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Chapter 2

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45 views11 pages

Chapter 2

Uploaded by

kiflomguesh4
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Financial Institutions and Markets-Chapter Two: Financial Institutions in the

Financial System

CHAPTER TWO

FINANCIAL INSTITUTIONS IN THE FINANCIAL SYSTEM

2.1 Financial Institutions and Capital Transfer


Business entities include nonfinancial and financial enterprises. Non-financial enterprises
manufacture products (e.g., cars, steel, and computers) and/or provide nonfinancial services (e.g.,
transportation, utilities, computer programming). Financial enterprises, more popularly referred
to as financial institutions, are those organizations, which are involved in providing various
types of financial services to their customers and are controlled and supervised by the rules
and regulations delineated by government authorities. Financial intermediaries are
financial institutions that engage in financial asset transformation. Financial institutions serve as
intermediaries by channeling the savings of individuals, business, and governments into loans
and investments. The primary suppliers of funds to financial institutions are individuals; the
primary demanders of funds are firms and governments. Generally, financial institutions
provide services related to one or more of the following:
a) Transforming financial assets acquired through the market and constituting them into a
different, and more widely preferable, type of asset—which becomes their liability. This is
the function performed by financial intermediaries, the most important type of financial
institution.
b) Exchanging of financial assets on behalf of customers.
c) Exchanging of financial assets for their own accounts.
d) Assisting in the creation of financial assets for their customers, and then selling those
financial assets to other market participants.
e) Providing investment advice to other market participants.
f) Managing the portfolios of other market participants.
Financial institutions can be either private or public in nature. 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


We have stressed that financial intermediaries play the basic role of transforming financial assets
that are less desirable for a large part of the public into other financial assets—their own
liabilities—which are more widely preferred by the public. This transformation involves at least
one of four economic functions: 1) providing a payment mechanism; 2) providing maturity
intermediation; 3) reducing risk via diversification; 4) reducing the costs of contracting and
information processing. Each function is described below as follow:

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. A

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Financial Institutions and Markets-Chapter Two: Financial Institutions in the
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debit card differs from a credit card in that in the latter case, a bill is sent to the credit card
holder periodically (usually once a month) requiring payments for transactions made. In the
past in the case of a debit card, funds are immediately withdrawn (that is, debited) from the
purchaser's account at the time the transaction takes place. In addition, financial institutions
perform check clearing and wire transfer services.
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.
Maturity transformation function of financial institution has two implications. First, it
provides investors with more choices concerning maturity for their investments; borrowing
has more choices for the length of their debt obligations. Second, because investors are
naturally reluctant to commit funds for a longer period of time, they will require that long-
time borrowers pay a higher interest rate than on a short-time borrowing. A financial
institution is willing to make long-term loans, and at a lower cost to the borrower than an
individual investor would, by counting on successive deposits providing the funds until
maturity. Thus, the second implication is that the cost of long-term borrowing is likely to be
reduced.
3. Reducing Risk Through Diversification: Consider the example of an investor who places
funds in an investment company. Suppose that the investment company invests the funds
received in the stock of a large number of companies. By doing so, the investment company
has diversified and reduced its risk. 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. The
diversification is the holding of many (rather than a few) assets reduces risk. Because all
assets don’t behave in the same way at the same time, therefore, the behavior of one asset
will on some occasions cancel out the behavior of another. Financial institutions
(intermediaries) also offer the risk reducing benefits of management expertise since they do
have a manpower that specializes in credit risk assessment & monitoring of borrowers.
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 (i.e., information collection enjoys economies of scale). An
economy of scale is a concept that costs reduction in trading and other transaction services
results from increased efficiency when financial institutions perform these services. Such
economies of scale of information production and collection tend to enhance the advantages
to investors of investing via financial institutions rather than directly investing themselves.

2.3 Classification of Financial Institutions

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Financial Institutions and Markets-Chapter Two: Financial Institutions in the
Financial System

Financial institutions are responsible for distributing financial resources in a planned way to the
potential users. There are a number of institutions that collect and provide funds for the
necessary sector or individual. Correspondingly, there are several institutions that act as the
middleman and join the deficit and surplus units. Investing money on behalf of the client is
another variety of functions of financial institutions. Basically, the services provided by the
various types of financial institutions may vary from one institution to another. Broadly
speaking, financial institutions are categorized in to two major parts, as follow:
a) Depository financial institutions; which include commercial banks, savings and loan
associations, mutual savings banks, credit unions.
b) Non-depository financial institutions; which comprises of contractual savings institutions
(insurance companies and pension funds); investment institutions (finance companies,
mutual funds, money market mutual funds, stock brokerage firms, investment banks,
asset management firms, etc.)
At the same time, there are several governmental financial institutions assigned with regulatory
and supervisory functions. These institutions have played a distinct role in fulfilling the financial
and management needs of different industries, and have also shaped the national economic
scene.

