FI&CM handout AUWC Extension 3rd year

Chapter Two

Financial Institution and their operation

2.1 Definition of Financial institutions
 In financial economics, a financial institution is an institution that provides financial
services for its clients or members.
 Probably the most important financial service provided by financial institutions is acting
as financial intermediaries. Most financial institutions are regulated by the government.
 Financial institutions provide service as intermediaries of financial markets.
 They are responsible for transferring funds from investors to companies in need of those
funds. Financial institutions facilitate the flow of money through the economy.
 To do so, savings are brought to provide funds for loans.
 Financial institutions in most countries operate in a heavily regulated environment as they
are critical parts of countries' economies.
 Regulation structures differ in each country, but typically involve prudential regulation as
well as consumer protection and market stability.
 Some countries have one consolidated agency that regulates all financial institutions
while others have separate agencies for different types of institutions such as banks,
insurance companies and brokers.

2.2. Types of financial Institution

 Even if there is no universal way of classifying financial institutions, they are generally
classified in to two; depository and non -depository institutions.
2.2.1. Deposit taking financial institutions and their operation
Depository institution include commercial banks (or simply banks), saving and loan associations,
saving banks and credit union.
 Depository institutions are financial intermediaries that accept deposits.
 These deposits represent the liabilities (debts) of the deposit accepting financial institutions.
 With the fund rose through deposits and other funding sources, depository institutions make
direct loans to various entities and also invest in securities.
 Thus, their income is derived from:

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 income generated from loans they make and

 income generated from the securities they purchased
 fees income
 There are some financial institutions which are highly specialized types of depository
institutions (these are called thrifts). Example, Saving banks, credit unions etc.
 They have not been permitted to accept deposits transferable by check or any negotiable
instrument.
 They have obtained funds primarily by tapping the savings of households.
 Depository institutions are highly regulated because of the important role that they play in the
financial system.
 Because of their important role, depository institutions are affording special privileges such as
access to federal deposit insurance and access to a government entity that provides funds for
liquidity of emergency needs.
1. Commercial Banks
Commercial Banks are those financial institutions which accept deposit from the public
repayable on demand and lend them for short periods.
Bank Funding; how banks raise funds?
 There are three sources of funds for banks.
(1) Deposit
(2) non-deposit borrowing and
(3) common stock and retained earnings.
Banks are highly leveraged financial institutions, which means, most of their
funds come from deposit, borrowing (non-deposit borrowing and borrowing
from Federal Reserve through the discount window facility).
Functions of Commercial Bank
1. Primary Functions of Comm. Banks
a. Accepting deposits -there are different types of deposit, such as:
i. Current or demand deposits (checking deposits):-pay no interest and can be withdrawn upon
demand using checks. Another deposit similar to demand deposit is negotiable order of
withdrawal accounts (NOW accounts). It can offer checkable deposits that pay interest when a
minimum balance is maintained on its books and withdraw able on demand. Now accounts
require the depositor to maintain a minimum account balance let say$500 to earn interest. If the

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minimum balance falls below some level (let below $500), NOW account becomes quite similar
with demand deposit since no interest is earned.
ii. Saving deposits:-pay interest do not have a specific maturity, and usually can be withdrawn
up on demand.
iii. Fixed or time deposits (certificate of deposit):-have fixed maturity date and pay either a
fixed or floating interest rates. If the depositor needs money before the maturity date, CDs can be
sold in the secondary market or by paying withdrawal penalty to the banks, it can withdraw the
total amount prior to maturity.
b. Lending Money
- Overdraft
- Cash credits
-Loans and advance
-Discounting of bill of Exchange
2. Secondary Services of Commercial Banks
a. Agency services: as an agent banker renders the following services
– Collection of cheques, drafts, and bill for their customers
– The collection of standing orders, e.g., payment of commercial bills, collection of
dividend warrants and interest coupons, payment of insurance premiums, rents,
etc
– Conduct of stock exchange transaction such as purchase and sale of securities for
the customers,
– Acting as executor and trustee,
– Providing income tax services,
– Conduct of foreign exchange business
b. General Utility service
• Safe keeping of valuables
• Issue of Commercial letters of credit and travellers’ cheque,
• Collecting trade information from foreign countries for their customers
• Arrange business tours
• etc
2.2.2. Non- Depository Institutions
These Non-depository institutions are financial institutions that do not mobilize deposits.
Depository institutions seek to generate income by the spread between the returns that they earn
on assets and the cost of their funds i.e. they are considered as spread business. Some of the non-
depository institutions such as life insurance companies and property –casualty insurance
companies are also considered as spread businesses. The other non-depository institutions like
pension funds are not in the spread business because they do not raise funds themselves in the

