EMPIRICAL RELATION BETWEEN FINANCIAL SYSTEM

AND ECONOMIC GROWTH

 CHAPTER TWO

FINANCIAL INSTITUTIONS IN THE

FINANCIAL SYSTEM
 Functions of Financial institutions
 Financial institutions play a vital role in the financial system
of any economy.
 Transforming Financial Assets
 Exchanging Financial Assets on Behalf of Customers
 Exchanging Financial Assets for Own Account
 Assisting in the Creation of Financial Assets
 Providing Investment Advice
 Managing Portfolios
 Classification of Financial Institutions
 These financial institutions are classified into two.
1. Depository Institutions and
2. Non-depository Institutions.
 Depository Institutions
 are financial intermediaries that accept deposits and make
direct loans to various entities and also invest in securities.
 include
 commercial banks,
 savings and loan associations, and
 credit unions
 their income is derived from:
 interest on loans,
 interest and dividend on securities, and
 fees income
 Commercial Banks
 are owned by private investors or bank holding companies.
 Their objective is to make a profit.
 services
 savings accounts,
 checking service,
 consumer, industrial and commercial loans,
 credit cards,
 investment banking, and
 safe keeping of valuable assets.
 Commercial Banks
 are the largest bank, both in assets and in geographic extent.
 They accept deposit make loans.
Bank Services
 Commercial banks provide numerous services in the
financial system;
 individual services,
 institutional services
 global services
 Commercial Banks
 Individual banking: It encompasses consumer lending,
residential mortgage lending, consumer installment loans,
credit card financing, student loan & individual oriented
financial investment service.
 They generate:
 Interest from loans
 Fee income from credit card financing
 Institutional banking: loans to non-financial corporations
& financial corporations (like insurance companies),
government, leasing companies etc.
 Commercial Banks
 They generate:
 interest from loan to corporation & leasing
 fees from management of private assets pension funds,
custodial services.
 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 & capital market & foreign exchange
products & services.
 Most global banking generates fee income rather than
interest income.
 Sources of funds
 Deposits-
 savings,
 demand, and
 time
 Non-deposit borrowings
 Common stock and Retained earnings
 Reserve requirements and borrowing
 The bank cannot invest all the money they obtained because the
entire bank must maintain specified percentage of their deposits
in a non interest bearing account in Federal Reserve banks.
 The specified percentage are called reserve ratios and the birr
amount based on them that are required to kept on deposit at
central bank are called required reserves.
 Reserve requirement- portion of deposit kept as a caution
against possible bank illiquidity.
 Regulation
 CBs banks are regulated & supervised by the central bank.
 areas of regulation include,
 Ceilings on deposit interest
 Permissible activities for CBs
 Capital requirements
 Geographical Restrictions on Branch Banking
 Regulation
Capital requirements
 aimed at preventing insolvency
 banks have high debt to equity ratio
 In Ethiopia CBs are required to have Br 500,000,000
 Saving & loan Association
 Saving and Loans Association represent a fairly old
institution.
 The basic purpose of establishing saving and loans
associations was pooling the savings of local residents for
financing the construction and purchase of a homes.
 The collateral for the loan would be the home being
financed.
 Saving and loans are either mutually owned (means there is
no stock outstanding) or have corporate stock ownership, so
technically the depositors are the owners.
 Saving & loan Association
 Traditionally, the only assets in which saving and loans
associations were allowed to invest have been:
 Mortgages (Loans secured by a property).
 Mortgage-backed securities.
 Government securities.
 The principal source of funds for S&L consisted of passbook
savings accounts and time deposits.
