Chapter One

1. Financial Institutions in the Financial System

1.1. Overview of financial institutions
A financial institution is an organization that conducts financial transactions such accepting
deposits and providing a loan. Know adays almost every one of us deals with financial institutions
on a regular basis. Everything from depositing money to taking out loans and exchanging
currencies can be done through financial institutions.
Financial institutions are firms such as commercial banks, credit unions, insurance companies,
pension funds, mutual funds, and finance companies that provide financial services to their
costumer, businesses, and government units. The distinguishing feature of these firms is that they
invest their funds in financial assets, such as business loans, stocks, or bonds, rather than in real
assets, such as manufacturing facilities and equipment. Financial institutions dominate the
financial system worldwide, providing an array of financial services to large multinational firms
and most of the financial services used by consumers and small businesses. Overall, financial
institutions are far more important sources of financing than securities markets.

1.2. Financial institutions and capital transfer

Whether simple or complex, all financial systems perform at least one basic function. They move
funds from those who save and lend (surplus-budget units) to those who wish to borrow and invest
(deficit-budget units). In the process, money is exchanged for financial assets however, the
transfer of funds from savers to borrowers can be accomplished in at least three different ways.
These are: - direct finance, semi-direct finance, and indirect finance.
1) Direct Finance
Borrowers borrow funds directly from lenders in financial markets by selling them securities.
Borrowers and lenders meet each other and exchange funds in return for financial assets. It is the
simplest method of carrying financial transactions. You engage in direct finance when you borrow
money from a friend and give him or her (a promise to pay) or when you purchase stocks or bonds
directly from the company issuing them. We usually call the claims arising from direct finance
primary securities because they flow directly from the lender to the ultimate users of funds.
 Direct Finance

Borrower-spenders
Funds Saver-Lenders
(Deficit budget units) (Surplus budget
units)
Primary securities (stocks, bonds,
notes, etc)

Primary Secondary
Securities Financial securities
intermediaries

Loan able funds Funds

Indirect Finance

Figure 1; the flow of funds in the financial system (direct and indirect finance)

The principal lender- mostly households are savers, but business enterprises and the government
(particularly state and local government), as well as foreigners and their governments, sometimes
also find themselves with excess funds and so lend them out. The most important borrower-
spenders are business and the government (particularly the federal government) but households
and foreigners also borrow to finance their purchases of cars, furniture, and houses.

 The following can be visible draw backs of this system:

i) Both borrower and lender must desire to exchange the same amount of funds at the same
time.
ii) The lender must be willing to accept the borrower’s (a promise to pay), which may be quite
risky, illiquid or slow to mature.
iii) There must be a coincidence of wants between surplus and deficit – budget units in terms
of the amount and form of a loan. Without that fundamentals coincidence, direct finance
breaks down.
iv) The borrower may have to contact many lenders before finding the one surplus – budget
unit with just the right amount of funds and willingness to take on the borrower’s.
2) Semi direct Finance
Early in the history of most financial systems, a new form of financial transaction appears which
we call semi direct finance.

Borrower- (Deficit Budget Units) Saver-Lenders (Surplus Budget

Securities Securities
Security brokers and dealers
Proceeds of security sales (less fees and commission)

Flow of
funds

Figure 2; the flow of funds in the financial system (semi-direct finance)

Here, some individuals and business firms become securities brokers and dealers whose essential
function is to bring surplus and deficit budget units together – thereby reducing information costs.
3) Indirect Finance/Financial Intermediation
The limitations of both direct and semi direct finance stimulated the development of indirect
finance carried out with the help of financial intermediaries. The process of indirect finance using
financial institutions, called financial intermediation, is the primary route for channeling funds
from lenders to borrowers, (see figure 1 above)
Financial intermediaries issue securities of their own or buy securities issued by corporations and
then sell those securities to investors.
1) They generally carry low default risk
2) They can generate enough amount of money to its customer
3) They are liquid (for most) and can be easily converted into cash

1.3. Functions of financial institutions

The economic system could not function without financial institutions. These institutions
including commercial banks, savings and loan associations, and credit unions are financial go-
betweens.
They keep money flowing throughout the economy among consumers, businesses, and
government. When people deposit money in a bank, that money does not sit in a vault. The bank
lends the money to other consumers and businesses. The dollars may be loaned to consumers to
help finance new cars, homes, college tuition, and other needs. Businesses may borrow the money
for new equipment and expansion. State and local governments may borrow to build new
highways, schools, and hospitals. The interaction that financial institutions create between
consumers, businesses, and governments keeps the economy alive.
Without financial institutions, consumers would probably keep their cash under a mattress or
locked in a safe. Money could not circulate easily. The nation’s money supply would shrink.
Funds would not be available for consumer spending. Demand for goods and services would fall.
Businesses could not get the money to modernize plants and develop new products. The economy
would slow down. Jobs would become scarce. As you can see, the economy depends on the flow
of money and the services financial institutions provide.

