chapter Two Financial Institutions in the Financial System.pptx

Financial system

1. Chapter two : Financial Institutions in the Financial System

2. Overview of Financial Institutions Financial institutions serve as intermediaries by channeling the savings of individuals, businesses, and governments into loans or investments. They are major players in the financial marketplace , with large amount of financial assets under their control.

3. Cont,d Financial institutions deal with various financial activities associated with financial systems, such as securities, loans , risk diversification , insurance, hedging, retirement planning , investment, portfolio management, and many other types of related functions. With the help of their functions, financial institutions transfer money or funds to various tiers of economy and thus play a significant role in acting upon the domestic and the international economic scenario.

4. Cont,d The channeling process which is known as financial intermediation is crucial to the well functioning of modern economy, since current economic activity depends heavily on credit and future economic growth depends heavily on business investment . For example, a student loan for college which increases the level of education and human capital, will promote future economic growth of a country.

5. Key Customers of Financial Institutions The key suppliers of funds to financial institutions and the key demanders of funds from financial institutions are: individuals, businesses, and governments.

6. 2.1 Financial institutions and capital transfer A financial institution is a channel that transferring the funds between the savers and the borrowers . Financial institution is only focuses on the financial transaction such as loan, bonds, debentures, insurance, investment and other various types of financial activities . The financial institutions are included insurance companies, banks, credit unions, stock brokerage firms, non banking financial institutions , building societies, and asset management firms.

7. Cont,d There are three different ways for transferring capital or fund from savers to borrowers in the financial system . This are 1 direct transfers of money and securities, 2.investment banking house, and 3. financial intermediaries.

8. Cont,d Direct transfer of money and securities is the easier way to transferring the capital or fund from both borrower and saver . The borrowers no need to go through the investment bankers or any financial intermediaries . The scenario of direct transfer of money and securities will only occur when the businesses sell the shares or bonds to the savers directly in the financial market without go through any financial institution.

9. Cont,d This direct transfer of money and securities is only suitable for the small firms and procedure is raised by a small amount of capital For example, a person needs capital to starting his new business but he is lack of capital. So his uncle lends him money to raise fund in order to starting business . So his uncle direct transfer the money to that person.

10. Cont,d 2. Investment banking house I f the company needs to raise up the capital faster so the company will prefer to go through the investment banking house to established new investment securities in order to help the company to obtain financing . For example, ABC company is temporary lacking in capital so ABC company need to sell the shares or bonds to the investment banking house in order to raise fund quickly.

11. Cont,d The purpose implements the investment banking house in order to exchange the securities into cash faster than the business sell the securities itself. But the investment might use the prices that lower than the market price to purchase these shares or bonds of the company. When the firms sell their securities to the investment banking house, the investment banking house will resell the securities to the savers . So , the investment banking house is the middleman between the business and the savers.

12. Cont,d 3. Financial intermediaries Financial intermediaries are institutions which are between savers and investors and moving funds between both of them . The types of intermediaries included banks, credit unions, saving and loan associations, Micro finance institutions, insurance companies, pension funds, mutual fund, broker and building societies . Banks are one type of intermediary, it receiving money from small savers and provide loan to borrowers to purchase homes, vacations, and so on to businesses and government units.

13. Cont,d In this indirect transfer through a financial intermediary , the financial intermediaries will collect the money from the savers that wish to invest or the savers purchase the intermediary securities. After that, the financial intermediary will use this amount of money to provide financial service such as provide loans to the borrowers to start up the business.

14. Functions of Financial Institutions Pooling the savings of individuals Providing safekeeping accounting and access to payment system Providing liquidity Currency exchange Reducing risk by diversifying Collection and processing information

15. Types of Financial Institutions The services provided by financial institutions depend on its type. For example , the services offered by the commercial banks are different from insurance companies . The most important financial institutions that facilitate the flow of funds from investors to firms are commercial banks, credit union , saving and loan association , micro finance institutions, mutual funds , security firms, insurance companies , and pension funds.

16. Cont,d Generally financial institutions are classified into two as depository and non-depository financial

17. Depository Financial institutions are a financial institution (such as commercial bank, savings bank , micro finance institutions and credit union ) that is legally allowed to accept monetary deposits from consumers. It contributes to the economy by lending much of the money saved by depositors.

