CHAPTER TWO:
2. Financial Institutions in the Financial System
Objectives of the chapter:
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Define financial institutions and their capital transfers
Describe the function and classification of financial institutions in the financial system
Differentiate depository financial institutions from non-depositary financial institutions
Explain the risks involved in the financial industry
2.1 What Is a Financial Institution (FI)?
Business entities include nonfinancial and financial enterprises. Nonfinancial enterprises
manufacture products (e.g., cars, steel, computers), provide nonfinancial services (e.g.,
transportation, utilities, computer services), or do both. 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 converting them into a
different and more widely preferable type of asset;1
2. Exchanging financial assets on behalf of customers;
3. Exchanging financial assets for their own accounts;
4. Assisting in the creation of financial assets for their customers, andthen selling those
financial assets to other market participants;
5. Providing investment advice to other market participants; and
6. Managing the portfolios of other market participants.
A financial institution (FI) is a company engaged in the business of dealing with financial and
monetary transactions such as deposits, loans, investments, and currency exchange. Financial
institutions encompass a broad range of business operations within the financial services sector
including banks, trust companies, insurance companies, brokerage firms, and investment
dealers.
Definition of Financial institutions
 Financial Institutions are the firms which provide access to financial markets. Financial
institutions (e.g., commercial and savings banks, credit unions, insurance companies, mutual funds)
perform the essential function of channeling funds from those with surplus funds (suppliers of funds)
to those with shortages of funds (users of funds). In financial economics, a financial institution is
an institution that provides financial services for its clients or members. It accepts deposits
from consumers, and "places the money in a variety of investment vehicles," such as loans and
mutual funds, to benefit both the consumers and the institution. Probably the most important
financial service provided by financial institutions is acting as financial intermediaries.
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2.2 Financial Institutions & capital Transfer (capital Transactions)
 Whether simple or complex, all financial systems perform at least one basic function – they
move scarce funds from those who save and lend to those who wish to borrow and invest.
In this process money is exchanged for financial assets.
 The transfer of funds from savers to borrowers can be accomplished by in at least three
different ways:
1) Direct finance: Direct transfers of money and securities
2) Semi-direct finance: Transfers through an investment banking houses which
underwrite the issue. An underwriter serves as a middleman and facilitates the
issuance of securities.
3) Indirect finance: Transfers through a financial intermediary
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1. Direct Finance: With the direct financing technique, borrowers and lenders meet each other
and exchange funds in return for financial assets without the help of a third party to bring
them together.
Direct method is the simplest method. But, both lenders and borrowers must frequently
incur substantial information cost simply to find each other.
 For one thing, both borrowers and lenders must desire to exchange the same amount of
fund at the same time.
Most importantly, the lender must be willing to accept the borrower’s IOU ("I Owe You."
), which may be too risky or too slow to mature.
What is an IOU?
The term IOU is the phonetic spelling of the phrase "I Owe You." In bookkeeping, it
signifies an outstanding debt.
How Does an IOU Work?
Usually, an IOU is a signed informal notice of an unpaid debt, sometimes because of partial
payment and an outstanding balance due. For example, Company XYZ may buy raw
materials for its production but until it sells the finished product, it does not have
sufficient cash flow to pay for the raw materials in full. In good faith, Company XYZ makes
a partial payment for the materials and issues an IOU for the balance.
Sometimes, a bond contract, the obligation of a bond issuer to repay bondholders, is referred
to as an IOU. However, in that case, the IOU or bond contract is a formal legal agreement
with specific terms, conditions, and penalties.
An IOU may also be the uncomplicated method of documenting small debts between
employees, friends or even family.
Brokers Vs. dealers
 Broker (individual or financial institution) who provides information regarding possible
purchases and sales of securities.
 A commissioned agent of a buyer (or seller) who facilitates trade to complete the desired
transaction.
 A broker does not take a position in the assets (not maintain inventories in these assets.
 The profits of brokers are determined by the commissions they charge to the users of their
services (either the buyers, the sellers, or both). Examples of brokers include real estate
brokers and stock brokers.
 Brokers do not actually buy or sell securities; they only execute their clients’ transaction at
the best possible price. They act merely as match makers, bringing SBUs and DBUs
together.
 A dealer also serves as an intermediary between buyers and sellers, but the dealer actually
acquires the seller’s securities in the hope of marketing them at a later time at a favorable
price.
 A dealer’s primary function is to “make a market” for a security.
2. Semi – Direct Financing
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Under this, bringing buyers and sellers together, a number of market specialists exist.
Some individuals and business firms become security brokers and dealers whose essential
function is to bring the SBU and the DBU together, thereby reducing information costs.
 It is an improvement over direct finance in a number of ways.
 It lowers the information cost for both savers and borrowers.
 In addition brokers and dealers facilitate the development of secondary market in which
securities can be offered for resale.
 Problems with the semi-direct financing: the ultimate lenders still winds up holding the
borrower securities and therefore, the lender use be willing to accept the risk, liquidity and
maturity characteristics of the borrower
3. Indirect Financing: Indirect Transfer through financial intermediary bank or mutual fund
obtains funds from savers and uses the money to lend or purchase securities
The following institutions are or can act as financial intermediaries:
 Banks.
 Mutual savings banks.
 Savings banks.
 Building societies.
 Credit unions.
 Financial advisers or brokers.
 Insurance companies.
 Collective investment schemes.
 Flows can be indirect if financial intermediaries are involved. Financial intermediaries
transform financial claims in ways that make them more attractive to the ultimate investor.
 Their fundamental role in the financial system is to serve both ultimate lenders and
borrowers but in much more complete way than brokers and dealers do.
 They generally carry low risk of default.
2.3 Role of Financial Intermediaries (institutions)
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 the form of loans, securities, or both. These
investments are referred to asdirect investments. Market participants who hold the financial
claims issued by financial intermediaries are said to have made indirectinvestments.
Examples
Commercial banks accept deposits and use the proceeds to lend funds to consumers and
businesses. The deposits represent the obligation of the commercial bank and a financial asset
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owned by the depositor. The loan represents an obligation of the borrowing entity and a
financial asset of the commercial bank. The commercial bank has made a direct investment in
the borrowing entity; the depositor effectively has made an indirect investment in that
borrowing entity.
An investment company is a financial intermediary which pools the funds of market
participants and uses those funds to buy a portfolio of securities, such as stocks and bonds.
Investment companies are more commonly referred to as “mutual funds.” Investors providing
funds to the investment company receive an equity claim that entitles the investor to a pro rata
share of the outcome of the portfolio. The equity claim is issued by the investment company.
The portfolio of financial assets acquired by the investment company represents a direct
investment that it has made. By owning an equity claim against the investment company, those
who invest in theinvestment company have made an indirect investment.
 The main purpose of a financial institution is to reduce information & transactions costs
by having efficient methods of monitoring and screening potential borrowers.
2.4 Functions of financial Institutions:
A. Transaction Costs: Definition: time and money spent on financial transactions. Reduce
transactions costs by developing expertise and taking advantage of economies of scale pool
savings of many small Surplus spending unit (SSU)s into large investments.
B. Currency Transformation – buy and sell financial claims denominated in various currencies.
C. Risk Sharing: Financial intermediaries reduce exposure of investors to risk (uncertainty about
the returns on assets) through risk sharing (selling assets with low risk, then use the funds to
purchase other assets with higher risk). Low transaction costs enable (FIs) to do risk sharing at
low cost, allowing them to earn profit on the spread between the returns of the low and high-risk
assets (also called asset transformation). FIs also help individuals in diversifying their assets and
therefore lowering their exposure to risk by creating portfolios.