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business. They seek to cover the cost of pension fund obligations at a minimum cost of that is
borne by the sponsor of the pension plan. Non-depository institutions include:
insurance company
Pension Funds
Mutual Funds
Investment Bankers
1. 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 and service) insurance policies, which are legally
binding contracts.
 Insurance companies promise to pay specified sum contingent on the occurrence of future
events, such as death or an automobile accident.
 Insurance companies are risk bearer.
 They accept or underwrite the risk for an insurance premium paid by the policyholder or
owner of the policy.
2. Pension Fund
 Pension plan is a fund that established for the payment of retirement benefits.
 Pension funds offer savings plans through which fund participant accumulate tax deferred
savings during their working years. The entities that establish pension plans are called
plan sponsors.
 Pension plan sponsors can be private businesses acting for their employees or public
organizations -on behalf of their employees, unions on behalf of their members or
individuals for themselves.
 Pension funds are financed by contributions by employers and employees.
 In some fund plans employer’s contribution are matched in some measure by employees.
 Pension plan assets are legally illiquid. It cannot be used before retirement even as
collateral.
 Pension fund is the most growing financial institution currently.
 The key factors for the pension fund growth are;

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 The employees’ and employers’ contribution are tax exempt.

 As well as the earnings of the fund’s assets are also tax exempt.
3. Mutual Funds
• A mutual fund raises funds from the pubic and invests the funds in a variety financial asset,
mostly equity both domestic and overseas and 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
• The stocks these mutual funds are very fluid and are used for buying or redeeming and/or
selling shares at a net asset value.
• Mutual funds posses share of several companies and receive dividends in lieu of them and
the earnings are distributed among the share holders
• 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
 Mobilizing small saving
 Professional management
 Diversified investment/ reduced risks
 Better liquidity
 Investment protection
 Low transaction cost (economy of scale)
 Economic Development
1. Mobilizing small saving
– Direct participation in securities is not attractive to small investors b/s of some
requirements which is difficult for them
– MF mobilizes funds by selling their own shares, known as units. This fund is invested in
shares of different institution, gov’t 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.

2. Professional management
Mutual funds employ professional experts who manage the investment portfolio
efficiently and profitably.
Investors are relied of the emotional stress in buying and selling securities since MF
take care of this function.
The Prof mgrs act scientifically with the right timing to buy and sell of shares for their
clients,
Automatic reinvestment of dividends and capital gains, etc.
3. 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 b/s they cannot afford to assess the profitability
and viability of different investment opportunities
– MF provide small investors the access to a reduced investment risk resulting from
diversification, economies of scale in transaction cost and professional financial mgt
4. Better liquidity
– There is always a ready market for the mutual fund units- it is possible for the investors
to divest 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.
5. Investment protection
– Mutual funds are legally regulated by guidelines and legislative provisions of regulatory
bodies (such as SEC in US, SEBI in India etc)
6. Low transaction cost (economy of scale)
– The cost of purchase and sale of mutual funds is relatively lower b/s of the large volume
of money being handled by MF in the capital market (economies of Scale)
– Brokerage fees, trading commission, etc are lower

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– This enhances the quantum of distributable income available for investors

7. Economic Development
– 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.
Return to Investors in the Mutual Fund
• Investors in the mutual fund have the potential to gain:
– They are entitled to a share in the capital appreciation of the underlying values of
existing assets, adds to the value of MF assets.
– They have a claim on the income generated by the underlying assets of the fund i.e.
dividend
– Capital gain when MF sells an asset at a price higher than the purchase price of the asset.
2.3. Risks in Financial Industry

There are different financial institutions risks that will impact their organizations. Below are the
major financial institutions risks:
1. Damage to Company Reputation
One of the most commonly cited fears was damage to their company’s reputation. This is not
surprising, as reputation is a vital ingredient to business success, whether in regards to
customer trust or employee loyalty. While key ingredients for acquiring a good corporate
reputation, such as high quality, outstanding service, and competitive prices, are relatively
well understood, there are seemingly countless ways in which a brand might be damaged
2. Cybercrime – As One of The Major Financial Institutions Risks
Speaking of data breaches, the fear of cybercrime also commonly appeared as a separate
response in our survey. And that is no wonder, as cyber-attacks like distributed denial of
service (DDoS) attacks are increasing in frequency every year. Such attacks can wreak havoc
on a company’s internet infrastructure, potentially sending domains and web-based services
offline for hours at a time and breaking functionality for their users.

