Chapt-3 Financial Mkt & institutions (Flash).pptx

Financial markets and institutions

1. FINANCIAL MARKETS AND INSTITUTIONS CHAPTER THREE: FINANCIAL INSTITUTIONS and Operations

2. Chapter Outline Introduction Classification of financial institutions Depository institutions Non-depository Institutions Functions of Central banking Risk management in financial institutions

3. 3.1. Introduction Financial institutions are organizations or intermediaries that help the financial system operate efficiently and transfer funds from savers and investors to: Individuals B usinesses , and G overnments that seek to spend or invest the funds in physical assets (inventories, buildings, and equipment). Financial intermediaries investigate the financial condition of the individuals and firms who want financing to figure out which have the best investment opportunities.

4. 3.2. Classification of Financial Institutions Based on their functions financial institutions can be categorized as Depository, and N on-depository institutions. Based on the institutions’ sources of funds and uses of funds , financial institutions are categorized as: Depository financial institutions O btain a large proportion of their funds from deposits Principle use the fund for the provision of loan. Example: C ommercial banks, building societies and credit cooperatives , etc.

5. Classification of Financial Institutions: Cont’d 2. Investment B anks Large fund from advising , use for investment Are an organization that underwrites and distributes new investment securities and helps businesses obtain financing . An underwrite is any party, usually a member of a financial organization, that evaluates and assumes , for a fee, another party’s risk mortgages, insurance, loans, or investment. Major activities of investment banks are: Help corporations design securities with features that are currently attractive to investors, Buy these securities from the corporation, and resell them to savers . Advisory services advising like mergers and acquisitions, portfolio restructuring and financial risk management.

6. Classification of Financial Institutions: Cont’d P rovide some loans to clients but are more likely to advise and assist a client to raise funds directly from the capital markets . 3. Contractual savings institutions Large fund from contract holder by periodic payment, and use for investment. For example, financial institutions such as insurance companies, and Pension funds ( are retirement plans funded by corporations or government agencies for their workers and administered primarily by the trust departments of commercial banks or by life insurance companies). the institution will make specified payouts to the holder of the contract if and when an event specified in the contract occurs.

7. Classification of Financial Institutions: Cont’d 4 Finance companies and G eneral F inanciers Large fund by issuing financial instruments ( such as commercial paper, medium-term notes and bonds in the money markets and the capital markets) , and use for investment . Unit trusts/trust funds Large fund from small investors or public by selling units in a trust, and use to make investment in large companies instrument by pooling this fund. F ormed under a trust deed and are controlled and managed by a trustee or responsible entity. Unit trusts attract funds by inviting the public to purchase units in a trust.

8. Classification of Financial Institutions: Cont’d The funds obtained from the sale of units are pooled and then invested by funds managers in asset classes specified in the trust deed. For example, Mutual funds are corporations that accept money from savers and then use these funds to buy stocks, long-term bonds, or short-term debt instruments issued by businesses or government units. Mutual funds pool funds and thus reduce risks by diversification.

9. 3 .3. The Role of Financial Intermediaries Intermediaries, including banks and securities firms, plays a key role in both direct and indirect finance. Financial markets are important because they price economic resources and allocate them to their most productive uses. Banks are still critical providers of financing around the world. Intermediaries determine which firms can access the stock and bond markets. Lending and borrowing involves both transactions costs and information costs.

10. The Role of Financial Intermediaries: Cont’d In their role as financial intermediaries, financial institutions perform the following main functions: Asset transformation Maturity transformation liquidity transformation Risk diversification Reduce information costs/economies of scale

11. The Role of Financial Intermediaries: Cont’d 1. Asset Transformation T he ability of financial intermediaries to provide a range of products that meet customers’ portfolio preferences. Financial intermediaries engage in asset transformation by offering their customers a wide range of financial products on both sides of the balance sheet, including deposit, investment and loan products. Without intermediation, surplus units that could generate only small levels of savings would not have any incentive to save; and users of funds, such as individuals and small businesses, would find the cost of obtaining loans too great to be worthwhile.

12. The Role of Financial Intermediaries: Cont’d Intermediaries specialize in the gathering of savings and can achieve economies of scale in their operations. They can profitably receive small amounts from many savers, pool them into larger amounts and make them available as loans to borrowers. The most straightforward economic function of a financial intermediary is to pool the resources of many small savers. By accepting many small deposits, banks empower themselves to make large loans.