Definition: One party to a financial transaction (e.g. borrower) knows more about the risk and
return of the transaction than the other party (e.g. lender).
D. Asymmetric Information (or inequality): This leads to two problems:
Adverse Selection (e.g., bad borrowers selected)
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Before transaction occurs
Potential borrowers most likely to produce adverse outcome are ones most likely to seek
a loan
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Similar problems occur with insurance where unhealthy people want their known medical
problems covered
Moral Hazard (e.g. borrowers take actions undesirable by lenders)
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After transaction occurs
Hazard that borrower has incentives to engage in undesirable (immoral) activities
making it more likely that won’t pay loan back
Again, with insurance, people may engage in risky activities only after being insured
Another view is a conflict of interest
2.5 Features of Financial Institutions
 It provides a high rate of return to the customers who have invested in the financial
institution.
 It reduces the cost of financial services provided.
 It is considered very important for the development of financial services in the
country.
 It also advises the customers on how to deal with the equity and the other securities
bought and sold in the market.
 It helps to improvise decision making because it follows a systematic approach to
calculate all the risks and rewards.
2.6 Classification of Financial Institution
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).
 DEPOSITORY INSTITUTIONS
Depository institutions include commercial banks, saving and loan institutions, saving banks, and
credit unions. These financial intermediaries accept deposits. Deposits represent the liabilities
(debt) of the deposit accepting institutions. With the fund rose through deposits and other funding
sources, depository institutions make direct loans to various entities and also invest in securities.
Saving and loan associations, saving banks, and credit unions are commonly called ―thrifts‖
which are specialized types of depository institutions.
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 Non Depository Institutions
The non-depository financial institutions include insurance companies, property and casualty
companies, pension funds, and investment companies. Their primary objective is acting as agent
and risk bearing for their customers the following are the basic reasons for the classification
1. The deposit liabilities of DTIs usually form the bulk of the 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 do 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.
2.6.1 DEPOSITORY INSTITUTIONS
Commercial Banks It may be said that, Banking in its simplest form, is as old as authentic history.
As early as 2000 B.C., Babylonians had developed a system of banks. In ancient Greece and Rome
the Practice of granting credit was widely prevalent. Banking had its roots in the earliest time in
the villages. The village moneylenders, the goldsmiths and the merchants were men of honesty,
integrity and reliability. They therefore, became custodians of the spare money of the villagers.
Thus, modern banks have their ancestors of repute, the merchants, the moneylenders and the
goldsmith. Merchants were men of honor and reputation. They were honest men in business. These
qualities put them distinct and they were regarded as trustworthy persons. They were persons to
whom any could be entrusted for safe custody. Accordingly, the practice arose for people who had
spare money to entrust it to merchants for safe custody. In turn, the merchants issued receipts for
such money accepted by them for safe custody. These receipts were purely acknowledgements of
abilities, which the merchants owed to those who entrusted money to them. These receipts were
similar to bank notes and were title to money and were assets to those who possessed them, just as
merchants had to honor all receipts issued by them.
Money lender as ancestor of commercial banks can be easily understood. The money lender was
man of some reputations in the village. He used to advance loans to the needy public at a nominal
rate of interest. For purposes of lending, he used his own capital and very often-accepted money
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from the members of the community who could spare it. Thus, he now becomes a borrower since
he borrows from the public who have money to spare and lent it to the needy. In the same way,
commercial banks accept spare money as deposits and lend it for those who need it. The goldsmith
was also a man of reputation and had means for safekeeping. So he began to attract and accept
spare money as well as valuables for safe custody and issues receipts for the same. This laid a
foundation to the emergence of the modern bank notes. He also undertook the task of transferring
funds from one account to another under oral or written instructions from his clients. This activity
has said to be developed to the modern cheque system. Generally, banking business has century‘s
age-old history associated with frequent changes in the character and content of the banking
institutions.
Nature and Classification of Banks/Types of Banks
A classification of financial institutions presents many problems. Banks are different nature. Thus
differences basically emanates from the differences in their functions in a given country. Thus, it
is very problematic and difficult to have a classification of financial institutions that can apply to
all conditions as economic conditions and financial needs vary from country to country. Countries
dependent on agriculture may establish banks operating in encouraging agricultural development
while others with small-scale industrial structure may find it necessary to have industrial
development banks. In other circumstances, they may be given a general and wider name of
Development banks. Hence, the nature of financial institutions, being shaped by the general
economic structure of a country considered, varies from one country to another.
However, from academic point of view, it is necessary to classify banks on some arbitrarily fixed
common basis. Accordingly, the possible basis for classifying banks into different types could be
their area of financing. Some banks are meant to finance agriculture, other industry and some other
to finance commence in general.
Secondly, common to all of them is their dealing with credits. Most banks receive deposits or
borrow money from the public and in turn lend the same to the public. However in financing
different spheres of the economy, some lend money for short periods while some grant for long
periods. In a broader sense, one can classify banks into two; these who deals with the banks
(commercial banks) and that who deal with financial institution (central bank). Being this is how
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banks are classified, central bank possess distinct features from other banks. In general context,
Banks can be classified into various types on the basis of their functions, ownership, domicile etc.
I. Classification on the basis of Functions:
1. Commercial Banks. The banks which perform all kinds of banking business and generally
finance trade and commerce all called commercial banks. Since their deposits are for a short
period, these banks normally advance short-term loans to the businessmen and traders and avoid
medium-term and long-term lending. However, recently, the commercial banks have also extended
their areas of operation to medium-term and long-term finance. Majority of the commercial banks
are in the public sector. But, there are certain private sectors banks operating as joint stock
companies. Hence, the commercial banks are also called joint stock banks.
2. Industrial Banks. Industrial banks, also known as investment banks, mainly meet the mediumterm and long-term financial needs of the industries. Such long-term needs cannot be met by the
commercial banks which generally deal with the short-term lending. The main functions of the
industrial banks are: (a) they accept long-term deposits (b) They grant long-term loans to the
industrialists to enable them to purchase land, construct factory building, purchase heavy
machinery. Etc. (c) They help selling or even underwrite the debentures and shares of industrial
firms. (d) They can also provide information regarding the general economic position of the
economy. (In Ethiopia, industrial banks, like Development Bank of Ethiopia is playing significant
role in the industrial development of country.
3. Agricultural Banks. Agricultural credit needs are different from those of industry and trade.
Industrial and commercial banks normally do not deal with agricultural finance. The agriculturists
require (a) short-term credit to buy seeds, fertilizers and other inputs, and (b) long-term credit to
purchase land, to make permanent improvements on land, to purchase agricultural machinery and
equipment, etc.
4. Exchange Banks. Exchange banks deal in foreign exchange and specialize in financing foreign
trade. They facilitate international payments through the sale and purchase of bills of exchange
and thus play an important role in promoting foreign trade. (In Ethiopia, these functions performed
by selected commercial banks and foreign banks).
5. Saving Banks. The main purpose of saving banks is to promote saving habits among the general
public and mobilize their small savings. (In India, postal saving banks do this job. They open
accounts and issue postal cash certificates.