18. Cont,d Depository institutions are financial firms that take deposits from households and businesses and manage, and make loans to other households and businesses . In other words depository institutions are those institutions which accept deposits from economic agents (liability to them) and then lend these funds to make direct loans or invest in securities (assets).   Deposits are m oney placed in an account at a depository institution & constituting a claim on the depository institutions. Loans are the borrowing of a sum of money by households or businesses from the depository institutions.

19. Cont,d Depository institutions drive their income from: interest on loans, interest and dividend on securities , and fees income

20. Assets and Liability Problem of DIs A depository institution seeks to earn a positive spread between the assets it invests in (loans and securities) and the cost of its funds ( deposits and other sources). The spread income should allow the institution to meet operating expenses and earn a fair profit on its capital .

21. Cont,d Depository institution makes a profit by borrowing from depositors at a low interest rate and lending at a higher interest rate . The depository institution earns no interest on reserves, but it must hold enough reserves to meet withdrawals. So the depository institution must perform a balancing act to balance the risk of loans (profits for stockholders) against the safety of reserves (the security for depositors).

22. Liquidity concerns Liquidity concerns for commercial banks arises due to short-term maturity nature of deposits. Besides facing credit risk & interest rate risk , Depository institutions should always be ready to satisfy withdrawal needs of depositors and meet loan demand of borrowers .

23. Cont,d Depository institutions use the following ways to accommodate withdrawal and loan demands: attract additional deposit; borrow using existing securities as a collateral (from a federal agency or financial institutions); sell securities it owns; raise short-term funds in the money market.

24. Types of depository institutions Depository financial Institutions include: commercial banks, savings and loan associations, and credit unions microfinance institutions

25. Commercial Banks Commercial banks are the largest and most diversified intermediaries on the basis of range of assets held and liabilities issued . Commercial banks provide numerous services in the financial system . Commercial banks accumulate deposits from savers and use the proceeds to provide credit to firms, individuals, and government agencies . Thus they serve investors who wish to “invest” funds in the form of deposits.

26. Cont,d Commercial banks use the deposited funds to provide commercial loans to firms and personal loans to individuals and to purchase debt securities issued by firms or government agencies. They serve as a key source of credit to support expansion by firms .

27. FUNCTIONS OF COMMERCIAL BANKS Commercial banks have to perform a variety of functions which are common to both developed and developing countries. These are known as ‘ General Banking’ functions of the commercial banks. The modern banks perform a variety of functions. These can be broadly divided into two categories: (a) Primary functions and (b) Secondary functions.

28. A. Primary Functions Acceptance of Deposits: Accepting deposits is the primary function of a commercial bank Banks generally accept three types of deposits viz., (a) Current Deposits (b) Savings Deposits, and (c) Fixed Deposits .

29. Advancing Loans: The second primary function of a commercial bank is to make loans and advances to all types of persons, particularly to businessmen and entrepreneurs. a) Overdraft Facilities: In this case, the depositor in a current account is allowed to draw over and above his account up to a previously agreed limit.

30. Cont,d Suppose a businessman has only Br. 30,000/- in his current account in a bank but requires Br. 60,000/- to meet his expenses. He may approach his bank and borrow the additional amount of Br. 30,000/-. The bank allows the customer to overdraw his account through cheques .

31. Cont,d b)Cash Credit: Under this account, the bank gives loans to the borrowers against certain security. But the entire loan is not given at one particular time, instead the amount is credited into his account in the bank; but under emergency cash will be given. The borrower is required to pay interest only on the amount of credit availed to him.

32. Cont,d c) Discounting Bills of Exchange: This is another type of lending which is very popular with the modern banks. The holder of a bill can get it discounted by the bank, when he is in need of money. After deducting its commission, the bank pays the present price of the bill to the holder. Such bills form good investment for a bank. They provide a very liquid asset which can be quickly turned into cash.

33. Cont,d e) Term Loans: Banks give term loans to traders, industrialists and now to agriculturialists also against some collateral securities. Term loans are so-called because their maturity period varies between 1 to 10 years.