13. The Role of Financial Intermediaries: Cont’d 2. Maturity Transformation It is common that savers prefer great liquidity in their financial assets, while borrowers tend to prefer a longer-term commitment in the funds they borrow. By managing the deposits they receive, intermediaries are able to make loans of a longer-term nature while satisfying savers’ preferences for shorter-term savings. This is referred to as maturity transformation. Banks provide a good example of the maturity transformation function of intermediaries. The deposits they receive are generally quite short term in nature (typically less than five years), however, these institutions’ lending constitute largely long-term loans. The banks therefore have a mismatch between the terms to maturity of a large proportion of their sources of funds and their loan liabilities.

14. The Role of Financial Intermediaries: Cont’d Financial intermediaries are able to perform maturity transformation for two reasons : 1).It is unlikely that all savers would choose to withdraw their deposits at the same time. Deposit withdrawals during any particular period are generally more or less matched by new deposits. 2).F inancial intermediaries that engage in maturity transformation rely on liability management. Liability management: banks’ management of their sources of funds (liabilities) in order to meet future loan demands (assets)

15. The Role of Financial Intermediaries: Cont’d 3. Risk Transformation R isk transformation occurs through the contractual agreements of intermediation. A saver has an agreement with the financial intermediary, and therefore the credit risk exposure of the saver is limited to the risk of the intermediary defaulting. The financial intermediary has a separate loan agreement with the borrower and is exposed to the credit risk of the borrower. Financial intermediaries specialize d in making loans develop an expertise in assessing the risk of potential borrowers. Hence, intermediaries’ skill in assessing potential risks involved in various investment opportunities helps to transfer and manage risks .

16. The Role of Financial Intermediaries: Cont’d F or example , Consider an investor who places funds in an investment company. Suppose the investment company invests the funds received in the stock of a large number of companies. The investment made in in different company’s instrument helps the investment company to diversify and reduce its risks. Investors who have a small sum to invest would find it difficult to achieve the same degree of diversification. However, by investing in the investment company for the same sum of money, investors can accomplish this diversification, thereby reducing risk.

17. The Role of Financial Intermediaries: Cont’d 4. Liquidity Transformation Surplus units ( Savers) usually prefer more liquidity in their investments because the timing of their income and expenditure flows will not perfectly coincide. In order to manage this timing problem, savers will tend to hold at least some of their financial assets in a very liquid form that can easily be converted to cash. Liquidity transformation is measured by the ability to convert financial assets into cash at something close to the current market price of the financial instrument.

18. The Role of Financial Intermediaries: Cont’d In converting financial assets into cash investors incur transaction costs. Transaction costs can often be quite high. However, a financial intermediary may have the capacity to lower transaction fees by spreading fixed costs across a large number of transactions. The time involved in carrying out a transaction may also be an important component of the total transaction cost. Many intermediaries provide highly liquid accounts in which individuals may store some of their wealth. For example, a demand (at-call) account with a bank represents complete liquidity.

19. The Role of Financial Intermediaries: Cont’d The depositor has the right to withdraw funds without notice. There is zero risk that the value of the asset, when it is converted into cash, will be less than the value of the deposit in the demand account. In addition, the transaction costs associated with converting the credit balance into cash are limited to transaction fees imposed by the bank. Intermediaries such as commercial banks can offer highly liquid assets to savers, which the ultimate users of funds would be most unlikely to be able to do. Banks also create liquidity by adopting systems such as electronic networks: automatic teller machines (ATMs) and electronic funds transfer at point of sale arrangements.

20. The Role of Financial Intermediaries: Cont’d 5. Economies Scale Financial intermediaries gain considerable economies of scale due to their size and the volume of business transacted, and therefore have the resources to develop cost-efficient distribution systems. Banks provide extensive technology-based distribution systems such as ATMs, electronic funds transfer , telephone banking and internet banking. The cost of the sophisticated computer and communication systems required to support such distribution networks is spread over the millions of transactions processed.

21. The Role of Financial Intermediaries: Cont’d Intermediaries also obtain cost advantages through effective knowledge management and the accumulation of financial, economic and legal expertise. For example, a bank will typically use standardised documentation for its deposit and lending products. The bank knows that these documents will comply with regulatory and legal requirements. Other cost advantages include a reduction in search costs for both savers and borrowers; that is, savers do not need to investigate the creditworthiness of the ultimate borrower. The intermediary will have that data available before making a loan decision.