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6. Central Bank. Central bank is the apex institution which controls, regulates and supervises the
monetary and credit system of the country. Important functions of the central bank are:
(a) It has the monopoly of note issue;
(b) It acts as the banker, agent and financial adviser to the state;
(c) It is the custodian of member banks ‘reserves;
(d) It is the custodian of nation‘s reserves of international currency;
(e) It serves as the lender of last resort;
(f) It functions as the bank of central clearance, settlement and transfer; and
(g) It acts as the controller of credit. Besides these functions, (Ethiopia‘s Central bank,
i.e., the National Bank of Ethiopia, also performs many developmental functions to
promote economic development in the country.
II. Classification on the Basis of ownership:
On the basis of ownership, banks can be classified into three categories: (1) Public Sector
Banks: These are owned and controlled by the government. (In Ethiopia, the Government
bank like Commercial Bank of Ethiopia and some of the Micro Finance Institutions come
under these categories.
(2) Private Sector Banks: These banks are owned by the private individuals or corporations
and not by the government. Example: Bank of Abyssinia.
(3) Co-operative Banks: Cooperative banks are operated on the cooperative lines.
Cooperative credit institutions are organized under the cooperative society‘s law and play an
important role in meeting financial needs in the rural areas.
III. Classification on the Basis of Domicile: On the basis of domicile, the banks are divided
into two categories:
(1) Domestic Banks: These are registered and incorporated within the country.
(2) Foreign Banks: These are foreign in origin and have their head offices in the country of
origin. Example: Western Union Bank, Commercial bank etc.
Portfolios of Financial Institutions (Commercial Banks)
Commercial banks are the financial stores of the financial system. They offer a wide array of
financial services than any other financial institution, meeting the credit, payments, and savings
needs of individuals, business and governments. The following are group of accounts that belong
to commercial banks:
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a) Cash and Due from bank (Primary Reserves)
All commercial bank hold a substantial part of their assets in primary reserves, consisting of cash
and deposits held with other banks, these reserves are the banker‘s first line of defense against
withdrawals by depositors and customer demand for loans. Banks generally hold no more than is
absolutely required to meet short–term contingencies because the yield on cash assets is minimal.
The deposits held with other banks do provide an implicit return for, however, because they are a
means of ‗paying ‗for correspondent banking services. In return for the deposits of smaller banks
the larger U.S correspondents provide such important services as clearing checks and processing
records by computer. Thousands of smaller bank across the U.S. invest their excess cash reserves
in loans to other banks, called federal funds, with the help of larger correspondent banks- referred
to as federal funds sold.
b) Marketable securities (Secondary Preservers)
Commercial banks hold securities acquired in the open market as investment and as a secondary
reserve to help meet short-term cash needs. Most of the investment securities held by banks are
money mark instruments, which are liquid and have an original maturity of one year or less, or
capital market instruments that the commercial bank intend to hold for one year of less. These
include bankers ‘acceptances, commercial, U.S government securities (Treasury bills, notes, and
bonds), U.S government agency securities, municipal bonds.
c) Loans: costumer & industrial loans
The business loans often referred to as C&I loans (commercial and industrial) which fall into four
main categories. Transaction loans: is negotiated for a specific purchase and is tailored to the
particular needs of the purchaser. The demand for these loans a particular borrower is typically
infrequent and hence each loan is negotiated separately every time. The loan is usually secured by
the assets being financed, and repayment is expected to come from the use of this asset. Working
capital loans: are used by firm to finance routine day to day transactions. Thus, they are general
purpose, short- term borrowing and are often used either to purchase current assets (e.g., inventory)
or to repay current liabilities incurred in purchasing current assets. These loans are also usually
secured by collateral such as accounts receivable or inventory. Term loans: they are longer
maturity loans used to buy fixed assets requiring large outlay of capital. Maturities typically run
from 3 to 10 years. Repayment is normally amortized because it comes out of the cash flows
generated by the asset financed with the loan.
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Combination
Working capital loans often include provisions that permit the conversion of short term borrowings
in to term loans. This is one way banks combine various types of loans to satisfy the especial needs
of their customers.
Consumer loans
The most important types of consumer loans are direct loans and bank credit card receivables. A
direct consumer loan is typically financing for the purchase of durable goods (e.g., cars and
appliances), and is secured with the asset being purchased. Bank credit card borrowings are a form
of short- term, unsecured credit used to finance almost any time costing less than the customer‘s
allowed credit limit. Credit cards were introduced by Franklin National Bank in 1951, but became
widely used only in the mid- 1960s. Credit card lending has proved to be very profitable for banks.
This profitability stems from two sources: (i) the discount at the bank purchases sales slips from
merchants which(who) typically ranges from 2% to 6%, and (ii) the interest rate charged to a card
user who chooses not to remain current in payments.
Mortgage loans
These are a specialized form of costumer and commercial lending. The purpose of a mortgage loan
is to finance the acquisition or improvement of real estate. These loans are almost a ways secured
by the real estate they finance. The three principal types of mortgage loans are residential,
construction and commercial. Until the advent of securitization, mort age loans were illiquid assets
because the uniqueness of each property, the severity of private information problems, and the
uncertain maturity of the loan due to the possibility of prepayment by the borrower. However,
securitization took care of many of theses impediments to the marketability of mortgages and
facilitated the liquidity of these instruments.
Commercial Bank Liabilities
To carry out their extensive lending and investing operations, commercial banks draw on a wide
verity of deposits and non-deposit source of funds. The vast majority of commercial bank liabilities
are in the form of deposits. However, non-deposit sources of funds include federal funds purchased
from other banks, security repurchase agreements (repos), and the issuance of capital notes.
Deposits
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The bulk of commercial bank funds (more than three-fourths) come from deposits. There are three
main types of deposits: demand, savings and time.
Demand Deposits
Demand deposits, more commonly known as checking accounts, are the principal means of making
payments because they are safer than cash and are widely accepted. Although outside the U.S
smart cards, credit cards, and transfers by electronic means have generally outstripped demand
deposits as payment media. During the past three decades, new forms of demand deposits
appeared, combining the essential features of both demand and savings deposits. These transaction
accounts include NOW accounts (negotiable orders of withdrawal) and automatic transfer services
(AST). NOW account may be drafted to pay bills but also earn interest, while ATS is a preauthorized payment service in which the bank transfers funds from an interest- bearing saving
account to a checking account as necessary to cover checks written by customer.
Savings Accounts
Savings deposits generally are in small dollar a mounts they bear a relatively low interest rate but
may be withdrawn by the depositor with no notice.
Time Deposits
Time deposits carry a fixed maturity and usually the highest rate a bank can pay. Time deposits
may be divided into non-negotiable certificates of deposit (CDs), which are usually small,
consumer-type accounts, and negotiable CDs that may be traded in the open market in million–
dollar amounts and are purchased mainly by corporations.
Non – Deposit sources of funds
One of the most market trends in commercial banking in recent years is greater use of non- deposit
funds, especially as competition for deposits increases. Principal non- deposit sources of fund for
commercial banks today include federal funds purchased from other banks, security repurchase
agreements where securities are sold temporarily by the commercial bank and then bought bank
later, and the issuance of capital notes. Capital notes have particular interest because many of these
securities may be counted under current regulation as capital for purposes of determining a
commercial bank‘s loan limit. Both state and federal laws limit the amount of money a commercial
bank can lend to any one borrower to a fraction of the bank‘s capital. To be counted as capital,
however, capital notes must be subordinated deposits, so that if a bank is liquidated, the depositors
have first claim to its assets.
