CHAPTER TWO

FINANCIAL INSTITUTIONS IN THE FINANCIAL SYSTEM

Objectives: - At the end of these unit students should be able to:-

 Define financial institution
 Explain functions of financial institutions
 Explain financial intermediaries and their role
 Classify depository and non-depository financial institutions
 Explain the principal risks of financial industries

2.1. Financial institutions

Institutions which permit indirect lending include both deposit-taking and non-deposit-
taking institutions. Financial institutions are the firms that provide access to the financial
markets; they sit between savers and borrowers and so are known as financial
intermediaries. A financial institution acts as an agent that provides financial services for
its clients. In general, financial institutions serve as intermediaries by channeling the
savings of individuals, business, and governments into loans and investments. The
primary suppliers of funds to financial institutions are individuals; the primary demanders
of funds are firms and governments.

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 1.1. Financial institutions and capital transfer

If an individual wanted to make a loan to IBM or General Motors, for example, he or she
would not go directly to the president of the company and offer a loan. Instead, he or she
would lend to such companies indirectly through financial intermediaries, institutions that
borrow funds from people who have saved and in turn make loans to others.

Financial systems are never static. They change constantly in response to shifting
demands from the public, the development of new technology, and change in law and
regulations. Competition in the financial market place forces financial institutions to
respond to public need by developing better and more convenient financial service. The
growth of industrial centers with enormous capital investment need and the emergence of
a huge middle class of savers have played major roles in the gradual evolution of the
financial system.
The transfer of funds from savers to borrowers can be accomplished by three different
ways:
1. Direct finance
2. Semi-direct finance
3. Indirect finance

1. Direct Finance

With the direct financing technique, borrowers and lenders meet each other and exchange
funds in return for financial assets without the help of a third party to bring them
together. Here, deficit units (DSUs) and surplus units(SSUs) exchange money and
financial claims directly (to each other) without the involvement of intermediaries –
DSUs issue financial claims on themselves and sell them for money in financial markets
to SSUs. The SSUs hold the financial claims in their portfolios as interest bearing assets.

The claims issued by the DSU are called direct claims and are typically sold in direct
credit markets, such as the money or capital markets: Direct financing gives SSUs an
outlet for their savings, which provides an expected return, and DSUs no longer need to

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postpone current consumption to forgo promising investment opportunities for lack of
funds. Thus, direct credit markets increase the efficiency of the financial system.

Direct method is the simplest method of carrying out financial transactions. However, it
has some limitations. For one thing, both borrowers and lenders must desire to exchange
the same amount of fund at the same time. Most importantly, the lender must be willing
to accept the borrower’s financial assets, which may be too risky or too slow to mature.
There must be want coincidence between the SBU and DBU.

Another problem is that both lenders and borrowers must frequently incur substantial
information cost simply to find each other.

2. Semi – Direct Financing

In early history of financial systems, a new form of financial transaction called semi
direct finance appears. To aid in the search process of bringing buyers and sellers
together, a number of market specialists exist. Some individuals and business firms
become security brokers and dealers whose essential function is to bring the surplus unit
and the deficit unit together, thereby reducing information costs.

Brokers are different from dealers in that a broker is merely an individual or financial
institution who provides information concerning possible purchases and sales of
securities. Either a buyer or a seller of securities may contact a broker, whose job is
simply to bring buyers and sellers together. Brokers do not actually buy or sell securities;
they only execute their clients’ transaction at the best possible price. They act merely as
matchmakers, bringing SSUs and DSUs together. Their profits are derived by bringing a
commission fee for their services.

A dealer also serves as an intermediary between buyers and sellers, but the dealer
actually acquires the seller’s securities in the hope of marketing them at a later time at a
favorable price.

