CHAPTER ONE

Meaning and nature of financial institutions

• Financial Institutions are establishments that focuses on
dealing with financial transactions, such as investments,
loans and deposits.
• Financial institutions are those organizations, which are
involved in providing various types of financial services,
and are controlled and supervised by the rules and
regulations delineated by government authorities
• The principal function of financial institutions is to
collect funds from the investors and direct the funds to
various financial services providers in search for those
funds.
 Cont. to Meaning and nature of financial institutions

• Financial institutions also impart a wide range of

educational programs to educate the investors on the
fundamentals of investment and also regarding the
valuation of stock, bonds, assets, foreign exchanges, and
commodities
• As a general rule, financial institutions are engaged in
intermediation. Intermediation means acting as a go-
between for two parties. The parties here are usually called
lenders and borrowers or sometimes surplus sectors or
units and deficit sectors or units.
 Classification of Financial Institutions
• Two main of financial institutions, depository & non
depository.
* Depository institutions are deposit-taking financial institutions
which accept deposits from customers (individuals, organizations and
government) and use the money collected, for lending purposes.
Includes banks and credit unions that is legally allowed to accept
monetary deposits, which pay interest on deposits from the interest
earned on the loans.
 Cont. to Depository Financial Institutions
• Depository institutions are popular financial institutions
for the following reasons:
 They offer deposit accounts
 They repackage funds received from deposits to provide loans
 They accept the risk on loans provided.
 They have more expertise
 They diversify their loans among numerous deficit units
 Commercial Banks
• Commercial Banks are institutions that offer deposit and
credit services as well as a growing list of newer services
as investment advice, security underwriting, selling
insurance and financial planning.
• Commercial Banks manage the customers' current and savings
accounts, pay out checks that have been drawn on the bank by
account holders.
• Banks implement a number of other procedures for payments to
customers, such as: ATM's (Automated Teller Machines), POS
(point of scale) and others
• Banks also provide loans to customers that are repayable in
installments as well as lending through investments in tradable debt
securities and other types of lending
 Cont. to Commercial Banks
• They are the largest and most important depository institutions.
They have the largest and most diverse collection of assets of all
depository institutions.
• Role of Commercial Banks in the Economic Development
1. Banks promote capital formation: Commercial banks accept
deposits from individuals and businesses, these deposits are then
made available to the businesses which make use of them for
productive purposes in the country
2. Investment in new enterprises: Businessmen normally hesitate to
invest their money in risky enterprises. The commercial banks
generally provide short and medium term loans to entrepreneurs to
invest in new enterprises
 Cont. to Role of Commercial Banks in the Economic Development
3. Promotion of trade and industry: With the growth of commercial
banking, there is vast expansion in trade and industry
4. Development of agriculture: The commercial banks particularly in
developing countries are now providing credit for development of
agriculture and small scale industries in rural areas.
5. Balanced development of different regions: They help in
transferring surplus capital from developed regions to the less
developed regions & ETC…….
Role of Banks in 21st Century: The commercial banks are now not
confined to local banking. They are on fast changing into global
banking i.e., understanding the global customer, using latest
information technology, competing in the open market with high
technology system, changing from domestic banking to investment
banking etc. The commercial banks are now considered the nerve
system of all economic development in the country.
• Virtual Banking: Providing the banking services
through extensive use of information technology
without direct recourse to the bank by the
customer is called virtual banking. The principal
types of virtual banking services include automated
teller machines (ATM’s), phone banking and most
recently internet banking. With the increasing use
of internet banking there is greater reliance now on
information technology and the decrease of physical
bank branches to deliver the banking services to the
customer.
 Other Depository Institutions
Savings and Loans Associations
• A savings and loan association (or S&L), also known as a thrift, is
a financial institutions that specializes in accepting savings, deposits
and making mortgage and other loans.
• They are often mutually held (often called mutual savings banks),
meaning that the depositors and borrowers are members with voting
rights and have the ability to direct the financial and managerial
goals of the organization.
• They are the predominant home mortgage lender in many countries,
making loans to finance the purchase of housing for individuals and
families.
 The characteristics of savings and loan associations
• The most important purpose of these institutions is to make
mortgage loans on residential property. These organizations, which
also are known as savings associations, building and loan
associations, cooperative banks and homestead associations, are the
primary source of financial assistance to a large segment of many
countries homeowners
• Some of the most important characteristics of a savings and loan
association are:
• It is generally a locally owned and privately managed home