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Commercial Bank Equity Capital
Equity capital (or net worth) supplied by a bank‘s stockholders only a minor portion (only about
8% on average) of total funds for most commercial banks today. One of the most important
functions of equity capital is to keep a banks open in the face of operating losses until management
can correct its problems. Recently federal law has mandated minimum capital-to-asset ratios for
commercial banks and many banks have recently expanded their equity capital positions. There is
also a set of cooperative international capital regulations for major banks in the U.S, Great Britain,
japans, and the nationals of Western Europe. The Basle Agreement, reached in 1988, now imposes
common minimum capital requirements on all banks in leading industrialized countries based on
the degree of risk exposure that each banks faces. There are three principal types of equitable that
make up the capital account: capital stock (preferred and common), retained earnings and special
reserve accounts.
Capital stock represents the direct investments into commercial bank and typically includes par
value and surplus. Surplus can be defined as the proceeds of from the sale of equity in excess of
their par value, plus earnings retained until the surplus account equals the common stock account.
Retained earnings comprise that portion of the bank‘s profit that is not paid out to shareholders
as dividends. Special reserve accounts are set up to cover anticipated losses on loans and
investment. They involve no transfers of funds setting aside of cash, they are merely a form of
retained earnings designed to reduce tax liabilities and stock holders‘ claims on current revenues.
Total Revenues
The majority of bank revenues come from interest and fees on loans. Recently fee income from
loans has risen faster than interest income as banks have resorted to fewer direct loans to customers
and instead earned fee income by guaranteeing customer borrowing elsewhere or advising and
assisting customers with new security offerings. Interest and dividends on security holdings are
the second most important source of commercial bank revenues after loan income. Other minor
sources of income include earnings from trust (fiduciary) activities and service charges on deposit
accounts.
Total Expenses
Bank expenses have risen rapidly in recent years, threatening to squeeze the industry‘s operating
income. Greater competition from bank and non-bank financial intermediaries has resulted in
dramatic increases in the real cost of raising funds, and
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The expense of upgrading computer, automated equipment and other technology has placed an
added drain on bank revenues. Interest on deposits and other borrowed funds is the principal
expense item for most commercial banks followed by the salaries and wages of employees.
The Interest Margin
First commercial bank income statements record all of their bank‘s interest income from loans and
security investments. Then the total interest paid out on borrowed funds is subtracted to derive a
commercial bank‘s net interest income or interest margin. This interest margin measures how
efficiently a bank is performing its function of borrowing and lending funds. For many banks the
interest margin is the principal determinant of their profitability.
The Non- interest Margin
Of increasing importance in the commercial banking industry is the non interest margin, which is
the difference between total non-interest income (e.g., trust department income and service fees
on deposits) and non-interest expenses (e.g., employee salaries/wages and occupancy expense- i.e.
charge for brick and mortar). The non-interest margin is growing in importance as a determinant
of commercial bank profits because banks are developing in more new services that generate noninterest fees (e.g., security underwriting, managing pension plans, and a host of other off-balance
sheet activities). Because bankers face stiff competition they work especially hard minimize their
non-interest expenses, particularly employee costs, by substituting automated equipment and
computerization for labor.
Functions of Commercial Banks
In the modern world, banks perform such a variety of functions that it is not possible to make an
all-inclusive list of their functions and services. However, some basic functions performed by the
banks are discussed below:
1. Accepting Deposits. The first important function of a bank is to accept deposits from those who
can save but cannot profitably utilize this saving themselves. People consider it more rational to
deposit their savings in a bank because by doing so they, on the one hand, earn interest, and on the
other, avoid the danger of theft. To attract savings from all sorts of individuals, the banks maintain
different types of accounts:
(i) Fixed Deposit Account. Money in these accounts is deposited for fixed period of time (say
one, two, or five years) and cannot be withdrawn before the expiry of that period. The rate of
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interest on this account is higher that that on other types of deposits. The longer the period, the
higher will be the rate of interest. Fixed deposits are also called time deposits or time liabilities.
(ii) Current Deposit Account. These accounts are generally maintained by the traders and
businessmen who have to make a number of payments every day. Money from these accounts can
be withdrawn in as many times and in as much amount as desired by the depositors. Normally, no
interest is paid on these accounts. Rather, the depositors have to pay certain incidental changes to
the bank for the services rendered by it. Current deposits are also called demand deposits or
demand liabilities.
(iii) Saving Deposit Account. The aim of these accounts is to encourage and mobilize small
savings of the public. Certain restrictions are imposed on the depositors regarding the number of
withdrawals and the amount to be withdrawn in a given period. Cheque facility is provided to the
depositors. Rate of interest paid on these deposits is low as compared to that on fixed despots.
(IV) Recurring Deposit Account. The purpose of these accounts is to encourage regular savings
by the public, particularly by the fixed income group. Generally money in these accounts is
deposited in monthly installments for a fixed period and is repaid to the depositors along with
interest on maturity. The rate of interest on these deposits is nearly the same as on fixed deposits.
(v) Home Safe Account. Home safe account is another scheme aiming at promoting saving habits
among the people. Under this scheme a safe is supplied to the depositor to keep it at home and to
put his small savings in it. Periodically, the safe is taken to the bank where the amount of safe is
credited to his account.
2. Advancing of loans. The second important function of a bank is advancing of loans to the
public. After keeping certain cash reserves, the banks lend their deposits to the needy borrowers.
Before advancing loans, the banks satisfy themselves about the credit worthiness of the borrowers.
Various types of loans granted by the banks are discussed below:
(i) Money at Call. Such loans are very short period loans and can be called back by the bank at a
very short notice of say one day to fourteen days. These loans are generally made to other banks
or financial institutions.
(ii) Cash Credit. It is a type of loan which is given to the borrower against his current assets, such
as shares, stocks, bonds, etc. Such loans are not based on personal security. The bank opens the
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account in the name of the borrowers and allows him to withdraw borrowed money from time to
time up to a certain limit as determined by the value of his current assets. Interest is charged only
on the amount actually withdrawn from the account.
(iii) Overdraft. Sometimes, the bank provides overdraft facilities to its customers though which
they are allowed to withdraw more than their deposits. Interest is charged from the customers on
the overdrawn amount.
(iv) Discounting of Bills of Exchange. This is another popular type of lending by the modern
banks. Through this method, a holder of a bill of exchange can get it discounted by the bank. In a
bill of exchange the debtor accepts the bill drawn upon him by the creditor (i.e., holder of the bill)
and agrees to pay the amount mentioned on maturity. After making some marginal deductions (in
the form of commission), the bank pays the value of the bill to the holder. When the bill of
exchange matures, the bank gets its payment from the party which had accepted the bill. Thus,
such a loan is self-liquidating.
(v) Term Loans. The banks have also started advancing medium-term loans. The maturity period
for such loans is more than one year. The amount sanctioned is either paid or credited to the
account of the borrower. The interest is charged on the entire amount of the loan and the loan is
repaid either on maturity or in installments.
3. Credit Creation. A unique function of the bank is to create credit. In fact, credit creation is the
natural outcome of the process of advancing loan as adopted by the banks. When a bank advances
a loan to its customer, it does not lend cash but opens an account in the borrower‘s name and
credits the amount of loan to this account. Thus, whenever a bank grants a loan, it creates an equal
amount of bank deposit. Creation of such deposits is called credit creation which results in a net
increase in the money stock of the economy. Banks have the ability to create credit many times
more than their deposits and this ability of multiple credit creation depends upon the cash-reserve
ration of the banks.