A dealer’s primary function is to “make a market” for a security. Dealers do this by

carrying an inventory of securities from which they stand ready either to buy or sell

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particular securities at stated prices. For example, a dealer making a market in a stock
might offer to buy shares from investors at Br. 100.00 and sell shares to other investors at
Br. 103.50. The bid price is (Br. 100.00) the highest price offered by the dealer to
purchase a given security; the ask price (103.50) is the lowest price at which the dealer is
willing to sell the security. The dealer’s gross profit is the Br. 3.50 differences between
the bid and the ask price, which is called the bid-ask spread.

Semi direct finance is an improvement over direct finance in a number of ways. It lowers
the information cost for both savers and borrowers. Usually, a dealer will split up a large
issue of primary securities in to smaller units affordable by even buyers of modest means
and, thereby, expand the flow of saving in to investment. In addition brokers and dealers
facilitate the development of secondary market in which securities can be offered for
resale.

Problems with the semi-direct financing: the ultimate lenders still winds up holding the
borrower securities and therefore, the lender have to be willing to accept the risk,
liquidity and maturity characteristics of the borrower financial assets. i,e there still must
be a fundamental coincidence of wants between surplus and deficit- budget units for
semi-direct financial transaction, to take place.

3. Indirect Financing

Flows can be indirect if financial intermediaries are involved. Financial intermediaries

transform financial claims in ways that make them more attractive to the ultimate
investor. Their fundamental role in the financial system is to serve both ultimate lenders
and borrowers but in much more complete way than brokers and dealers do. They
generally carry low risk of default.

The limitation of both direct and semi-direct financing stimulated the development of
indirect finance carried out with the help of financial intermediaries. Financial
intermediaries issue securities of these own-secondary securities to ultimate lenders and
at the same time accept financial assets from borrowers.

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2.2. Functions of Financial Institutions
Financial institutions provide a service as intermediaries of the capital and debt markets.
These institutions provide services related to one or more of the following:
 Transforming financial assets acquired through the market and constituting them
into a different, and more widely preferable, type of asset-which becomes their
liabilities.
 Exchanging of financial assets on behalf of customers (Broker & dealer
functions)
 Exchanging of financial assets for their own account
 Assisting in the creation of financial assets for their customers, & then selling
those financial assets to other market participants(underwriting)
 Providing investment advice to other market participants.
 Managing the portfolios of other market participants.
2.3. Financial intermediaries and their roles
In a world of perfect financial markets there would be no need for financial
intermediaries (middlemen) in the process of lending and/or borrowing (Costless
transactions, Securities can be purchased in any denomination and Perfect information
about the quality of financial instruments).
A financial intermediary is defined as a bank when it performs both savings
mobilisation and lending. If a financial intermediary is only active on “one side of the
balance sheet” (i.e. it offers deposits but does not lend out to the public, or it offers loans
but gets funding from sources other than private savings) it is classified as a
non-bank financial intermediary. Many financial institutions play the role of a financial
intermediary. Services provided by financial intermediaries
• Information • Intergenerational Wealth
• Liquidity Transfer
• Reduced Transaction Costs
• Transmission of Monetary Policy
• Credit Allocation
• Payment Services

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Role of financial intermediaries (economic functions):

1. Transfer funds from savers to depositors: - funds transfer from surplus units to deficit
units through financial markets directly or indirectly through financial institutions.
2. Maturity intermediation: - In the absence of a CB, the borrower would have to borrow for
a short term, or find an entity that is willing to invest for the length of the loan sought, and/or
investor who makes deposits in the bank would have to commit funds for longer length of
time than they want. The CB by issuing its own financial claims in essence transforms a
longer-term asset into a shorter-term one by giving the borrower a loan for the length of time
sought and the investor/depositor a financial asset for the desired investment horizon.
3. Reducing risk via diversification: - Attaining cost-effective diversification in order to
reduce risk by purchasing the financial assets of financial intermediary is an important
economic benefit.
4. Reducing the cost of contracting; and information processing:- reduce cost of writing
loan contracts (contracting cost) , cost of time to process the information about the financial
asset & its issuer or cost of acquiring such information (information processing costs) and
cost of enforcing the terms of the loan agreement. All this activities requires professionals the
employment of such professionals is cost effective for financial intermediaries.
5. Providing a payment mechanism: - Most transactions made today are not done with cash.
Instead payments are made using checks, credit cards and electronic transfer of funds. These
methods for making payments called payment mechanisms are provided by certain financial
intermediaries.