financing institution.
• It receives individuals' savings and uses these funds to make long-
term amortized loans to home purchasers.
• It makes loans for the construction, purchase, repair, or refinancing
of houses.
• It is state or federal chartered.
 Credit Unions
• A credit union is a member-owned financial cooperative,
democratically controlled by its members, and operated for the
purpose of promoting thrift/saving, providing credit at competitive
rates, and providing other financial services to its members
• They are house hold oriented intermediaries, offering deposit and
credit services to individuals and families. They are cooperative,
self-help association of individuals rather than profit motivated
institutions accepting deposits from and making loans to their
members, all of whom have a common bond.
• Like savings and loans. Credit unions were originally restricted by
law to accepting savings deposits and making consumer loans
• Credit union policies governing interest rates and other matters are
set by a volunteer Board of Directors elected by and from the
membership itself.
• Only a member of a credit union may deposit money with the credit
union, or borrow money from it
 The following are some the unique characteristics of a credit union:
1. Nonprofit status: For-profit banks and other lending institutions are looking for a
return on an investment but not CU
2. Democratic process: The board of directors is elected by the union's membership
and works on a volunteer basis.
3. Inclusiveness: Credit unions have long-standing reputations for allowing spouses,
siblings, and children of members to join.
4. Lower fees: Comparatively, credit unions have lower fees for services than banks.
5. Better interest rates on loans: Interest rates are typically better through credit
unions, which traditionally have been among the leaders in auto loans.
6. Funds returned to members: If there are excess funds, they are generally
returned to the members in the form of dividends.
7. Easy to join: You need only ask your employer, family members, or neighbors
about credit unions that they may be part of. The process is then fairly simple, and
minimum balances are usually very low.
 Credit Unions and Banks
• The major difference between the credit unions and
banks is that the credit unions are owned by the
members unlike banks.
• The policies of credit unions are governed by a volunteer
Board of Directors that is elected by and from the
membership itself. This board of directors also decides on
the interest rates to be charged. According to the
regulation of credit unions, only the members of the credit
union are eligible to deposit money in the union or borrow
money from the union.
 Micro-Finance Institutions
• A micro finance institution (MFI) is an organization that offers
financial services to the very poor ones.
• The main focus of micro financing is on the poor, through provision
of small credit and acceptance of small savings
• The two main mechanisms for the delivery of financial services to
such clients are:
(1) Relationship-based banking for individual entrepreneurs and small
businesses;
(2) Group-based models, where several entrepreneurs come together to
apply for loans and other services as a group.
In some countries microfinance is used to describe the supply of
financial services to low-income employees,
 Cont. to Micro-Finance Institutions
• The Distinguishing characteristics of micro finance from Conventional
Banks
• Procedures are designed to be helpful to the client and therefore are
user friendly.
• Loan amounts especially at the first loan cycle are too small, much
smaller than the traditional banks
• Borrowers are usually required to be savers.
• Together with their long term sustainability they have the objective
of ending poverty
 Non-depository Institutions
• Government or private organization (such as building
society, insurance company, investment trust, or mutual
fund or unit trust) that serves as an intermediary between
savers and borrowers, but does not accept time deposits.
Such institutions fund their lending activities either by
selling securities (bonds, notes, stock/shares) or insurance
policies to the public.
• Non-depository institutions serve various functions in
financial markets, ranging from financial intermediation
to selling insurance against risk.
 Functions of Financial Institutions
1. Intermediation: They connect savers and borrowers.
2. Payment Facilitation: They enable secure fund transfers.
3. Resource Pooling: They combine funds for investment
diversification.
4. Credit Provision: They offer loans and credit lines.
5. Risk Management: They assist in managing various
financial risks.
6. Market Facilitation: They provide financial transactions
and market services.
7. Asset Management: They help manage investments for
individuals and institutions.
8. Corporate Finance: They support businesses with financial
services.
9. Regulatory Compliance: They ensure adherence to
financial regulations.
Roles of Financial Institution
Financial institutions are pivotal in the economy, performing various
roles:
1. Regulating Money Supply: They control the money supply to
stabilize the economy.
2. Banking Services: Providing savings, loans, and mortgage services.
3. Insurance Services: Managing risk through life, health, and
property insurance.
4. Capital Formation: Mobilizing savings for productive investments.
5. Investment Advice: Assisting clients in making informed
investment decisions.
6. Brokerage Services: Offering access to diverse investment options.
7. Pension Fund Management: Helping individuals plan for
retirement.
8. Trust Fund Services: Safeguarding and managing clients' assets on
behalf of clients.
9. SME Financing: Providing funds for small and medium-scale
enterprises.
10.Government Collaboration: Supporting economic growth
initiatives.