CHAPTER ONE: INTRODUCTION TO FINANCIAL INSTITUTIONS

An Overview of the Financial System

Financial managers and investors don’t operate in a vacuum—they make decisions

within a large and complex financial environment. This environment includes
financial markets and institutions, tax and regulatory policies, and the state of
the economy. The environment both determines the available financial alternatives
and affects the outcomes of various decisions. Thus, it is crucial that investors and
financial managers have a good understanding of the environment in which they
operate. History shows that a strong financial system is a necessary ingredient for a
growing and prosperous economy. Companies raising capital to finance capital
expenditures as well as investors saving to accumulate funds for future use require
well-functioning financial markets and institutions. Over the past few decades,
changing technology and improving communications have increased cross-border
transactions and expanded the scope and efficiency of the global financial system.
Companies routinely raise funds throughout the world to finance projects all
around the globe.

Financial system is the mechanism through which loanable funds reach borrowers.
It provides for efficient flow of funds from saving to investment by bringing savers
and borrowers together via financial markets and financial institutions (see figure
1.1). The financial system provides the essential channel necessary for the creation
and exchange of financial assets between savers and borrowers so that real assets
can be acquired. Financial system exists to facilitate the design, sale, and exchange
of a broad set of contracts with a very specific set of characteristics. We obtain
financial resources through this system:

• Directly from markets, and

• Indirectly through institutions.

Indirect Finance: An institution stands between lender and borrower.

• We get a loan from a bank or finance company to buy a car.

Direct Finance: Borrowers sell securities directly to lenders in the financial

markets.

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 • Direct finance provides financing for governments and corporations

People and organizations with surplus funds are saving today in order to
accumulate funds for future use. A household might save to pay for future
expenses such as their children’s education or their retirement, while a business
might save to fund future investments. Those with surplus funds expect to earn a
positive return on their investments. People and organizations who need money
today borrow to fund their current expenditures. They understand that there is a
cost to this capital, and this cost is essentially the return that the investors with
surplus funds expect to earn on those funds.

Figure 1.1: Funds Flowing through the Financial System

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The Functions of the Financial System

The role of the financial system is to facilitate production, employment, and

consumption. Resources are channeled through the system so that they flow to
their most efficient uses.

The five major functions of a financial system

1. To facilitate trades of goods and services. An efficient financial system

reduces information and transaction costs in trade and helps the payments.

2. To increase savings mobilization by improving the savers confidence.

3. To produce information on the investment projects. It can be difficult to

obtain reliable information on the projects or on the borrowers. The financial
system can reduce this issue by devoting some agents to the screening of
projects.

4. To afford a better repartition and diversification of risk, and finally a better

risk management. A higher diversification allows risk adverse people to invest
in riskier projects with higher returns. In addition, a well-performing financial
system reduces liquidity risk: some products used to finance risky projects can
be easily converted into money.

5. To favor the monitoring during all the investment process, and develop a
corporate governance control.

The financial system has three main components:

– Financial instruments/assets (loans, deposits, bonds, equities, etc.)

– Financial markets (money market, capital market, forex market, etc.)

– Financial institutions (regulators, intermediaries and non-intermediaries -banks,

mutual funds, insurance companies, etc.)

• Assets:

Financial assets - a legal contract that gives its owner a claim to payments,
usually generated by a real asset. It is a claim against the income or wealth of
a business firm, household, or government unit, usually created by or related
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 to the lending of money. Most financial assets are highly liquid. Examples of
financial assets include stocks, bonds, insurance policies and credit held in
the bank etc.

Real assets – entities that generate a flow of goods or services over time.
They constitute tangible properties such as automobiles, houses, machineries
etc. Other examples include land, factories, inventions, business plans, and
goodwill with consumers, reputation. They are less liquid than financial
assets because it may be extremely difficult to sell them in hurry without
facing a substantial loss.

• Markets:

 Factor markets - In factor markets, consuming units sell their labor and
other resources to those producing units offering the highest prices. The
factor markets allocate factors of production – land, labor, and capital – and
distribute income- wages, rental payments, and so on – to the owners of
productive resources.,

 Products markets - In product markets – consuming units use most of their

income from factor markets. They buy, among other things, food, clothing,
shelter, automobiles. Medicare and other services sold in product market.

 Financial markets - The financial market performs a vital function within

the economic system. Financial market channels savings to those individuals
and institutions needing more funds for spending that could not be met out
of their current income.

