31/10/2025
CHAPTER THREE
Financial Institutions: Deposit Type,
Contractual, and Other Financial Institutions
3.1 Deposit type institutions
3.2 Contractual saving institutions
3.3 Investment funds
3.4 Other types of financial institutions
1
31/10/2025
Introduction
Financial institutions are the firms that provide access to the
financial markets, both to savers who wish to purchase financial
instruments directly and to borrowers who want to issue them.
Because financial institutions sit between savers and borrowers,
they are also known as financial intermediaries, and what they do
is known as intermediation.
Banks, insurance companies, securities firms, and pension funds
are all financial intermediaries.
2
31/10/2025
Cont’d
These institutions are essential; any disturbance to the services
they provide will have severe adverse effects on the economy.
To understand the importance of financial institutions, think what
the world would be like if they didn’t exist.
Without an intermediary, individuals and households wishing to
save would either have to hold their wealth in cash or figure out
some way.
All finance would be direct, with borrowers obtaining funds
straight from the lenders.
3
31/10/2025
Cont’d
Such a system would be unlikely to work very well, for a number of
reasons.
First, individual transactions between saver-lenders and spender-
borrowers would likely be extremely expensive.
Not only would the two sides have difficulty finding each other, but even
if they did, writing the contract to effect the transaction would be very
costly.
Second, lenders need to evaluate the creditworthiness of borrowers and
then monitor them to ensure that they don’t abscond with the funds.
Individuals are not specialists in monitoring.
4
31/10/2025
Cont’d
Third, most borrowers want to borrow for the long term, while
lenders favor more liquid short-term loans.
Lenders would surely require compensation for the illiquidity of
long-term loans, driving the price of borrowing up.
All these problems would restrict the flow of resources through
the economy.
Healthy financial institutions open up the flow, directing it to the
most productive investments and increasing the system’s
efficiency.
5
31/10/2025
The Role of Financial Institutions
Financial institutions reduce transactions costs by specializing
in the issuance of standardized securities.
They reduce the information costs of screening and
monitoring borrowers to make sure they are creditworthy and
they use the proceeds of a loan or security issue properly.
Financial institutions curb information asymmetries and the
problems that go along with them, helping resources flow to
their most productive uses.
6
31/10/2025
Cont’d
At the same time that they make long-term loans, financial
institutions also give savers ready access to their funds.
That is, they issue short-term liabilities to lenders while
making long-term loans to borrowers.
By making loans to many different borrowers at once,
financial institutions can provide savers with financial
instruments that are both more liquid and less risky than the
individual stocks and bonds they would purchase directly in
financial markets.
7
31/10/2025
Cont’d
In analyzing the structure of the financial industry, we can start by
dividing intermediaries into two broad categories.
Depositoryand
Non-depository institutions
Depository institutions take deposits and make loans;
Theyare what most people think of as banks, whether they are
commercial banks, savings banks, or credit unions.
Non depository institutions include insurance companies, securities
firms, mutual fund companies, private equity or venture capital firms,
finance companies, and pension funds.
Each of these serves a very different function from a bank.
Some screen and monitor borrowers; others transfer and reduce risk.
Still others are primarily brokers.
8
31/10/2025
3.1 Deposit Type Financial Institutions
These are financial institution that are legally
permitted to solicit and accept monetary deposits
from the general public.
It accepts deposits from surplus units and provides
credit to deficit units through loans and purchase of
securities
9
31/10/2025
Types of Depository Institutions
The following are the three main categories of depository institutions:
1. Commercial Banks
A commercial bank is a kind of financial institution that carries all the
operations related to deposit and withdrawal of money for the general
public, providing loans for investment, and other such activities.
These banks are profit-making institutions and do business only to
make a profit.
The two primary characteristics of a commercial bank are lending and
borrowing.
The bank receives the deposits and gives money to various projects to
earn interest (profit).
10
31/10/2025
Cont’d
The rate of interest that a bank offers to the depositors is known as the
borrowing rate, while the rate at which a bank lends money is known as
the lending rate.
