Financial institutions and Capital Markets.

Chapter Two : Financial Institutions in Financial System

2.1 Financial Institutions at a Glance

Financial institutions are those organizations, which are involved in providing various types of
financial services to their customers. The financial institutions are controlled and
supervised by the rules and regulations delineated by government authorities. Some
of the financial institutions also function as mediators in share markets and debt
security markets.

The principal function of financial institutions is to collect funds from the investors and
direct the funds to various financial services providers in search for those funds.
These institutions include: Banks, Stock Brokerage Firms , Non Banking Financial Institutions,
Building Societies , Asset Management Firms, Credit Unions and Insurance Companies.
Financial institutions deal with various financial activities associated with bonds, debentures,
stocks, loans, risk diversification, insurance, hedging, retirement planning, investment, portfolio
management, and many other types of related functions.

With the help of their functions, the 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. For carrying out their business operations, financial institutions implement
different types of economic models. They assist their clients and investors to maximize their
profits by rendering appropriate guidance. Financial institutions also impart a wide range of
educational programs to educate the investors on the fundamentals of investment and also
regarding the valuation of stock, bonds, assets, foreign exchanges, and commodities.

Financial institutions can be either private or public in nature.

Granted that financial institutions manufacture loans out of money which people lend, what else
can we say about what they do? As a general rule, financial institutions are engaged in what is
called intermediation. Intermediation means acting as a go-between for two parties. The parties
here are usually called lenders and borrowers or sometimes surplus sectors or units and deficit
sectors or units.

What general principles are involved in this going between? The first thing to say is that it
involves more than just bringing two parties together. One could imagine a firm which did this. It
could keep a register of people with money to lend and a register of people who wished to
borrow. Every day, people would join and leave each register and the job of the firm would be to
scan the lists continuously, crying eureka (or some thing else of an appropriate kind) every time it
finds a potential lender whose desires match those of a potential borrower. It would then charge a
commission for introducing them to each other. Something else has to be provided.

As a general rule what financial intermediaries do is to create assets for savers and liabilities for
borrowers which are more attractive to each than would be the case if the parties have to deal
with each other directly.

2.2 The role of financial institutions

1
 Financial institutions and Capital Markets.

1. Providing a payments mechanism.

Most transactions made today are not done with cash; instead payments are made using checks,
credit cards, debit cards and electronic transfers of funds. These methods for making payments
are provided by certain financial institutions.

2. Maturity transformation.
The financial institutions ( e.g. banks) perform the valuable functions of converting funds that
savers are willing to lend for only short period of time into funds the financial institution
themselves are willing to lend to borrowers for longer periods
3. Reducing risk through diversification
Investors who have a small sum to invest would find it difficult to achieve the same degree of
diversification because they don't have sufficient funds to buy shares of a large number of
companies. Because financial institutions acquire funds from large numbers of surplus units and
provide funds to large numbers of deficit units, substantial diversification is effected and the risk
of financial loss is reduced.
4. Reducing transaction costs
Not only do Financial institutions have a greater incentive to collect information, but also their
average cost of collecting relevant information is lower than for individual investor and etc.

2.3 Classification of Financial Institutions

Depository Institutions.

Depository institutions are financial institutions that raise loanable funds by selling deposits to the
public or in other words they are those institutions whose funds come significantly from customer
deposits. They accept deposits from individuals and firms and use these funds to participate in the
debt market, making loans or purchasing other debt instruments such as Treasury bills.

The major types of depository financial institutions are: Commercial banks Saving and Loan
Associations Mutual Savings Banks Micro Finance Institutions (MFIs) and Credit Unions.

The major assets of depository institutions are loans (financial assets) and reported on the left
hand side of the balance sheet. The major liabilities (sources of funds) of depository institutions
are deposits and are presented on the right hand side of the balance sheet.

Depository institutions can also be generally categorized in to commercial banks and other
depository institutions (such as saving and loan institutions, credit unions, and microfinance
institutions).

Distinction between commercial banks and other depository institutions

Area of Commercial Other Depository
Difference Banks Institutions
Size of Loan Large Small
Composition Diversified and Broader Few
Liabilities Include liabilities other than deposits Principally include deposits
Regulation Stringent Not stringent

2
Financial institutions and Capital Markets.

When a depository institution offers a loan, it is acting as a creditor, just as if it had purchased a
debt security. Yet, the more personalized loan agreement is less marketable in the secondary
market than a debt security, because detailed provisions on a loan can differ significantly among
loans. Any potential investors would need to review all provisions before purchasing loans in the
secondary market.