4. Promoting Cheque System. Banks also render a very useful medium of exchange in the form
of cheques. Through a cheque, the depositor directs the bakers to make payment to the payee.
Cheque is the most developed credit instrument in the money market. In the modern business
transactions, cheques have become much more convenient method of settling debts than the use
of cash.
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5. Agency Functions. Banks also perform certain agency functions for an on behalf of their
customers:
(i) Remittance of Funds. Banks help their customers in transferring funds from one place to another
through cheques, drafts, etc.
(ii) Collection and Payment of Credit Instruments. Banks collect and pay various credit
instruments like cheque, bills of exchange, promissory notes, etc.
(iii) Execution of Standing Orders. Banks execute the standing instructions of their customers for
making various period payments. They pay subscriptions, rents, insurance premium, etc. on behalf
of their customers.
(iv) Purchasing and Sale of Securities. Banks undertake purchase and sale of various securities
like shares, stocks, bonds, debentures etc. on behalf of their customers. Banks neither give any
advice to their customers regarding these investments nor levy any charge on them for their service,
but simply perform the function of a broker.
(v) Collection of Dividends on Shares. Banks collect dividends, interest on shares and debentures
of their customers.
(vi) Income Tax Consultancy. Banks may also employ income-tax experts to prepare income-tax
returns for their customers and to help them to get refund of income-tax.
(vii) Acting as Trustee and Executor. Banks preserve the wills of their customers and execute them
after their death.
(viii) Acting as Representative and Correspondent. Sometimes the banks act as representatives and
correspondents of their customers. They get passports, traveler‘s tickets, book vehicles, plots for
their customers and receive letters on their behalf.
6. General Utility Function. In addition to agency services, the modern banks provide many
general utility services as given below:
(i) Locker Facility. Banks provide locker facility to their customers. The customers can keep their
valuables and important documents in these lockers for safe custody.
(ii) Traveler‘s Cheques. Banks issue traveler‘s cheques to help their customers to travel without
the fear of theft or loss of money. With this facility, the customers need not take the risk of carrying
cash with them during their travels.
(iii) Letter of Credit. Letters of credit are issued by the banks to their customers certifying their
creditworthiness. Letters of credit are very useful in foreign trade
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(iv) Collection of Statistics. Banks collect statistics giving important information relating to
industry, trade and commerce, money and banking. They also publish journals and bulletins
containing research articles on economic and financial matters.
(v) Underwriting Securities. Banks underwrite the securities issued by the government, public or
private bodies. Because of its full faith in banks, the public will not hesitate in buying securities
carrying the signatures of a bank.
(vi) Gift Cheques. Some banks issue cheques of various denominations to be used on auspicious
occasions.
(vii) Acting as Referee. Banks may be referred for seeking information regarding the financial
position, business reputation and respectability of their customers.
(viii) Foreign Exchange Business. Banks also deal in the business of foreign currencies. Again,
they may finance foreign trade by discounting foreign bills of exchange.
Role of Commercial Banks in a Developing Economy
A well-developed banking system is a necessary pre-condition for economic development in a
modern economy. Besides providing financial resources for the growth of industrialization, banks
can also influence the direction in which these resources are to be utilized. In the developing
countries, not only the banking facilities are limited to a few developed urban areas, but also the
banking activities are limited mostly to trade and commerce, paying little attention to industry and
agriculture. Structural as well as functional reforms in the banking system are needed to enable the
banks perform developmental role in developing countries.
Banks and Economic Development
In a modern economy, banks are to be considered not merely as dealers in money but
also the leaders in development. Commercial banks can contribute to a country‘s
economic development in the following way.
Capital Formation:
Capital formation is the most important determinant of economic development and
banks promote capital formation. Capital formation has three well-defined stages: (a)
generation of savings, (b) mobilization of saving, and(c) canalization of saving in
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productive uses. Banks play a crucial role in all the three stages of capital formation: (a)
They stimulate savings by providing a number of incentives to the savers, such as, interest
on deposits, free and cheap remittance of funds, safe custody of valuables, etc. (b) By
expanding their branches in different areas and giving various incentives, they succeed in
mobilizing the savings generated in the economy.
Encouragement to Entrepreneurial Innovations.
In underdeveloped countries, entrepreneurs generally hesitate to invest in new ventures
and undertake innovations largely due to lack of funds. Facilities of bank loans enable the
entrepreneurs to step up their investment and innovational activities, adopt new
methods of production and increase productive capacity of the economy. Monetization
of Economy.
Monetization of the economy is essential for accelerating trade and economic activity.
Banks help the process of monetization in two ways: (a) They monetize debts. In other
words, they buy debts (i.e., securities which are not acceptable as money) and, in
exchange, create demand deposits (which are acceptable as money). (b) By spreading
their branches in the rural and backward areas, the banks convert the non-monetized
sectors of the economy into monetized sectors.
Economic Activity. Banks can directly influence economic activity on (a) the rate of interest, and
(b) the availability of credit. a) Variations in Interest Rates. A reduction in the interest rates makes
the investment more profitable and stimulates economic activity. An increase in the interest rate,
on the other hand, discourages investment and economic activity. b) Availability of Credit. Bankers
can also influence economic activity by the availability of credit. Credit creation is an important
function of banks and bank credit forms the major portion of money supply.
Implementation of Monetary Policy. Economic development needs an appropriate monetary
policy. But, a well-developed banking system is a necessary pre-condition for the effective
implementation of the monetary policy.
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Promotion of Trade and Industry. Economic progress in the industrially advanced countries in
the last two hundred years or so is mainly due to expansion in trade and industrialization which
could not have been made possible without the development of banking system. The use bank
cheque, the bank draft and the bill of exchange has revolutionized the internal and international
trade, which, in turn, has encouraged specialization and accelerated the pace of industrialization.
Encouragement to Right Type of Industries. By granting loans (particularly medium-term and
long term) the banks can provide financial resources to the right type of industries to secure
necessary material, machines and other inputs, In a planned economy, it is necessary that the banks
should formulate their loan policies in accordance with the broad objectives and strategy of
industrialization as adopted in the plan. This will promote right type of industrialization in the
economy.
Regional Development. Banks can also play an important role in achieving balanced development
in different regions of the economy. They can transfer surplus capital from the developed regions
to the less-developed regions where it is scarce and most needed. This reallocation of funds
between regions will promote economic development in underdeveloped areas of the economy.
Development of Agriculture and Other Neglected Sectors. Underdeveloped economies are
primarily agricultural economies and majority of the population in these economies live in rural
areas. Therefore, economic development in these economies requires the development of
agriculture and small-scale industries in rural areas. Thus, Necessary structural and functional
reforms in the banking system of the underdeveloped countries should be made in order to
encourage the banks to play developmental role in these economies.
2.6.2 NON- DEPOSITORY FINANCIAL INSTITUTIONS
2.6.2.1 Insurance Companies
Insurance companies are financial intermediaries that, for a price, will make a payment if certain
event occurs. They function as risk bearers. Insurance is a form of risk management primarily used
to hedge the risk of a contingent loss. The company that sells the insurance is called insurer. The
payment made by the insured (the insurance policy holder) to the insurer is called premium.
