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Chapter Two
Financial Institutions in the Financial System
2.1 Financial Institution and Capital transfer
Business entities include nonfinancial and financial enterprises. Nonfinancial
enterprises manufacture products (e.g., cars, steel, computers, etc) and/or provide
nonfinancial services (e.g., transportation, utilities, computer programming). Financial
enterprises, more popularly referred to as financial institutions, provide services related
to one or more of the following:
1. 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.
2. Exchanging of financial assets on behalf of customers.
3. Exchanging of financial assets for their own accounts.
4. Assisting in the creation of financial assets for their customers, and then selling
those financial assets to other market participants.
5. Providing investment advice to other market participants.
6. Managing the portfolios of other market participants.
Financial intermediation consists of “channeling funds between surplus and deficit agents”. A
financial intermediary is a financial institution that connects surplus and deficit agents. The
classic example of a financial intermediary is a bank that transforms bank deposits into bank
loans. As we can see from the above example, financial institutions in facilitating the flow of
fund they will act both as borrower and lender.
Through the process of financial intermediation, certain assets or liabilities are transformed into
different assets or liabilities. As such, financial intermediaries channel funds from people who
have extra money (savers) to those who do not have enough money to carry out a desired
activity (borrowers).
The second and third services in the list above are the broker and dealer functions. The
fourth service is referred to as underwriting. As we explain later, typically a financial
intermediary that provides an underwriting service may also provide a brokerage and/or
dealer service.
A financial intermediary is typically an institution that facilitates the channeling of funds
between lenders and borrowers indirectly. That is, savers (lenders) give funds to an
intermediary institution (such as a bank), and that institution gives those funds to
spenders (borrowers). This may be in the form of loans or mortgages.

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As we have seen, financial intermediaries obtain funds by issuing financial claims

against themselves to market participants, and then investing those funds.
The investments made by financial intermediaries—their assets—can be in loans and/or
securities. These investments are referred to as direct investments. Market participants
who hold the financial claims issued by financial intermediaries are said to have made
indirect investments.
2.2 Function of Financial Intermediaries
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 five economic functions: (1) providing maturity
intermediation; (2) reducing risk via diversification; (3) reducing the costs of
contracting; (4) Information Production and (5) providing a payment mechanism. Each
function is described below.
1. Risk reduction through diversification:
By choosing portfolio of investment rather than investing all one’s resources in a single
asset, the financial intermediary reduces the total risk to which they are expensed. Even
if individuals can also do this on their own, they may not be able to do this as cost
effective as institutions depending on the amount of funds they have to invest.
2. Maturity Intermediation:
Financial intermediaries provide the service of intermediating across maturity or
borrowing short and lending long. This means that they accepts fund from investors
who desire to lend their funds for short period and they gives those funds to their
borrowers who desire a long maturity. Maturity intermediation presents two
implications to financial markets: (a) Investors have more choice concerning the
maturity of their investment; borrowers have more choice for length of their debt
obligation. (b) Counting up on successive short term deposits (which has a lower
interest rate) providing fund until maturity, the financial institutions can provide fund to
borrowers at a rate lower than that offered by individual investors.
3. Reduces the cost of contacting:
Intermediaries can reduce the cost of writing and understanding financial contract.
They can also reduce the cost of monitoring the activities of the contracting parties to
ensure that the terms of contract are observed. This is possible by appointing
professional by financial intermediaries as investment of funds are their normal