Commercial banks offer consumers and small to mid-sized businesses
with basic banking services including deposit accounts and loans.
These banks make money from a variety of fees and by earning interest
income from loans.
Banks have traditionally been located in physical locations, but a
growing number now operates exclusively online.
Commercial banks are important to the economy because they create
capital, credit, and liquidity in the market.
11
31/10/2025
How Commercial Banks Work?
Commercial banks provide basic banking services to the general
public—to both individual consumers and small to mid-sized businesses.
These services include checking and savings accounts, loans and
mortgages, basic investment services such as CDs, as well as other
services such as safe deposit boxes.
A certificate of deposit (CD) is a savings account that holds a fixed
amount of money for a fixed period of time, such as six months, one
year, or five years, and in exchange, the issuing bank pays high interest.
Banks make money from service charges and fees.
These fees vary based on the products, ranging from account fees
(monthly maintenance charges, minimum balance fees, overdraft fees,
non-sufficient funds (NSF) charges), safe deposit box fees, and late fees.
12
31/10/2025
Cont’d
Maintenance charge: is a regular fee that a bank charges to keep your
account active — usually every month or sometimes once a year.
Minimum balance fee: is a charge that a bank applies when your
account balance falls below a required minimum amount.
Overdraft fee: is a charge a bank imposes when you spend more money
than you have in your account, causing your balance to go below zero.
Non-sufficient funds (NSF) charge: is a fee banks charge when you try
to make a payment or withdrawal but don’t have enough money in your
account to cover it, and the bank declines the transaction.
Safe deposit box fee: is the annual or monthly charge a bank collects
for renting you a secure storage box in its vault., and
Late fee: is a charge a bank (or lender) imposes when you fail to make a
required payment on time.
13
31/10/2025
Cont’d
Banks also earn money from interest they earn by lending out money to
other clients.
The funds they lend comes from customer deposits.
However, the interest rate paid by the bank on the money they borrow is
less than the rate charged on the money they lend.
Commercial banks are an important part of the economy.
Not only do they provide consumers with an essential service, but they
also help create capital and liquidity in the market.
This entails taking money that their customers deposit for their savings
and lending it out to others.
14
31/10/2025
Cont’d
Commercial banks play a role in the creation of credit, which leads to
an increase in production, employment, and consumer spending,
thereby boosting the economy.
As such, commercial banks are heavily regulated by central banks.
Forinstance, central banks impose reserve requirements on commercial
banks.
This means banks are required to hold a certain percentage of their
consumer deposits at the central bank as a cushion (protect) if there's a
rush to withdraw funds by the general public.
15
31/10/2025
Functions of Commercial Banks
The functions of commercial banks are classified into two main
divisions.
A. Primary Functions
a. Accepts deposit: The bank takes deposits in the form of saving,
current, and fixed deposits.
The surplus balances collected from the firm and individuals are lent to the
temporary requirements of the commercial transactions.
There are various products offered by the bank to the customers for the
deposit of their money, like
Savings account (more suitable for keeping spare cash safe and earning
interest on that money)
Current account (usually the best option for managing everyday transactions,
such as paying bills and withdrawing cash),
Fixed deposit (The deposited amount is locked in for a set period of time)
and
Recurring deposit (allow individuals to make regular deposits over a set
period of time).
16
31/10/2025
Cont’d
b. Provides loan and advances: Another critical function of this
bank is to offer loans and advances to the entrepreneurs and
business people, and collect interest.
For every bank, it is the primary source of making profits.
In this process, a bank retains a small number of deposits as a
reserve and offers (lends) the remaining amount to the borrowers
c. Credit cash: When a customer is provided with credit or loan, they are
not provided with liquid cash.
First, a bank account is opened for the customer and then the
money is transferred to the account. This process allows the bank
to create money.
17
31/10/2025
Cont’d
B. Secondary Functions
a. Discounting bills of exchange: It is a written agreement acknowledging the
amount of money to be paid against the goods purchased at a given point of
time in the future.
