Summary Notes: Chapter Three

Financial Institutions and Management

3.1 Depository and Non-Depository Financial Institutions

Financial institutions are organizations that collect funds from savers and transfer them to
borrowers.

Main Categories:
1. Depository Institutions
2. Non-Depository Institutions

Depository Institutions:
- Accept deposits from the public.
- Main liabilities are deposits.
- Main assets are loans and investments.

Examples:
- Commercial banks
- Savings and loan associations (S&Ls)
- Savings banks
- Credit unions

Non-Depository Institutions:
- Do not accept deposits.
- Raise funds through premiums, contributions, or securities.

Examples:
- Insurance companies
- Pension funds
- Mutual funds

Savings and Loan Associations (S&Ls)

S&Ls mainly provide housing and mortgage loans.

Characteristics:
- Accept savings deposits.
- Provide long-term residential mortgage loans.
- Originally established to help households finance homes.

Problems of S&Ls:
- Rising interest rates reduced profit margins.
- Short-term deposit costs exceeded earnings on long-term loans.
- Increased competition from money market funds.
- High operating costs and loan default risks.

Trends:
- Many small S&Ls merged into larger institutions.
- Number of S&Ls declined while average size increased.

Ethiopian Perspective:
- Intended to serve low-income groups.
- Provide small loans to poor households.
- Funded partly by government enterprises.
- High risk of default and high operating costs.
- Loan interest rates may reach about 18%.

Savings Banks
Savings banks were established to meet the needs of small savers.

Functions:
- Accept savings deposits.
- Invest in:
* Mortgage loans
* Government securities
* Corporate bonds and stocks
* Municipal bonds

Characteristics:
- Owned technically by depositors.
- Main source of funds is deposits.
- Net earnings distributed as dividends to depositors.
- Strong regulations ensure safety of deposits.

Money Market Mutual Funds

Money market mutual funds pool savings from individuals and businesses and invest in
short-term money market instruments.

Features:
- Invest in highly liquid and low-risk securities.
- Offer returns linked to prevailing money market interest rates.
- Developed due to restrictions on bank deposit interest rates.

Ethiopian Context:
- Ethiopia has a government ceiling on deposit interest rates.
- Deposit rates cannot exceed the maximum rate set by government.
- Loan rates are competitive.

3.1.2 Non-Depository Institutions

Non-depository institutions do not mobilize deposits.

Examples:
- Insurance companies
- Pension funds
- Mutual funds

Some non-depository institutions operate as spread businesses:

- Earn profit from difference between investment returns and funding costs.

Others, like pension funds:

- Focus on covering retirement obligations at minimum cost.

Insurance Companies
Insurance companies compensate policyholders against losses in exchange for premiums.

Functions:
- Sell insurance policies.
- Underwrite risks.
- Provide protection against uncertain future events.

Types:

1. Life Insurance
- Covers death, disability, illness, and retirement.
- Pays lump-sum or periodic payments to beneficiaries.

Sources of Funds:
- Premium receipts.

Factors Affecting Premium:

- Mortality rate
- Investment income
- Operating expenses

2. Property and Casualty (P&C) Insurance

- Covers property damage, theft, accidents, and liabilities.

Categories:
- Personal line insurance
- Commercial line insurance

Main Revenue Sources:

- Underwriting income
- Investment income

Main Expenses:
- Claim expenses
- Claim adjustment expenses
- Administrative costs
- Taxes

Concepts:
- Underwriting profit occurs when revenues exceed expenses.
- Underwriting loss occurs when expenses exceed revenues.

Pension Funds
Pension funds provide retirement benefits.

Features:
- Contributions made by employers and employees.
- Funds accumulate during working years.
- Pension assets are legally illiquid before retirement.

Reasons for Growth:

- Contributions are tax exempt.
- Earnings are tax exempt.

Types:
1. Private pension funds
2. Public pension funds

Importance:
- Encourage long-term savings.
- Provide retirement security.

Mutual Funds
Mutual funds pool money from many investors and invest in diversified portfolios.

Features:
- Invest in stocks, bonds, and money market securities.
- Shares are redeemable at net asset value.
- Earnings distributed to shareholders.
Advantages:
1. Mobilize small savings
2. Professional management
3. Diversification
4. Better liquidity
5. Lower transaction costs
6. Investment protection
7. Support economic development

Returns to Investors:
- Dividends
- Capital gains
- Appreciation in asset values

Investment Banking
Investment banking involves raising debt and equity securities for corporations and
governments.

Main Activities:
- Underwriting securities
- Private placements
- Trading securities
- Securitization
- Mergers and acquisitions
- Risk management services

Underwriting Functions:
1. Advising issuers
2. Buying securities from issuers
3. Distributing securities to investors

Firm Commitment:
- Investment bank buys securities at fixed price.
- Assumes risk of selling to public.

Gross Spread:
- Difference between price paid to issuer and price charged to public.

Nature of Liabilities of Financial Institutions

Liabilities are classified according to certainty of timing and amount.

Type-I Liability:
- Amount and timing known with certainty.
- Example: fixed deposits.
Type-II Liability:
- Amount known but timing uncertain.
- Example: life insurance policy.

Type-III Liability:
- Timing known but amount uncertain.
- Example: floating-rate contracts.

Type-IV Liability:
- Both timing and amount uncertain.
- Example: property-casualty insurance obligations.

3.3 Management of Financial Institutions

Management of financial institutions involves planning, controlling, and directing financial
operations.

Major Components:
1. Strategic planning
2. Risk management
3. Financial performance management
4. Regulatory compliance
5. Customer relationship management
6. Human resource management
7. Technology and innovation
8. Corporate governance

Asset Management
Asset management refers to managing investments to maximize returns while controlling
risk.

Main Activities:
- Portfolio management
- Investment analysis
- Risk management
- Performance monitoring
- Client relationship management
- Compliance management
- Asset allocation and rebalancing

Investment Strategies:
- Active management
- Passive investing
- Value investing
- Growth investing
- Income investing

Liability Management
Liability management focuses on managing sources of funds and obligations.

Main Areas:
- Funding strategy
- Liability structure
- Liability diversification
- Cost of funds management
- Liquidity management
- Risk management
- Regulatory compliance

Objectives:
- Maintain stable funding
- Minimize funding cost
- Ensure sufficient liquidity

Liquidity Management
Liquidity management ensures availability of cash to meet short-term obligations.

Key Activities:
- Liquidity planning
- Cash flow management
- Liquidity risk assessment
- Asset-liability matching
- Contingency funding planning
- Market monitoring

Regulatory Ratios:
- Liquidity Coverage Ratio (LCR)
- Net Stable Funding Ratio (NSFR)

Importance:
- Prevents liquidity crisis.
- Maintains public confidence.

Capital Adequacy Management

Capital adequacy management ensures that financial institutions maintain sufficient capital
to absorb losses.

Main Areas:
- Capital assessment
- Regulatory compliance
- Capital planning
- Stress testing
- Risk-based capital allocation
- Capital monitoring
- Capital conservation

Capital Types:
- Tier 1 capital
- Tier 2 capital

Importance:
- Protects depositors and investors.
- Supports financial stability.
- Increases investor confidence.