MAU MFI Chapter One

CHAPTER ONE
INTRODUCTION TO FINANCIAL INSTITUTION
Contents
1.1. Meaning and nature of financial institutions
1.2. Types of financial institutions
1.3. Functions of financial institutions
1.4. Role of financial institutions
1.1 MEANING AND NATURE OF FINANCIAL INSTITUTIONS

FINANCE:- “ The science of managing money matters”. It involves activities such as:
Raising funds (through loans, equity, savings, etc)
Allocating resources (investing in assets, projects, or businesses)
Managing risks (through insurance, diversification, hedging, etc)
Planning for future financial stability
Finance is essential for individuals, businesses, governments, and economies because it supports
wealth creation, capital formation, and economic growth. Finance is the art and science of managing
money.
Classification of finance
Public finance
Private finance
Public finance:- Involves financial management by governments at national, regional, or local levels,
Managing the revenue, expenditure, and debt of government entities (local, state/provincial,
national). Public finance mostly Focus in Taxation policy, government budgeting, public expenditure,
national debt management, fiscal policy, allocation of public resources, economic stabilization. Its
Goals are Provide public goods/services, promote social welfare, achieve macroeconomic stability,
and redistribute income.
Example: The Ethiopian government preparing an annual budget or issuing treasury bonds to finance
road construction.
Private Finance
i. Personal Finance:- Managing an individual's or household's financial resources.
Budgeting, saving, investing, retirement planning, insurance, tax planning, estate planning, managing
debt (mortgages, credit cards).
Goal: Achieve personal financial security and goals.
Example: Planning for a child's education, buying a home, or investing in a retirement fund.
ii. Business Finance:- It is that business activity which deals with the acquisition and conservation
of capital funds in meeting the financial needs and over all objectives of business
[Link] for its capital expenditure and working capital.

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Example: A company deciding whether to finance a new factory through a bank loan or issuing
shares.

The Financial System

Financial System is a set of complex and closely interconnected financial institutions, markets,
instruments, services, practices, and transactions. Financial System provides for efficient flow of funds
from saving to investment by bringing savers and borrowers together via financial markets and
financial institutions.
Financial System consists of four parts:
A financial system is a complex network of institutions, markets, instruments, regulations, and
practices that facilitates the flow of money, capital, and financial services throughout an economy.
Financial Institutions
Financial Markets
Financial Instruments component of financial system
Financial Regulation
Financial system exists to facilitate the design, sale, and exchange of a broad set of contracts with a
very specific set of characteristics. Indirect Finance: An institution stands between lender and
borrower. We get a loan from a bank or finance company to buy a car. Direct Finance: Borrowers sell
securities directly to lenders in the financial markets. Direct finance provides financing for
governments and corporations.

Direct and Indirect Finance

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Financial Institutions: are organizations that provide financial services, like accepting deposits,
lending money, or managing investments. Financial institutions (also called financial intermediaries)
facilitate flows of funds from savers to borrowers.

Examples: Banks, credit unions, insurance companies, investment firms, pension funds.

Financial markets are markets for financial instrument, also called financial claims or securities.
Financial Markets are Platforms or systems where financial assets are bought and sold.
Examples: Stock markets, bond markets, foreign exchange markets, derivatives markets.
Financial Instruments: are Contracts or products that represent a financial value or obligation.
Securities” is a name that commonly refers to financial instruments that are traded on financial
markets. A security (financial instrument) is a formal obligation that entitles one party to receive
payments and/or a share of assets from another party; e.g., loans, stocks, bonds. Even an ordinary bank
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loan is a financial instrument. Examples: Shares, bonds, derivatives, loans, deposits.