22. The Role of Financial Intermediaries: Cont’d The fact that the borrower knows whether he or she is trustworthy, while the lender faces substantial costs to obtain that information, results in an information asymmetry . Borrowers have information that lenders don’t. By collecting and processing standardized information, financial intermediaries reduce the problems that information asymmetries create.

23. The Role of Financial Intermediaries: Cont’d 6. Information Asymmetries and Information Costs Financial intermediaries are major contributors to information production . They are especially good at selling information about a borrower’s credit standing. The need for information about financial transactions occurs because of asymmetric information. Asymmetric information occurs when buyers and sellers do not have access to the same information; sellers usually have more information than buyers. This is especially true when the seller owns or has produced the asset to be sold to the buyer.

24. The Role of Financial Intermediaries: Cont’d Transaction costs are all fees and commissions paid when buying or selling securities, such as search costs, cost of distributing securities to investors, cost of SEC registration, and the time and hassle of the financial transaction. In general, the greater the transaction cost, the more likely it is that a financial intermediary will provide the financial service. Banks and other financial intermediaries are experts in reducing transaction costs. Much of the cost savings come from economies of scale and from the use of sophisticated digital technology.

25. The Role of Financial Intermediaries: Cont’d Asymmetric information is a serious hindrance to the operation of financial markets. A symmetric information problems occur in two forms: Adverse selection: arises before the transaction occurs. Lenders need to know how to distinguish good credit risks from bad. Moral hazard: occurs after the transaction. Will borrowers use the money as they claim?

26. The Role of Financial Intermediaries: Cont’d 1. Adverse Selection The adverse selection problems are more severe for small business and consumers because of the lack of publicly available information. Small businesses or consumers who need to borrow money will paint a positive picture about their financial situation. Firms or consumers with the most severe financial problems also have the greatest incentive to lie and “cook the books” to get a loan. The key to the deadlock is to gather more information about a business’s or individual’s credit situation. However, gathering additional information is not free. Banks must decide if the cost of gathering additional information is warranted.

27. The Role of Financial Intermediaries: Cont’d Loan pricing is particularly difficult when intermediaries don’t know who is a good or bad credit risk. For example, assume a bank lacks reliable information. If the bank sets the loan rate too high, the good credit risks will look elsewhere, leaving only bad borrowers. If the loan rate is too low, the bank will be swamped with borrowers of low credit standing, and the bank stands a good chance of losing more money on the bad credit risks than it will earn on its good borrowers. Hence, if reliable information is not available at a reasonable cost, the banker may decide not to make any loans to businesses or consumers in a particular market. This leads to market failure .

28. The Role of Financial Intermediaries: Cont’d 2. Moral Hazard Moral hazard arises when we cannot observe people’s actions and therefore cannot judge whether a poor outcome was intentional or just a result of bad luck. Moral hazard problems occur after the transaction (loan) takes place. This information asymmetry arises because the borrower knows more than the lender about the way borrowed funds will be used and the effort that will go into a project. They occur if borrowers engage in activities that increase the probability that the borrower will default

29. The Role of Financial Intermediaries: Cont’d The loan’s default risk is much higher than the lender was led to believe at the time the loan was made. Assume a woodworking shop owner requested a loan for additional working capital. Let’s say that the bank made the loan. Rather than using the money for working capital, however, the owner takes half the money and puts 10 percent down to buy a new high-tech machine that will increase his shop’s operating efficiency, design capability, and (he hopes) sales. But it’s a lot of money for one machine, and the monthly payments are large given current sales. T he large monthly payment, which is a fixed cost, increases the loan’s default risk above the original deal.

30. 3.4. Depository Institutions Deposit-type financial institutions are financial institutions: A ccept deposits from economic agents (liabilities to them ), and L end these funds to make direct loans or invest in securities. For example, commercial banks, thrift institutions (saving and loan associations and saving banks), and credit unions. Depository financial institutions are the most commonly recognized intermediaries because most people use their services on a daily basis.