2.3.1 Commercial Banks

Commercial Banks are institutions that offer deposit and credit services as well as a growing list
of newer services as investment advice, security underwriting, selling insurance and financial
planning. Unlike the name “commercial”, commercial banks expanded their services to
consumers and Government units to be a financial department store of the financial system.

The borrowing process of banks is carried out by receiving funds in savings accounts and current
accounts and receiving term deposits, as well as through issuance of debt securities, such as
bonds and banknotes. Banks also provide loans to customers that are repayable in installments as
well as lending through investments in tradable debt securities and other types of lending. Banks
offer a comprehensive variety of payment facilities, and a bank account is regarded as
indispensable by the majority of Governments, business enterprises, and individuals.

1. Functions of Commercial Banks

Commercial banks play an indispensable role in the economic activities of every country.
Accordingly, the following are among the main functions of the commercial banks:
They process payments with the help of online banking, telegraphic transfer, debit card, and
other methods;
They issue banknotes, such as promissory notes;
Acceptance of funds on term deposits;
Issuance of bank checks and bank drafts;
Offering performance bonds, guarantees, letters of credit, and other types of documents
related to underwriting commitments for securities;
Safe custody of important documents and other valuable items in safe deposit vaults or safe
deposit boxes;
Providing loans through installment loans, overdrafts, and others; and
Selling and brokerage services related to unit trust and insurance products and
Foreign exchange services.

Correspondingly, commercial banks are business corporations that accept deposits, make loans,
and sell other financial services, especially to other business firms, to households and
Governments. They are the largest and most important depository institutions. They have the
largest and most diverse collection of assets of all depository institutions. Their main source of
funds is demand deposits (i.e., checking account deposits) and various types of savings deposits
(including time deposits and certificates of deposit).

The major use of funds by commercial banks is making loans. They are assets of the commercial
bank. These loans could include real estate loans and loans to businesses & automobile loans.
The remaining commercial banks' assets include securities (primarily federal government bonds),
vault cash, and deposits at the central bank. Commercial banks also allow for a diversity of
deposit accounts, such as checking, savings, and time deposit. These institutions are run to make
a profit and owned by a group of individuals.

3
Financial institutions and Capital Markets.

While commercial banks offer services to individuals they are primarily concerned with receiving
deposits and lending to businesses

2. Importance of Commercial Banks

 Banks are principal means of making payments.
 Create money from excess reserves of public deposits.
 Use excess cash reserves to make loans and investments.
 They are principal channel for government monetary policy.

3. Activities and Services of Commercial Banks

Activities of commercial banks can be too much; however, the following are the main and
common activities that are crucial in the economic and commercial system of any country.
A. Loans and Advances
Commercial Banks gives various types of loans and advances to various business sectors. The
major ones include Domestic trade, Import and export trade, Agriculture, Hotel and tourism,
Manufacturing, Construction, Transport, Services (education, health, etc), and others. Most of
these loans are extended to customers on the basis of collaterals. The commonly acceptable
collaterals are: Buildings/Houses, Motor vehicles, Bank guarantees, and Unconditional Life
Insurance at surrender value.

 Types of Credit Facilities

The main forms of credit facilities issued by the Commercial Banks are:
1. Term Loan
A term loan is a loan granted to customers to be repaid with interest within a specific period of
time. The loan can be repaid in periodic installments or in a lump sum on the due date of the loan,
as the case may be. This loan is granted in three forms, i.e., short-term, medium-term and long-
term loan. Example: Agricultural Loans, Manufacturing loans, Trade and Service loans, Building
and construction loan, Transport loans, Merchandise Loan, Import and Exports Loan and etc.

2.3.2 Other Depository Institutions.

1. Savings and Loans Associations
A savings and loan association is a financial institution that specializes in accepting savings
deposits and making mortgage loans. Savings and loans associations (S&Ls) were originally
designed as mutual associations, (i.e., owned by depositors) to convert funds from savings
accounts into mortgage loans. They are the predominant home mortgage lender in many
countries, making loans to finance the purchase of housing for individuals and families.

