Chapter two: financial institutions and financial markets
1. Financial Institutions and Capital Transfer:
Financial institutions play a crucial role in transferring capital from savers (who have surplus
funds) to borrowers (who need funds). They act as intermediaries, facilitating the flow of money
in the economy.
Example: A bank collects deposits from individuals and uses these funds to provide
loans to businesses and consumers, allowing capital to flow from savers to those who
need financing.
2. Functions of Financial Institutions:
Financial institutions perform several essential functions that help support economic activity:
1. Capital Mobilization: They gather savings from individuals, businesses, and
governments and channel them into productive uses, like loans and investments.
o Example: A pension fund collects employee contributions and invests them in
bonds and stocks to ensure future retirement payments.
2. Risk Management: They help manage financial risks by offering insurance, hedging
tools, and investment diversification.
o Example: Insurance companies provide risk coverage, such as life or health
insurance, protecting individuals from unexpected financial losses.
3. Liquidity Provision: They provide liquidity by offering accounts where funds can be
easily accessed or withdrawn.
o Example: Checking accounts at banks allow people to withdraw cash or make
payments quickly.
4. Payment Systems: They facilitate the smooth functioning of payment systems, allowing
individuals and businesses to conduct transactions efficiently.
o Example: Banks enable wire transfers, credit card payments, and other electronic
transactions.
5. Credit Allocation: They allocate credit by assessing borrowers' creditworthiness and
providing loans or credit to those who need it.
o Example: A commercial bank evaluates loan applications and provides business
loans to companies seeking to expand.
3. Depository Financial Institutions:
Depository institutions accept deposits from the public and use these funds to make loans and
other investments. The main feature of these institutions is that they offer accounts where
customers can safely store their money.
Examples:
o Commercial Banks: Provide savings and checking accounts, and extend loans to
individuals and businesses.
o Credit Unions: Member-owned cooperatives that offer similar services to banks
but focus on serving their members.
o Savings and Loan Associations: Specialize in offering savings accounts and
home mortgage loans.
Capital Transfer Example: A person deposits money into a savings account at a bank.
The bank pools this money with other deposits and provides a mortgage loan to a family
buying a home.
4. Non-Depository Institutions:
Non-depository institutions do not accept deposits but offer various financial services, including
insurance, investment, and pension fund management. They play a significant role in the
financial system by facilitating investment and protecting against risks.
Examples:
o Insurance Companies: Provide protection against various risks (e.g., life, health,
property) and invest the premiums collected.
o Pension Funds: Manage retirement savings and invest in diversified portfolios to
provide income to retirees.
o Investment Firms (Mutual Funds, Hedge Funds): Pool money from investors
and invest it in securities like stocks, bonds, and other assets.
Capital Transfer Example: A mutual fund collects investments from individual
investors and uses the pooled funds to purchase a diversified set of assets, such as stocks
and bonds.
5. Risks in the Financial Industry:
Financial institutions face various risks that can impact their stability and operations. Key risks
include:
1. Credit Risk: The risk that borrowers will default on their loans or other obligations.
o Example: A bank provides a loan to a business that later becomes unable to repay
it, resulting in a loss for the bank.
2. Market Risk: The risk of losses due to changes in market prices, such as fluctuations in
stock prices, interest rates, or exchange rates.
o Example: An investment firm holding a portfolio of stocks may experience losses
if the stock market declines sharply.
3. Liquidity Risk: The risk that a financial institution will not have enough liquid assets to
meet its short-term obligations.
o Example: A bank may face liquidity risk if a large number of customers
withdraw their deposits at the same time (a bank run).
4. Operational Risk: The risk of loss due to failures in internal processes, systems, or
external events.
o Example: A bank suffers losses due to a data breach, causing a loss of customer
trust and legal penalties.
5. Regulatory Risk: The risk that changes in laws or regulations will negatively affect the
institution's operations or profitability.
o Example: New government regulations may increase the capital requirements for
banks, reducing their profitability.
Summary Example:
A commercial bank collects deposits from customers (capital mobilization) and uses these
funds to provide loans to businesses and individuals (credit allocation). It helps manage liquidity
by allowing customers to withdraw their money whenever needed. Meanwhile, a pension fund
collects contributions from employees and invests them in stocks and bonds to ensure retirement
benefits. Both institutions face risks, such as credit risk from borrowers defaulting on loans or
market risk from stock market fluctuations affecting the pension fund's investments.
In conclusion, financial institutions are essential for transferring capital, managing risk, and
ensuring liquidity, but they also face various risks that must be carefully managed to ensure the
stability of the financial system.