31. Depository Institutions: Cont’d Typically, deposit institutions issue: a variety of checking or savings accounts. And time deposits, and they use the funds to make consumer, business, and real estate loans. The main sources of income for these institutions are: Income generated from the loans they make; Income generated from the securities they purchase; and Fee income from other financial services

32. 3.4.1. Risks of Depository Institutions Depository institutions face the following risks in their operations: Credit/default risk Funding risk Liquidity risk Exchange rate risk P olitical risk

33. Risks of Depository Institutions: Cont’d Credit/Default risk I s the risk that a borrower will default on a loan obligation to the depository institutions or that the issuer of a security that the depository institution holds will default on its obligation. How financial institutions manage their credit risk? Diversify their portfolios Conduct a careful credit analysis of the borrower to measure default risk exposure, M onitor the borrower over the life of the loan or investment to detect any critical changes in financial health, which is just another way of expressing the borrower’s ability to repay the loan.

34. Risks of Depository Institutions: Cont’d 2. Funding/Interest rate risk Interest Rate Risk = Cost or interest rate paid on liabilities > Interest rate( return) earned on assets Interest rate movement adversely affects the profits of the company. A security’s price or reinvestment income caused by changes in market interest rates. Example : suppose that a depository institution raises $100 million by issuing a deposit account that has a maturity of one year and by agreeing to pay an interest rate of 7%. Ignoring the reserve requirement, let’s assume that the depository institution can invest the entire amount, in a government security at 9% interest rate for 15 years.

35. Risks of Depository Institutions: Cont’d The institution can earn a return of 2% (9% - 7%). This is the spread for only the first year, though, because the spread in future years will depend on the interest rate this depository institution will have to pay depositors in order to raise $ 100 million after the one year time deposit matures. Hence, If the deposit interest rate declines, the spread income will increase If the deposit interest rate rise, the spread income will decline.

36. Risks of Depository Institutions: Cont’d 3. Liquidity risk I s the risk that a financial institution will be unable to generate sufficient cash inflow to meet required cash outflows or Cash inflow < Cash outflow What is could be the cause of Liquidity risk? When depositors unexpectedly withdraw funds or when depository institution incurs unexpectedly high claim losses (in case of insurance company) as a result of an earthquake, fire, flood, etc.

37. Risks of Depository Institutions: Cont’d How Depository institutions can reduce liquidity risk? By attracting additional deposits By using existing securities as collateral for borrowing from a federal agency or other financial institutions. Selling securities that it owns if it is liquid and have little price risk. Raising short term funds in the money market.

38. Risks of Depository Institutions: Cont’d 4. Foreign Exchange rate risk How foreign exchange rate risk arises? Potential change in the exchange rate of one currency in relation to another or fluctuation in the earnings or value of a financial institution that arises from fluctuations in exchange rates . An institution when they have assets or operations across national borders (during domestic currency a preciated ) or If they have loans or borrowings in a foreign currency (during domestic currency deppreciated ) .

39. Risks of Depository Institutions: Cont’d 5. Political risk What is the reason of political risk? Fluctuation in value of a financial institution resulting from the actions of the government or foreign governments. Domestically , if the government changes the regulations faced by financial institutions, their earnings or values are affected . For example: 1. Before some years the government of Ethiopia prohibited beer factory not to promote their product on public medias, which affect the value of Beer factor. 2. Sanction of the America Government on Ethiopia in 2014/ 2015 on different products as the result war, which affects different companies.

40. 3.4.2. Commercial Banks Are the largest and most diversified intermediaries on the basis of range of assets held and liabilities issued. Form of checking accounts savings accounts, and various time deposits.

41. Commercial Banks: Cont’d What are the Functions and activities of commercial banks within a financial system? T ake deposits from customers (larg e proportion). I nvest those deposits by making loans (large proportion) If loan demand is forecasted to increase: Banks enter the capital markets and borrow the necessary funds required(directly from the domestic and international capital markets).

42. Commercial Banks: Cont’d Generally, c ommercial banks’ products and services include: B alance-sheet transactions: are assets (e.g. loans), liabilities (e.g. deposits) and shareholders’ funds (equity). O ff-balance-sheet transactions: are contingent liabilities; that is, they are transactions that do not appear on the balance sheet (a substantial volume of business that is not recorded as assets or liabilities on their balance sheets), includes: Expertise in the provision of risk management products, using a range of over-the counter and exchange-traded derivative instruments. Provision of products and services that assist their customers to carry out import and export business

43. Commercial Banks: Cont’d What are the Sources of funds of commercial banks? The main sources of commercial banks’ fund are: 1. C urrent account deposits 5. Bill acceptance liabilities 2. Call or demand deposits 6. D ebt liabilities 3. T erm deposits 7 . F oreign currency liabilities 4. N egotiable certificates of deposit 8. Loan capital and shareholders’ equity.