The Meaning and nature of financial institutions

The financial system is complex, comprising many different types of private-sector

financial institutions, including banks, insurance companies, mutual funds, finance
companies, and investment banks—all of which are heavily regulated by the
government. The tremendous increase in capital flows between countries means
that the international financial system has a growing impact on domestic
economies. Whether a country fixes its exchange rate to that of another is an
important determinant of how monetary policy is conducted. Whether there are

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capital controls that restricts the mobility of capital across national borders has a
large effect on domestic financial systems and the performance of the economy.

Financial institutions are what make financial markets work. Without them,
financial markets would not be able to move funds from people who save to people
who have productive investment opportunities. They thus play a crucial role in
improving the efficiency of the economy.

A financial institution is an establishment that conducts financial transactions such

as investments, loans and deposits. Almost everyone deals with financial
institutions on a regular basis. Everything from depositing money to taking out
loans and exchanging currencies must be done through financial institutions.
Financial institutions in most countries operate in a heavily regulated environment
as they are critical parts of countries' economies. Regulation structures differ
among countries, 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. The
regulatory body in Ethiopia is the National Bank of Ethiopia (NBE). It licenses,
supervises and regulates the operations of banks, insurance companies and other
financial institutions in the country.

Financial institutions serve as intermediaries by channeling the savings of

individuals, businesses, and governments into loans or investments. They are major
players in the financial marketplace, with a huge financial asset of most economies
under their control. They often serve as the main source of funds for businesses
and individuals. Financial intermediaries are also defined as companies whose
primary function is to intermediate between lenders and borrowers in the economy.
Financial institutions perform the essential functions of channeling funds from
those with surplus funds to those with shortages of funds. Some financial
institutions accept customers’ savings deposits and lend this money to other
customers or to firms. In fact, many firms rely heavily on loans from institutions
for their financial support. Financial institutions are required by the government to
operate within established regulatory guidelines.

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Although we might categorize or group financial institutions as life insurance
companies, banks, finance companies, and so on, they face many common risks.
Specifically, all financial institutions (1) hold some assets that are potentially
subject to default or credit risk and (2) tend to mismatch the maturities of their
balance sheet assets and liabilities to a greater or lesser extent and are thus exposed
to interest rate risk. Moreover, all financial institutions are exposed to some degree
of liability withdrawal or liquidity risk, depending on the type of claims they have
sold to liability holders. In addition, most financial institutions are exposed to some
type of underwriting risk, whether through the sale of securities or the issue of
various types of credit guarantees on or off the balance sheet. Finally, all financial
institutions are exposed to operating cost risks because the production of financial
services requires the use of real resources and back-office support systems (labor
and technology combined to provide services). Because of these risks and the
special role that financial institutions play in the financial system, financial
institutions are singled out for special regulatory attention.

Financial institutions are what make financial markets work. Without financial
institutions, financial markets would not be able to move funds from who save to
people who have productive investment opportunities; and thus have important
effects on the performance of the economy as a whole. The most important
financial institution in the financial system of an economy is the central bank, the
government agency responsible for the conduct of monetary policy. In addition to
the central bank, institutions in the financial system include; commercial and
savings banks, insurance companies, mutual funds, stock and bond markets, credit
unions and non-formal financial institutions (that are common in least developed
countries including Ethiopia).

Banks are financial institutions that accept deposits and make loans. Included
under the term banks are firms such as commercial banks, savings and loan
associations, mutual savings banks, and credit unions. Banks are the financial
intermediaries that the average person interacts with most frequently. A person
who needs a loan to buy a house or a car usually obtains it from a local bank. Many
citizens keep a large proportion of their financial wealth in banks in the form of
checking accounts, savings accounts, or other types of bank deposits. Because

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banks are the largest financial intermediaries in any economy, they deserve careful
study. However, banks are not the only important financial institutions. Indeed,
other financial institutions such as insurance companies, finance companies,
pension funds, mutual funds, and investment banks have been growing at the
expense of banks, and so we need to study them as well.

In recent years, the economic environment has become an increasingly risky place.
Interest rates have fluctuated wildly, stock markets have crashed, speculative crises
have occurred in the foreign exchange markets, and the failures of financial
institutions have reached levels unprecedented since the Great Depression. It is
worth noting the 2008 global financial crisis during which the U.S. economy was
hit by the worst financial crisis since the Great Depression. From 2007 to 2009,
defaults in subprime residential mortgages led to major losses in financial
institutions, producing not only numerous bank failures, but also leading to the
demise of Bear Stearns and Lehman Brothers, two of the largest investment banks
in the United States. To avoid wild swings in profitability (and even possibly
failure) resulting from this environment, financial institutions must be concerned
with how to cope with increased risk.