34. Cont,d d) Money at Call: Bank also grant loans for a very short period, generally not exceeding 7 days to the borrowers, usually dealers or brokers in stock exchange markets against collateral securities like stock or equity shares, debentures, etc., offered by them .

35. Cont,d f) Consumer Credit: Banks also grant credit to households in a limited amount to buy some durable consumer goods such as television sets, refrigerators, etc., or to meet some personal needs like payment of hospital bills etc.

36. Cont,d ( g) Miscellaneous Advances: Among other forms of bank advances there are packing credits given to exporters for a short duration , export bills purchased/discounted, import finance-advances against import bills, finance to the self employed, credit to the public sector, credit to the cooperative sector and above all, credit to the weaker sections of the community at concessional rates.

37. Cont,d 3. Creation of Credit: A unique function of the bank is to create credit. Banks supply money to traders and manufacturers. They also create or manufacture money. Bank deposits are regarded as money.

38. Cont,d 4. Promote the Use of Cheques : The commercial banks render an important service by providing to their customers a cheap medium of exchange like cheques . It is found much more convenient to settle debts through cheques rather than through the use of cash. 5. Financing Internal and Foreign Trade: The bank finances internal and foreign trade through discounting of exchange bills. Sometimes, the bank gives short-term loans to traders on the security of commercial papers.

39. Cont,d 6 . Remittance of Funds: Commercial banks, on account of their network of branches throughout the country, also provide facilities to remit funds from one place to another for their customers by issuing bank drafts , mail transfers or telegraphic transfers on nominal commission charges.

40. B. Secondary Functions Secondary banking functions of the commercial banks include: 1. Agency Services 2. General Utility Services 1. Agency Services: (a) Collection and Payment of Credit Instruments: (b) Purchase and Sale of Securities: Collection of Dividends on Shares: Acts as Correspondent (e)Income-tax Consultancy: (f) Execution of Standing Orders (g) Acts as Trustee and Executor

41. 2. General Utility Services: (a) Locker Facility: Bank provides locker facility to their customers. The customers can keep their valuables, such as gold and silver ornaments, important documents; shares and debentures in these lockers for safe custody. (b) Traveller’s Cheques and Credit Cards: Banks issue traveller’s cheques to help their customers to travel without the fear of theft or loss of money.

42. Cont,d (c) Letter of Credit: Letters of credit are issued by the banks to their customers certifying their credit worthiness. Letters of credit are very useful in foreign trade. (d) Collection of Statistics: Banks collect statistics giving important information relating to trade, commerce, industries, money and banking. (e) Acting Referee: Banks may act as referees with respect to the financial standing, business reputation and respectability of customers. (f) Underwriting Securities: Banks underwrite the shares and debentures issued by the Government, public or private companies .

43. Savings and loan associations Savings and loan associations (S&Ls) are old institutions established to provide finance for acquisitions of homes . They can be mutually owned or have corporate stock ownerships . NB : Mutually owned means depositors are the owners. They have traditionally served individual savers , residential and commercial mortgage borrowers , take the funds of many small savers and then lend this money to home buyers and other types of borrowers . The collateral for the loan would be the home being financed.

44. Cont,d The institutions were not to take in demand deposits but instead were authorized to offer savings accounts that paid slightly higher interest than offered by commercial banks account to commercial customers . In function, Savings and loan associations are similar to commercial banks , and in recent years the distinction between commercial banks and savings and loan institutions has become blurred as the financial services industry has become more homogeneous.

45. Credit unions Credit unions are the smallest and the newest of the depository institutions owned by a social or economic group that accepts saving deposits and makes mostly consumer loans. They established by people with a common bond . They are mutually owned established to satisfy saving and borrowing needs of their member s. Credit unions, called by various names around the world, are member-owned , not-for-profit financial cooperatives that provide savings, credit and other financial services to their members.