44. Commercial Banks: Cont’d C urrent Account Deposits Called cheque account or Operating account More liquid ( highly liquid nature) P rovide a stable source of funds for the banks. Generally pay interest on credit funds in the account. The level of interest paid is usually quite low, b/c highly liquid nature and low risk

45. Commercial Banks: Cont’d 2. Call or Demand Deposits Called saving accounts Holders usually receive interest payments, but the return on funds invested is low. As current account, the low rate of return represents the highly liquid nature and low risk Banks typically charge transaction and account service fees on savings-type accounts.

46. Commercial Banks: Cont’d 3. Term Deposits Lodged in an account with a bank for a specified period of time . Receive a fixed rate of interest for the period of the investment. The saver nominates the term to maturity at the time the funds are invested. R ange from one month through to five years to maturity. Higher rate of return than current accounts or call deposits. Use as an investment alternative for surplus funds that are not immediately required. Particularly attractive to a conservative investor , b/c safe and stable investment .

47. Commercial Banks: Cont’d 4 . Negotiable Certificates of Deposit (CD) Short-term sources of fund used by banks Pay to the bearer the face value of the CD at the specified maturity date. A bank may issue a CD directly into the money market. Does not include any interest payments . Sold at a discount to the face value. Hence . It is called a discount security . May sell in the secondary market to any other party. At the maturity date, the holder of the CD who receives the face value from the issuing bank . As the banks’ funding requirements change the yield offered on new CDs can be adjusted. It is important in the liability management approach of banks.

48. Commercial Banks: Cont’d 5. Bill Acceptance Liabilities A business may seek to raise funds through the issue of a bill of exchange. Bill of exchange: a short-term money market discount security A commercial bank may take two different roles in this type of funding arrangement: T he bank may act as acceptor to the bill and, T he bank may discount the bill. If a bank takes on the acceptance role, then the bill of exchange is said to be a bank-accepted bill.

49. Commercial Banks: Cont’d A bill is a discount security, and face value of the bill is repayable at the maturity date The bill does not pay interest. Acceptance : a bank puts its name on a bill issued by a third party; bank accepts primary liability to repay the face value of the bill at maturity. The acceptor (bank), on behalf of the issuer, will repay the face value of the bill to the holder at maturity. The bank may also agree to discount and buy the bill from the issuer. In this situation the bank has incurred a liability on its balance sheet because of the acceptance commitment, that is, the agreement to repay the face value to the holder at maturity.

50. Commercial Banks: Cont’d 6. Debt Liabilities (Debt Instruments) Issued by Banks in both the money and the capital markets . For example, Negotiable certificate of deposit ( CD) principal issued in money-market. Debentures , unsecured notes and transferable certificates of deposit issued in capital market Debentures and unsecured notes are bonds issued by corporations, including banks.

51. Commercial Banks: Cont’d Debentures : C orporate bond with a fixed and/or floating charge over the assets of the issuer. Bank-issued debenture is usually a collateralized floating charge over the assets of the institution. Unsecured note: A corporate bond issued without any form of underlying security attached. Transferable certificates of deposit: long-term fixed-rate instruments typically issued with terms to maturity of three to five years.

52. Commercial Banks: Cont’d 7. Foreign Currency Liabilities D ebt instruments issued into the international capital markets that are denominated in another currency. The types of debt issued are essentially the same as those issued in the domestic markets and include discount securities, medium-term notes, debentures and unsecured notes.

53. Commercial Banks: Cont’d 8. Loan Capital and Shareholders’ Equity Loan capital : is a sources of funds that have the characteristics of both debt and equity. For example, a bank may issue subordinated notes. These instruments are subordinated, which means that the holder of the security will only be paid interest payments, or have the principal repaid, after the entitlements of all other creditors (but before ordinary shareholders) have been paid. Commercial banks issues equity securities such as ordinary shares Equity is an important source of long-term funds for the commercial banks.

54. 3.4.3 Uses of Funds by Commercial Banks Funds used by commercial banks appear as assets on their balance sheets. What are the assets of Banks? Personal and housing finance Commercial lending L ending to government O ther bank assets.