Financial Services: Activities provided by institutions to facilitate transactions and investment.
Examples: Payment processing, investment advice, insurance coverage, risk assessment.
Financial Regulations & Laws: Rules and frameworks governing financial activities.
Examples: Banking regulations, securities laws, anti-money laundering rules.`

1.1.1 Meaning of financial institutions

Financial institutions are business organizations that act as mobilizers and depositories of savings,
and as purveyors of credit or finance. A financial institution is an institution that provides financial
services for its clients or members. Any institution that collects money and puts it into assets such as
stocks, bonds, bank deposits, or loans is considered a financial institution.
Financial Institution is an institution whose primary activity is buying, selling and holding financial
assets. It is institution that collects funds from public or other institutions and invests them in financial
assets. It exists for the primary purpose of facilitating the intermediation process.
Financial intermediation is the process of acquiring surplus funds from economic units for the purpose
of making available such funds to deficit economic units.
Financial intermediaries are a special group of financial institutions that obtain funds by issuing claims
to market participants and use these funds to purchase financial assets.

A financial institution (FI) is a company engaged in the business of dealing with monetary
transactions, such as deposits, loans, investments and currency exchange.
Financial institutions are business organizations that act as mobilizes and depositories of savings, and
as tellers of credit or finance.

In financial economic, financial institution is a mechanism that provides financial service for their
customers and members. Financial institution provides the most important financial services are called
as financial intermediaries. The financial institution can be controlled by either government or non-
government organization. But, most of the financial institution was handled by government. Function
of the financial institution is to transfer of capital between savers and those who need capital.

Financial institutions are important in a financial system because of the following reasons:
1. Solving Asymmetric information problems (Adverse Selection and Moral Hazard)
Asymmetric information is a lack of complete information in financial markets to make accurate
decisions. Financial intermediaries also use their expertise to screen out bad credit risks and monitor
borrowers. Adverse Selection refers to the problem that arises before a loan is made because
borrowers who are bad credit risks tend to be those who most actively seek out loans. Financial
intermediaries can help solve this problem by gathering information through credit reference bureaus
and sharing information on delinquent accounts (non-performing loans) about potential borrowers and
screening out bad credit risks. Moral Hazard refers to the problem that arises after a loan is made
because borrowers may use their funds irresponsibly. Financial intermediaries such as credit reference

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bureaus can help solve this problem by monitoring borrowers’ activities by providing sufficient
financial information.

2. Reduction of transaction cost:

Transaction costs involve the time and money spent in carrying out financial transactions. Financial
intermediaries can reduce substantially transaction costs because they have developed expertise in
lowering them and also because of economies of scale advantages.
3. Risk Sharing and Diversification
Risk is uncertainty about the returns investors will receive on any particular asset. By purchasing a
large number of different assets issued by a wide range of borrowers, financial intermediaries use
diversification to help with risk sharing. The process of risk sharing is further enhanced through the
diversification of assets, which involves spreading out funds over a portfolio of assets with different
types of risk.
4. Reduction of Monitoring Costs: - Suppliers of funds who directly invest in a fund user’s financial
claim face a high cost of monitoring the fund user’s actions in an accurate and timely manner.
Financial institutions such as mutual funds and collective investment schemes enable suppliers of
funds to pool their resources and invest through skilled financial analysts who have superior skills in
monitoring and collecting information.
5. Money Supply Transmission: - Depository institutions are the channel through which monetary
policy actions affect the economy in general and the rest of the financial system.
6. Credit Allocation:- often viewed as the major source of financing for a particular sector of the
economy (e.g. farming and real estate).

1.1.2. Nature of Financial Institutions

Intermediation: Link savers with borrowers.