46. Cont,d Credit union membership is based on a common bond, a linkage shared by savers and borrowers who belong to a specific community, organization, religion or place of employment such as employees of a given firm or union. Credit unions pool their members' savings deposits and shares to finance their own loan portfolios rather than rely on outside capital . Members benefit from higher returns on savings , lower rates on loans and fewer fees on average

47. Cont,d Regardless of account size in the credit union, each member may run for the volunteer board of directors and cast a vote in elections . In some countries, members encounter their first taste of democratic decision making through their credit unions.   The major regulatory differences between credit unions and other depository institutions are: the common bond requirement, the restriction that most loans are to consumers, their exemption from federal income tax because of their cooperative nature.

48. Microfinance institutions (MFIs) The active poor require a full set of micro finance services mainly in the form of saving and credit facilities . These services help the poor: Start new business or expand existing ones Improve productivity of farmers and micro enterprises. Improve human and social capital throughout their life Deal with vulnerabilities and poverty reduction

49. Cont,d However, the active poor , both in the urban and rural areas, are neglected by formal bank and non bank financial institutions because of different reasons. Such as: Collateral requirement of formal bank. High transactions cost(mini transaction) and High perceived risk (such as difficulty in contract enforcement and harvest failure)

50. Cont,d Activities of MFI Small loans, typically, for working capital informal appraisal of borrowers and investments collateral substitutes, such as a group guarantee or compulsory savings access to repeated and large loans, based on repayment performanc e

51. Non-depository institutions Non-depository institutions are financial intermediaries that do not accept deposit s but do pool the payments of many people in the form of premiums or contributions and either invest it or provide credit to others. Hence, non depository institutions form an important part of the economy. These institutions receive the public's money because they offer other services than just the payment of interest.

52. Cont,d They can spread the financial risk of individuals over a large group, or provide investment services for greater returns or for a future income. Non-depository financial institutions are defined as those institutions that serve as an intermediary between savers and borrowers , but do not accept deposits . It includes: Insurance companies Pension funds Mutual funds Investment Banking Firms Brokers and dealers

53. A. Insurance Companies Insurance offer insurance policies to the public and make payments , for a price , when a certain event occurs. Insurance companies distribute/spread risks to individuals, through the “ Rule of large number ” and they act as risk bearers. Insurance companies periodically receive payments (premiums) from their policyholders, pool the payments, and invest the proceeds until these funds are needed to pay off claims of policyholders.

54. Cont,d They commonly use the funds to invest in debt securities issued by firms or by government agencies. They also invest heavily in stocks issued by firms. Thus they help finance corporate expansion .

55. Cont,d Insurance companies employ portfolio managers who invest the funds that result from pooling the premiums of their customers. An insurance company may have one or more bond portfolio managers to determine which bonds to purchase, and one or more stock portfolio managers to determine which stocks to purchase.

56. Cont,d The objective of the portfolio managers is to earn a relatively high return on the portfolios for a given level of risk . In this way, the return on the investments not only should cover future insurance payments to policyholders but also should generate a sufficient profit, which provides a return to the owners of insurance companies.

57. Cont,d Like mutual funds , insurance companies tend to purchase securities in large blocks , and they typically have a large stake in several firms . Thus they closely monitor the performance of these firms. They may attempt to influence the management of a firm to improve the firm’s performance and therefore enhance the performance of the securities in which they have invested.

58. Cont,d Like banks , insurance companies are also challenged by the information asymmetry problems of adverse selection and moral hazard. Insurance companies can solve an adverse selection by screening applicants. That is, verifying information in the application, checking the applicant’s history and by applying restrictive covenant in the insurance contract. However, the solution of moral hazard is depending on the type of insurance offered .

59. B. Pension Funds A pension fund is a fund that is established for the payment of retirement benefits. Most pension fund assets are in employer-sponsored plans . The entities that establish pension plans are called the plan sponsors. pension plans can be established by both governmental & private organizations on behalf of their employees.

60. Cont,d Pension funds receive payments (called contributions ) from employees, and/or their employers on behalf of the employees, and then invest the proceeds for the benefit of the employees . They typically invest in debt securities issued by firms or government agencies and in equity securities issued by firms.

61. Cont.d Pension funds employ portfolio managers to invest funds that result from pooling the employee/employer contributions. They have bond portfolio managers who purchase bonds and stock portfolio managers who purchase stocks. Because of their large investments in debt securities or in stocks issued by firms, pension funds closely monitor the firms in which they invest

62. Cont,d Like mutual funds and insurance companies , they may periodically attempt to influence the management of those firms to improve performance.

