Chapter 3: Financial Institutions in the Financial System

Chapter Three
Financial Institutions in the Financial System

Part I: Depository Institutions

 Commercial Banks
 Non-Bank Thrift Institutions
 Credit Unions
 Savings & Loan Associations (S & Ls)
 Savings Banks
 Money Market Mutual Funds

Prepared By:
 Chapter 3: Financial Institutions in the Financial System

Chapter Three
Financial Institutions in the Financial System

3.1. Financial Institutions: Classification and their Portfolio

3.1.1. Classification of Financial Institutions

Financial institutions may be grouped in a variety of ways. One of the most important
distinctions is between:
1. Depository Institutions: include commercial banks and non-bank thrift institutions
(like savings & loan associations, savings banks, credit unions, and money market
mutual funds)
 Depository institutions derive the bulk of their loanable funds from deposit
accounts sold to the public
2. 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 institutions sell shares to the public and invest the proceeds in stocks,
bonds, and other securities.
3.1.2. Financial Institutions and their Portfolio of Financial Assets

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
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

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 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
 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
Part I: Depository Institutions
3.2. Commercial Banks and Money Creation

3.2.1. Commercial Banks: General

This institution offers the public both deposit and credit services
 Fewer & more innovative services provided also include
 Investment advice & execution
 Tax and travel planning
The name commercial implies that the banks devote a substantial portion of their resources
to meeting the financial needs of business firms.
 In recent years, the services are expanded to consumers and units of government
Nowadays, commercial banks satisfy a broad range of financial service needs in an
economy.
3.2.2. 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

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 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
3.2.3. Portfolio Characteristics
The assets of Commercial Banks generally comprise primary reserves, secondary reserves,
security holdings, and various kinds of loans; while deposits, non-deposit sources
(borrowings), and equity comprise the financial claims (and/or liabilities) of Commercial
Banks.
I. 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 bank’s first line of defense against
 Withdrawal by depositors
 Customer demand for loans
 Immediate cash needs to cover expenses
Commercial Banks often hold an amount of cash that is just sufficient to meet short run
contingencies
 No more cash than is absolutely required
 The yield on cash asset is minimal or nonexistent
Deposits held with other banks are also considered primary reserves.
 Such deposits are a means of “paying” for correspondent banking service, i.e. for
the services of other banks or for “Bank to Bank” transactions, and hence, provide
an implicit return.
 In return for the deposits of smaller banks, larger correspondent banks provide
services like: clearing of checks, management of security portfolios, and computer
processing of records
 With the help of their larger correspondents, smaller banks invest their
excess cash reserves in loans to other banks (usually called Federal Funds)
 Primary reserves also include reserves held behind deposits as required by
Federal Reserve System (“National Bank”, in case of Ethiopia).
II. Security Holdings and Secondary Reserves
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.
Municipal securities – bonds and notes issued by state, city, and local governments are
largest portion of their security investments.
 Such securities provide tax-exempt interest income

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 Banks also tax shelter their income

 Through purchase & leasing of equipment to business firms
 Through setting aside a portion of current income as an operating expense
for protection against possible losses on loans (as bad debt expenses)
 Banks favor treasury bills & short term treasury notes and bonds.
 Such securities are readily marketable
 Such securities are freed from default risk
 Commercial banks also hold small amounts of corporate bonds and notes, though
they generally prefer to make direct loans to business as opposed to purchasing their
securities in the open market.
 Commercial banks are forbidden to purchase corporate stock
However, banks do hold small amounts of corporate stock as collateral for loans.
III. Loans
The principal business of commercial banks is to make loans to qualified borrowers.
 Loans are among the highest yielding assets a bank can hold in its portfolio
 Provide the largest portion of their operating revenue
 Make loans of reserves to other banks through the federal funds market and to
securities dealers through repurchase agreements.
Direct loans to business & individual constitute the largest portion of bank loans
 Arise from negotiation
 Result in written agreement for adequate security & income
Historically, commercial banks have preferred to make short term loans to business,
principally to support purchases of inventory.
 Recently, commercial banks extended to provide term loans to finance purchase of
buildings, machinery, etc.
 The long term loans carry greater risk
 The new loans carry variable interest rates that can be changed in response to
shifting market conditions.
 Are sometimes in the form of equipment leasing plans available from larger banks
and the subsidiaries of bank holding companies.
 Bank holding companies are those invested in or acquired shares of banks.
 For example, Dashen Bank is one of the privately owned commercial banks
in Ethiopia, which is owned by MEDROC – a well diversified conglomerate
in the context.
 In this case, MEDROC is considered a Bank Holding company.
Leases
Leases are the functional equivalent of a loan.
 Lease financing carries
 Significant tax advantage for a bank

