
2. Bank Liabilities
 Liabilities are either the deposits of customers or
money that banks borrow from other sources to
use to fund assets that earn revenue.
A.  Checkable/Demand deposits

 Checkable or demand deposits are deposits where

depositors can withdraw the money at will.

 Most checkable or demand accounts pay very

little interest or no interest.

 Bank Balance Sheet
B. Saving and Time deposits
  Since saving accounts are not used as a payment
system, banks are forced to pay more interest for it.
 Saving deposits are mostly passbook saving accounts,
where all transactions were recorded in a passbook.
C. Certificate of Deposit (CD)
  CD is a deposit where the depositor agrees to keep
the money in the account until the certificate of
deposit expires.
 The bank compensates the depositor with a higher
interest rate.
 Bank Balance Sheet
D. Borrowing
I. Banks usually borrow money from other banks in
what is called the central/federal funds market.
II. Banks also borrow funds from non-depository
institutions, such as insurance companies, pension
fund.
However, most of these loans are collateralized in the
form of repurchase agreement, where the bank gives
the lender securities, usually Treasury bills, as
collateral for a short-term loan.
 Bank Balance Sheet
III. As a last resort, banks can also borrow funds from
the central bank.
But since borrowing from the central bank shows
that banks are under financial stress and unable to
get funding elsewhere, they do this rarely.
 Bank Balance Sheet
3. Bank Capital
  Banks can also get more funds either from the bank’s
owners if it is a corporation or by issuing more stocks.
Functions of Commercial Banks
1. Primary Functions (Accepting deposits and lending
money)
2. Secondary Functions (agency services and general
utility service)
Primary Functions of Comm. Banks

1. Accepting deposits
 Current or demand deposits
 Saving deposits
 Fixed or time deposits
2. Lending Money
 Overdrafts
 Cash credit
 Loans and Advances
 Discounting of bill of Exchange
Secondary Services of Comm. Banks

1. Agency services: as an agent banker renders the

following services
 Collection of cheques, drafts, and bill for their
customers
 The collection of standing orders, e.g., payment of
commercial bills, collection of dividend warrants
and interest coupons, payment of insurance
premiums, rents, etc
Secondary Functions:
Agency service (Cont’d)
 Conduct of stock exchange transaction such as
purchase and sale of securities for the customers,
 Acting as executor and trustee,
 Providing income tax services,
 Conduct of foreign exchange business
Secondary Functions :
General Utility service
 Safe keeping of valuables
 Issue of Commercial letters of credit and travellers’
cheque,
 Collecting trade information from foreign
countries for their customers
 Arrange business tours
 etc
Regulation of Commercial Banks

 Financial Institutions provide various services:

 the provisions of a payments mechanism;
 maturity transformations;
 risk transformations;
 liquidity provisions; and
 reduction of transaction, information and search
costs.
Regulation……
 Failure to provide these services or a breakdown in
their efficient provision can be costly to both the
ultimate providers (households) and users (firms) of
funds.
 Because of the vital nature of the services they
provide, Commercial Banks (CmBs) are regulated to
protect against a disruption in the provision of these
services and the cost this would impose on the
economy and society at large.
Types of Regulations of CBs
1. Safety and soundness regulation,
2. Monetary policy regulation,
3. Credit allocation regulation,
4. Consumer protection regulation,
5. Investor protection, and
6. Entry and chartering regulation,
1. Safety and soundness regulation,