63. C. Mutual Funds 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 sell shares to individuals, pool these funds, and use them to invest in securities. In other words a mutual fund pools the funds of many people and managers invest the money in a diversified portfolio of securities to achieve some stated objective.

64. Cont,d These organizations pool funds and thus reduce risks by diversification . They also achieve economies of scale in analyzing securities, managing portfolios , and buying and selling securities. They continually stands ready to sell new shares to the public and to redeem its outstanding shares on demand at a price equal to an appropriate share of the value of its portfolio which is computed daily at the close of the market.

65. Cont,d Different funds are designed to meet the objectives of different types of savers. Hence, there are bond funds for those who desire safety, stock funds for savers who are willing to accept significant risks in the hope of higher returns , and still other funds that are used as interest-bearing checking accounts (the money market funds ). Thus, mutual funds are classified into three broad types. These are:

66. Cont,d Money market mutual funds pool the proceeds received from individual investors to invest in money market (short-term) securities issued by firms and other financial institutions. Bond mutual funds pool the proceeds received from individual investors to invest in bonds , and Stock mutual funds pool the proceeds received from investors to invest in stocks.

67. Cont,d Mutual funds are regulated by the Securities and Exchange Commission (SEC). Primary objective of regulation is the enforcement of reporting and disclosure requirements to protect the investor .

68. Investment Banking Firms Investment bank is a financial institution engaged in securities business. Investment banking firms perform activities related to the issuing of new securities and the arrangement of financial transactions . They mainly involved in primary markets , the market in which new issues are sold and bought for the first time. They advice issuers on how best raise funds , and then they help sell the securities.

69. Cont,d Investment banking is a type of financial service that focuses on helping companies acquire funds and grow their portfolios. Investment banking firms assist client companies in obtaining funds by selling securities , i.e., raise funds for clients and act as brokers or dealers in the buying and selling securities in secondary markets, i.e., assisting clients in the sale or purchase of securities.

70. Types of Modern investment banks 1. The Corporate Business. The corporate side of investment banking is a fee-for service business; that is, the firm sells its expertise . The main expertise banks have is in underwriting securities , but they also sell other services. They provide merger and acquisition advice in the form of prospecting for takeover targets, advising clients about the price to be offered for these targets, finding financing for the takeover, and planning takeover tactics or, on the other side, takeover defenses .

71. Cont,d 2. The Sales and Trading Business. Investment banks that underwrite securities sell them on the sales and trading end of their business to the bank’s institutional investors. These investors include mutual funds, pension funds, and insurance companies. Sales and trading also consists of public market making , trading for clients, and trading on the investment banking firm’s own account .

72. Cont,d 3. Market making requires that the investment bank act as a dealer in securities, standing ready to buy and sell, respectively, at wholesale ( bid ) and retail ( ask ) prices. The bank makes money on the difference between the bid and ask price , or the bid-ask spread . Banks do this not only for corporate debt and equity securities , but also as dealers in a variety of government securities. In addition, investment banks trade securities using their own fund , which is known as proprietary trading . Proprietary trading is riskier for an investment bank than being a dealer and earning the bid-ask spread, but the rewards can be commensurably larger.

73. Risks in Financial Industry Credit or default risk: is the risk that a Deficit Spending Unit (DSU) will not pay as agreed, thus affecting the rate of return on an asset. Interest rate/Funding/ risk: is the risk of fluctuations in a security's price or reinvestment income caused by changes in market interest rates. I t is a risk caused by interest rate changes when DIs borrow long(short) and lend short(long). Liquidity risk: is the risk that the financial institution’s cash inflows will not be able to meet its cash outflows.

74. Risks in Financial Industry Foreign exchange risk: is the risk that fluctuations in the foreign exchange rates will affect the profit of the financial institution. Political/regulatory/ risk is the risk that actions of foreign governments or regulators will affect the profit of the financial institution. It is the risk that regulators will change the rules so as to impact the earnings of the institution unfavorably.

75. End of chapter Two