Chapter One

Introduction to Financial institutions

Meaning of Financial System

Financial system is a system that allows the exchange of funds between financial market
participants such as lenders, investors, and borrowers. A financial system is the set of global,
regional, or firm-specific institutions and practices used to facilitate the exchange of funds.

A financial system is a combination of people, institutions, businesses, and processes that

facilitate financial transactions.

Financial system can be formal or informal.

1. Formal finance: is financing capital that has been sourced from banks and other formal
financial intermediaries/institutions.
2. whereas informal finance is the capital which has been sourced from friends, family,
relatives or private money lenders

Elements of a Financial System

A financial system consists of individuals like borrowers and lenders and institutions like banks,
stock exchanges, and insurance companies actively involved in the funds and assets transfer. It
gives investors the ability to grow their wealth and assets, thus contributing to economic
development.

There are several financial system components to ensure a smooth transition of funds between
lenders, borrowers, and investors.

The five elements of a financial system are lenders and borrowers, financial intermediaries,
financial instruments, financial markets and money/currency.

These financial-system components keep money flowing between people and businesses in an
organized manner.

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1. Lenders and Borrowers: Lenders loan money to borrowers

Although people can be lenders on a private basis, lenders in a financial system are typically
financial institutions. example

I. A home buyer often finances the purchase of their home through a mortgage loan,
making them a borrower.
II. Businesses men also take out loans from financial institutions.

One characteristic of a good financial system is regulation surrounding lending.

2. Financial Intermediaries (Financial Institutions)

Financial intermediaries act in between two financial institutions/borrowers and savers to make
the entire financial system more stable.

Think of a financial intermediary as a "middle man." Financial intermediaries rarely own the
money they hold. Rather, these businesses and organizations move funds from one part of the
financial system to the next. Banks are one example of a financial intermediary.

3. Financial Instruments/Tradables: A financial instrument is a contract for trading a

financial asset.

Financial instruments are an important part of a financial system because they allow wealth to
keep moving throughout the system. Checks, bonds, certificates of deposit, stock trades and
stock options contracts are all examples of financial instruments.

4. Financial Markets: A financial market is any marketplace, physical or virtual, where

financial instruments can be traded between people and financial institutions. Example of
financial markets are: stock market, bonds market and foreign exchanges market.
5. Money /Currency: Financial systems rely on money circulating throughout them.

A government may introduce new money to the market by printing it. there must be an
adequate amount of money circulating to keep the financial system going.

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 FINANCIAL INSTITUTIONS

MEANING AND NATURE OF FINANCIAL INSTITUTION

Financial Institution are business organizations that act as mobilisers and depositories of
savings, and as creators of credit and finance. Also provide various financial services to the
community. They differ from non-financial (industrial and commercial) business organizations
in, these institutions are deals with deposits, loans, securities and so on.

FUNCTIONS OF FINANCIAL INTERMEDIARIES

Funds can move from lenders to borrowers by indirect finance because it involves a financial
intermediary that stands between the lender and the borrower and helps to transfer funds from
one to other.

A financial intermediary does this by borrowing funds from the lender and uses these funds to
make loans to borrowers. The process of indirect finance using financial intermediaries called
financial intermediation and it is the primary root for moving funds from lenders to borrowers.

The financial institutions/ intermediaries have a very useful role to play in a modern economy.
They perform the following functions:

A. They bringing the savers and the borrowers together.

B. They promote saving and investment habits among the ordinary people by putting surplus
funds to profitable and productive use and by providing credit loans to the consumers.
C. They encourage the growth of the business sector by providing facilities for investment in
plant, equipment, etc. through loans, mortgages, purchase of bonds, shares, etc.
D. They assist the governments by purchasing their bonds and securities.
E. They increase the earnings of the savers, lenders as well as their own. The savers earn
interest on their deposits and the financial intermediaries earn profits.

THE ROLE OF FINANCIAL INSTITUTIONS

1. Providing a payments mechanism: Most transactions made today are not done with
cash; instead, payments are made using checks, credit cards, debit cards and electronic
transfers of funds. These methods for making payments are provided by financial
institutions. Financial institutions perform check clearing and wire transfer services.