 Then it was expanded to negotiable order of withdrawal
(NOW) account, which is similar with demand account.
 Credit Unions
 They are the smallest and the newest depository institution.
They are either cooperative or mutually owned.
 established by people with a common bond
 can be cooperatives or mutually owned
 they are nonprofit and owned by their customers
 Established to satisfy saving and borrowing needs of their
members
Non-depository institutions
 Non-depository institutions
 are financial institutions that do not mobilize deposits
 These include:
 Insurance companies
 Pension funds
 Investment companies
 Investment Banking Firms
 Insurance companies
 They offers insurance policies to the public
 It provides social security and promotes individual welfare.
 They distribute/spreading risks to a number of individuals.
 The primary function of insurance companies is to
compensate individuals and corporations (policyholders) if
perceived adverse event occur, in exchange for premium
paid to the insurer by policyholder.
 Insurance companies
 provide (sell and service) insurance policies, which are
legally binding contracts.
 Insurance companies promise to pay specified sum
contingent on the occurrence of future events, such as death
or an automobile accident.
 Therefore, they are risk bearer. That is, they accept or
underwrite the risk for an insurance premium paid by the
policyholder or owner of the policy.
 Insurance companies
Features of Insurance companies
1. Insurance policy & premium: Insurance policy is a
legally binding contract for which the policy holder
(owner) pays premium in exchange for the insurance
company's promise to pay specified sum contingent of
future events.
 When the policy is accepted by an insurance company, it
becomes an asset for the owner & a liability for the
insurance company.
 Insurance companies
Features of Insurance companies
2. Surplus & reserves: The surplus of an insurance company
is the difference b/n its assets & liabilities. And reserve is
the amount of cash set aside by insurance company as a
contingent liability.
3. Determination of profits: An insurance company's
revenue for a fiscal year is generated from two sources:
 Premium earned during the fiscal period.
 Investment income earned from invested assets.
 Insurance companies
Features of Insurance companies
4. Government guarantees: unlike the liabilities of
depositary institutions insurance policies are not
guaranteed by any federal entity.
 Insurance companies
Types of Insurance Business
 There are two types of insurance companies:
1. Life insurance companies. (The claim is fixed and
certain). a type of insurance that pays money to the family
of someone who has died.
2. Property & causality insurance company. (The claim is
variable and uncertain). The risk insured by property and
casualty insurance companies is the damage to various
types of property.
 Pension funds
 Pension funds are major institutional investors and
participants in the financial markets.
 A pension fund is a fund that is established for the payment
of retirement benefits
 Pension funds
 The entities that establish pension plans-called plan
sponsors- may be:
 private business entities acting for their employees,
 federal, state, and local entities on behalf of their employees,
 unions on behalf of their employee and
 individuals for themselves.
 Thus, pension funds are financed by contribution from
employer and/or employees
 Investment companies
 Investment companies are financial intermediaries
that sell share to the public and invest the
proceeds in a diversified portfolio of securities.
 Each share that they sell represents a
proportionate interest in the portfolio of securities
owned by the investment company.
 Investment Banking Firms
 Investment bank is a financial institution engaged
in securities business.
 These financial institutions play a crucial role in
the distribution and trading of huge amounts of
securities
 They mainly involve in primary markets, the
market in which new issues are sold and bought
for the first time.
Indirect Transfer using Investment Banker