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business and they have large amount of fund to be invested. The intermediaries can
promise better service to lenders compared to borrowers of the fund.
4. Information Production:
Financial intermediaries provide the services of production of information about the
value of assets.
Intermediaries expend considerable resources in collecting, processing, analyzing and
interpreting facts and opinions about future profitability and financial strength of the
firm they are financing. Intermediaries can also hire specialists in the production of the
information. The collection and analysis of information is important to them as their
success depends on the management of investment based on their information.
5. Providing a payment mechanism
Most of the business transactions made today is not done with cash. Instead payments
are made using checks, credit cards, debit cards, and electronic transfer of funds.
Financial intermediaries provide these methods of making payments
2.3 Classification of Financial Institutions
Financial institutions are divided into three class:
1. Depository Financial Institutions
2. Non-Depository Financial Institutions
3. Investment Companies
2.3.1 Depository Institutions
Depository institutions are financial intermediaries that accept deposits usually demand
deposits and savings deposits from customers and invests those funds in loans and
securities. Deposits are liabilities of these institutions. With the fund raised through
deposits they make direct loans to various entities. Their income comes from the loans
they make and securities they purchase. One key characteristics of a depository
institution is that its liabilities include various deposits, such as time, saving, or
checking accounts. Further, most depository institutions also specialize in asymmetric
information problems specific to loan markets.
They include commercial banks (or simply banks), savings and loan associations
(S&Ls), savings banks, and credit unions. It is common to refer to depository
institutions other than banks as “thrifts.” Depository institutions are highly regulated
and supervised because of the important role that they play in the financial system.
Each of them is briefly discussed in the following part:
A) Commercial banks

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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. 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. Historically, commercial banks were the
dominant direct lender to firms. In recent years, however, other types of financial
institutions have begun to provide more loans to firms. Like most other types of firms,
commercial banks are created to generate earnings for their owners.
In general, commercial banks generate earnings by receiving a higher return on their use
of funds than the cost they incur from obtaining deposited funds. For example, a bank
may pay an average annual interest rate of 4 percent on the deposits it obtains and may
earn a return of 9 percent on the funds that it uses as loans or as investments in
securities. Such banks can charge a higher interest rate on riskier loans, but they are
then more exposed to the possibility that these loans will default.
Although the traditional function of accepting deposits and using funds for loans or to
purchase debt securities is still important, banks now perform many other functions as
well. In particular, banks generate fees by providing services such as travelers’ checks,
foreign exchange, personal financial advising, and other service in the financial market.
Thus commercial banks in a well-developed financial system are able to offer
customers “one stop shopping.”
B) Savings and credit Associations
Savings and credit Associations are depository institutions that traditionally have
specialized in extending mortgage loans to individuals who wish to purchase homes.
Just as there is asymmetric information in business loan deals, a person who wants a
mortgage loan may or may not become a bad risk after receiving the loan. And so there
are adverse selection and moral hazard problems specific to mortgage lending.
C) Credit Union
The credit unions are the smallest of all depository institution. A credit union is a
depository institution that accepts deposits from and makes loans only to a closed
group of individuals. To be a member of a credit union and eligible for its services, a
person usually must be employed by a business with which the credit union is affiliated.
Most credit unions specialize in making consumer loans, although some have branched
into mortgage loan business.
D) Micro Finance Institution

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Microfinance, also called microcredit, is a type of banking service provided to

unemployed or low-income individuals or groups who otherwise would have no other
access to financial services.
The microfinance sector consistently focuses on understanding the needs of the poor
and on devising better ways of delivering services in line with their requirements,
developing the most efficient and effective mechanisms to deliver finance to the poor.
Continuous efforts towards automation of operations is steady improving in efficiency.
The automated systems have also helped accelerate the growth rate of the
microfinance sector.

The goal for MFIs should be:

 To improve the quality of life of the poor by providing access to financial and
support services;
 To be a viable financial institution developing sustainable communities;
 To mobilize resources in order to provide financial and support services to the
poor, particularly women, for viable productive income generation enterprises
enabling them to reduce their poverty;
 Learn and evaluate what helps people to move out of poverty faster;
 To create opportunities for self-employment for the underprivileged;
 To train rural poor in simple skills and enable them to utilize the available
resources and contribute to employment and income generation in rural areas.
2.3.2 Non-Depository Financial Institutions
Non-depository or contractual intermediaries bundles the provision of some other
contractual services, with the investment of funds e.g., insurance companies.
A. Insurance company
Insurance companies provide individuals and firms with insurance policies that reduce
the financial burden associated with death, illness, and damage to property. These
companies charge premiums in exchange for the insurance that they provide. They
invest the funds received in the form of premiums until the funds are needed to cover
insurance claims. Insurance companies commonly invest these funds in stocks or
bonds issued by corporations or in bonds issued by the government.