2. Credit Unions

Credit Unions are house hold oriented intermediaries, offering deposit and credit services to
individuals and families. They are cooperative, self-help association of individuals rather than
profit motivated institutions accepting deposits from and making loans to their members, all of
whom have a common bond, such as working for the same employer.

4
Financial institutions and Capital Markets.

2. Micro-Finance Institutions
Micro finance is defined as the provision of financial intermediation through distribution of small
loans acceptance of small savings and the provision of other financial products and services to the
poor. A micro finance institution (MFI) is an organization that offers financial services to the
very poor. They are making small loans available to the poor through schemes specially designed
to meet the Poor’s particular needs and circumstances. The main focus of micro financing is on
the poor through provision of small credit and acceptance of small savings.

Micro-finance clients are typically self-employed, entrepreneurs. In rural areas, they are usually
small farmers and others who are engaged in small income generating activities such as food
processing and petty trade. In urban areas, micro-finance activities are more diverse and include
shopkeepers, service providers, artisans, street vendors, etc.

Types of Services Provided by Micro-Financing Institutions

Credit provision & saving mobilization are the core financial products /services provided by
MFIs. But there are other services provided by MFI. Micro financial Institutions provide the
Credit provision, Saving mobilization and other types of services:

1. Credit provision (Small size credit/loans) to: Rural and urban poor households; Petty traders;
Handcraft producers; Unemployed youth and women ...etc.

2. Saving mobilization: One of the objectives of MFIs is to encourage the saving habit of the poor
society.

3. Other services: Now a days, in addition to credit provision and saving mobilization, some
MFIS provide other financial services like local money transfer, insurance and pension
fund administration and short-term training to clients.

 The Distinguishing characteristics of micro finance from Conventional Banks

The most distinguishing characteristics of MFIs from the conventional banks are:

1. Procedures are designed to be helpful to the client and therefore are user friendly. They
are simple to understand, locally provided and easily and quickly accessible.
2. The traditional lender's requirement for physical collateral (such as land, house and
productive assets) is usually replaced by system of collective guarantee groups whose
members are mutually responsible for ensuring individual loans are repaid. Loans are
dependent not only on individual's repayment performance, but also on that of every other
group members.

3. Loan amounts especially at the first loan cycle are too small, much smaller than the
traditional banks would find it viable to provide and service.

4. Borrowers are usually also required to be savers.

5. Together with their long term sustainability they have the objective of ending poverty and

6. MFI's operating costs as well as administrative cost per loan are higher than the
conventional bank's.

5
Financial institutions and Capital Markets.

 Objectives of the Micro finance Institutions

The goal of MFIs as development organizations is to service the financial needs of un-served or
underserved markets (the poor) as a means of meeting development objectives. The development
objectives generally include one or more of the following:

To reduce poverty.
To help existing businesses grow or diversify their activities and to encourage the
development of new businesses.

To create employment and income opportunities through the creation and expansion
of micro enterprise and ,

To increase the productivity and income of vulnerable group, especially women and
the poor.

3. Mutual Savings Banks

Mutual savings banks are much like savings and loans, but are owned cooperatively by members
with a common interest, such as company employees, union members, or congregation members.

Saving banks play an active role in the residential mortgage banks but are more diversified in
their investments, purchasing corporate bonds and common stocks, making customer loans and
investing in commercial mortgage banks. Saving banks are owned by their depositors to which all
earnings not retained are paid as owner’s dividend. Mortgage and Mortgage related instruments
are principal assets followed by investments in non-mortgage loans, corporate bonds, corporate
stocks and government bonds.

 The principal source of funds for saving banks is deposits, which is a liability for them.
Money Market Funds
4.
Money Market Funds are financial intermediaries pooling deposits of many individuals and
investing those in short-term, high quality, money market instruments. Money fund offer
accounts whose yields are free to reflect prevailing interest rates in the money market.
(Dear Learners! We will see the details of this concept in the “Money Market”
study/portion in the first unit of second module of this course.).

2.4 Non-depository Institutions

Unlike depository institutions, non-depository institutions do not accept checkable deposits. With
one exception that will be noted shortly, you cannot simply write a "check" to withdraw funds
from a non-depository institution.