 Objective of this regulation is to protect depositors

and borrowers against the risk of commercial
banks failure. These regulation include:
Layer 1 protection: Commercial banks should
diversify their assets-
 In US banks are prohibited from making loans exceeding
10% of their own equity capital fund to any one company
or borrower (credit limit )
1. Safety and soundness regulation
(cont’d)
Layer 2 protection:
 Stockholders’ contribution (equity) to the total fund of
the banks should be adequate in such a way that it
protects liability claim holders against insolvency risk.
 The higher the proportion of capital contributed by
owners the greater the protection
1. Safety and soundness regulation
(cont’d)
Layers 3 protection: Provision of guarantee fund
(such as Bank insurance Fund in US)
Deposit insurance mitigates a rational incentive for
depositors otherwise have to withdraw their funds
at the first hint of trouble, creating banking panic
or bank run- sudden withdrawal of deposits by
depositors.
2. Monetary Policy Regulation
 In most countries, regulators commonly impose a
minimum level of required cash reserve to be held
against deposits
 (see cash reserve ratio requirements of MP
instruments)
3. Credit Allocation Regulation
 Credit allocation regulation supports the
commercial bank’s lending to socially important
sectors as housing, farming etc. For example;
 a commercial bank may be required to extend a
certain amount to a particular sector of the economy
 The regulator may set maximum interest rate, price or
fees to subsidize certain sectors
4. Consumer Protection Regulation
 This regulation is concerned about the discrimination on the
basis of age, race, sex, of income-( Banks should not
discriminate on such grounds).
 For example, the US congress passed the Home Mortgage Disclosure
Act (MHDA) in 1975 to prevent discrimination by lending institutions.
 Since 1992, CBs have had to submit reports to regulators summarizing
their lending on a geographic basis, showing the relationship between
the demographic area to which they are lending and the demographic
data (such as income and percentage of minority population) for that
location.
 CBs must now report the reason that they granted or denied credit.
5. Investor Protection Regulation
 In US a considerable laws protect investors who use
CBs directly to purchase securities and/or indirectly
to access securities markets through investing in
mutual banks or pension funds managed by CBs.
 Various laws protect investors against abuse such as
insider trading, lack of disclosure, outright , and
breach of fiduciary responsibilities.
6. Entry and Chartering Regulation
 The entry of CBs and branch expansion might be
regulated.
 Increasing or decreasing the cost of entry into a
financial sector affects the profitability of firms
already competing in that industry.
 Thus, the industries heavily protected against new
entries by high direct costs (e.g. through capital
requirements) and high indirect costs (e.g. by
restricting the type of individuals who can establish
CBs) of entry, produce larger profits for existing
firms than those in which entry is relatively is easy
 Risks faced by Commercial Banks
 A depository institution has many risks that must be
managed carefully, especially since a bank uses a large
amount of leverage.
 Without effective management of its risks, it could very
easily become insolvent.
 In addition to the previously mentioned risks faced by
depository institutions, commercial banks face the
following risks.
1. foreign exchange risk
2. sovereign risk and
3. operational risk
 Risks faced by Commercial Banks
1. foreign exchange risk
 International banks trade large amounts of currencies,
which introduces foreign exchange risk, when the
value of a currency falls with respect to another.
 A bank may hold assets denominated in a foreign
currency while holding liabilities in their own currency.
 If the exchange rate of the foreign currency falls, then
both the interest payments and the principal
repayment will be worthless than when the loan was
given, which reduces a bank’s profits.
 Risks faced by Commercial Banks
 Banks can reduce this risk by hedging the risk with
forward contract, future contract or swaps which will
guarantee an exchange rate at some future date.
2. Sovereign risk:

 Many foreign loans are paid in U.S. dollars and repaid

with dollars.
 Some of these foreign loans are made to countries with
unstable governments.
 If political problems arise in the country that threatens
investments, investors will pull their money out to
prevent losses arising from sovereign risk.
 Risks faced by Commercial Banks

 In this case, the local currency declines rapidly

compared to foreign currencies, and governments will
often impose capital controls to prevent more capital
from leaving the country.
3. Operational risk:

 It arises from faulty business practices or when

buildings, equipment, and other property required to
run the business are damaged or destroyed.  
 Risks faced by Commercial Banks

 Many types of operational risk, such as the destruction

of property, are covered by insurance.
 However, good management is required to prevent
losses due to faulty business practices, since such
losses are not insurable.
 B.Saving & loan Association
 The basic purpose of establishing saving and loans
associations was pooling the savings of local residents
for financing the construction and purchase of a
homes.
 The collateral for the loan would be the home being
financed.
 Saving and loans are either mutually owned (means
there is no stock outstanding) or have corporate stock
ownership, so technically the depositors are the
owners.
 Saving & loan Association
 Traditionally, the only assets in which saving and
loans associations were allowed to invest have
been:
 Mortgages (Loans secured by a property).
 Mortgage – backed securities
 Government securities
 Saving and Loans Associations invest in short-term
assets for operational (liquidity) and regulatory
purpose.
 C.Saving banks
 Saving banks are institutions similar to saving and
loans associations even though they are much
older than S & Ls.
 Originally, they were established to provide a

means for small depositors and earn a return on

their deposits.
 They can be either mutually owned (i.e., mutually

saving banks) or stockholder owned.