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In this way, they finance the needs of deficit units and thus serve as important financial
intermediaries. Their overall performance is linked to the performance of the stocks and
bonds in which they invest.
Types of Insurance Companies
There are two basic kinds of insurance companies classified on the basis of the major
types of insurance policies they are offering.
i. Life insurance companies: charge premiums for policies that insure people
against the financial consequences associated with death. They also offer
specialized policies, called annuities, which are financial instruments that
guarantee the holder fixed or variable payment at some future date.
ii. Property and casualty insurers: insuring against risks relating to property
damage and liabilities arising from injuries or deaths caused by accidents or
adverse natural events. Property and casualty insurance companies offer
policies that insure individuals and businesses against possible property
damages or other financial losses resulting from injuries or deaths sustained as
a result of accidents, adverse weather, earthquakes and soon.

Most insurance companies especially here in Ethiopia are formed by combining the
above two types of insurance services, as a result in the current financial system of
Ethiopia expect the newly introduced life insurance company all other financial
institutions are selling both life and non-life insurance policies.
B. Pension Funds
Pension funds are institutions that specialize in managing funds that individuals have
put away to serve as a nest egg when they retire from their jobs and careers. Part of
what many workers get paid is in the form of contributions that their employers make to
such funds.
The key specialty of pension funds is creating financial instruments called pension
annuities. These are similar to the annuities offered by life insurance companies. But
life insurance annuities usually are intended as supplements to a person’s income at
some fixed point in the future, Whether or not a pension is working at the time. In
contrast, pension annuities apply only to the future event of retirement. Most people
regard pension annuities as their main source of future income after requirement.
Why do people use the services of pension funds instead of saving funds on their own?
One reason certainly is asymmetric information, because those who operate pension
funds may be better informed about financial instruments and markets than those who

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save for retirement. But there is another reason that probably is more important. This is
the existence of economies of scale. Many people would find it very costly to monitor
the instruments they hold on a day-by-day basis throughout their lives. Pension funds
do this for many people at the same time, thereby spreading the costs across large
numbers of individuals.
Pension funds exist to protect future pensioners from losses on their retirement
savings.
Hence, they specialize in monitoring capital market instruments for risks that might
arise from adverse selection and moral hazard problems experienced by issuers.
C. Mutual Funds
A Mutual fund is a mix of redeemable instruments, called “shares” in the fund. These
shares are claims on the returns on financial instruments held by the fund, which
typically include equities, bonds, government securities, and mortgage backed
securities.
Mutual funds usually are operated by investment companies, which charge
shareholders fees to manage the funds. One reason for the growth of mutual funds is
that many shareholders believe that Investment Company managers know best how to
balance risks and returns on their behalf. This makes shareholders willing to pay fees
for the manager’s knowledge and skill.
There is more important reason, however, for the growth of mutual funds. Like pension
funds, mutual funds take advantage of financial economies of scale. Mutual fund
shareholders typically pay lower fees to investment companies than they might have to
pay brokers to handle their funds on a personal basis. The reason is that mutual fund
managers can spread the costs of managing shareholders’ funds across all the
shareholders.
2.3.3 Investment companies
a) Investment banking firms
Investment Banking is financial institutions that underwrites and distributes new
investment securities and helps businesses obtain financing. Investment banking
houses in the US such as Goldman Sachs or Credit Suisse Group provides a number of
services to both investors and companies planning to raise capital. Such organizations:
 help corporations design securities with features that are currently attractive to
investors,
 then buy these securities from the corporation, and
 resell them to savers.