1.4. Classifications of Financial Institutions

It is common to categorize financial institutions as depository and non-depository. a depository
institution is type of financial institution that accepts deposits, while a non-depository institution
does not accept deposits". And then let us see some examples of "depository" institutions
(commercial banks, credit unions, savings and loans); and examples of "non-depository"
institutions (mutual funds, pension companies, insurance companies).

1.4.1. Depository financial

institutions Commercial Banks
Commercial banks accept deposits and provide security and convenience to their customers.
Part of the original purpose of banks was to offer customers safe keeping for their money. By
keeping physical cash at home or in a wallet, there are risks of loss due to theft and accidents,
not to mention the loss of possible income from interest. With banks, consumers no longer need
to keep large amounts of currency on hand; transactions can be handled with checks, debit cards
or credit cards, instead.
Commercial banks also make loans that individuals and businesses use to buy goods or expand
business operations. If banks can lend money at a higher interest rate than they have to pay for
funds and operating costs, they make money.
 Banks also serve often under-appreciated roles as payment agents within a country and between
nations. Not only do banks issue debit cards that allow account holders to pay for goods with
the swipe of a card, they can also arrange wire transfers with other institutions.

Savings and Loans

Savings and loan associations, also known as S&Ls, resemble banks in many respects. Most
consumers don't know the differences between commercial banks and S&Ls. By law, Savings and
loans typically offered lower borrowing rates than commercial banks and higher interest rates on
deposits; the narrower profit margin was a byproduct of the fact that such S&Ls were privately or
mutually owned.

Credit Unions
Credit unions are another alternative to regular commercial banks. Credit unions are almost always
organized as not-for-profit cooperatives. Like banks and S&Ls, credit unions can be chartered at
the federal or state level. Like S&Ls, credit unions typically offer higher rates on deposits and
charge lower rates on loans in comparison to commercial banks.
In exchange for a little added freedom, there is one particular restriction on credit unions;
membership is not open to the public, but rather restricted to a particular membership group. In the
past, this has meant that employees of certain companies, members of certain religious institution,
and so on, were the only ones allowed to join a credit union. In recent years, though, these
restrictions have been eased considerably.

1.4.2. Non-depository financial institutions

Insurance Companies
Insurance companies pool risk by collecting premiums from a large group of people who want to
protect themselves and/or their loved ones against a particular loss, such as a fire, car accident,
illness, lawsuit, disability or death. Insurance helps individuals and companies manage risk and
preserve wealth. By insuring a large number of people, insurance companies can operate profitably
and at the same time pay for claims that may arise. Insurance companies use
statistical analysis to project what their actual losses will be within a given class. They know that
not all insured individuals will suffer losses at the same time or at all.

Mutual Funds
One of the difficulties that small investors face is that it can be expensive to construct a well-
diversified portfolio. Most brokerages require you to make purchases of a minimum size (although
this size limit has fallen dramatically with the advent of internet brokerages). If you only had
$1,000 to invest, and you wanted to buy shares in 20 different companies, it would be difficult to
do. Also, the cost per share, when buying this number of shares, is much higher than if you could
make an order for 10,000 shares. One way to get around these problems is to pool your money
with other investors and together buy large chunks of shares.
Mutual funds do exactly that. Investors buy shares in the fund and the mutual fund uses the
proceeds to buy securities such as stocks and bonds. Because the mutual fund is pools with
thousands of investors, they have millions of dollars to invest, and so pay low transactions fees on
their purchases and can hold a large number of different stocks and bonds. Most mutual fund
companies offer a wide variety of funds to reflect the different interests of the investors.

Pension Funds
Pension funds are financial intermediaries that handle the financial activity behind retirement
plans. The standard company pension fund invests current funds (recorded as contributions by the
company, the employee, or some mix) and uses the proceeds from the investments to pay the
pension in the future.
Pension funds come in two different types: Defined Benefit and Defined Contribution. Defined
benefit plans offer a fixed payout upon retirement. An example of this kind of plan is where you
work for a company for 30 years. Upon retirement, you are paid a pension of 70% of your average
salary for the last three years you worked at the company. This kind of plan has the benefit of
letting you know exactly how much you will be paid when you retire, but generally it forces you
to stay with the same company a large part of your working career.
A defined contribution program fixes the amount that you pay into the program, which is invested
in stocks and bonds. However, the amount that you have when you retire depends on the returns
you get on the assets you invested in. In this plan, an amount is taken out of your check each pay
period before you have to pay taxes on it. It may be invested in various assets through the
company or through a mutual fund or other investment company. You do not pay taxes on any
earnings until you pull the money out of the plan when you retire. Companies like this plan
because it reduces the risk to them of managing the pension plan. Employees like it because it
gives them control over their investing, because of the tax advantages and because the funds stay
with you even if you move jobs.