 However, most saving banks are of the mutual

form.
 Saving banks
 Asset structure of saving banks and S & Ls are almost
similar.
 The principal assets of saving banks are residential
mortgages.
 The principal source of funds for saving banks is
deposits which is very similar with S & Ls.
 They have obtained funds primarily by tapping the
savings of households.
 D.Credit Unions
  

 They are the smallest & nonprofit depository

institution.
 They can obtain either a state or federal charter.

 Their unique aspect is the “common bond”

requirement for membership, such as:

 the employees of a particular company,
 unions,
 religious affiliations or who
 live in a specific area etc.

 They are governed by a board of volunteers.

 Credit Unions
 Credit Unions are either cooperatives or mutually
owned.
 There is no corporate stock ownership.
 Since they are nonprofit and owned by their
customers, they charge lower loan rates and pay
higher interest rates on savings.
 Therefore, the dual purpose of credit unions is to serve
their members saving and borrowing needs.
3: Non depository Institutions
 These Non-depository institutions are financial
institutions that do not mobilize deposits as their
primary function. But this does not mean that they
never mobilize savings
 These include (among others):
• Insurance companies
• Mutual funds
• Pension funds
• Investment Banking Firms
• Micro Finance Institutions
A. Insurance Companies

 The primary function of insurance companies is to

compensate individuals and corporations
(policyholders) if perceived adverse event occur, in
exchange for premium paid to the insurer by
policyholder.
Insurance Companies
 Insurance companies provide (sell and service)
insurance policies, which are legally binding
contracts.
 Insurance companies promise to pay specified sum
contingent on the occurrence of future events, such
as death or an automobile accident.
 Insurance companies are risk bearer. They accept or
underwrite the risk for an insurance premium paid
by the policyholder or owner of the policy.
Types of Insurance Business
 Insurance industry is classified in to two
 Life insurance
 General or Property-causality insurance
Types of Insurance Business
1. Life insurance: deals with death, illness
disablement and retirement policies. Products of
life insurance companies include:
1. Term insurance
2. Whole of life insurance
3. Endowment policies
4. Annuities
2. General insurance: deals with theft, property,
house, car and general accident insurance.
Property insurance is normally divided into two:
personal and commercial
Insurance Companies
 Income of Insurance Companies:
 Insurance premium
 Investment income that occur over time

The profit of the insurance companies = )insurance

premium + investment income) – (operating expense +
insurance payment or benefits)
Types of Insurance business-Cont’d

According to Fabozzi, insurance

products and contracts are classified as:
1. Life insurance
2. Health insurance
3. Property and causality insurance
4. Liability insurance
Types of Insurance business-Cont’d

5.Disability insurance
6. Long-term care insurance
7. Structured settlements
8. Investment-Oriented Products
Students are advised to read about types of
insurance and other insurance related topics
 B. Mutual Funds
 A mutual fund is a special type of investment
institution which acts as an investment conduit.
 It pools the savings of relatively small investors
and invests them in a well-diversified portfolio of
sound investments, thus enabling them to
participate indirectly in the benefits of investment
in industrial securities.
 B. Mutual Funds
 Mutual funds are also able to enjoy economies of
scale by incurring lower transaction costs and
commission.
 Mutual funds mobilize more savings and channel them to
the more productive sectors of the economy
 The efficient functioning of mutual funds contributes to an
efficient financial system.
 This in turn paves ways for the efficient allocation of the
financial resources of the country which in turn
contributes to the economic development.
B. Mutual Funds
 As an investment intermediary, it offers a variety of
services to small investors such as:
 diversification of portfolio and consequent
reduction of risk
 expert professional management
 liquidity of investment
 tax shelter and reduced cost.
 It is called a mutual fund in USA, unit trust in UK
and India
 B. Mutual Funds