Why Study about Financial Institutions?

Understanding how financial institutions are managed is important because there

will be many times in our life, as an individual, an employee, or the owner of a
business, when we will interact with them. Dealing with financial institutions is
almost unavoidable these days. In particular, we need to study about financial
institutions because:

1. They play key role (intermediation) in any economy.

2. They involve too much risk and hence need to be properly managed and
regulated.

3. Every player in the economy has a stake in financial institutions.

4. They employ many citizens and hence attract the interest of governments.

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The Types of Financial Institutions

Though there is no generally accepted method of classification, financial

institutions can be classified as Deposit Taking Institution (DTI) and Non Deposit
Taking Institution (NDIT). There are three reasons for this.

1. The deposit liabilities of DTIs usually form the bulk of a country’s money
supply. The quantity and growth of these deposits is thus of considerable
policy interest to the government and central bank and so DTIs are often
subject to pressures and influences which may not apply to NDITs.

2. As deposit liabilities are money, the failure of a DTI means that people lose, at
least temporarily, access to means of payment. This is a serious issue and
DTIs are usually subject to supervision and regulation which is not applied to
NDTIs.

3. Customers hold deposits for reasons which are rather different from those
reasons which cause them to hold other types of financial products.

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 funds
raised through deposits they make direct loans to various entities. Their income
comes from the loans they make and securities they purchase. Depository
institutions include commercial banks, saving and loan institutions, saving banks,
and credit unions. They are called depository institutions because a significant
proportion of their funds come from customer deposits. Deposits represent the
liabilities (debt) of the deposit accepting institutions. With the funds rose through
deposits and other funding sources, depository institutions make direct loans to
various entities and also invest in securities. Depository institutions other than
banks such as savings and loan associations, saving banks, and credit unions are
commonly called “thrifts” which are specialized types of depository institutions.
Depository institutions are highly regulated and supervised because of the
important role that they play in the financial system.

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Non – Depository Financial Institutions

The non-depository financial institutions also known as contractual intermediaries

include insurance companies, property and casualty companies, pension funds, and
investment companies. Their primary objective is acting as agents and risk bearing
for their customers

The major categories of financial institutions include:

 Investment banks –organizations that underwrite and distribute new investment

securities and helps businesses obtain financing. They usually perform the role
of financial mediator for various businesses and the government and are not
limited to the gathering of deposits like commercial banks. There are three
functions of an investment bank:

• Helping corporations design securities with features that are currently

attractive to investors;
• Buying these securities from the corporations; and
• Reselling them to savers.

 Commercial banks – these are traditional “department stores of finance”

because they serve a variety of savers and borrowers.

 Financial services corporation – a firm that offers a wide range of financial

services, including investment banking, brokerage, operations, insurance, and
commercial banking.

 Credit unions – cooperative associations whose members have a common bond,

in which their savings can be loaned only to other members.

 Pension funds – retirement plans funded by corporations or government

agencies for their workers.

 Mutual funds – organizations that pool investor funds to purchase financial

instruments and thus reduce risks through diversification.

 Exchange Traded Funds – institutions that buy a certain portfolio of stocks or

bonds, and then sell their shares to shareholders who want to invest on the
shares the latter institution bought.

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 Private equity companies – organizations that operate much like hedge funds;
but rather than purchasing some of the stock of a firm, private equity player buy
and then manage entire firms.

The Functions/Roles of financial institutions

The major services of financial institutions include one or more of the following.

Transforming financial assets acquired through the market and constituting

them into a different and more preferable type of asset—which becomes
their liability. This is the function performed by financial intermediaries, the
most important type of financial institution.

Exchanging financial assets on behalf of customers.

Exchanging financial assets for their own account.

Assisting in the creation of financial assets for their customers and then
selling those financial assets to other market participants.

Providing investment advice to other market participants.

Managing the portfolios of other market participants.

Financial intermediaries include: depository institutions that acquire the bulk of

their funds by offering their liabilities to the public mostly in the form of deposits;
insurance companies (life and property and casualty companies); pension funds;
and finance companies. The second and third services in the list above are the
broker and dealer functions. The fourth service is referred to as securities
underwriting. Typically, a financial institution that provides an underwriting
service also provides a brokerage and/or dealer service.