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There are two types of insurance companies: life insurance companies and property and
casualty insurance companies. The principal event that the former insure against is death. Upon
the death of a policyholder, a life insurance company agrees to make either a lump sum payment
or a series of payments to the beneficiary of the policy. Life insurance protection is no longer the
only financial product sold by these companies; a major portion of the business of life insurance
companies is now in the area of providing retirement benefits. In contrast, property and casualty
insurance companies insure against a wide variety of occurrences. Two examples are automobile
and home insurance and we‘ll discuss others in the next section. The key distinction between life
insurance and property and casualty insurance companies lies in the difficulty of projecting
whether a policyholder will be paid off and how much the payment will be. While this is no easy
task for either type of insurance company, it is easier from actuarial perspective for a life insurance
company. The amount and timing of claims on property and casualty insurance companies are
more difficult to predict because of the randomness of natural catastrophes and the unpredictability
of court awards in liability cases. This uncertainty about the timing and amount of cash outlays to
satisfy claims has an impact on the investment strategies of the funds of property and casualty
insurance companies compared to life insurance companies. While we have distinguished the two
types of insurance companies here because of the nature of the events they insure against, most
large insurance companies do underwrite both life insurance and property and casualty insurance
policies. Usually a parent company has a life insurance company subsidiary and a property and
casualty insurance company subsidiary.
The Insurance Principle The insurance business is founded upon the law of large numbers. This
mathematical principle states that a risk that is not predictable for one person can be forecast
accurately for a sufficiently large group of people with similar characteristics. No insurance
company can accurately forecast when any one person will die, but its actuarial estimates of the
total number of policy holders who will die in any given year are usually quite accurate. The vast
majority of insurance policies are provided for individual members of very large classes. The
existence of a large number of homogeneous exposure units allows insurers to benefit from the socalled ―law of large numbers‖ which in effect states that as the number of exposure units
increases, the actual results are increasingly likely to become close to expected results.
Investments of Life Insurance Companies Life insurers invest the bulk of their funds in longterm securities such as bonds, stocks, and mortgages, thus helping to fund real capital investment
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by businesses and governments. They are inclined to commit their funds for a long term due to the
high predictability of their cash inflows and outflows. This predictability normally would permit
a life insurance company to accept considerable risk in the securities it acquires. However, both
law and tradition require a life insurer to act as a ―prudent person.‖ This restriction is imposed to
ensure that sufficient funds are available to meet all legitimate claims from policy holders or their
beneficiaries at precisely the time those claims mature.
Life insurance companies generally pursue income certainty and safety of principal in their
investments. Life insurers frequently follow a ―buy and hold‖ strategy, acting as long-term
holders of securities rather than rapidly turning over their portfolios. This investment approach
reduces the risk of fluctuations in income and avoids having to rely on forecasting interest rates.
We should note, however, that in recent years some life insurers have become more active traders
in securities. Emphasizing performance more than permanence in their investments, larger life
insurance companies have set up trading rooms to more closely monitor the performance of their
investment holdings, selling out and reinvesting in higher yielding alternatives when
circumstances warrant. Because this new investment strategy creates additional risk, some larger
insurers now use financial futures contracts and other risk-hedging tools and more closely match
asset and liability maturities to protect themselves against losses from fluctuating interest rates.
Government securities play a secondary but still important role in the portfolios of life insurance
companies. These securities serve the important function of providing a reservoir of liquidity
because they may be sold with little difficulty when funds are required. The industry has only a
limited need for the tax-exempt income provided by state and local bonds because its tax rate is
relatively low. One asset whose importance increased dramatically during the l970s and early
1980s is loans to policy holders. The holder of an ordinary (whole life) insurance policy can borrow
against the accumulated cash value of that policy, which increases each year. The interest rate on
policy loans is stated in the policy contract and in some policies is quite low. Policy loans tend to
follow the business cycle, rising in periods when economic activity and interest rates are
increasing, and declining when the economy or interest rates are headed down. Because of this
cyclical characteristic, policy loans are a volatile claim on the industry‘s resources. When policy
loan demand is high, life insurance companies frequently are forced to reduce their purchases of
bonds and stocks. In recent years, however, most new whole life policies have had floating loan
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rates tied to an index of corporate bond yields, and policy holder borrowing has declined relative
to other industry assets.
Casualty and Property Insurance Companies
Property-Casualty (P/c) insurers offer protection against fire, theft, bad weather, negligence, and
other acts and events that result in injury to persons or property. So broad is the range of risk for
which these companies provide protection that Property-Casualty insurers are sometimes referred
to as insurance super markets. In addition to their traditional insurance lines — automobile, fire,
marine, personal liability, and property coverage — many of these firms have branched into the
health and medical insurance fields, clashing head-on with life insurers offering the same services.
Property and casualty (P&C) insurance companies provide a broad range of insurance protection
against:
 Loss, damage, or destruction of property
 Loss or impairment of income-producing ability
 Claims for damages by third parties because of alleged negligence
 Loss resulting from injury or death due to occupational accidents
Makeup of the Property-Casualty (P/C) Insurance Industry
The Property-Casualty insurance business has grown rapidly in recent years due to the effects of
inflation, rising crime rates, and an increasing number of lawsuits arising from product liability
and professional negligence claims. There were about 3,900 Property-Casualty companies in the
United States in W92, holding more than $600 billion in total assets. Stockholder-owned
companies are dominant, holding about three fourths of the industry‘s total resources. Mutual
companies — owned by their policy holders — command roughly one fourth of all industry
resources.
Changing Risk patterns in property/Liability Coverage
Property-Casualty insurance is a riskier business than life insurance. The risk of policy holder
claims arising from crime, fire, personal negligence, and similar causes are much less predictable
than is the risk of death. Inflation has had a potent impact on the cost of property and services for
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which this form of insurance pays. For example, the cost of medical care and repair of automobiles
has more than doubled over the past decade.
Equally important, basic changes now seem to be under way in the risk patterns of many large
insurance programs, creating problems in forecasting policy holder claims and in setting new
premium rates. Examples include a rapid rise in medical malpractice suits; a virtual explosion in
product liability claims against manufacturers of automobiles, home appliances, and other goods;
and the emergence of billions of dollars in claims from so- called toxic torts, arising from
individuals suffering from illness or injury caused by exposure to asbestos, nuclear radiation, and
other hazardous substances. To reduce risk, more Property-Casualty insurers have become
multiple-lute companies, diversifying into many different lines of insurance. Another riskreducing device of growing importance is the reinsurance market, in which an insurer contracts
with other companies to share some of the risks of its insurance underwriting in return for a share
of the insurer‘s premium income.
It is interesting to compare the distribution of assets held by life insurance companies and by
Property-Casualty companies. The net cash flows of the two industries — their annual premium
income are roughly comparable. Yet life insurers hold about three times the assets of PropertyCasualty insurers. Much of the difference is explained by the fact that life insurance is a highly
predictable business, whereas property and personal injury risks are not. Most life insurance
policies are long-term contracts, and claims against the insurer are not normally expected for
several years.
In contrast, Property-Casualty claims are payable from the day a policy is written because an
accident or injury may occur at any time. Therefore, although life insurers can stay almost fully
invested, Property-Casualty insurers must be ready at all times to meet the claims of their policy
holders. In addition, claims against Property-Casualty companies are directly affected by inflation,
which drives up repair costs. Most life insurance policies, in contrast, pay the policy holder or
beneficiary a fixed sum of money.