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 Significant cost & tax advantage for the customer too.

 Commercial Banks are important lenders in the real estate field supporting
construction of residential and commercial structures
 Also provide longer maturities on installment loans
 Finance purchases by households

IV. Deposits
The bulk of commercial bank funds come from deposits.
 There are non deposit sources of funds, however.
Types of deposits
 Demand Deposits
 Demand deposits are checking accounts
 They are also called transaction accounts
 Significant portion of bank funds are generated through demand deposits
 Demand deposits are principal means of making payments
 Demand deposits are safer than cash & widely accepted
 Savings Deposits
 Small in birr amount
 Bear relatively low-interest rate
 Withdrawn with little or no notice
 Time Deposits
 Carry a fixed maturity
 Offer the highest interest rates a bank can pay
 Can be divided into:
A) Non-negotiable CDs
 Are contracts negotiated between two parties and hence, the
liability cannot be transferred to a third party
 Usually are small in amount
 Consumer type accounts
B) Negotiable CDs
 May be traded in the open market
 Purchased mainly by corporations
 New forms of checkable (demand) deposits include:
 Negotiable orders of withdrawals (NOWs)
 Accounts drafted to pay bills but also earn interest
 Automatic transfer service (ATS)

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 A preauthorized payments service in which the bank transfers funds from an

interest bearing savings account to a checking account (also called transaction
accounts ) as necessary to cover checks written by the customer.
 Nowadays, customers are more financially sophisticated and have a greater
tendency to “shop around” for the highest returns available on both
transactions and savings deposits
 As a result, the average cost of bank deposits has increased.
 The cost of attracting customer funds has been further increased by
the tendency of bankers to expand services, offering their customers
better financial convenience.
 To retain old deposits and attract new ones, thus, many banks have developed
1. Security brokerage services so that customers can purchase stocks &
bonds and pay by charging their deposit accounts
2. Insurance counters to make life, health, and property casualty policies,
usually sold by non bank firms, available to their customers.
3. Networking agreements with other banks to help customers access their
deposit accounts while traveling
4. Financial & tax counseling services to aid customers decisions.
5. Merchant banking services to aid major corporations with mergers
However, the new services created complexities for bank management and demanded
greater efficiency.
V. Non-Deposit sources of Funds
Borrowed funds to meet bank cash needs (when competition for deposits increased)
 Purchases of reserves (federal funds from other banks)
 Security repurchase agreement (where securities are sold temporarily by a bank and
then bought back later)
 Capital notes counted under regulations as equity capital
 Lending & borrowing of a bank is limited to a banks equity capital (net
worth)
 In order to be counted as equity capital, however, capital notes must be
subordinated to deposit, so that if a bank is liquidated the depositors have a
first claim on its assets.
VI. Equity Capital
Net worth supplied by a banks shareholders
 Provides only a minor portion of the total funds of most firms
 The most important functions of equity capital is to keep a bank open even in the
face of operating losses until management can correct its problems.
 Recently the U.S. Federal law has mandated minimum ratio of capital to assets for
banks.
 This helps to improve equity capital positions
VII. Revenues and Expenses