The amount can also be cleared before the quoted time through a discounting method of
a commercial bank.
b. Overdraft facility: It is an advance given to a customer by keeping the
current account to overdraw up to the given limit. Purchasing and selling of
the securities.
The bank offers you with the facility of selling and buying the securities.
It is a type of financial product through which you can withdraw money from
your savings or current account, even if your account balance is zero.
c. Locker facilities: A bank provides locker facilities to the customers to
keep their valuables or documents safely.
It is a completely secured facility for safekeeping of his/her valuable items,
confidential documents and other valuables against from any unfortunate
incident.
The banks charge a minimum of an annual fee for this service.
18
31/10/2025
Cont’d
There are different types of commercial banks.
I. Private bank:- It is a type of commercial banks where private
individuals and businesses own a majority of the share capital.
II. Public bank:– It is a type of bank that is nationalized, and the
government holds a significant stake.
19
31/10/2025
2. Credit Unions
Credit unions are non-profit depository institutions that are financial
cooperatives owned by people belonging to a particular group, such as
the employees of a particular company, a union, or a religious group, or
who live in a specific area, and they are governed by a board of
volunteers.
Because they are non-profits, (they pay no federal or state tax) and
owned by their customers, they charge lower loan rates and pay higher
interest rates on savings, and they offer a wide variety of financial
services for their owners.
Credit unions can be used to deposit and to borrow money, so
members of a credit union can consider it as a bank.
Membership in the credit union is not, however, as open as
commercial banks; one must belong to the particular group to use its
services.
20
31/10/2025
3. Saving Institutions
Saving and loan associations are similar to a bank, but they are owned
and managed by the clients (the depositors and the borrowers).
That means, if you are member of a saving and loan association, you
co-own the association, but you also save and/or borrow from this same
association.
Therefore, depositors and borrowers have voting rights in important
decisions.
Worldwide they are known to facilitate mortgage loans (loan to buy a
house) and other loans for expensive household investments (for
example, a car).
Note that in the Ethiopian context, many households do not use
officially registered savings and loan- institutions, but rather rely on
informal financing methods such as Eqqub or Iddir.
21
31/10/2025
3.2 Contractual saving institutions
Contractual savings institutions, such as insurance companies and
pension funds, are financial intermediaries that acquire funds at
periodic intervals on a contractual basis.
Because they can predict with reasonable accuracy how much they will
have to pay out in benefits in the coming years,
they do not have to worry as much as depository institutions about losing funds
quickly.
As a result, the liquidity of assets is not as important a consideration for
them as it is for depository institutions, and
They tend to invest their funds primarily in long-term securities such as
corporate bonds, stocks, and mortgages.
22
31/10/2025
Cont’d
A. Life Insurance Companies:-
Life insurance companies insure people against financial hazards
following a death and sell annuities (annual income payments
upon retirement).
They acquire funds from the premiums that people pay to keep
their policies in force and use them mainly to buy corporate
bonds and mortgages.
They also purchase stocks, but are restricted in the amount that
they can hold.
23
31/10/2025
Cont’d
B. Fire and Casualty Insurance Companies
These companies insure their policyholders against loss from
theft, fire, and accidents.
They are very much like life insurance companies, receiving
funds through premiums for their policies, but they have a greater
possibility of loss of funds if major disasters occur.
For this reason, they use their funds to buy more liquid assets
than life insurance companies do.
Their largest holding of assets consists of bonds.
24
31/10/2025
Cont’d
C. Pension Funds and Government Retirement Funds
Private pension funds and state and local retirement funds provide
retirement income in the form of annuities to employees who are
covered by a pension plan.
Funds are acquired by contributions from employers and from
employees, who either have a contribution automatically deducted
from their paychecks or contribute voluntarily.
The largest asset holdings of pension funds are corporate bonds
and stocks.
The establishment of pension funds has been actively encouraged
by the federal government, both through
Legislation requiring pension plans and
Through tax incentives to encourage contributions.
