FINANCIAL ECONOMICS

[Econ 3091]

CHAPTER THREE

FINANCIAL INSTITUTIONS: DEPOSIT

TYPE, CONTRACTUAL, AND OTHER
FINANCIAL INSTITUTIONS

Wondesen M. (MSc)
 Introduction 2

 The financial market is composed of a number of financial institutions

that perform a variety of functions.

 In most contexts, financial institutions can be considered

synonymous with financial intermediaries in the financial markets.

 In a nutshell, financial intermediaries are the financial institutions that

pool resources and channel funds from savers/lenders to
spenders/borrowers.
Cont’d 3

 Smooth functioning of these institutions is very important for:

▪ an efficient financial market, which stimulates economic activity

▪ proper functioning of monetary policy, which aims to stabilize the price

level.

▪ proper functioning of fiscal policy, because in case of a budget deficit,

financing is obtained through financial institutions. On the other hand, in
cases of a budget surplus, the government may deposit in a financial
institution.

 Due to their crucial importance, almost all financial intermediaries are

regulated—some are subjected to very tight regulations whereas others
operate under less stringent regulations.
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Financial Intermediaries/Institution

 A large number of financial institutions serve as financial

intermediaries.

 The essential economic function of the financial markets is to

channel surplus funds from individuals who have saved from their
incomes to individuals who want to finance consumption or
businesses that need funds to finance capital investments.

 Look up Table 2 for an overview of Ethiopia‘s financial institutions.

 Types of financial institutions: depository institutes, contractual saving

institutes, investment funds and others.
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3.1. Deposit type of institutions
 Depository institutions, which are usually just called banks, are
categorized as such because their primary source of funding is the
deposits of savers.
 In most developed countries, their savings accounts are insured by a
governmental organization. For example, if an American bank is
unable to repay saving deposits, the Federal Deposit Insurance
Corporation (FDIC) will repay it for them up to certain limits.
 There are three types of depository institutions: commercial banks,
thrifts and credit unions.
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3.1.1. Commercial banks

 The primary business of commercial banks is to serve businesses,

although with banking deregulation they have entered into the
consumer business as well.
 Commercial banks provide the widest variety of banking services.
 The commercial bank‘s major activities in Ethiopia are
▪ savings accounts,
▪ checking services,
▪ consumer loans,
▪ commercial and industrial loans,
▪ import loans and credit cards
▪ ATMs services
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Cont’d

 The deposit itself is a liability owed by the bank to the depositor. Bank
deposits refer to this liability rather than to the actual funds that have
been deposited.

 When someone opens a bank account and makes cash deposit, he

gives the cash to the bank, so the cash becomes an asset of the bank.

 In turn, the account is a liability to the bank.

 There are different types of deposit accounts, of which the two most
known are the current account and the savings account.
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Current account/Checking account/ Demand deposit

 A current account is a basic checking account or a demand deposit.

 Consumers deposit money and the deposited money can be withdrawn

as the account holder desires on demand.

 This implies liquidity for the account holder. These accounts often allow
the account holder to withdraw funds using bank cards.

 In the case of Ethiopia, the current account holders receive interest on

demand deposits.
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Savings accounts:

 Savings accounts offer account holders more interest on their deposits.

 However, in some cases, when the savings are below the agreed
threshold, the bank may refuse to pay interest.

 Although savings accounts are not linked to paper checks or cards

like current accounts, their funds are relatively easy for account
holders to access.

 Worldwide more than 65% of people aged 15+ have access to a

commercial bank account (see Table A.1.2 ).
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3.1.2 Thrifts (savings and loan associations and
savings banks)

 Saving and loan associations are similar to a bank, but they are
owned and managed by the clients (the depositors and the
borrowers).
 If you are member of a saving and loan association, you co-own the
association, but you also save and/or borrow from it.
 Therefore, depositors and borrowers have voting rights in important
decisions.
 Worldwide they are known to facilitate mortgage loans and other
loans for expensive household investments (for example, a car).
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Cont’d
 Saving banks have a core task to collect household savings and to
supply them in the financial market. They are not owned by its
members.

 Note that in the Ethiopian context, many households do not use

officially registered savings- and loan- institutions, but rather rely on
informal financing methods such as equb or idir.
 These are informal and bottom-up, which is in many cases a solution to
the lack of access to formal thrifts.
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3.1.3 Credit unions

 Credit unions are non-profit depository institutions that are financial

cooperatives owned by people belonging to a particular group, such as the
employees of a particular company, a union, or a religious group, or who
live in a specific area, and they are governed by a board of volunteers.

 Because they are non-profits and owned by their customers, they charge
lower loan rates and pay higher interest rates on savings, and they offer a
wide variety of financial services for their owners.

 Credit unions can also be used to deposit and to borrow money, so for all
practical purposes, members of a credit union can consider it as a bank.