2.3.1 Depository Financial Institutions


Depository institutions are financial intermediaries that accept deposits from individuals and
institutions and make loans. The primary functions of financial institutions are:
 Accepting Deposits;
 Providing Commercial Loans;
 Providing Real Estate Loans;
 Providing Mortgage Loans; and
 Issuing Share Certificates.
Depository institutions are popular financial institutions for the following reasons:
 They offer deposit accounts
 They provide loan facilities
 They accept the risk on loans provided
 They have more expertise
 They diversify their loans among numerous deficit units
These institutions include commercial banks and the so-called thrift institutions (thrifts). Thrift
institutions comprised savings and loan associations (S&L), savings banks, and credit unions.

A. Commercial Banks
Commercial banking is also known as business banking. These financial intermediaries raise
funds primarily by issuing checkable deposits (deposits on which checks can be written), savings
deposits (deposits that are payable on demand but do not allow their owner to write checks), and
time deposits (deposits with fixed terms to maturity). They then use these funds to make
commercial, consumer, and mortgage loans and to buy government securities and municipal

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Financial Institutions and Markets-Chapter Two: Financial Institutions in the
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bonds. They are the largest financial intermediary and have the most diversified portfolios
(collections) of assets.

B. Saving Institutions
These depository institutions include saving and loan associations (S&L) and savings banks and
they obtain funds primarily through savings deposits (often called shares) and time and
checkable deposits.
1. Saving & Loans Associations (S&L): These organizations, which also are known as
savings associations, building and loan associations, cooperative banks (in New
England). The terms "S&L" or "thrift" are mainly used in the United States. These are the
primary source of financial assistance to a large segment of American homeowners. A
savings and loan association (or S&L), is a financial institution that specializes in
accepting savings deposits and making mortgage and other loans. The most important
purpose of these institutions is to make mortgage loans on residential property. The basic
motivation behind the creation of saving & loans associations was provision of funds for
financing the purchase of home. The collateral for the loans would be the homes being
financed. Saving and loans associations are either mutually owned or have corporate
stock ownership. Mutually owned means there is no stock outstanding, so technically the
depositors are the owners. To increase the ability of saving and loans associations to
expand the sources of funding available to bolster/strengthen their capital, legislation
facilitated the conversion of mutually-owned companies in to a corporate stock
ownership structure. To sum up, saving and loans associations offer deposit accounts to
surplus units and channel these deposits to deficit units and unlike commercial banks,
they concentrated on residential mortgage loans to the owners (shareholders) of the
institutions.
2. Savings Banks: Savings banks are institutions similar to, although much older than,
saving and loans associations. They can be either mutually owned in which case they are
called mutual savings banks or stock holder owned. Most savings banks are of the mutual
form. While the total deposits at savings banks are less than saving and loans
associations, savings banks are typically larger institutions. Asset structures of savings
banks and saving and loans associations are similar. The principal source of funds for
savings banks is deposits.

C. Credit Unions
Credit unions are not-for-profit financial cooperatives whose members own it. Credit unions are
the smallest and the newest of the depository institutions. They are varying small co-operative
lending institutions organized around a particular group and owned by their members, member
deposits are called shares. The distribution paid to members is therefore in the form of dividends,
not interest. You are eligible to join a particular credit union if you belong to the field of
membership defined in its charter. All members have the right to democratically elect a board of
directors. Examples of credit unions can be union members, employees of a particular firm.
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Financial Institutions and Markets-Chapter Two: Financial Institutions in the
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Credit unions are different from other depository institutions because they are non- profit and
restrict their funds to provide loans to their members only. Historically, credit unions encourage
thrift among members and provide them with credit at a low rate.
The credit unions are called by different names in different countries. In many African countries
they are called “Savings and Credit Cooperative Organizations (SACCOs).” In Spanish-speaking
countries, they are often called “cooperativas de ahorro y crédito.” In Mexico they are typically
called a caja popular. French terms for credit union include “caisse populaire and banque
Populaire.” Afghan credit unions are called "Islamic investment and finance cooperatives"
(IIFCs).
2. Non-Depository Institutions
Non-depository financial institutions are intermediaries that cannot accept deposits but do pool
the payments in the form of premiums or contributions of many people and either invest it or
provide credit to others. Hence, non-depository institutions form an important part of the
economy. These non-depository institutions are sometimes referred to as the shadow banking
system, because they resemble banks as financial intermediaries, but they cannot legally accept
deposits. Consequently, their regulation is less stringent, which allows some non-depository
institutions, such as hedge funds, to take greater risks for a chance to earn higher returns. These
institutions receive the public's money because they offer other services than just the payment of
interest. They can spread the financial risk of individuals over a large group, or provide
investment services for greater returns or for a future income. The basic non-depository financial
institutions include insurance companies, pension funds, mutual funds, finance companies,
money market mutual funds, etc.