25
31/10/2025
3.3 Investment funds
This category of financial intermediaries includes finance
companies, mutual funds, money market mutual funds, and
investment banks
Finance Companies:- Finance companies raise funds by selling
commercial paper (a short-term debt instrument) and by issuing
stocks and bonds.
They lend these funds to consumers (who make purchases of
such items as furniture, automobiles and home
improvements) and to small businesses.
Some finance companies are organized by a parent
corporation to help sell its product.
26
31/10/2025
Cont’d
Mutual Funds: These financial intermediaries acquire funds by selling
shares to many individuals and,
use the proceeds to purchase diversified portfolios of stocks and bonds.
Mutual funds allow shareholders to pool their resources so that they
can take advantage of lower transaction costs when buying large
blocks of stocks or bonds.
In addition, mutual funds allow shareholders to hold more
diversified portfolios.
Shareholders can sell shares at any time, but the value of these
shares will be determined by the value of the mutual fund’s holdings
of securities.
Because these fluctuate greatly, the value of mutual fund shares will,
too; therefore, investments in mutual funds can be risky.
27
31/10/2025
Cont’d
Money Market Mutual Funds : is a kind of mutual fund that invests in
highly liquid, near-term instruments. These instruments include cash.
These financial institutions have the characteristics of a mutual fund
but also function to some extent as a depository institution because
they offer deposit-type accounts.
Like most mutual funds, they sell shares to acquire funds that are
then used to buy money market instruments that are both safe and
very liquid.
The interest on these assets is paid out to the shareholders.
A key feature of these funds is that shareholders can write checks
against the value of their shareholdings.
In effect, shares in a money market mutual fund function like
checking account deposits that pay interest.
28
31/10/2025
Cont’d
Investment Banks: despite its name, an investment bank is not a bank
or a financial intermediary in the ordinary sense; that is, it does not take
in deposits and then lend them out.
Instead, an investment bank is a different type of intermediary that
helps a corporation issue securities.
First it advises the corporation on which type of securities to issue
(stocks or bonds); then
It helps sell (underwrite) the securities by purchasing them from the
corporation at a predetermined price and reselling them in the
market.
Investment banks also act as deal makers and earn enormous fees by
helping corporations acquire other companies through mergers or
acquisitions.
29
31/10/2025
3.4. Other types of financial institutions
Most financial institutions have been discussed so far, but a particular
one, Capital Goods Finance Companies (CGFCs), has not yet been
discussed.
CGFCs provide capital to purchase capital goods
Capital goods are durable goods (ones that do not quickly wear out)
that are used for the production of more capital goods as well as
consumer goods.
Capital Good is defined as any equipment or machine that may be
used to produce products or to provide services and includes
accessories.
CGFCs are established with the aim of providing financial services
through finance lease
30
31/10/2025
Cont’d
Lease financing enables manufactures and other producers to use
equipment and machineries without having to pay the full costs of the
investment goods.
A lease is a contractual arrangement under which the owner of an asset
agrees to allow the use of his asset by another partly in consideration of
periodic payments for a specific period.
In lease financing, the owner of an asset gives another person the right
to use that asset against periodical payments. The owner of the asset is
known as lessor and the user is called lessee.
In the case of Ethiopia, a CGFC is a company that is licensed by the
National Bank of Ethiopia to undertake Capital Goods Finance
Business.
31
31/10/2025
Cont’d
UP to August 9, 2019, six companies have been granted Capital
Goods Finance Business License to operate in different regions of
the country. Namely:
Waliya capital goods finance company – Amhara region;
Oromia capital goods finance company – Oromiya region;
Debub capital goods finance company – SNNPRS;
Addis capital goods finance company – Addis Ababa City
Administration;
Kaza capital goods finance business company – Tigray region;
and
Ethio Lease Ethiopian capital goods finance company – Addis
Ababa
32
31/10/2025
Cont’d
Basically, CGFCs are established with the aim of providing
financial service to individuals and/or enterprises that have the
desire, knowledge and profession to participate in various
investment activities but could not act due to a lack of capital.
In this regard, the SMEs will be the primary beneficiaries of these
companies because they lack collateral to access loan from
classical banks.
33