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Securities Firms
Securities firms provide a wide variety of functions in financial markets. Some
securities firms act as a broker, executing securities transactions between two parties.
The broker fee for executing a transaction is reflected in the difference (or spread)
between the bid quote and the ask quote. The markup as a percentage of the
transaction amount will likely be higher for less common transactions, since more time
is needed to match up buyers and sellers. The markup will also likely be higher for
transactions involving relatively small amounts, so that the broker will be adequately
compensated for the time required to execute the transaction.
In addition to brokerage services, securities firms place newly issued securities for
corporations and government agencies; this task differs from traditional brokerage
activities because it involves the primary market. When securities firms underwrite
newly issued securities, they may sell the securities for a client at a guaranteed price or
may simply sell the securities at the best price they can get for their client.
Furthermore, securities firms often act as dealers, making a market in specific
securities by maintaining an inventory of securities. Although a broker’s income is
mostly based on the markup, the dealer’s income is influenced by the performance of
the security portfolio maintained. Some dealers also provide brokerage services and
therefore earn income from both types of activities.
Some securities firms offer advisory services on mergers and other forms of corporate
restructuring. In addition to helping a company plans it’s restructuring, the securities
firm also executes the change in the client’s capital structure by placing the securities
issued by the company. The securities firms that offer these services are commonly
referred to as investment banks.
Hedging funds
Hedge funds are similar to mutual funds because they accept money from savers and
use the funds to buy various securities, but there are some important differences. While
mutual funds are registered and regulated, hedge funds are largely unregulated. This
difference in regulation stems from the fact that mutual funds typically target small
investors, whereas hedge funds typically have large minimum investments (often
exceeding $1 million) that are effectively marketed to institutions and individuals with
high net worth’s. Hedge funds generally charge large fees, than mutual funds. Some
hedge funds take on risks that are considerably higher than that of an average
individual stock or mutual fund.
2.4 Risk in Financial Industry

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Financial institutions have to take risks all the time to make money. Risk arises from the
occurrence of some unexpected events in the economy or the financial markets which
causes in erosion in asset values and consequently, reduces the institution’s intrinsic
value.
The money lent to customer may not be repaid due to the failure of a business, decline
in market value of bond or stock and due to adverse change in interest rates or default
in derivative contract to purchase foreign currency by a counter party on the due date.
There are many types of risk incurred by financial institutions. The most important risks
are as follows:
1. Business/Strategic risk
Business risk is a possibility of company getting lower profit than expected or
experiencing loss than getting profit. It caused by various factor such as sales volume,
per-unit price, input costs, competition, the overall climate and government regulation. A
company with a higher business risk should choose a capital structure that has a lower
debt ratio to unsure it can meet its financial obligation.
2. Credit risk
Credit risk is the one that most would be familiar with as economies continue to recover
from the more recent occurrence in the history of financial services: the subprime crisis.
Credit risk is a risk of default on loan that arises due to failure of borrowers to make
repayment. It is a risk of lender which leads to the loss of principal and interest,
disruption to cash flows and increase collection costs. The loss may be complete or
partial.
3. Market risk
Market risk is a possibility of investors to experience loss due to the factors that affect
the overall performance of financial market in he/she involved. Market risk is also called
systematic risk. Means it cannot be eliminated through diversification. Market risk can
occur due to recession, political turmoil, natural disaster, or terrorist attacks.
4. Liquidity risk
Liquidity risk is the risk that a company may be unable to meet short term financial
demand. This is usually happen due to inability to convert security or other asset in to
cash without loss of capital or income in the process. In other words, liquidity risk
arises when a business or individual with immediate cash needs holds valuable asset
that cannot be traded or sold at a market value due to lack of buyer, or due to an
inefficient market where it is difficult to bring buyer and seller together.
5. Operational risk

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Operational risk is change in a value caused by deviation actual outcome incurred due
to inadequate or failed internal process, people and system differ from expected
outcome.
6. Foreign exchange risk
Foreign exchange risk is also known as FX risk. Foreign exchange risk occurs when a
financial transaction is denominated in a currency other than that of the base currency
of the company. Exporting and importing firm faces exchange rate risk which can have
severe financial consequences.

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