Some nonfinancial businesses have subsidiaries that provide financial services. For
example, many large manufacturing firms have subsidiaries that provide financing
for the parent company’s customer. These financial institutions are called captive
finance companies.

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To better understand the important economic function of financial institutions,
imagine a simple world in which financial institutions do not exist. In such a
world, households generating excess savings by consuming less than they earn
would have the basic choice: They could hold cash as an asset or invest in the
securities issued by corporations. In general, corporations issue securities to
finance their investments in real assets and cover the gap between their investment
plans and their internally generated savings such as retained earnings.

Figure 1.2: Flow of funds in a world without financial institutions

As shown in Figure 1.2, in such a world, savings would flow from households to
corporations; in return, financial claims (equity and debt securities) would flow
from corporations to household savers.

In an economy without financial institutions, the level of fund flows between

household savers and the corporate sectors is likely to be quite low. There are
several reasons for this. Once they have lent money to a firm by buying its
financial claims, households need to monitor, or check, the actions of that firm.
They must be sure that the firm’s management neither absconds with nor wastes
the funds on any projects with low or negative net present values. Such monitoring
actions are extremely costly for any given household because they require
considerable time and expense to collect sufficiently high-quality information
relative to the size of the average household saver’s investments. Given this, it is
likely that each household would prefer to leave the monitoring to others; in the
end, little or no monitoring would be done. The resulting lack of monitoring would
reduce the attractiveness and increase the risk of investing in corporate debt and
equity.

The relatively long-term nature of corporate equity and debt, and the lack of a
secondary market in which households can sell these securities, creates a second
disincentive for household investors to hold the direct financial claims issued by

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corporations. Specifically, given the choice between holding cash and holding
long-term securities, households may well choose to hold cash for liquidity
reasons, especially if they plan to use savings to finance consumption expenditures
in the near future. Finally, even if financial markets existed (without financial
institutions to operate them) to provide liquidity services by allowing households
to trade corporate debt and equity securities among themselves, investors also face
a price risk on sale of securities, and the secondary market trading of securities
involves various transaction costs. That is, the price at which household investors
can sell securities on secondary markets such as the New York Stock Exchange
(NYSE) may well differ from the price they initially paid for the securities.

Because of (1) monitoring costs, (2) liquidity costs, and (3) price risk, the average
household saver may view direct investment in corporate securities as an
unattractive proposition and prefer either not to save or to save in the form of cash.

However, the economy has developed an alternative and indirect way to channel
household savings to the corporate sector. This is to channel savings via financial
institutions. Because of costs of monitoring, liquidity, and price risk, as well as for
some other reasons, explained later, savers often prefer to hold the financial claims
issued by financial institutions rather than those issued by corporations.

Figure 1.3: Flow of funds in a world with financial institutions (FIs)

Consider Figure 1.3 above, which is a closer representation than Figure 1.2 of the
world in which we live and the way funds flow in our economy. Notice how
financial intermediaries or institutions are standing, or intermediating, between the
household and corporate sectors. These intermediaries fulfill two functions; any

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given financial institutions might specialize in one or the other or might do both
simultaneously.

Financial Institutions Function as Brokers

• The first function is the brokerage function. When acting as a pure broker, a
financial institution acts as an agent for the saver by providing information and
transaction services. For example, full-service securities firms carry out investment
research and make investment recommendations for their retail (or household)
clients as well as conducting the purchase or sale of securities for commission or
fees. Discount brokers carry out the purchase or sale of securities at better prices
and with greater efficiency than household savers could achieve by trading on their
own. This efficiency results in reduced costs of trading, or economies of scale.
Independent insurance brokers identify the best types of insurance policies
household savers can buy to fit their savings and retirement plans. In fulfilling a
brokerage function, the financial institution plays an extremely important role by
reducing transaction and information costs or imperfections between households
and corporations. Thus, the financial institution encourages a higher rate of savings
than would otherwise exist.