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2.4. Classifications of Financial Institutions
2.4.1. Depository and non-depository financial institutions.
Depository institutions are financial intermediaries that accept deposits from individuals and
institutions and make loans. These institutions make direct loan to the entities and invest in
securities. Their income is generated from the loans they make and the securities they purchased
(interest spread or margin) and fee income. depository institution can accommodate withdrawal
and loan demand: by attracting additional deposit, Use existing securities as collateral for
borrowing from federal agency or other financial institution such as investment bank, and Raise
short term funds in the monetary market. Depository financial institutions include; Commercial
banks, saving and loan associations, saving banks and Credit unions.
[Link]. Commercial banks
Commercial banks are owned by private investors (stockholders), or by companies (bank
holding companies). Commercial banks are “for profit” organizations their objective is to make a
profit. Commercial banks provide numerous services in our financial system. These can be
classified as follows
a) Individual banking: - encompasses consumer lending, residential mortgage lending,
consumer installment loans, credit card financing, automobile financing, brokerage services,
student loans, and individual oriented financial investment services. Interest income and fee
income are generated from mortgage lending and credit card financing. Fee income is
generated from brokerage services.
b) Institutional banking: - Loans to nonfinancial corporations, financial corporations and
governmental entities.
c) Global banking:- It is in the area of global banking that banks began to compete head to
head with investment banking (or securities) firms. Global banking covers a broad range of
activities involving corporate financing and capital market and foreign exchange products
and services. Corporate financing: - involves first is procuring of funds for a bank’s
customers and the second one is that advice on strategies for obtaining funds, corporate
restructuring, and acquisitions. Capital market and foreign exchange products and services
involve transactions where the bank acts as a dealer or a broker in a service. Most global
banking activities generate fee income rather than interest income.

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Sources of funds for banks:
1. Deposits:-
 Demand deposits (checking account) pay no interest and can be withdrawn upon demand.
 Saving deposit pay interest, typically below market rates, don not have specific maturity,
and usually can be withdrawn upon demand.
 Time deposit also called certificate of deposit, have a fixed maturity date and pay either a
fixed or floating interest rate.
2. Non-deposit borrowing: - includes borrowing from the Federal Reserve through the
discount window and borrowing by issuance of securities in the money and bond markets.
3. Issuing common stock
4. Retained earnings.

Regulators of commercial banks: - Because of the special role that commercial banks play in
the financial system, banks are regulated & supervised by federal & state government entities.

[Link]. Saving and Loan Association (S&Ls)

S&Ls are either mutually owned or have corporate stock ownership. Mutually owned means
there is no stock outstanding, so technically the depositors are the owners. Like banks, the S&Ls
may be chartered under either state or federal statute. At the federal level, the primary regulator
of S&Ls is the federal saving and loan associations agency.
[Link]. Saving Banks
Saving banks are institutions similar to, though much older than, S&Ls. They can be either
mutual owned (mutual saving banks) or stockholder owned. Asset structures of saving banks are
similar with that of S&Ls. The principal assets of saving banks are residential mortgages. The
principal sources of funds for saving banks are deposits. It offers similar deposits with S&Ls but
the ratio of deposit with that its total asset is greater than S&Ls. Deposits can be insured by
either the bank insurance fund or savings association insurance fund.
[Link]. Credit Unions
They are either cooperative or mutually owned. The members deposit is called shares and the
distribution paid to the members is in the form of dividends, not interest. They are the only
financial institutions that are tax-exempt and can be chartered either by the states or by the