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Cybercrime can have serious consequences for a company’s bottom line in several ways,
whether measured in lost time and productivity, cost necessary to fight the attacks, or simply
in the loss of customer trust following a leak of sensitive data or failure to provide services
according to expectations.
3. Economic Slowdown
It seems that no matter where you turn for news, there is discussion about worldwide
economic stagnation. Whether focusing specifically on Europe or China, Japan or the United
States, the one constant seems to be the belief in some kind of synchronized global economic
slowdown.
In modern financial theory, a firm’s exposure to general market risk is known as its “beta.”
Although the betas of banks and financial service companies are relatively low compared to
other industries, they are still correlated in a positive direction, meaning that they are still
expected to be negatively impacted in response to a fall in the overall market.

Few financial organizations outside the biggest banks can hope to achieve any kind of
influence over fiscal and monetary policy, making the signs of an impending global
economic slowdown concerning for financial professionals who are otherwise mostly
powerless in the face of an economic downturn. With that said, there are ways for a company
to prepare for widespread economic turbulence.
4. Regulatory/Legislative Changes
Similar to fears of general economic slowdown, a good number of financial professionals
responded that regulatory and legislative changes pose a risk to their companies in 2019.
Much talk has already been generated about the exceptionally high costs of compliance for
companies in the financial industry, with overall regulations seemingly doubling every few
years and costing banks upwards of one hundred billion dollars annually.
5. Increasing Competition
In an economic system marked by competition, successful companies cannot simply sit on
their laurels, lest an ambitious industry upstart appear and offer superior products or lower
prices to entice customers away. This is no different in the financial industry, with the advent
of financial technology and new means to invest and save appearing along with the
proliferation of smartphones and other mobile internet-connected devices.

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6. Failure to Innovate
In the face of such increasing competition in the financial sector, it is necessary for
companies to be able to innovate to continue to prosper. In technology, Apple was a
dominant force for innovation during the time of Steve Jobs, but sales decline has come
along rumblings concerning a lack of innovation coming out of the company.
7. Disruptive Technologies
Innovation that lets one company stay ahead of the competition could end up changing the way
the entire industry operates, leaving those slower to adapt behind. Disruptive technologies can
take the form of service ecosystems like Apple Pay, new investing platforms like the Robin
Hood app, or even would-be money of the future like crypto currencies.

In such a constantly changing industry as finance, there is always the threat of new technologies
that could draw consumers away from traditional practices. For organizations to be successful
and survive long into the future, such changes must either be anticipated or adapted to as well as
possible. Apple Card, for instance, promises to attract existing Apple users with its ease of use
and lack of annual fees, which has undoubtedly already spurred other major credit card
companies to evaluate and improve their own offerings where they see fit.
8. Failure to Attract
The problem of attracting and retaining quality talent was another common refrain from the
financial professionals we surveyed. High turnover rates require resources to be devoted to hiring
and training employees rather than put towards other valuable business development goals. It
also can affect employee morale and make it difficult to create a positive company culture, where
employees understand and share the organization’s values and mission.

With unemployment low across the US, companies must work hard to attract the best and
brightest, offering perks such as professional development program, an appealing workplace
culture, and sometimes simply just more money than competitors.

9. Business Interruptions
“Time is money,” and nowhere is this more true than in the financial sector. Business
interruptions result in lower productivity, lower profit, and, depending on the situation, potential
brand damage. Purchasing business interruption insurance is one option some companies use to
mitigate such a risk, although such policies cover only loss or damage to tangible items and not
lost profits. In any case, there is no doubt that business interruptions are best to be avoided.
10. Political Risk and Uncertainty

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Similar to the fear of regulatory or legislative changes, political risk and uncertainty also factored
among the twelve most common survey responses. Sudden changes in the political winds can
have very real consequences for companies
11. Third Party Liability
Speaking of lack of control, respondents also mentioned third party liability as a major risk that
they fear in 2019. While the exact situations where third party liability arises may vary between
different industries, it can occur whenever a firm uses an outside company to provide some kind
of service. Third party liability risk is especially important in the financial industry, where
financial service firms face liability for the actions of vendors.
12. Commodity Price Risk
Rounding out the list of the 12 most common survey responses is commodity price risk.
Commodity price risk is defined as “the price uncertainty that adversely impact the financial
results of those who both use and produce commodities.” Notable commodities that cause price
risk for companies and consumers alike include oil, corn, cotton, aluminium, and steel.

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