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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
3.2.4. Money Creation and Destruction by Banks
Commercial banks differ from many other financial institutions in one critical aspect
“Commercial Banks have the power to create money in the form of new checkable
deposits.”
 The banking system creates and destroys money each year.
 An individual bank cannot create any more money in the form any checkable
deposit than the volume of excess reserves that it holds.
 However, the banking system as whole can create a volume of money equal to a
multiple of any excess reserves deposited with it simply by extending credit (i.e.
making loans and purchasing securities)
1. Reserve requirement and excess reserve
Money creation by banks is made possible because
 The public readily accepts claims on bank deposits (mainly checks) in payment
for goods and services, and
 The law requires individual banks to hold only a fraction of the amount of
deposits received from the public as reserves and, thus, fringe up the majority of
incoming funds for the making of loans and purchasing of securities.
Banks and other depository institutions must hold reserves in cash or in deposit form
behind their transaction accounts and non personal time deposits.
 These reserve requirements are linked to the size of the depository
institution and require that a specified percentage of all deposit must be
placed at the Federal Reserve Bank (in U.S.) or National Bank of
Ethiopia (NBE) and/or cash in the bank vault
 As a practical matter, banks hold most of the reserves in the form of
deposits with regional federal reserve banks (in case of U.S.)
The vault cash and deposits at the Federal Reserve Constitute a banks holdings of legal
reserve – those assets acceptable for meeting reserve requirement behind the public’s
deposits
 A banks legal reserve may be divided in to two:

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 Required Reserves – are equal to the legal reserve requirement ratio

times the volume of deposits subject to reserve requirements; and
 Excess Reserves – are equal to the difference between the total legal
reserves actually held by a bank and the amount of its required
reserves.
Example 1
Assume that a given commercial bank holds birr 20,000,000 in transaction accounts and
birr 30,000,000 in non-personal time deposits. If the law requires commercial banks to hold
3% of both deposits in legal reserves, how much would be the level of the required reserve
on the above deposits.
In this case, the required reserve for this bank is determined as follows:
Required Reserve = 0.03 x 50,000,000
= 1,500,000
Example 2
Assume that, on a given date, the bank in Example 1 above has birr 500,000 in cash in its
premises and birr 1,500,000 on deposit with the Federal Reserve Bank in its region. Is there
any excess reserve? If so, how much is it?
 The answer is yes, this bank clearly holds birr 500,000 in excess reserves.
 Since legal reserve assets earn little or no interest income, most commercial bank
try to keep their holding of excess reserve as closest to zero as possible.
 This bank, thus, opt to lend the birr 500,000 in excess reserve.
2. The creation of money and credit
The distinction between legal and required reserves is important because it plays a key role
in the growth of profits in the economy and the creation of money by the commercial
banking system.
Illustration
Assume that the Federal Reserve has set basic reserve requirements of 20% behind the
publics deposits. Assume also that, initially the banking system is “loaned up”, that is,
bankers have loaned out all excess legal reserves available to them. No additional reserves
are made available to the banking system from some external sources.
In addition, assume that all bankers are profit maximizes and will attempt to loan out
immediately any excess funds available to them in order to earn the maximum interest
income as possible. Suppose, in this case, that a deposit of Birr 1000.00 is made in Bank A
from some source outside the banking system.
Assuming the credit – creation process works through the entire banking system and there
are no leakages, how much will the banking system ultimately hold in deposits and create
loans.
Solution
Hint: Commercial banks often face that when they make loans, the borrowed funds are
withdrawn rapidly as borrowers spend the proceeds of their loans. Moreover, it is likely
that most of the borrowed funds will wind up as deposits in other banks as loan customers
write checks against their accounts.

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For this reason, Banks A will not loan out any more than the excess legal reserves it
currently holds. This way, when the borrower spends the funds and the money flows to
other banks, Bank A will have sufficient funds in reserve to cover the cash letters
demanding payment, which it will receive from other banks.
The transactions within the banking system, thus, will be:
List of Banks Deposit Required Excess Loans made to
(Commercial) Received Reserves Reserves Customers
A Birr 1000.00 200.00 800.00 800.00
B “ 800.00 160.00 640.00 640.00
C “ 640.00 128.00 512.00 512.00
D “ 512.00 102.00 410.00 410.00
Final amounts for all
Banks in the System Birr 5000.00 1000.00 4000.00 4000.00
Clearly, by making loans whenever and wherever excess reserves appear, the banking
system eventually creates total deposits and total loans several times larger than the original
volume of funds received.
Therefore, Total deposits created = Initial Deposit entered the Banking System
by the banking system Percentage of Legal Reserve Required