55. Uses of Funds by Commercial Banks: Cont’d Personal and housing finance : includes housing loans, term loans and credit card facilities, provision of loans to purchase residential property. Commercial lending: is loans provided to the business sector, including overdrafts, term loans and mortgage finance. Lending to government: Banks mainly lend to government by purchasing government securities Other Bank Assets such as provide lease finance (bank purchases an asset that is leased to a customer), Banks also accumulate other assets such as physical infrastructure, For example , branches, and electronic information and product delivery systems.

56. 3.4.5 Off-balance-sheet Business of Commercial Banks What are the elements of Off-balance sheet of Banks? The main types of off-balance-sheet business conducted by commercial banks can be divided into four major categories : D irect credit substitutes T rade- and performance-related items C ommitments F oreign exchange contracts, interest rate contracts and other market-rate-related contracts.

57. Off-balance-sheet Business: Cont’d Direct Credit S ubstitutes I tems generally involve the bank in supporting or guaranteeing the obligation of a client to a third party. Provided by a commercial bank to support a client’s financial obligations. The bank does not provide the finance from its own balance sheet. Is a form of a stand-by letter of credit where a bank to make payment to a specified third party if the bank’s client fails to meet its financial obligation to that party.

58. Off-balance-sheet Business: Cont’d 2. Trade- and performance-related Items are also guarantees made by a bank on behalf of its client, but in this case they are made to support a client’s non-financial contractual obligations. The obligations may include trade-related undertakings or contractual agreements to provide goods or services. In trade and performance related activity, the bank provides a guarantee on behalf of its client that it will make a payment to the third party subject to the terms of the specific commercial contract .

59. Off-balance-sheet Business: Cont’d 3. Commitments Involve a bank in an undertaking to advance funds to a client , to underwrite debt and equity issues or to purchase assets at some future date. Examples: Outright forward purchase agreements : where a bank contracts to buy a specified asset, such as foreign currency, from its client at an agreed exchange rate on a specified date. Repurchase agreements : where a bank sells assets, such as government securities, on the understanding that the bank will repurchase them at a specified date.

60. Off-balance-sheet Business: Cont’d Underwriting facilities : in which a b ank guarantees a client that, subject to a range of conditions, it will cover any shortfall in funds received from a primary market issue of debt or equity securities. Loans approved but not yet drawn down : f or example, a bank has agreed to provide a borrower with a loan at a future date upon completion of the loan documentation.

61. Off-balance-sheet Business: Cont’d 4, Foreign exchange Interest rate and other market-rate-related contracts principally involve the use of derivative products—that is, futures, options, swaps and forward contracts. These instruments are primarily designed to facilitate hedging against risk. Derivative contracts are also bought and sold by traders in an attempt to make profits from movements in contract prices.

62. 3.4.6 Thrift Institutions Savings and loan associations, and mutual savings banks are commonly called thrift institutions. What are the source of Funds for Thrift Institutions? Issuing checking accounts savings accounts, and a variety of consumer time deposits . For What purpose they use this Funds? purchase real estate loans consisting primarily of long-term mortgages. They are the largest providers of residential mortgage loans to consumers ( finance the construction and purchase of homes),

63. 3.4.7 Credit Unions Authorised deposit taking institutions that accept retail deposits and provide loans to members. Credit unions obtain the majority of their funds from deposits lodged by their members. To a limited extent, they supplement their deposit base by borrowing from other credit unions , or issuing promissory notes and other securities into the financial markets . For whom the union provides loan? P rovide loans to members for residential housing, personal term loans, credit card facilities and limited commercial lending to small businesses .

64. 3.5. Non-depository Financial Institutions Non-depository institutions are financial institutions that do not mobilize deposits. What are non-depository Financial Institutions? These institutions include; I nvestment banks Managed Funds ( mutual funds and Trust funds) I nsurance companies finance companies pension funds, etc.

65. 3.5.1 Investment Banks Unlike commercial banks, investment banks do not have a depositor base from which to acquire assets. Investment banks will provide some limited lending to clients , but usually on a short-term basis. What are the source of Funds of Investment Banks (core Activities)? Hence , their principal income is a fee income associated with their off-balance-sheet activities . Advising services Advise their clients on all aspects of raising funds, restructuring ( merger and acquisition), and derivatives, offer information on when & how to place their securities in the market).