Funds Funds

saver

investment
banker firm

Securities Securities
 Investment Banking Firms

Activities of investment banking firms

 Public offering (underwriting of securities)

 Private placement of securities

 Securitization of assets

 Merger and acquisition

 Merchant banking trading

 Money management
 Investment Banking Firms
1. Public offering (underwriting) of
securities
 Investment bankers performing one or more of the
following three functions:
A. Advising the issuer on the terms and the timing of
the offering.

B. Buying the securities from the issuers.

C. Distributing the issue to the public.

 Investment Banking Firms
1. Public offering (underwriting) of
securities
 When investment banking firm buys the security
from the issuer and accept the risk of selling the
securities to investors at a lower price, it is
referred to as an underwriter.

 The function of buying the securities from the

issuer is called underwriting.

 Thus, the fee earned from underwriting the

security is the difference between the price paid
to the issuer and the price at which the
investment bank re-offers the security to the
public.
 Investment Banking Firms
2. Private placement of securities
 In addition to underwriting securities for
distribution to the public, investment banking
firms place securities with a limited number of
institutional investors like insurance companies,
pension fund etc.

 Investment banking firms assist in the private

placement of securities in several ways, for
example, they work with the issuer on the design
and pricing of securities.
 Investment Banking Firms

3. Securitization of Assets
 Securitization of assets refers to the issuance of
securities that have a pool of assets as collateral.

 Securitization is the process of conversion of

existing assets or future cash flows into
marketable securities.

 In other words, securitization deals with the

conversion of assets which are not marketable
into marketable ones

 securitization is an instrument of structured

finance used by banks for pooling together various
types of assets and transforming them into
marketable securities
 Investment Banking Firms
4. Merger and Acquisition
 A merger is a combination of two companies to
form a new company, while an acquisition is the
purchase of one company by another in which no
new company is formed.

 Investment banking firms are active in merger and

acquisition.

 They may participate in merger and acquisition

activity in one of the following ways:
1. Finding merger and acquisition candidates.
2. Assisting acquiring companies in obtaining the
necessary funds to finance a purchase.
 Risk in Financial Industry
Most Common Types of risks
1. Credit Risk
2. Liquidity Risk
3. Interest Rate Risk
4. Market risk
5. Off-balance sheet Risk
6. Foreign Exchange Risk
7. Country (sovereign) Risk
8. Technology and Operational Risk
9. Insolvency Risk
Risk in Financial Industry
1. Credit Risk
 the chance that debtors default on
their obligation
 debt securities with long-term
maturity pose more credit risk than
securities with short-term maturity
 banks, thrifts and life insurance
companies have higher degree of
exposure to credit risk
Financial markets and Institutions Wednesday, December 18, 2
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 Credit Risk...
 managerial efficiency and credit
risk management strategy affects
credit risk of a loan portfolio
 Loan diversification can help
eliminate firm specific credit risk

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024
 2. Liquidity risk
 the likelihood that a FI becomes
unable to meet demand for
withdrawal,loan, or indemnity
 may compel FIs to dispose illiquid
assets at a cheap price
 may cause a ‘bank run‘
 deposit insurance

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024
 3. Interest Rate (funding)Risk

 caused by maturity mismatch of assets and

liabilities coupled with interest rate volatility
o Refinancing risk- assets have long-term
maturity and liabilities of short-term maturity.
Cost of refinancing may exceed return on assets
o Reinvestment risk- result from fact that the
interest or dividend earned fron an investnent
cannot be reinvested with the same rate of
return as it was acquring earlier
o Price risk- arise due to the possibiity that the
price of the share, commodiy, investment may
40 Financial markets and Institutions Wednesday, December 18, 2
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 4. Market Risk
 risk incurred in trading assets due
to change in interest rate,
exchange rate, and other asset
prices
 faced by FIs engaged in active
trading of assets
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 5. Off-balance sheet risk
 arises in relation with contingent
assets and liabilities
Eg. Credit guarantees
6. Foreign exchange risk
Foreign Exchange Risk is the risk of
loss due to changes in the international
value of
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Financial markets and)
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 7. Country (sovereign) Risk
 the risk that repayment from foreign
borrowers may be interrupted because
of interference from foreign
governments
 governments may control foreign
currency outflows to mitigate currency
shortages
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024
 8. Technology and
 technology risk arises when FIs
operational risk
technological investment fails to
fetch the anticipated benefit
 economies of scale and
economies of scope

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 4.1 Types of risks
 operational risk arises when the
existing technology or support
system mulfunctions or breaks down
 may also arise due to employee
fraud, misrepresentations, and
account errors
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 4.1 Types of risks

9. Insolvency risk
 the risk that an FI may not have
enough capital to offset a sudden
decline in the value of its assets
relative to its liabilities

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