Sources of Income Like life insurance firms, Property-Casualty insurers plan to break even on
their insurance product lines and earn most of their net return from their investments. Achieving
the break-even point in insurance underwriting has been difficult in recent years, however, due to
rising costs, increased litigation, and new forms of risk. For example, in 1991 the industry ran a
net underwriting loss of almost $20 billion. It was the ninth consecutive year of record
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underwriting losses. While investment income usually offsets underwriting losses, industry profits
are highly volatile from year to year due to unexpected losses and to the refusal of many state
insurance commissions to adjust premiums as fast as industry expenses change.
Investments by Property-Casualty (P/C) Companies
The majority of funds received by Property-Casualty companies are invested in state and local
government bonds and common stock. Property-Casualty insurers, unlike most financial
institutions, are subject to the full federal corporate income tax rate 9except that policy holder
dividends are tax deductible for the issuing company). Faced with a potentially heavy tax burden,
these companies find tax-exempt state and local government bonds an attractive investment.
Another important asset — corporate stock — is intended to protect industry earnings and net
worth against inflation. Other significant investments include U.S. government securities, federal
Agency securities and corporate bonds. Property-Casualty insurers have stepped up their purchases
of federal government securities and corporate bonds in recent years due to their higher yields and,
in the case of government bonds, their greater safety and liquidity.
Business Cycles, Inflation, and Competition
Property-Casualty insurance is an industry whose earnings and sales revenue reflect the ups and
downs of the business cycle. This cyclical sensitivity, coupled with the vulnerability of PropertyCasualty insurers to inflation, has created a difficult environment for insurance mangers. Inflation
has pushed up to cost of claims, while intense competition has held premium rates down. Among
US Property-Casualty companies, a key challenge today is the rapid growth of foreign insurance
underwriters who have entered the United States in large numbers. Moreover, many U.S.
corporations have started their own captive insurance companies. To improve their situation for
the future, Property-Casualty insurers must become more innovative in developing new services
and more determined to eliminate those services that result in underwriting losses. This will not
be easy due to extensive regulations and public pressure for lower insurance rates. Moreover, the
insurance industry in the United States has been exempted from antitrust prosecution (and
therefore has been relatively free to exchange information between companies) under the
McCarran—Ferguson Act for many years. But recently numerous Congressional proposals have
been put forward to modify or repeal that law and the special protection it gives this industry.
2.6.2.2 Pension Funds
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Pension funds protect individuals and families against loss of income in their retirement years by
allowing workers to set aside and invest a portion of their current income. a pension plan places
current savings in a portfolio of stocks, bonds, and other assets in the expectation of building an
even larger pool of funds in the future. In this way, the pension plan member can balance planned
consumption after retirement with the amount of savings set aside today.
Investment Strategies of Pension Funds
Pension funds are long-term investors with limited need for liquidity. Their incoming cash receipts
are known with considerable accuracy because a fixed percentage of each employee‘s salary is
usually contributed to the fund. At the same time, cash outflows are not difficult to forecast,
because the formula for figuring benefit payments is stipulated in the contract between the fund
and its members. This situation encourages pensions to purchase common stock, long-term bonds,
and real estate and hold these assets on a permanent basis. In addition, interest income and capital
gains from investments are exempt from federal income taxes, and pension plan members are not
taxed on their contributions unless cash benefits are actually paid out. Although favorable taxation
and predictable cash flows favor longer-term, somewhat riskier investments, the pension fund
industry is closely regulated in all its activities. The Employee Retirement Income Security Act
(ERISA) requires all U.S. private plans to be funded, which means that any assets held plus
investment income must be adequate to cover all promised benefits. ERISA also requires that
investments must be made in a ―prudent‖ manner, which is usually interpreted to mean that they
be invested in highly diversified holdings of high-grade common stock, corporate bonds, and
government securities and only limited real estate investments.
Although existing regulations emphasize conservatism in pension investments, private pensions
have been under intense pressure in recent years by management and employees of sponsoring
companies to be more liberal in their investment policies. The sponsoring employer has a strong
incentive to encourage its affiliated pension plan to reduce operating expenses and earn the highest
possible returns on its investments. This permits the company to minimize its contributions to the
plan. However, in 1985 the Financial Accounting Standards Board issued SEAS 87, which calls
upon defined-benefit pension plans (that is, those promising specific retirement benefits to their
members) to more fully disclose their funding status, asking businesses to make projections of
their future pension obligations, publish estimate of how much in pension benefits employees will
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receive, and report any unfunded portion of pension benefits (that is, total obligations to pension
plan members less the fair value of plan assets) on each business‘s balance sheet as a liability.
These accounting requirements make some business firms offering pension plans look weaker and,
along with stricter government regulations, have caused many businesses to abandon their pension
programs, leaving it to their employees to develop and manage their own retirement plans.
Sponsoring employers and employees both have a keen interest in seeing that their pension plan
earns a high enough return on its investments to at least keep pace with inflation. Otherwise, the
employees will tend to seek other jobs whose pension programs offer more lucrative returns. One
result of these pressures has been a significant rise in pension fund purchases of ―junk‖ (low
credit-quality) bonds. By the beginning of the 1990s, the pension fund industry held about 15
percent of all junk bonds. State regulatory agencies, however, have acted recently to limit pension
fund exposure to the high risks inherent in these debt instruments.
Pension funds are financed by contributions by the employer and/or the employee; in some fund
plans employer contributions are matched in some measure by employees. The great success of
private pension plans is somewhat surprising because the system involves investing in an asset
(i.e., the pension contract) that for the most part has been and is largely illiquid. It cannot be usednot even as collateral-until retirement. The key factor explaining pension fund growth despite this
serious limitation is that the employer's contributions and up to a specified amount of the
employee's contributions, as well as the earnings of the fund's assets, are tax-exempt. In essence a
pension is a form of employer remuneration for which the employee is not taxed until funds are
withdrawn.. Pension funds also have served traditionally to discourage employees from quitting,
as usually the employee lost at least the accumulation resulting from the employer contribution,
i.e., pension benefits have not been portable. As we will discuss later, portability of pension
benefits has increased somewhat as a result of federal legislation (the Employee Retirement
Income Security Act of 1970).
Types of Pension Plans
A pension is a steady income given to a person (usually after retirement). Pensions are typically
payments made in the form of a guaranteed annuity to a retired or disabled employee. Some
retirement plan (or superannuation) designs accumulate a cash balance (through a variety of
mechanisms) that a retiree can draw upon at retirement, rather than promising annuity payments.
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These are often also called pensions. In either case, a pension created by an employer for the
benefit of an employee is commonly referred to as an occupational or employer pension. Labor
unions, the government, or other organizations may also fund pensions.
There are two types of pension plans: defined contribution plans and defined benefit plans. In a
defined contribution plan, the plan sponsor is responsible only for making specified contributions
into the plan on behalf of qualifying participants. The amount contributed is typically either a
percentage of the employee's salary or a percentage of profits. The plan sponsor does not guarantee
any certain amount at retirement. The payments that will be made to qualifying participants upon
retirement will depend on the growth of the plan assets; that is, payment is determined by the
investment performance of the funds. A defined contribution plan is any plan with individual
accounts. A traditional pension plan that defines a benefit for an employee upon that employee's
retirement is a defined benefit plan. The benefit in a defined benefit pension plan is determined by
a formula that can incorporate the employee's pay, years of employment, age at retirement, and
other factors. A simple example is a flat plan design that provides Br.100 per month for every year
an employee works for a company; with 30 years of employment, that participant would receive
Br. 3,000 per month payable for their lifetime.