A. Insurance Companies
The primary function of insurance companies is to compensate individuals and corporations
(policyholders) if perceived adverse event occur, in exchange for premium paid to the insurer by
policyholder. Insurance companies provide (sell) insurance policies, which are legally binding
contracts and promise to pay specified sum contingent on the occurrence of future events, such
as death or an automobile accident. Insurance companies are risk bearers. They accept or
underwrite the risk for an insurance premium paid by the policyholder or owner of the policy.
Income of insurance companies is:
– Initial underwriting income (insurance premium)
– Investment income that occur over time

Therefore, profit of insurance companies = (insurance premium + investment income) –


(operating expense + insurance payment or benefits).

Insurance companies can be classified in to life insurance and general (Property-causality)


insurance.
 Life insurance companies: Life insurance companies insure people against financial
insecurities following a death and sell annuities (annual income payments upon

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Financial Institutions and Markets-Chapter Two: Financial Institutions in the
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retirement). They acquire funds from the premiums that people pay to keep their policies
in force and use them mainly to buy corporate bonds and mortgages. Because claim
payments are more predictable, life insurance companies invest mostly in long-term
bonds, which pay a higher yield, and some stocks.
 Property and Casualty Insurance: These companies insure policyholders against loss
from theft, fire, and accidents. They are very much like life insurance companies,
receiving funds through premiums for their policies, but they have a greater possibility of
loss of funds if major disasters occur. For this reason, they use their funds to buy more
liquid assets than life insurance companies
B. Pension Funds
Pension funds receive contributions from individuals and/or employers during their employment
to provide a retirement income for the individuals. Most pension funds are provided by
employers for employees. The employer may also pay part or all of the contribution, but an
employee must work a minimum number of years to be vested—qualified to receive the benefits
of the pension. Self-employed people can also set up a pension fund for themselves through
individual retirement accounts or other types of programs. While an individual has many options
to save for retirement, the main benefit of government-sanctioned pension plans is tax savings.
Pension plans allow either contributions or withdrawals that are tax-free. As a consequence of
the regular contributions and the tax savings, pension funds have enormous amounts of money to
invest. And because their payments are predictable, pension funds invest in long-term bonds and
stocks, with more emphasis on stocks for greater profits.

C. Mutual Funds
A mutual fund (in US) or unit trust (in UK and India) raise funds from the public and invests the
funds in a variety of financial assets, mostly equity, both domestic and overseas and also in
liquid money and capital market.They are investment companies that pool money from investors
at large and offer to sell and buy back its shares on a continuous basis and use the capital thus
raised to invest in securities of different companies. Mutual funds possess shares of several
companies and receive dividends in lieu of them and the earnings are distributed among the
shareholders on a pro-rata basis. Mutual funds sell shares (units) to investors and redeem
outstanding shares on demand at their fair market value. Thus, they provide opportunity of small
investors to invest in a diversified portfolio of financial securities. Mutual funds are also able to
enjoy economies of scale by incurring lower transaction costs and commission.

Advantage of Mutual Funds


i. Mobilizing small saving
 Direct participation in securities is not attractive to small investors because of some
requirements which are difficult for them.
 Mutual fund mobilizes funds by selling their own shares, known as units. These funds are
invested in shares of different institution, government securities, etc.

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 To an investor, a unit in a mutual fund means ownership of a proportionate share of