66. Investment Banks, Core Activities, Cont’d 2. Operating as foreign exchange dealers Investment banks that operate as foreign exchange dealers quote both bid (buy) and offer (sell) prices on all major currencies. 3. Acting as the underwriter of new share and debt issues In which the issuing corporation enter into an underwriting agreement with an investment bank, whereby the underwriter agrees, subject to the terms of the contract, to purchase any securities that are not purchased by investors.

67. Investment Banks, Core Activities, Cont’d 4. The placement of new issues with institutional investors A corporate client may wish to raise additional debt or equity by issuing new securities. 5. Conducting feasibility studies and advising clients on project finance 6. Identifying client risk exposures and advising on risk management strategies : 7. Advising on, and partial provision of, venture capital . An investment bank may take on the role of lead manager in bringing together a large group of other investment and commercial banks who will all provide funding for the project.

68. 3 .5.2 Managed Funds Investment vehicles through which the pooled savings of individuals are invested. Managed funds include mutual funds, trust funds, etc . Trust fund managed funds established under a trust deed ; managed by a trustee or responsible entity. The investor in the trust obtains a beneficial right to the assets of the fund and An entitlement to share in the income and capital gains (losses) derived from the fund . Mutual funds Managed funds that are established under a corporate structure where investors purchase shares in the fund.

69. Managed Funds, Mutual Funds, Cont’d Pool funds from savers/investors by selling shares/units and then use these funds to invest in a potentially wide range of securities or other assets such as; buy stocks, long-term bonds, or short-term debt instruments issued by businesses or government units. These companies thus provide a mechanism for small investors to “team up” to obtain the benefits of large-scale investing. Achieve economies of scale in analyzing securities, managing portfolios, and buying and selling securities.

70. Managed Funds, Mutual Funds, Cont’d Advantages of Mutual Funds Mobilize small saving Mutual funds mobilize funds by selling their own shares, known as units. 2. Professional management M utual fund companies have expertise of security analysts and portfolio managers who attempt to achieve superior investment results for their investors. Thus, investors are relieved of the emotional stress in buying and selling securities since mutual fund take care of this function.

71. Managed Funds, Mutual Funds Advantages, Cont’d 3. Diversified investment/ reduced risk Mutual fund provides small investors the access to a reduced investment risk resulting from diversification, economies of scale in transaction cost and professional financial managers . 4. Better liquidity Securities held by the mutual fund can be converted into cash at any time. Thus , mutual funds could not face problem of liquidity to satisfy the redemption demand of unit holders

72. Managed Funds, Mutual Funds Advantages, Cont’d 5 . Investment protection Mutual funds are legally regulated by guidelines and legislative provision of regulatory bodies of a country. 6. Low transaction cost Because they trade large blocks of securities, mutual fund companies can achieve substantial savings on brokerage fees and commissions. 7. Economic development Mutual funds mobilize more savings and channel them to the more productive sectors of the economy.

73. 3.5.3 Insurance Companies What is the primarily use of Insurance Companies? To manage risk management or to compensate individuals & corporations (policy holder) if perceived adverse event occur, in exchange for premium paid to the insurer by policy holder. Types of insurance business: Life insurance policy : provides a named beneficiary with a financial payment in the event of the death of the policyholder. General or property-casualty insurance: cover specified risks and provide a promise to pay the insured a predetermined amount in the event that the peril that is insured against occurs. Activity Read more on the insurance products provided by life insurance and general insurance policy.

74. 3.5.4 Pension Funds What are source of funds for Pension Funds? In Ethiopia, f rom employer (11%) and employee (7%) contributions monthly payments upon retirement. What they use these Funds? I nvest these funds in corporate bonds and equity obligations. Further reading on pension funds

75. 3.6. Central Banks (National Bank in Ethiopia) Apex bank in a country. Regulates (m anages the monetary system of the country) the supply, availability, and cost of money (Interest) . D irects and controls other banking institutions. The national bank of Ethiopia, for example, regulates and supervises the activities of financial institutions- both deposit and non-deposit taking- in the country.

76. Central Banks, Functions, Cont’d Issuer of the national currency. Banker, Fiscal agent and advisor to the government; Banker and lender of last resort to the commercial banking system; C ustody and management of the foreign exchange reserves; C redit control Activity: read on these core activities of central banks

77. Reading Assignment Risk Management in Financial Institutions

78. End of chapter three