Types and Role of Non-depository Financial Institutions

Non-depository institutions serve various functions in financial markets, ranging from financial
intermediation to selling insurance against risk. The following are some of the types of non-
depository financial institutions with their role in the financial system.

A. Financial brokers
Brokerage Houses or firms: buy/sell old securities on behalf of individuals. Brokerage firms serve

6
Financial institutions and Capital Markets.

the valuable function of linking buyers and sellers of financial assets. In this regard, they
function as intermediaries, earning a fee for each transaction they create. Modern brokerage firms
compete with depository institutions in the deposit market, where they attract depositors with
money market mutual funds.

B. Investment Institutions (Finance Companies, Investment Companies and Mutual Funds)

i) Finance Companies: are sometimes called department stores of consumer and business credit.
They grant credit to businesses and consumers for a wide variety of purposes acquiring their
funds mainly from debt. Like banks, they use people's savings to make loans to businesses, but
instead of holding deposits, they sell bonds and commercial papers.

ii) Investment companies: provide an outlet for the savings of many individual investors
towards bonds, stocks, and money market securities. Most investment companies stocks are
highly liquid because they repurchase their outstanding shares at current market price.
i) Mutual funds: are especially attractive to small investor, which purchase shares of these funds
and gain greater diversification, risk sharing, lower transaction cost, opportunities for
capital gains and indirect access to higher yielding securities that can be purchased only in
large blocks. They pool funds of savers and make them available to business and
government demanders.

They obtain funds through sale of shares and uses proceeds to acquire bonds and stocks issued by
various business and government units. They create a diversified and professionally managed
portfolio of securities to achieve a specified investment objective, such as liquidity with high
return. Some mutual funds, called money market mutual funds, invest in short-term, safe assets
like Treasury bills and large bank certificates of deposit.
C. Pension Funds
A Pension fund is a pool of assets forming an independent legal entity that are bought with the
contributions to a pension plan for the exclusive purpose of financing pension plan benefits.
Pension funds are savings plan through which fund participants accumulate savings during their
working days so that they withdraw the fund during their retirement years.

A pension plan is a promise by a pension plan sponsor to a plan member to provide a pension
upon retirement. The sponsor may be a company, an employer, a union or a jointly trusteed plan
where both management and unions in an industry appoint trustees to a board which manages the
plan. This promise is legally stated in the "pension plan document" which states the provisions
for the plan. Pension plans may be regulated by governments or financial institutions.

A trustee is appointed to hold the assets in trust for the benefit of the plan members. Usually the
trustee is also the custodian, which holds the plan investments. Pension plans usually hire an
outside investment manager to invest the plan assets. The sponsor may also appoint an
"investment consultant" to advice on investment issues and help select and assess the
performance of investment managers.

D. Insurance

Insurance can be defined from the view points of the individual and the society. From an
individual point of view insurance is an economic device whereby the individual substitutes a

7
Financial institutions and Capital Markets.

small certain cost (the premium) for a large uncertain financial loss (the contingency insured
against) that would exist if it were not for the insurance. Insurance is the protection against
financial loss. The creation of the counterpart of risk is the primary function of insurance.
Insurance doesn’t decrease the uncertainty for the individual as to whether the event will occur,
nor does it alter the probability of occurrence, but it does reduce the probability of financial loss
concerned with the event.

From the viewpoint of the society, insurance is an economic device for reducing and eliminating
risk through the process of combining a sufficient number of homogenous exposures into a group
to make the losses predictable for the group as a whole. From the viewpoint of the insured,
insurance is a transfer device. From the viewpoint of the insurer, insurance is a retention and
combination device. The distinctive feature of insurance as a transfer device is that it involves
some pooling of risks; i.e., the insurer combines the risks of many insured. Insurance does not
prevent losses, nor it reduces the cost of losses to the economy as a whole. The existence of
insurance encourages some losses for the purpose of defrauding the insurer, and in addition,
people are less careful and may exert less effort to prevent losses than they might if the insurer
did not exist.

 Major Classes of Insurance Companies

Insurance companies create insurance policies by grouping risks according to their focus. This
provides a measure of uniformity in the risks that are covered by a type of policy, which in turn
allows insurers to anticipate their potential losses and set premiums accordingly. Insurance
Companies may be classified in to life insurance companies and Non-life (Property-casualty)
insurance companies.

