Chapter 2
Chapter 2
Financial System
CHAPTER TWO
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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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past in the case of a debit card, funds are immediately withdrawn (that is, debited) from the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.
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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.
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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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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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
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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.
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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.
• 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:
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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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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.
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