 Membership in the credit union is not, however, as open as commercial

banks—one must belong to the particular group to use its services.
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3.2 Contractual Savings Institutions

 Contractual savings institutions are financial intermediaries that acquire funds

periodically on a contractual basis and invest them in such a way that they have
financial instruments maturing when contractual obligations must be met.

 For depository institutions (see 3.1) it is not exactly clear when clients will deposit
and how much they will deposit, but for contractual saving institutions it is clear
when money will be transferred.

 Contractual saving institutions are mostly present in developed countries, in the

form of (life) insurance companies, private pension funds, mutual funds and
funded social pension insurance systems.

 In some countries, such as Switzerland, the Netherlands, and the United Kingdom,
the resources mobilized by life insurance companies and pension funds
correspond to well over 100 percent of annual GDP.
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Cont’d

 They have long-term liabilities and stable cash flows and are therefore ideal
providers of term finance, not only to government and industry, but also to municipal
authorities and the housing sector.

 Except for Singapore, Malaysia, and a few other countries, most developing
countries have small and insignificant contractual savings industries, because high
inflation strongly discourages such long-term saving schedules.

 Furthermore, issues like pensions are mostly organised by the employer (which is
often the government). However, there is an insurance sector in most developing
countries.

 The basic concept of insurance is that one party, the insurer, will guarantee payment
for an uncertain future event.
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Cont’d

 Meanwhile, another party, the insured or the policyholder, pays a smaller

premium to the insurer in exchange for that protection on that uncertain future
occurrence.

Life insurance companies:

 insure people against financial hazards following a death and they also provide
annuities (that is: annual income payments after retirement).

 They acquire funds from the premiums that people pay to keep their policies in
force and use them mainly to buy corporate bonds, mortgages and stocks.

 In Ethiopia, in contrary to most developed countries, only 7.6% of the insurance

premiums written are life insurances.
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Cont’d

Fire and Casualty Insurance Companies:

 Fire and Casualty Insurance Companies insure people 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 do. Their largest holding of assets consists of bonds.
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Cont’d

Two types of insurance are mandatory in Ethiopia:

 Motor third-party liability insurance (insures damage to third party

health and property caused by an accident for which driver and/or
owner of the car was responsible).

 Professional indemnity insurance (a business insurance of

compensating clients for loss or damage resulting from negligent
services or advice provided by a business).
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3.3. Investment funds/ investment intermediaries

 An investment intermediary makes a very large portfolio containing

diverse stocks and bonds, in order to facilitate investments for a whole
group of investors.
 the benefit from investing in a portfolio of diverse assets as a group is
that the unsystematic risks are reduced.
 Investment funds allow to:
✓ hire professional investment managers, who may offer better returns and
more adequate risk management;
✓ benefit from economies of scale, i.e., lower transaction costs;
✓ increase the asset diversification to reduce unsystematic risk.
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Cont’d

 With investment funds, individual investors do not make decisions

about how a fund's assets should be invested. They simply choose a
fund based on its goals, risk, fees and other factors.
 A fund manager oversees the fund and decides which assets it should
hold, in what quantities and when the assets should be bought and
sold.
 An investment fund can be broad-based, or it can be tightly focused
in small stocks.
 There are three types of funds: mutual funds, ETF‘s and hedge funds.
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Mutual funds: Open-end vs. closed-end:

 Mutual funds are the traditional form of investment funds. A mutual

fund pools the money of many investors together, and this money is
used to buy a large portfolio with many stocks and bonds.

 Most investment fund assets belong to open-end mutual funds. These

funds consist of shares which the investor can buy.

 The open-end fund issues new shares as investors add money to the
pool and retire shares as investors take their money back from the fund.

 These funds are typically priced just once at the end of the trading day.
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Cont’d

 Closed-end funds trade more similarly to stocks than open-end funds.

 Closed-end funds are managed investment funds that issue a fixed

number of shares, and trade on an exchange.

 While a net asset value (NAV) for the fund is calculated, the fund trades
based on investor supply and demand.

 Therefore, a closed-end fund may trade at a premium or a discount to

its NAV.
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Cont’d

Exchange-traded funds (ETFs)

 ETFs emerged as an alternative to mutual funds for traders who wanted
more flexibility with their investment funds.

 Similar to closed-end funds, ETFs trade on exchanges, and are priced

and available for trading throughout the business day.

 Compared to mutual funds, ETFs are more flexible (they can be bought
and sold at any moment) and have slightly lower managing costs.
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Hedge Funds:

 A hedge fund is an investment type which is only available to

accredited very rich investors that want to invest in the longer run.
 Hedge funds are private and not publicly traded.
 Typically, hedge funds are known for taking higher risk positions with the
goal of higher returns for the investor.
 As such, they do not only include bonds and stock, but they also
include derivatives like options and alternative assets.
 Overall, hedge funds are usually managed much more aggressively
(more risk but also more returns) than mutual funds and ETF‘s.
Cont’d 24
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Reading Assignment

Capital Goods Finance Companies (CGFCs)

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END OF CHAPTER THREE

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