Investment Companies
Investment companies sell shares to the public and invest the proceeds in a diversified portfolio of
securities. Each share they sell represents a proportionate interest in a portfolio of securities. The
securities purchased could be restricted to specific types of assets such as common stock,
government bonds, corporate bonds, or money market instruments
Nature of Liabilities of Financial Institutions
A liability is a cash outlay that must be made at a specific time to satisfy the contractual terms of
an obligation.
There are 4 types of liabilities. These are:
1. A Type I liability: is one for which both the amount and timing of the liabilities are known
with certainty. An example would be when an institution knows that it must pay birr 8
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million six months from now assuming that the depositor does not withdraw funds prior to
the maturity date.
2. A Type II liability: is one for which the amount of the cash outlay is known, but the timing
of the cash outlay is uncertain. The most obvious example of a Type II liability is a life
insurance policy.
3. A Type III liability: is one for which the timing of the cash outlay is known, but the amount
is uncertain. A 2-year, floating-rate CD for which the interest rate resets quarterly, based
on some market interest rate
4. A Type IV liability: is one for which there is uncertainty as to both the amount and the timing of
the cash outlay. Probably the most obvious examples are automobile and home insurance policies
Asset/liability Management of Financial Institutions
Asset Liability Management (ALM) can be defined as a mechanism to address the risk
faced by a bank due to a mismatch between assets and liabilities either due to liquidity or
changes in interest rates.
Liquidity is an institution’s ability to meet its liabilities either by borrowing or converting
assets
Apart from liquidity, a bank may also have a mismatch due to changes in interest rates as
banks typically tend to borrow short term (fixed or floating) and lend long term (fixed or
floating). A comprehensive ALM policy framework focuses on bank profitability and long
term viability by targeting the net interest margin (NIM) ratio and Net Economic Value
(NEV), subject to balance sheet constraints.
In generating spread income a depository institution faces several risks. These include :
a. credit risk,
b. regulatory risk,
c. and interest rate risk
With respect to the risks, the manager must consider the risks of both the assets and the liabilities.
Institutions may calculate three types of surpluses:
1. economic,
2. accounting, and
3. regulatory.
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The method of valuing assets and liabilities greatly affects the apparent health of a financial
institution.
Unrealistic valuation, although sometimes allowable under accounting procedures and regulations,
is not sound investment practice. The economic surplus of any entity is the difference between the
market value of all its assets and the market value of its liabilities i.e. Economic surplus = Market
value of assets – Market value of liabilities The market value of the liabilities is simply the present
value of the liabilities, where the liabilities are discounted at an appropriate interest rate
Institutional investors must prepare periodic financial statements. These financial statements must
be prepared in accordance with “generally accepted accounting principles” (GAAP). Thus, the
assets and liabilities reported are based on GAAP accounting and the resulting surplus is referred
to as accounting surplus.
Institutional investors that are regulated at the state or federal levels must also provide financial
reports to regulators based on regulatory accounting principles (RAP). The surplus, as measured
using RAP accounting, is called regulatory surplus or statutory surplus
2.7 Risks in Financial Industry
The risks associated with financial intermediaries are:
1. Liquidity Risk
Because of the asset transformation function of FIs mismatches between assets and
liabilities can occur:
i. maturity mismatches
ii. liquidity mismatches
If runs (bankers’ risk), or unusually high demand for withdrawals of demand deposits
occur, this can cause a liquidity crisis for the FI, which can begin a spiral down…asset
sales at bargain prices…etc.
2. Interest Rate Risk
The positive spread between borrowed funds and invested funds can be threatened because
of interest rate changes….if the maturity of the sources of funds does not equal the maturity
of uses:
Two types:
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A. Source of funds is shorter term than the term the funds are invested.. (refinancing risk)
B. Reinvestment risk: The risk that the returns on funds to be reinvested will fall below
the originally anticipated returns. (the use of funds is shorter term than the source of
funds)
3. Maturity Matching
 Addresses both interest rate and liquidity risk
 However, this works against the role of the FI providing true ACTIVE ASSET
TRANSFORMATION services.
 maturity-matching
 doesn’t work with equity investments
 Is only an approximation….duration matching is more accurate.
4. Market Risk
 As traditional activities of the banks decline in relative proportions (deposit-taking and
lending) other forms of activities have grown in importance.
 Especially trading …. Actively investing in stocks, bonds, and derivative securities…as
a profit-center.
 Market Risk is the risk that in active trading, the market value of the bank’s asset(s)
declines.
5. Credit Risk
 Is the likelihood that a borrower will default on a loan…or that the issuer of a bond that
the FI has invested in, default on interest or principal repayment.
 Default risk
 Obviously, FIs are ‘diversified’ investors…their portfolio of financial assets and
portfolio of loans must be widely diversified across industries, geographical regions
and income groups.
 Firm-specific credit risk is the risk of default of the borrowing firm associated with the
specific types of project risk undertaken by that firm.
 Systematic credit risk is the risk of default associated with the health of the general
economy.
 Off-balance-sheet activity, by definition, does not appear on the current balance
sheet of the FI
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 Commercial letter of credit is an irrevocable obligation to make payment to a
beneficiary of documents evidencing shipment of goods.
 BAs - Bankers Acceptances as the guarantor…of such financial instruments, the
Bank remains liable for payment, and there is always a chance that the client may
become insolvent, leaving the Bank with obligation to pay…but without recourse.
6. Foreign Exchange Risk
 Mismatches between the amount of foreign currency denominated assets and
liabilities can lead to foreign exchange losses or gains depending on the relative
movement of the two currencies involved.
7. Country and Sovereign Risk
 Is the risk of losses experienced by an FI due to changing, social, economic, or
political factors specific to one country….
 Hong Kong reverting to Chinese control….
 Mexico, Argentina imposing restrictions on debt repayments of domestic
corporations…etc.
 Greece potentially defaulting on international loan obligations.
8. Actuarial Risk
 Actuaries estimate future liabilities for insurance companies based on the law of
large numbers and using conservative financial forecasting assumptions.
 Actuarial risk is the risk that those estimates turn out to be wrong.
 Of course, actuaries, continually review their estimates as time moves on….they
will identify “actuarial surpluses” and “actuarial deficits” in funds that are
accumulating for the purpose of meeting a future liability.
This way the fund
sponsor can be informed about their progress toward their target terminal value,
and can take action in advance to avoid a crisis.
 Adverse selection is the tendency of those most at risk in a group to take out
insurance so that the insuring FI that priced the contract with respect to the average
in the group is faced with losses.
 Moral Hazard is the risk that the insured (or beneficiary) will alter his or her
behavior after contracting in order to benefit from the contract
9. Operating/Technological/Systemic Risk
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 Efficient electronic payments/communications/data-base/information/processing
systems form the back-bone of a modern FI
 once in place, it is possible for the FI to add more services and serve more clients
with little or no impact on the systems infrastructure of the FI
 Economies of scale is the degree to which a FI’s average unit costs of producing
financial services fall as its output of services increases.
 Economies of scope is the degree to which a FI can generate cost synergies by
producing multiple financial service products.
 Correspondent Banking is the provision of reciprocal banking services between
pairs of FIs, often in two separate jurisdictions.
 Note: Correspondent Bank: A bank that has limited access to certain financial
markets and therefore must use the services of another bank to conduct certain
transactions. Correspondent banks are usually small. Agreements with other banks
allow it to provide necessary services for account holders without incurring the
expense of setting up a branch in another city or country.
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