Advantage of Mutual Funds

1. Mobilizing small saving
2. Professional management
3. Diversified investment/ reduced risks
4. Better liquidity
5. Investment protection
6. Low transaction cost (economy of scale)
7. Economic Development
Return to Investors in the Mutual
Fund
 Investors in the mutual fund have the potential to
gain:
 They are entitled to a share in the capital appreciation
of the underlying assets,
 They have a claim on the income generated by the
underlying assets of the fund
C. Pension Funds
 Pension funds are major institutional investors
and participants in the financial markets.
 Pension plan is established for the eventual
payment of retirement benefits
 The entities that establish pension plans-called
plan sponsors- may be private business entities
acting for their employees, federal, state, and
local entities on behalf of their employees.
 Pension funds are financed by contribution
from employer and/or employees
 C, Pension Funds
 Brain Strom
 How is the pension fund being managed and used
in Ethiopia?
 Is there no any possibility of using this fund for
investment purpose to benefit the pensioners and
the national economy?
D. Investment Banking Firms
 It is specialized financial institution engaged in securities
business.
 They perform activities related to the issuing of new
securities and the arrangement of financial transactions.
 They mainly involve in primary markets, the market in which
new issues are sold and bought for the first time.
 They advice issuers on how best to raise funds, and then they
help to sell the securities.
 They are also involved in planning and executing other types
of financial transactions such as merger, acquisition and
restructuring.
Activities of investment banking firms

Public offering (underwriting of

1.
securities)
 Investment bankers performing one or more

of the following three functions:

 Advising the issuer on the terms and the timing of
the offering.
 Buying the securities from the issuers.
 Distributing the issue to the public.
Activities of investment banking firms

2. Private Placement of Securities

 In addition to underwriting securities for
distribution to the public, investment
banking firms place securities with a limited
number of institutional investors like
insurance companies, pension fund etc.
3. Securitization of Assets
 Securitization of Assets refers to the issuance of
securities that have a pool of assets as collateral.
Activities of investment banking firms

4. Merger and Acquisition

 They may participate in merger and acquisition activity in one
of the following ways:
 Finding merger and acquisition candidates.

 Adjusting acquiring companies or target companies with

respect to price and non price terms of exchanges or
helping companies fend off (defend) an unfriendly
takeover.
 Assisting acquiring companies in obtaining the necessary
funds to finance a purchase.
Activities of investment banking firms

5. Merchant Banking
 When an investment banking firm commits
its own fund by either taking an equity
interest or credit position in companies, this
activity referred to as merchant banking.
Activities of investment banking firms

6. Trading and Creation of Derivative Instruments

 derivative instruments allow an investment banking firms to
realize revenue in the following ways:
 Customers generate commissions from the exchange
traded instruments they buy and sell. That is,
commission generated by the brokerage service
performed for customers when they are bought and
sold.
 There are certain derivative instruments that an
investment banking firm creates for its clients. Eg.
Swap.
Activities of investment banking firms

7. Money Management
 Investment banking firms have created
subsidiaries that manage funds for individual
investors or institutional investors such as pension
funds.
 Micro Finance Institutions

 Microfinance is a form of financial services for

entrepreneurs and small businesses lacking access to
banking and related services
 Microfinance is a type of financial service that is provided to
unemployed or low-income individuals or groups who
would otherwise have no access to the formal banking
source of finance.
 Microfinance refers to a variety of financial services that
target low-income clients, particularly women

 Micro Finance Institutions

 Microfinance is the provision of savings accounts,

loans and money transfers and other banking
services to customers that lack access to traditional
financial services, usually because of poverty.
 Making small loans to individuals who lack the
necessary resources to secure traditional credit is
known as micro credit