I. Life Insurance Companies

Human values are far greater and more important than all the different property values combined.
Human resource is the most important resource for a nation’s development than other resources.
A human life has value for many reasons. Many of these reasons are philosophical in nature, and
would lead us in to the realm of religion, esthetics, sociology, psychology and other behavioral
sciences. A human life has an economic value to all depends on the earning capacity of that life,
particularly to two central economic groups - the family and the employer.

There are four major perils that can destroy, wholly or partially, the economic value of a human
life. These include premature death, loss of health, old age, and unemployment which are
categorized under personal risk. Every person faces two basic contingencies concerning life.

 First, he/she may die too soon, or this is a physical death.

 Second, he/she may live too long. It means that the person may outlive his/her financial
usefulness or his/her ability to provide for his/her needs.

Life insurance is designed to provide protection against these two distinct risks: premature death
and superannuation. Thus, life insurance may be defined as a social and economic device by
which a group of people may cooperate to ameliorate (to make better) the loss resulting from the
premature death or living too long of members of the group. The main purpose of life insurance,
therefore, is financial protection i.e. to provide dependents of the insured with financial

8
Financial institutions and Capital Markets.

compensation amounting to the sum assured if the insured faces premature death while the policy
is in force. It gives the family financial security for a certain period.

In general, there are many different types of life insurance, but the standard arrangement is a
contact specifying that upon death of the person whose life is insured, a stated sum of money (the
policy's face amount) is paid to the person designated in the policy as he beneficiary.

Life insurance is a risk-pooling plan, which is an economic plan through which the risk of
premature death is transferred from the individual to the group. However, there are characteristics
that differentiate from other types of insurance contract. That is,

 The event insured against is an eventual certainty;

 Life insurance is not a contract of indemnity;
 The application of principle of insurable interest is different;
 Life insurance contracts are long-term contract; and
 There is no possibility of partial loss.

Not all people need exactly the same kind of protection from life insurance. It is so because there
are differences in ages; incomes and financial obligations; the number of their dependents; and
other related variables. To provide all the different types of protection that are needed, insurance
companies offer a variety of policies. The basic types of contracts are: Term insurance, Whole
life insurance, Endowment insurance, and Annuities.

A. Term Insurance
Term insurance provides protection only for a definite period (term) of time. A term insurance
policy is a contract between the insured and the insurer where by the insurer promises to pay face
amount of the policy to a third party (the beneficiary) if the insured dies within a given period of
time. If the insured manages to survive during the period for which the policy was taken, the
insurance company is not required to pay anything. Common types of term life insurance are 1-
year term, 5-years term, 10-years term, 20-years term, and to age 60 or 65.

B. Whole life insurance

As the name suggests, it is a permanent insurance that extends over the life time of the insured. It
provides for the payment of the face value upon the death of the insured, regardless of when it
may occur. Whole life insurance policies promise to pay the beneficiary whenever death occurs.
It also promise payment if the insured reaches age 100. Whole life insurance premium is greater
than that of term, as claims are certain and the insurer must collect enough premiums to pay them.

Whole life insurance contracts contain savings elements called cash values. The cash values are
due to the overpayment of the insurance premiums during early years. As a result policy owner
builds cash equity in the policy. If the policyholder decides to terminate it prior to the insured's
death, the cash value can be refunded which is not in the case of term insurance.

C. Endowment Insurance
It differs from other policies in that the death of the insured is not required for payoff. At the
maturity' date, the value of the policy is remitted to the insured, if surviving, otherwise to the

9
Financial institutions and Capital Markets.

beneficiary. It is to mean that endowment contracts provide death benefits for a specified period
of time, just as term insurance does.

D. Annuity Contracts
An annuity may be defined as a periodic payment to commence at a stated date and to continue
for a fixed period or the duration of a designated life. The person who receives the periodic
payments or whose life governs the duration of payments is known as the annuitant.

In one sense, an annuity may be described as the opposite of life insurance. Life insurance creates
an immediate estate and provides protection against dying too soon before financial assets can be
accumulated. The fundamental purpose of a life annuity is to provide a lifetime income that
cannot be outlived to an individual. An annuity insurance operation transfers funds from those
who die at a relatively early age to those who live to a relatively old ages.