= Birr 1000
0.2
= Birr 5000

Additional deposit (and/or loan) created by the banking system is obtained as

= Total Deposit in the Banking System – Initial Deposit made in the Banking
System
= Birr 5000 - birr 1000
= Birr 4000
In the real world, leakages from the banking system greatly reduce the size of the deposit
multiplier, however.
 The reciprocal of the reserve requirement ratio (i.e. 1/0.2) is known as the
deposit multiplier
 In the above example, one birr of required reserves supports birr 5 in
deposits.
Among the most important leakages are:
 The public desire to convert a portion of new demand deposits into currency and
coin (pocket money) or into time and savings deposits; and
 The presence of underutilized lending capacity, which results because banks either
cannot find qualified borrowers or wish to hold a protective cushion of reserves
3. Destruction of Deposits and reserves
Money supply can also contract by a multiple amount when reserves are withdrawn from
the banking system.

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 In the forgoing illustration, the depositor in bank A if decides to withdraw the birr
1000 from the transaction, the balance of deposit created by the banking system
begins to shrink.
 Suppose bank A decides to sell securities in the amount of Birr 800. However, the
individual and institutions that purchase those securities pay for them by writing
checks against their deposits in other banks, reducing the legal reserves of those
institutions.
 Assume that bank B loses deposits of birr 800 and required reserves of birr 160 as
bank A gains these funds
o Considering bank A and bank B together, total deposits have fallen by birr
1,800
o This deposit contraction has freed up about birr 360 (birr 200 + birr 160) in
required reserves
 Further contraction of deposits will occur as bank B attempts to cover its reserve
deficiency (birr 640) by drawing reserves from other banks.
 In fact, with a 20% reserve requirement and no other leakages from the banking
system, deposits will contract by a full birr 5000 as banks try to cover their reserve
deficits by raising funds at the expense of other banks.
 Implications for the financial system
o Creation of money by banks is one of the most important sources of credit
funds in the economy
 An important supplement to the supply of savings in providing funds
for investment so the economy can grow faster
o Money created by banks is instantly available for spending and, therefore,
unless controlled carefully by government action, can fuel inflation.
3.3. Non-Bank Thrift Institutions
A. General
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.

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 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.
B. 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.

3.3.1. Credit Unions

1. 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.
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.

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 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 upto a
certain percentage of the amount of the loan.
o 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.
2. 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 non profit association (Labor union, church, fraternal, or social
organization)
 Common areas of residence – such as Kebele, towns, etc.
3. Regulations of Loans, Investments, and Dividends (U.S. case)
Like commercial banks, credit unions are heavily regulated
 In the services they are permitted to offer
 The rates charged for credit
 Dividends paid on members’ deposits
These institutions are permitted to make
 In the services they are permitted to offer
 The rates charged for credit
 Dividends paid on members’ deposits
Credit unions are permitted to
 Acquire (invest in) U.S. government securities
 Hold savings deposits at commercial banks, savings, and loan associations,
savings banks, and federally insured credit unions.
They pay dividends to their members, but are considered non-profit associations doing
business only with their owners.
 They are classified as tax-exempt mutual organizations.
3.3.2. Savings and Loan Associations

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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.
1. 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.
2. 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
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. How Funds are Raised and Allocated
S & Ls are broadening their role
 Many choosing to offer a full line of financial services for individuals & families.
 Other S & Ls are branching out into business credit and commercial real estate
lending.
A. Asset Portfolios
Residential Mortgage loans still are the dominant assets of S & Ls. In addition to this, the
following are also assets included in their portfolio:
 Mortgaged backed securities issued by governments.
 Consumer loans
 Commercial paper
 Corporate debt securities
 Mutual funds and municipal revenue bonds
B. Liabilities of S & Ls

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Savings deposits are the bulk sources of the available funds.