1.5. Risks in Financial Industry

Now let’s turn our attention back to financial institutions, which, in providing financial
intermediation services to consumers and businesses, must transact in the financial markets.
Financial institutions intermediate between SBUs and DBUs in the hope of earning a profit by
acquiring funds at interest rates that are lower than they charge when they sell their financial
products. But there is no free lunch here. The differences in the characteristics of the financial
claims financial institutions buy and sell expose them to a variety of risks in the financial markets.
In their search for higher long-term earnings and stock values, financial institutions must manage
and balance five basic risks: credit risk, interest rate risk, liquidity risk, foreign exchange risk, and
political risk. Each of these risks is related to the characteristics of the financial claim (e.g., term to
maturity) or to the issuer (e.g., default risk). Each must be managed carefully to balance the
tradeoff between future profitability and potential failure. The next paragraphs have summarize the
five risks and briefly discuss how they affect the management of financial institutions.

CREDIT RISK
When a financial institution makes a loan or invests in a bond or other debt security, the institution
bears credit risk (or default risk) because it is accepting the possibility that the borrower will fail to
make either interest or principal payments in the amount and at the time promised. To manage the
credit risk of loans or investments in debt securities, financial
institutions should (1) diversify their portfolios, (2) conduct a careful credit analysis of the
borrower to measure default risk exposure, and (3) monitor the borrower over the life of the loan
or investment to detect any critical changes in financial health, which is just another way of
expressing the borrower’s ability to repay the loan.

INTEREST RATE RISK

Interest rate risk is the risk of fluctuations in a security’s price or reinvestment income caused by
changes in market interest rates. The concept of interest rate risk is applicable not only to bonds
but also to a financial institution’s balance sheet. The savings and loan association industry is the
prime example of how interest rate risk adversely affects a financial institution’s earnings. In the
volatile interest rate environment of the late 1970s and early 1980s, many savings and loan
associations (S&Ls) failed because the interest rates they paid on deposits (liabilities) increased
faster than the yields they earned on their mortgage loans (assets), causing earnings to decline.

LIQUIDITY RISK
Liquidity risk is the risk that a financial institution will be unable to generate sufficient cash inflow
to meet required cash outflows. Liquidity is critical to financial institutions: Banks and thrifts need
liquidity to meet deposit withdrawals and pay off other liabilities as they come due, pension funds
need liquidity to meet contractual pension payments, and life insurance companies need liquidity
to pay death benefits. Liquidity also means that an institution need not pass up a profitable loan or
investment opportunity because of a lack of cash. If a financial institution is unable to meet its
short-term obligations because of inadequate liquidity, the firm will fail even though the firm may
be profitable over the long run.

FOREIGN EXCHANGE RISK

Foreign exchange risk is the fluctuation in the earnings or value of a financial institution that arises
from fluctuations in exchange rates. Many financial institutions deal in foreign currencies for their
own account, or they buy or sell currencies for their customers. Also, financial institutions invest in
the direct credit markets of other countries, or they may sell indirect financial claims overseas.
Because of changing international economic conditions and the relative supply and demand of
U.S. and foreign currencies, the rate at which foreign currencies can be converted into U.S. dollars
fluctuates. These fluctuations can cause gains or losses in the currency positions of financial
institutions, and they cause the U.S. dollar values of non-U.S. financial investments to change.

POLITICAL RISK
Political risk is the fluctuation in value of a financial institution resulting from the actions of the
governments. Domestically, if the government changes the regulations faced by financial
institutions, their earnings or values are affected. For example, if the FDIC, which insures deposits
at banks and thrift institutions, decided to increase the premium charged for deposit insurance,
earnings at the affected institutions would likely decline. It is important for managers of financial
institutions to monitor and predict as best as possible changes in the regulatory environment.
Managers must be prepared to react quickly when regulatory changes occur. Internationally, the
concerns are much more dramatic, especially when institutions consider lending in developing
countries without stable governments or well-developed legal systems. Governments can repudiate
(i.e., cancel) foreign debt obligations. Repudiations are rare, but less rare are debt rescheduling in
which foreign governments declare a moratorium on debt payments and then attempt to renegotiate
more favorable terms with the foreign lenders. In either case, the lending institution is left “holding
the bag.” To grow and be successful in the international arena, managers of financial institutions
must understand how to measure and manage these risks.