securities in the portfolio of a mutual fund.
ii. Professional management
 Mutual funds employ professional experts who manage the investment portfolio efficiently
and profitably.
 Investors are relived of the emotional stress in buying and selling securities since Mutual
fund take care of this function.
 The professional managers act scientifically at the right time to buy and sell for their client,
and automatic reinvestment of dividends and capital gains, etc.
iii. Diversified investment/reduced risks
 Funds mobilized from investors are invested in various industries spread across the
country/globe.
 This is advantage to the small investors because they cannot afford to assess the
profitability and viability of different investment opportunities
 Mutual funds provide small investors the access to a reduced investment risk resulting
from diversification, economies of scale in transaction cost and professional financial
management
iv. Better liquidity
 There is always a ready market for the mutual fund units- it is possible for the investors to
disinvest holdings any time during the year at the Net Asset Value (NAV)
 Securities held by the fund could be converted into cash at any time. Thus, mutual funds
could not face problem of liquidity to satisfy the redemption demand of unit holders.
v. Investment protection
 Mutual funds are legally regulated by guidelines and legislative provisions of regulatory
bodies (such as SEC in US, SEBI in India etc.)
vi. Low transaction cost (economy of scale)
 The cost of purchase and sale of mutual funds is relatively lower because of the large
volume of money being handled by MF in the capital market (economies of Scale)
 Brokerage fees, trading commission, etc., are lower
 This enhances the quantum of distributable income available for investors
vii. Economic Developments
 Mutual funds mobilize more savings and channel them to the more productive sectors of
the economy
 The efficient functioning of mutual funds contributes to an efficient financial system.
 This in turn paves ways for the efficient allocation of the financial resources of the country
which in turn contributes to the economic development.
The investors’ return in the mutual fund includes capital appreciation (capital gain from price
appreciation of the underlying assets), and the income generated by the assets of the fund.

Types of Mutual Funds

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Financial Institutions and Markets-Chapter Two: Financial Institutions in the
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Mutual funds can be categorized in to two; open-ended mutual funds and closed-ended mutual
funds
1. Open-ended Mutual Funds
Characteristics
• New investors can join the funds at any time.
• A fund (unit) is accepted and liquidated on a continuous basis by mutual fund manager
• The fund manager buys and sells units constantly on demand by investors-it is always
open for the investors to sell or buy their share units.
• It provides an excellent liquidity facility to investors, although the units of such are not
listed. No intermediaries are required. There is a certainty in purchase price, which takes
place in accordance with the declared NAV.
• Investors in Mutual fund own a pro rata share of the overall portfolio, which is managed
by an investment manager of the fund who buys some securities and sells others.
• The value or price of each share of the portfolio is called net asset value (NAV).
• NAV equals the market value of the portfolio minus the liability of the mutual fund
divided by the number of shares owned by the mutual fund investors.

Market Valueof Portfolio−Liabilities


• NAV=
Number of shares outstanding

• The NAV is determined only once each day, at the close of the day. For example the
NAV for a stock of a mutual fund is determined from closing stock price for the day.
Business publications provide the NAV each day in their mutual fund.
• All new investments into the fund or withdrawal from the fund during a day are priced at
the closing NAV (investment after the end of the day) and a non-business day are priced
at the next day’s closing NAV)
• The total number of shares in the fund increases if more investments than withdrawals are
made during the day, and vice versa.
• The NAV of a mutual fund may increase or decrease due to an increase or decrease in the
price of the securities in the portfolio

Examples 1: Suppose today a mutual fund contains 1000 shares of ABC which are traded at
$37.75 each, 2,000 shares of Exxon (currently traded at $43.70) and 1,500 shares of Citigroup
currently trading at $46.67. The mutual fund has 15,000 shares outstanding held by investors.
Thus, today’s NAV is calculated as:

( 1,000 X $ 37.75 )+ ( 2,000 X $ 43.70 ) +(1,500 X $ 46.67)


NAV = =$ 13.01
15,000
If tomorrow ABC’s shares increase to $45, Exxon’s shares increase to $48, and Citigroup’s
shares increase to $50, the NAV (assuming the number of shares outstanding remains the same)
would increase to:

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Financial Institutions and Markets-Chapter Two: Financial Institutions in the
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( 1,000 X $ 45 ) + ( 2,000 X $ 48 ) +(1,500 X $ 50)


NAV = =$ 14.40
15,000
Example2: Suppose that today 1,000 additional investors buy one share each of the mutual fund
(MF) at the NAV of $13.01. This means the MF manager has $13,010 additional funds to invest.
Suppose that the fund manager decides to use these additional funds to buy additional shares in
ABC. At today’s market price, the manager could buy 344 ($13,010/$37.75 = 344) shares of
ABC additional shares: Thus,
 Its new portfolio of shares has 1344 in ABC, 2000 in Exxon, and 1,500 in Citigroup.
 Given the same rise in share value as assumed above, tomorrow’s NAV will be:

( 1,344 X 45 )+ ( 2,000 X 48 ) +(1,500 X 50)


NAV = =$ 14.47
16,000
The additional shares and the profitable investment made with the new funds from these resulted
in a slight higher NAV than had the number of shares remained static ($14.47 versus $14.40)