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federal government. The principal sources of funds for saving banks are deposits. It offer similar
deposits with S&Ls but the ratio of deposit with that its total asset is greater than S&Ls.
Deposits can be insured by either the bank insurance fund or savings association insurance fund.
2.4.2. Non-depository institutions.
Non depository Institutions are institutions that serves as an intermediary between savers and
borrowers, but does not accept deposits. It includes financial service corporations, insurance
companies, investment banks, investment companies, mutual fund and exchange trade funds.
[Link]. Financial Services Corporations:
Financial Services Corporation is in the lending or financing business, but they are not
commercial banks. One well known financial service corporation is GE capital, the finance unit
of the General Electric Corporation. GE capital provides commercial loans, financing programs,
commercial insurance, equipment leasing, and other services in over 35 countries around the
world. GE capital also provides credit services to more than 130 million customers that range
from retailers, auto dealers, consumers offering products and services from credit cards to debt
consolidation to home equity loans.
[Link]. Insurance Companies
Insurance companies sell insurance to individuals and businesses to protect their investments.
They collect premium and hold the premium in reserves until there is an insured loss and then
pay out claims to the holders of the insurance contracts. Later, these reserves are deployed in
various types of investments including loans to individuals, businesses and the government.
[Link]. Investment banks
Are specialized financial intermediaries that help companies and governments raise money and
provide advisory services to client firms on major transactions such as mergers. Firms that
provide investment banking services include Bank of America, Goldman Sachs, Morgan Stanley
and JP Morgan Chase.
[Link]. Investment companies
Investment companies are financial institutions that pool the savings of individual savers and
invest the money in the securities issued by other companies purely for investment purposes.
[Link]. Mutual Funds and Exchange Traded Funds (ETFs)
Mutual funds are professionally managed according to a stated investment objective.
Individuals can invest in mutual funds by buying shares in the mutual fund at the net asset value

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(NAV). NAV is calculated daily based on the total value of the fund divided by the number of
mutual fund shares outstanding. Mutual funds can either be load or no-load funds. The term load
refers to the sales commission that you pay when acquiring ownership shares in the fund. These
commissions typically range between 4.0 to 6.0%. A mutual fund that does not charge a
commission is referred to as a no-load fund.
An exchange-traded fund (ETF) is similar to a mutual fund except that the ownership shares in
the ETF can be bought and sold on the stock exchange. Most ETFs track an index, such as the
Dow Jones Industrial Average and generally have relatively low expenses.
Mutual funds and ETFs provide a cost-effective way to diversify and reduce risk. If you had only
$10,000 to invest, it would be difficult to diversify since you will have to pay commission for
each individual stock. However, by buying a mutual fund that invests in S&P 500,you can
indirectly purchase a portfolio that tracks 500 stocks with just one transaction.

Hedge funds:- are similar to mutual funds but they tend to take more risk and are generally
open only to high net worth investors. Management fees also tend to be higher for hedge funds
and most funds include an incentive fee based on the fund’s overall performance, which typically
runs at 20% of profits.
Private Equity Firms:- Private equity firms include two major groups: Venture capital (VC)
firms and Leveraged buyout firms (LBOs).
a) Venture capital firms raise money from investors (wealthy individuals and other financial
institutions) that they then use to provide financing for private start-up companies when they
are first founded.
b) Leveraged buyout firms acquire established firms that typically have not been performing
very well with the objective of making them profitable again and selling them. An LBO
typically uses debt to fund the purchase of a firm.
2.5. Risks in Financial Industry
Financial institutions face the following risks;

1. Credit or default risk: - is the risk that a direct debt security issuer will not pay as agreed,
thus affecting the rate of return on a loan or security.
2. Interest rate risk: - is the risk of fluctuations in a security's price or reinvestment income
caused by changes in market interest rates.

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3. Liquidity risk: - is the risk that the financial institution will be unable to generate sufficient
cash flow to meet required cash outflows.
4. Foreign exchange risk: - is the risk that foreign exchange rates will vary in the future
affecting the profit of the financial institution.
5. Political risk: - is the cost or variation in returns caused by actions of sovereign
governments or regulators.

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