Formal Regulation: Operate under the authority of regulators (e.g., NBE in Ethiopia).
Risk Management: Offer financial products that manage and transfer risk (e.g., insurance).
Liquidity and Payments: Ensure the smooth functioning of payment systems and liquidity in the
market.
Profit or Development Focused: May aim for profit (commercial banks) or development (government-
owned banks).
1.2 TYPES OF FINANCIAL INSTITUTIONS
There are two types of financial institutions
1. Depository institutions: pay you interest on your deposits and use the deposits to make loans.
Examples: Banks, Credit unions, Trust companies and Mortgage loan companies.
Commercial Banks: is a financial institution that provides services like loans, certificates of deposits;
savings bank accounts bank overdrafts, etc. to its customers. These institutions make money by lending
loans to individuals and earning interest on loans.
Accept various deposits (checking, savings, time deposits) and make a wide range of loans (consumer,
mortgage, business). Provide payment services (checks, cards, transfers).

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Savings and Loan Associations (S&Ls) / Thrift Institutions: Traditionally focused on accepting
savings deposits and making mortgage loans.

Credit Unions: Member-owned cooperatives. Accept deposits from and provide loans primarily to
their members (who share a common bond like employer, location, association). Often offer favorable
rates.

2. Non-depository institutions: non-depository institutions do not accept checkable deposits. They

are financial institutions that fund their investment from the sale of securities or insurance. The
following are some of the types of non-depository financial institutions.
i. Financial Brokers:
a. Investment Banks: organizations that underwrite and distribute new investment securities and helps
businesses obtain financing. They usually perform the role of financial mediator for various businesses
and the government and are not limited to the gathering of deposits like commercial banks. There are
three functions of an investment bank:
Helping corporations design securities with features that are currently attractive to investors
Buying these securities from the corporations; and
Reselling them to savers
b. Brokerage Houses or Firms: buy/sell old securities on behalf of individuals.
ii. Investment Institutions:
a. Mutual Funds: Get money from small savers (individuals), who buy shares in the fund; they in turn
invest in variety of stocks, bonds, etc.; allow the individuals to “pool” their savings, diversify (avoid
risk). Some mutual funds, called money market mutual funds, invest in short-term, safe assets like
Treasury bills and large bank certificates of deposit
b. Finance Companies: like banks, they use people’s savings to make loans to businesses, but instead
of holding deposits, they sell bonds and commercial paper.

iii. Contractual Intermediaries: they hold and store individuals’ savings over long term. These are
insurance companies and pension funds.
a. Insurance Companies: Insurance companies protect individuals against risk for regular payments
from individuals in exchange for contracted payments in the event of the insured’s’ loss. The assets
insurance-companies hold are purchased with insurance premiums rather than deposits. Thus, it is not
possible to write a check against an insurance policy.
b. Pension Funds: retirement plans funded by corporations or government agencies for their workers.

Types of Financial Institutions in Ethiopia

Depository Institutions: Accept deposits and give loans.
Examples: Commercial Bank of Ethiopia, Awash Bank, Cooperative Bank of Oromia.
Non-Depository Institutions: Do not take public deposits but provide other financial services.
Examples: Ethiopian Insurance Corporation, private insurance companies.
Development Financial Institutions: Support long-term development projects and sectors.

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Example: Development Bank of Ethiopia (focuses on industrial, agricultural development).

Microfinance Institutions (MFIs): Provide small loans, especially to low-income individuals.
Examples: Omo Microfinance, Amhara Credit and Saving Institution (ACSI).
Cooperative Financial Institutions: Owned by members; serve mutual benefit.
Examples: SACCOs (Savings and Credit Cooperatives) in rural and urban areas.

1.3 FUNCTIONS OF FINANCIAL INSTITUTIONS

FIs perform several vital functions essential for a functioning economy:

 Intermediation: Financial institutions act as intermediaries between savers and borrowers.

Mobilization of Savings: Encourage individuals and businesses to save by offering secure
options.
 Risk Management: By pooling resources, financial institutions help spread risk

 Liquidity Management: Financial institutions provide liquidity by enabling the easy conversion
of assets into cash. Ensure availability of cash and short-term funding.