 End of chapter-Two


Thank You!!
Types of Mutual Funds
1. Open-ended mutual funds
2. Closed-ended mutual funds
Open-ended mutual funds-
Characteristics
 New investors can join the funds at any time
 A fund (unit) is accepted and liquidated on a
continuous basis by mutual fund manager
 The fund manager buys and sells units constantly on
demand by investors-it is always open for the
investors to sell or buy their share units
 It provides an excellent liquidity facility to investors,
although the units of such are not listed.
 No intermediaries are required.
 There is a certainty in purchase price, which takes
place in accordance with the declared NAV.
Open-ended mutual funds-
Characteristics
 Investors in Mutual fund own a pro rata share of the
overall portfolio, which is managed by an investment
manager of the fund who buys some securities and
sells others
 The value or price of each share of the portfolio is
called net asset value (NAV)
 NAV equals the market value of the portfolio minus
the liability of the MF divided by the No of shares
owned by the NF investors
 Open-ended:
NAV
 NAV= Mkt V of Portfolio-Liabilities
No of shares outstanding
 The NAV is determined only once each day, at the close of the
day. For e.g. the NAV for a stock MF is determined from closing
stock price for the day. Business publications provide the NAV
each day in their MF.
 All new investments into the fund or withdrawal from the fund
during a day are priced at the closing NAV (investment after
the end of the day or a non-business day are priced at the
next day’s closing NAV)
Open-ended:
NAV
 The total No of shares in the fund increases if
more investments than withdrawals are made
during the day, and vice versa.
 If the price of the securities in the portfolio
change, both the total size of the portfolio and
therefore, the NVA will change.
Open-ended:
NAV
 Overall, the NAV of a mutual fund increase or
decrease due to an increase, or decrease in the price
of the securities in the portfolo.
 The No of shares in the fund increase or decrease due
to the net deposits or withdrawal from the fund.
 And the total value of the fund increases or decreases
for both reasons.
Open-ended:
NAV
 Examples 1:
 Suppose today a MF contains 1000 shares of ABC which
are traded at $37.75 each, 2,000 shares of Exxon (currently
traded at $43.70) and 1,500 shares of Citigroup currently
trading at $46.67. The MF has 15,000 shares outstanding
held by investors. Thus, today’s NAV is calculated:
(1000x 37.75) + (2,000x43.7) +1,500 x 46.67 =13.01
15,000
Open-ended:
NAV
 If tomorrow ABC’s shares increase to $45, Exxon’s
shares increase to $48, and Citigroup’s shares
increase to $50, the NAV (assuming the No of
shares outstanding remains the same) would
increase to:
1000x45 + 2000 x 48 + 1500x 50 = 14.40
15,000
Open-ended:
NAV
 Example2:
 Suppose that today 1,000 additional investors buy one
share each of the mutual fund (MF) at the NAV of
$13.01. This means the MF mgr has $13,010
additional funds to invest.
 Suppose that the fund mgr decides to use these
additional funds to buy additional shares in ABC.
Open-ended:
NAV
 At today’s mkt price, the mgr could buy 344
($13,010/$37.75 = 344) shares of ABC additional
shares: Thus,
 its new portfolio of shares has 1344 in ABC, 2000 in Exxon,
and 1,500 in Citigroup.
 Given the same rise in share value as assumed above,

tomorrow’s NAV will be:

1,344 x $45 + 2,000 x $48 + 1,500 x $50 = 14.47
16,000
Open-ended:
NAV
 The additional shares and the profitable
investment made with the new funds from these
resulted in a slight higher NAV than had the No of
shares remained static ($14.47 versus $14.40)
Closed End Fund
 The shares of a closed-end fund are similar to the
shares of common stock of a corporation. The new
shares of a closed-end fund are initially issued by an
underwriter for the fund.
 And after the new issue, the No of shares remains
constant.
 After the initial issue, no sale or purchase of fund
shares are made by the fund company as in open-
end funds.
 Instead, the shares are traded on a secondary
market, either on an exchange or in the over-the-
counter market
 Closed End Fund
 Since the number of shares available for purchase, at
any moment in time, is fixed, the NAV of the fund is
determined by the underlying shares.
 The return for holders of the fund’s shares is
determined by the underlying shares as well as by
the demand for the investment company’s shares
themselves.
Closed End Fund
 When demand for the investment company’s
shares is high, because the supply of shares in the
fund is fixed the shares can trade for more than the
NAV of he securities held in the fund’s assets
portfolio.
 In this case the shares said to be trading at a
premium.
 If demand is low, the shares are sold for discount.
Difference b/n Open-end and Closed-
end MF
1. The No of shares of an open-end 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.
2. In contrast, closed-end fund have a constant number of
shares outstanding because the fund sponsor does not
redeem shares and sell new shares to investors except at
the time of a new underwriting.
Thus, supply and demand in the market determines the
price of the fund shares, which may be above or below
NAV, as previously discussed.
C. Pension Funds
 Pension funds are major institutional investors and
participants in the financial markets.
 Pension plan is established for the eventual payment
of retirement benefits
 The entities that establish pension plans-called plan
sponsors- may be private business entities acting for
their employees, federal, state, and local entities on
behalf of their employees.
 Pension funds are financed by contribution from
employer and/or employees
Pension Funds
 The key factor explaining pension fund growth is
that the employer’s contribution and a specified
amount of the employee’s contribution, as well as
the earnings of the fund’s assets, are tax exempt.
 In essence, a pension is a form of employee
remuneration for which the employee is not taxed
until funds are withdrawn.
Types of pension Plans
 Two basic and widely used types of pension plans
are:
 Defined benefit plans- sponsor agrees to make specified
(or defined) payment to qualifying employees at
retirement and
 Defined contribution plans- sponsor is responsible only for
making specified (or defined) contribution into the plan on
behalf on qualifying employees, but does not guarantee
any specified amount at retirement.
 In addition a hybrid of plans, called a cash plan,
combination features of both pension plan types may be
used.
 D. Investment Banking Firms
 It is a financial institution engaged in securities business.
 They perform activities related to the issuing of new
securities and the arrangement of financial transactions.
 They mainly involve in primary markets, the market in
which new issues are sold and bought for the first time.
 They advice issuers on how best to raise funds, and then
they help to sell the securities.
 They are also involved in planning and executing other
types of financial transactions such as merger,
acquisition and restructuring.
 Thus, they perform two general functions:
1. They assist both government and nongovernmental
companies in obtaining funds by selling securities,
i.e., raise funds for clients.
2. They act as brokers or dealers in the buying and selling of
securities in secondary markets, i.e., assisting clients in
the sale or purchase of securities.
 Activities of investment banking firms

Public offering (underwriting of securities)

1.
 Investment bankers performing one or more of

the following three functions:

 Advising the issuer on the terms and the timing of the
offering.
 Buying the securities from the issuers.
 Distributing the issue to the public.
 Activities of investment banking firms

2. Private Placement of Securities

 In addition to underwriting securities for
distribution to the public, investment banking
firms place securities with a limited number of
institutional investors like insurance companies,
pension fund etc.
3. Securitization of Assets
 Securitization of Assets refers to the issuance of
securities that have a pool of assets as collateral.
 Activities of investment banking firms

4.Merger and Acquisition

 They may participate in merger and acquisition

activity in one of the following ways:

 Finding merger and acquisition candidates.
 Adjusting acquiring companies or target companies
with respect to price and non price terms of exchanges
or helping companies fend off (defend) an unfriendly
takeover.
 Assisting acquiring companies in obtaining the
necessary funds to finance a purchase.
 Activities of investment banking firms

5. Merchant Banking
 When an investment banking firm commits its
own fund by either taking an equity interest or
credit position in companies, this activity
referred to as merchant banking.
 Activities of investment banking firms

6. Trading and Creation of Derivative

Instruments
 derivative instruments and they allow an

investment banking firms to realize revenue in

the following ways:
 Customers generate commissions from the exchange
traded instruments they buy and sell. That is, commission
generated by the brokerage service performed for
customers when they are bought and sold.
 There are certain derivative instruments that an
investment banking firm creates for its clients. Eg. Swap.
 Activities of investment banking firms

7. Money Management
 Investment banking firms have created subsidiaries
that manage funds for individual investors or
institutional investors such as pension funds.
 END OF CHAPTER TWO

Thank You!!