2. Closed-ended Fund
Characteristics
• The shares of a closed-end fund are similar to the shares of common stock of a
corporation. The new shares of a closed-end fund are initially issued by an underwriter
for the fund and after the new issue the number of shares remains constant.
• After the initial issue, no sale or purchase of shares are made by the fund company as in
open-end funds. Instead, the shares are traded on a secondary market, either in an
exchange or in the over-the-counter market.
• Since the number of shares available for purchase, at any moment in time, is fixed, the
NAV of the fund’s shares is determined by the underlying shares as well as by the
demand for the investment company’s shares themselves.
• When demand for the investment company’s shares is high, because the supply of shares
in the fund is fixed, the shares can be traded for more than the NAV of the securities held
in the fund’s assets portfolio. In this case the shares said to be trading at a premium; if
demand is low, the shares are sold for discount.
The main difference between an open-ended and a closed-ended mutual fund is; the number of
shares of an open-end fund varies because the fund sponsor sells new shares to investors and
buys existing shares from shareholders. By doing so the share price is always the NAV of the
fund. In contrast, closed-ended funds have a constant number of shares outstanding because the
fund sponsor does not redeem shares and sell new shares to investors except at the time of a new
underwriting. Thus, supply and demand in the market determines the price of the fund shares,
which may be above or below NAV, as previously discussed.

D. Finance Companies
Finance companies raise funds by selling commercial paper (a short-term debt instrument) and
by issuing stocks and bonds. They lend these funds to consumers, who make purchases of such
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Financial Institutions and Markets-Chapter Two: Financial Institutions in the
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items as furniture, automobiles, and home improvements, and to small businesses. Some finance
companies are organized by a parent corporation to help sell its product. For example, Ford
Motor Credit Company makes loans to consumers who purchase Ford automobiles.

E. Money Market Mutual Funds


These relatively new financial institutions have the characteristics of a mutual fund but also
function to some extent as a depository institution because they offer deposit-type accounts. Like
most mutual funds, they sell shares to acquire funds that are then used to buy money market
instruments that are both safe and very liquid. The interest on these assets is then paid out to the
shareholders. A key feature of these funds is that shareholders can write checks against the value
of their shareholdings. In effect, shares in a money market mutual fund function like checking
account deposits that pay interest.

2.4 Risks in Financial Industry


One of the major objectives of a financial institution’s managers is to increase the financial
institution returns for its owners. Increased returns often come at the cost of increased risk,
which comes in many forms:
1. Credit Risk (Default Risk): the risk that promised cash flows from loans and securities
held by financial institutions may not be paid in Full. Therefore, financial institutions
face credit risk or default risk if their clients default on their loans and other obligations.
2. Liquidity Risk: the risk that a sudden and unexpected increase in liability withdrawals
may require a financial institution to liquidate assets in a very short period of time and at
low prices. They encounter liquidity risk as a result of excessive withdrawals of liabilities
by customers.
3. Interest Rate Risk: the risk incurred by financial institution when the maturities of its
assets and liabilities are mismatched and interest rates are volatile. Financial institutions
face interest rate risk when the maturities of their assets and liabilities are mismatched.
4. Market Risk: the risk incurred in trading assets and liabilities due to changes in interest
rates, exchange rates, and other asset prices. They incur market risk for their trading
portfolios of assets and liabilities if adverse movements in the prices of these assets or
liabilities occur.
5. Off-Balance -Sheet Risk: the risk incurred by financial institution as the result of its
activities related to contingent assets and liabilities. Modern-day financial institutions
also engage in significant amount of off-balance-sheet activities, thereby exposing them
to off-balance-sheet risks —changing values of their contingent assets and liabilities.
6. Foreign Exchange Risk: the risk that exchange rate changes can affect the value of
financial institution’s assets and liabilities denominated in foreign currencies. If financial
institutions conduct foreign business, they are subject to foreign exchange risk.
7. Country or Sovereign Risk: Business dealings in foreign countries or with foreign
companies also subject financial institutions to sovereign risk. It is the risk that

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Financial Institutions and Markets-Chapter Two: Financial Institutions in the
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repayments by foreign borrowers may be interrupted because of interference from foreign


governments or other political entities.
8. Technology Risk: the risk incurred by financial institution when its technological
investments do not produce anticipated cost savings.
9. Operational Risk: the risk that existing technology or support systems may malfunction,
that fraud may occur that impacts the financial institution’s activities , and/or external
shocks such as hurricanes and floods occur.
10. Insolvency Risk: the risk that financial institution may not have enough capital to offset
a sudden decline in the value of its assets relative to its liabilities. FIs face insolvency risk
when their overall equity capital is insufficient to withstand the losses that they incur as a
result of such risk exposures.
The effective management of these risks—including the interaction among them—
determines the ability of a modern FI to survive and prosper over the long run.

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