The role/functions of financial institutions as intermediaries are:

• Provision of payment mechanism
• Creation of desirable assets and liabilities
• Risk transformation/management
• Liquidity provision
• Cost efficiency (transaction, information and search costs)
• Provision of efficient monitoring mechanism.
The costs of financial intermediation include among others:
 Brokerage cost: fee charged by the broker for execution of order or
transaction;

 Evaluation cost: cost of feasibility study, inspection, survey carried out by

financial institutions to assess the creditworthiness of the loan applicant or
borrower;

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  Cost of monitoring performance: is the cost of supervision. Supervision is
necessary to ensure that the money borrowed has actually been used for the
purposed for which it was obtained/ sanctioned;

 Cost of enforcing the contract: litigation cost for enforcing the contract.

Financial Institutions Function as Asset Transformers

The second function is the asset-transformation function. In acting as an asset

transformer, the financial institution issues financial claims that are far more
attractive to household savers than the claims directly issued by corporations. That
is, for many households, the financial claims issued by financial institutions
dominate those issued directly by corporations as a result of lower monitoring
costs, lower liquidity costs, and lower price risk. In acting as asset transformers,
financial institutions purchase the financial claims issued by corporations—
equities, bonds, and other debt claims called primary securities—and finance
these purchases by selling financial claims to household investors and other sectors
in the form of deposits, insurance policies, and so on. The financial claims of
financial institutions may be considered secondary securities because these assets
are backed by the primary securities issued by commercial corporations that in turn
invest in real assets. Specifically, financial institutions are independent market
parties that create financial products whose value added to their clients is the
transformation of financial risk.

Financial Institution’s Role as Delegated Monitor

One problem faced by an average saver directly investing in a commercial firm’s

financial claims is the high cost of information collection. Household savers must
monitor the actions of firms in a timely and complete fashion after purchasing
securities. Failure to monitor exposes investors to agency costs, that is, the risk
that the firm’s owners or managers will take actions with the saver’s money
contrary to the promises contained in the covenants of its securities contracts.
Monitoring costs are part of overall agency costs. That is, agency costs arise
whenever economic agents enter into contracts in a world of incomplete
information and thus costly information collection. The more difficult and costly it
is to collect information, the more likely it is that contracts will be broken. In this

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case the saver (the so-called principal) could be harmed by the actions taken by the
borrowing firm (the so-called agent).

One solution to this problem is for many small savers to place their funds with a
single financial institution. This financial institution groups these funds together
and invests in the director primary financial claims issued by firms. This
agglomeration of funds resolves several problems. First, the large financial
institution now has a much greater incentive to collect information and monitor
actions of the firm because it has far more at stake than does any small individual
household. In a sense, small savers have appointed the financial institution as a
delegated monitor to act on their behalf. Not only does the financial institution
have greater incentive to collect information, the average cost of collecting
information is lower. For example, the cost to a small investor of buying a $100
broker’s report may seem inordinately high for a $10,000 investment. For a
financial institution with $10 million under management, however, the cost seems
trivial. Such economies of scale of information production and collection tend to
enhance the advantages to savers of using financial institutions rather than directly
investing themselves.

Financial Institution’s Role as Information Producer

Second, associated with the greater incentive to monitor and the costs involved in
failing to monitor appropriately, financial institutions may develop new secondary
securities that enable them to monitor more effectively. Thus, a richer menu of
contracts may improve the monitoring abilities of financial institutions. Perhaps the
classic example of this is the bank loan. Bank loans are generally shorter-term debt
contracts than bond contracts. This short-term nature allows the financial
institution to exercise more monitoring power and control over the borrower. The
information the financial institution generates regarding the firm is frequently
updated as its loan renewal decisions are made. When bank loan contracts are
sufficiently short term, the banker becomes almost like an insider to the firm
regarding informational familiarity with its operations and financial conditions.
Indeed, this more frequent monitoring often replaces the need for the relatively
inflexible and hard-to-enforce covenants found in bond contracts. Thus, by acting
as a delegated monitor and producing better and timely information, financial

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institutions reduce the degree of information imperfection and asymmetry between
the ultimate suppliers and users of funds in the economy.

Other functions of financial institutions

• Provision of payment mechanism (options to pay through Cheques, Credit cards,

Electronic transfers, Debit cards etc.)

• Facilitation of lending and borrowing.

• Provision of insurance, foreign exchange and other services.

Reducing transactions costs (Efficiency)

 Financial institutions make profits by reducing transactions costs (search

costs)

 Reduce transactions costs by developing expertise and taking advantage of

economies of scale (liquidity services)

Risk Sharing

 Create and sell assets with low risk characteristics and then use the funds to
buy assets with more risk (also called asset transformation, by pooling of
funds).

 Also lower risk by helping people to diversify portfolios

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