 The deposit mix has significantly been shifting in recent years from saving accounts
earning the lowest interest rate to deposits earning much higher and more flexible
returns.
 Money market deposit accounts
 CDs
 NOWs
 S & Ls also relay on non deposit sources of funds.
 Federal home funds bank system advances (Borrowed funds)
 Provides extra liquidity in periods where withdrawals are heavily or when
loan demand exceeds incoming deposits
 Securitized assets – where mortgages or portfolios of S & L assets are packed (often
backed by the guarantee of a government agency) and debt securities are issues
against these pooled assets are sold to investors to raise longer term, lower cost
funds –due to guarantee & less risk of default
 Loan sales – sales of mortgages and other loans to investors in the secondary
market
 When loan demand is high & deposit growth is sluggish
 Give S & Ls the opportunity to invest in new, higher yielding loans
C. Trends in Revenues & Costs (U.S. case)
S & Ls have experienced one of the darkest periods in their long history
 Many S & Ls remain unprofitable
 Are becoming cling to desperately thin net worth positions
Circumstances that brought a trouble in the U.S. S & Ls are:
 S & Ls historically have issued mortgage loans with fixed interest rates, while
accepting deposits whose interest rates are sensitive to changing market conditions.
 Their assets are rate insensitive (Loans); whereas
 Their liabilities are rate sensitive (deposits & borrowing)
 In periods of rapidly raising interest rates, the S & L net interest margin – the
difference between the interest earning on assets and its interest cost on borrowed
funds has been severely squeezed.
 In several recent periods, short –term interest rates paid on deposits exceeded
interest rates earned on long-term loans, turning the net interest margin in to
negative.
 Individuals & families whose savings provide the bulk of the S & Ls association
funds have become more financially sophisticated, withdrawing deposits whenever
higher returns were available else where or whenever there was even a hint of
trouble in the thrift industry.
 Federal regulations in the past limited the interest rates S & Ls could pay on savings
accounts, hurting their ability to compete with money market funds (i.e. limited in
flow of funds).

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 High & rising operating costs & risk of default on loans is also contributing to
trouble of the S & Ls.
D. Trends in Industry Structure
The pressure of rising costs & the resulting squeeze on earnings have caused many savings
& loans to merge or be absorbed by larger associations.
 They are unable to take advantages of economies of scale & scope
 Thus, the number of S & Ls is declining but the average size S & L has increased.
 With large numbers of relatively small S & Ls, continuing increases in costs and
competition, and heavy pressures on earnings, more savings & loans are likely to be
absorbed into larger financial institutions in the future.
E. Possible remedies for S & Ls Industry’s Problems
1. Sound decision making by management to diversify operations and identifying
innovative (or new) services to offer to the public.
2. Further relaxation of government regulations to permit the offering of new services
and the merging of smaller associations into larger ones.
F. S & Ls – Ethiopian Perspective
 The initial objective of S & Ls in Ethiopia is to reach the poor
 The poor can’t get loan from banks due to collateral requirement.
 Bank require investment proposal & see business standing of borrowers
 Thus, S & Ls in Ethiopia are ultimately aimed at providing loans in small
denominations to the low income groups in the society.
 The fund to this S &Ls is coming from giant government enterprises like Ethiopian
Air Lines, Tele, EEPCO, etc.
 The risk of default is much higher on the loans provided.
 Due to such risks, their smaller size, and high operating costs, the S & Ls in
Ethiopia are providing the highest costing loans reaching about 18 % to the users of
such funds.
3.3.3. Savings Banks
 Initially started to meet the financial needs of small savers.
 Plays active role in the residential mortgage market as do S &Ls but are more
diversified in their investments.
 Purchase corporate bonds and common stock
 Make consumer loans
 Invest in commercial mortgage
 Designated their financial services to appeal to individual and families. The saving
banks investment is limited (as required by law) for
 First mortgage loans
 U.S government and federal agency securities
 High grade corporate bonds and stocks

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 Chapter 3: Financial Institutions in the Financial System

 Municipal bonds
 Technically saving banks are owned by their depositors.
 The principal sources of funds for saving banks are deposits.
 All net earnings available after funds are set aside to provide adequate reserves
must be paid to the depositors as owner’s dividends.
 Regulations exercised primarily by the states are designed to ensure maximum
safety of deposits.
3.3.4. 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 3 % 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 can not 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.

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