 Payment System Facilitation: Financial institutions support the efficient functioning of payment
systems, allowing for the smooth transfer of funds between individuals, businesses, and
governments. Provide mechanisms for transferring funds, issuing checks, digital payments, etc.
 Capital Formation: Financial institutions assist in the formation of capital by providing avenues
for saving and investing.

 Financial Advisory: Guide individuals and firms on investment, retirement, and financing
decisions.
 Monetary Policy Implementation: Central banks regulate the financial system and control the
money supply to maintain economic stability.
1.4 ROLE OF FINANCIAL INSTITUTIONS

The role of financial institution is extremely crucial in any economy. Finance is the backbone of a
country because it helps in procuring funds for creation of investment opportunities, development
of infrastructure, boosting trade and commerce and overall development.

The financial institutions are the ones that facilitate in conducting transactions related to loans,
deposits, investment opportunity, buying and selling or making and receiving payments related to any
kind of business. The role of financial institutions in economic development lies in the fact that such
institutions help in channelizing funds that are earned and saved by individuals or corporates. It is
important to direct those funds towards proper uses where they will be invested in projects or areas
where finance is urgently required for development and expansion.

These institution facilitate allocation of money efficiently by facilitating flow of money within
business, banks, credit unions, insurance companies and individuals which highlights the role of
financial institutions in economic development.

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The following is the list of roles performed by financial institutions: -

1. Regulation of monetary supply

Financial institutions like the Central Bank help regulate the money supply in the economy to
maintain stability and control inflation. For example, the Central Bank applies various measures like
increasing or decreasing repo rate, cash reserve ratio, and open market operations, i.e., buying and
selling government securities, to regulate liquidity in the economy

2. Banking services

Among various nature and role of financial institutions, these institutions, like commercial banks,
help their customers by providing savings and deposit services. In addition, they offer credit
facilities like overdraft facilities to the customers to cater to the need for short-term funds.
Commercial banks also extend loans like personal loans, education loans, mortgages, or home loans
to their customers.

3. Insurance services

Financial institutions, like insurance companies, help to mobilize savings and investment in
productive activities. In return, they assure investors against their life or some particular asset at the
time of need. In other words, they transfer their customer’s risk of loss to themselves.

4. Capital formation

Financial institutions help in capital formation, i.e., increase in capital stock like the plant, machinery,
tools and equipment, buildings, transport, communication, etc. Moreover, they mobilize the idle
savings from individuals in the economy to the investor through various monetary services.

5. Investment advice

There are many investment options available at the disposal of individuals and businesses. But it is
not easy to choose the best option in the current swiftly changing environment. Almost all financial
institutions (banking or non-banking) have an investment advisory desk that helps customers,
investors, and businesses to select the best investment option available in the market according to
their risk appetite and other factors.

6. Brokerage services

These institutions provide their investors access to several investment options available in the market,
ranging from stock bonds (common investment alternative) to hedge funds and private
equity investment (lesser-known alternative).

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7. Pension fund services

Through their various kinds of investment plans, financial institutions help individuals plan their
retirement. One such investment option is a pension fund. The individual contributes to
the investment pool by employers, banks, or other organizations and gets the lump sum or monthly
income after retirement.

8. Trust fund services

Some financial organizations provide trust fund services to their clients. They manage the client’s
assets, invest them in the best option available in the market, and take care of its safekeeping.

9. Financing the small and medium-scale enterprises

Financial institutions help small and medium-scale enterprises set up themselves in their initial
business days. They provide long-term as well as short-term funds to these companies. The long-term
fund helps them form capital, and short-term funds fulfill their day-to-day working capital needs.

10. Act as a government agent for economic growth

The government regulates financial institutions on a national level. They act as a government agent
and help grow the nation’s economy and ensures that there is an important role of financial
institutions in rural marketing as well. For example, to help out an ailing sector, financial institutions,
as per the guidelines from the government, issue a selective credit line with lower interest rates to
help the industry overcome the issues it is facing

11. Employment Generation

12. Crisis Stabilization

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