E. Credit Life Insurance

Credit life insurance is meant to protect lenders against a borrower’s death prior to repayment of
a debt contract. It can be issued through other financial institutions.

II. Non-life Insurance

Non-life insurance is also called property-casualty insurance and can be divided in to property
insurance and casualty (liability) insurance. Property insurance involves coverage related to loss,
damage or destruction of real and personal property.

Properties to be covered, range from personal jewelry to industrial plant and machinery. Property
insurance is intended to indemnify the loss suffered by the insured. Indemnity may be in the form
of payment of money, repair, replacement or re-instatement. Casualty insurance, on the other
hand, provides protection against legal liability exposure resulting from negligence. Payment is
made to the injured third party by the insurance company.

 Distinction between life insurance and non-life insurance companies

Insurance contracts can be classified commonly (most of the time) in to life insurance and
non-life insurance contracts or risk coverage’s. As the name imply their detailed agreements
and contract may vary so. Accordingly,

1. Asset portfolios of non-life insurance companies largely contain liquid assets or short term
investments due to the fact that events are difficult to predict statistically than are death rates
in population.
2. Non-life insurance companies are riskier and administratively more expensive than life
insurance because of the following reasons:
 Greater complexity in asset valuation and determination of payouts
 Higher incidence of claims
 Higher likelihood of fraudulent claims which requires significant administrative resources
to verify the claim and the cause of loss
3. Life insurance company’s claims and liabilities are relatively long term in nature
 Reinsurance

10
Financial institutions and Capital Markets.

Reinsurance is the shifting of part or all of the insurance originally written by one insurance to
another insurer. The insurer that initially writes the business is called Ceding Company. Ceding
company may get commission from the reinsurer on the account of bringing business for the
reinsurer. The insurer that accepts part or all of the insurance from the ceding company is called
the reinsurer. The amount of insurance retained by the ceding company for its own account is
called the retention limit or net retention. The amount of the insurance ceded to the reinsurer is
known as a premium cession. The reinsurer in turn may obtain reinsurance from another insurer.
This is known as a retrocession. In this case, the second reinsurer is called a retrocessionaise.

The main Reasons for Reinsurance include increase underwriting capacity (allows the reinsured
to write larger amounts of insurance, and a ceding company’s capacity for retaining such
coverage is limited by capital and surplus, regulatory and other factors), and stabilize profit. Loss
experience can fluctuate widely because of social and economic conditions, natural disaster, and
chance. If a large, unexpected loss (catastrophe) occurs, the reinsurer would pay the portion of the
loss in excess of some specified limit.

E. Investment Banking Firms

Investment is the commitment of money or capital to purchase financial instruments or
other assets in order to gain profitable returns in the form of interest, income, or appreciation of
the value of the instrument. Investment is related to saving or deferring consumption.
An investment involves the choice by an individual or an organization such as a pension fund,
after some analysis or thought, to place or lend money in a vehicle, instrument or asset, such as
property, commodity, stock, bond, financial derivatives (e.g. futures or options), or the foreign
asset denominated in foreign currency, that has certain level of risk and provides the possibility of
generating returns over a period of time.

When an asset is bought or a given amount of money is invested in the bank, there is anticipation
that some return will be received from the investment in the future. Investment is a term
frequently used in the fields of economics, business management and finance. It can mean
savings alone, or savings made through delayed consumption. Investment can be divided into
different types according to various theories and principles. While dealing with the various
options of investment, the defining terms of investment need to be kept in mind.

Investment banking firms provide their clients with the opportunity to generate funds through
different processes. At the same time, they also provide professional services to the investors for
identifying different investment opportunities and to invest in the same. The investment banking
firms provide various financial services to a wide range of clients. There are both institutional as
well as individual clients of these firms. At the same time, these firms also offer a number of
services to different national Governments.

 Services provided by Investment Banking Firms

The clients of the investment banking firms are provided with advisory services. The firms also
offer a range of capital raising opportunities to the clients. They help the clients to place their
equities in such a manner that they can produce highest yields. At the same time, the firms are
also involved in the syndication of primary market on behalf of their clients. The investment
banking firms also play a major role in arranging debt securities for their clients. The corporate
clients of the companies are offered with several other services as well. The mergers and
acquisitions are a very important part of the business expansion plans.

11
Financial institutions and Capital Markets.

12