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 In credit card a bill is sent to the credit card holder periodically (usually once a month)
requiring payments for transactions made. In the case of a debit card, funds are immediately
withdrawn (that is, debited) from the purchaser's account at the time the transaction takes
place.

2. Maturity transformation: The financial institutions (e.g. banks) perform the valuable
functions of converting funds that savers are willing to lend for only short period of time into
funds the financial institution themselves are willing to lend to borrowers for longer periods.
Maturity transformation function of financial institution has two implications. First, it
provides investors with more choices concerning maturity for their investments; borrowing
has more choices for the length of their debt obligations. Second, because investors are
naturally reluctant to commit funds for a longer period of time, they will require that long-
time borrowers pay a higher interest rate than on a short -time borrowing.
3. Reducing risk through diversification: Because financial institutions acquire funds
from large numbers of surplus chapters and provide funds to large numbers of deficit
chapters, substantial diversification is affected and the risk of financial loss is reduced.
The diversification is the holding of many (rather than a few) assets reduces risk. Because
all assets don’t behave in the same way at the same time, therefore, the behavior of one
asset will on some occasions cancel out the behavior of another. Financial institutions
(intermediaries) also offer the risk reducing benefits of management expertise since they
do have a manpower that specializes in credit risk assessment & monitoring of borrowers.
4. Reducing transaction costs/Information cost: Not only do financial institutions have a
greater incentive to collect information, but also their average cost of collecting relevant
information is lower than for individual investor (i.e., information collection enjoys
economies of scale).

TYPES OF FINANCIAL INSTITUTIONS

Financial institutors are fall in to three major categories.

1. DEPOSITORY FINACIAL INSTITUTIONS (BANKS): are financial intermediaries that

accept deposits from individuals and institutions and make loans. They are involved in the
creation of deposits which is an important component of the money supply. These institutions

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 include commercial banks, savings and loans association, mutual savings banks and credit
union.
1.1. Commercial banks: these financial intermediaries raise funds primarily by issuing
i. Saving deposits/saving account (deposits that are payable on demand but don’t allow
their owners to write checks)
ii. Demand deposits: deposits that transacted through writing check.
iii. Time deposits (deposits with fixed terms to maturity offer a higher interest rates a bank
can pay).
1.2. Saving and loan association: obtain funds primarily through saving deposits,
time deposits and checkable deposits. The acquired funds have been used to make mortgage
loans (long term loan). Saving and loan association are the second largest group of financial
intermediaries because most mortgages are long-term loans with maturities in excess of 25
years.
1.3. Mutual savings banks: are very similar to saving and loans association. They raise
funds by accepting deposits and use them primarily to make mortgage loans. Their corporate
structure is somewhat different from that of saving and loan association in that they are
always structured as mutual or cooperatives. The depositors own the bank.
1.4. Credit unions: these financial institutions are very small cooperative lending institutions
organized around a particular group: unions’ members, employees of a particular firm and
etc. They acquire funds from deposits called shares and make consumer loans.
2. CONTRACTUAL SAVINGS INSTITUTIONS

Contractual saving institutions such as insurance companies and pension funds are financial
intermediaries that acquire funds at periodic intervals on contractual bases.

2.1. Life insurance companies: insure people against financial hazards following a death and
sell an annuity (annual income payments up on retirements). They acquire funds from the
premiums that people pay to keep their policies enforce and use mainly to buy corporate
bonds and mortgages. They also purchase stocks but are restricted in the amount that they
can hold.

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2.2. Fire and causality insurance companies: these companies insure their policyholders
against lose from theft, fire and accident. They are very much like life insurance companies
receiving funds through premiums.
2.3. Pension funds and government retirement funds: private pension funds and state
retirement funds provide retirement income in the form of annuities to employee’s who are
covered by a pension plan. Funds are acquired by contributions automatically deducted from
their paychecks/salary.
3. INVESTMENT INSTITUTE/ INTERMEDIARIES: This category of financial intermediaries
includes finance companies’ mutual funds and money market mutual funds.
3.1. Finance companies: rise funds by selling commercial paper (a short-term debts without
collateral) and by issuing stocks and bonds. They lend these funds to consumers who make
purchase of such item as furniture, automobile, home improvements and small business.
3.2. Mutual funds: these financial intermediaries acquire funds by selling shares to many
individuals and use the proceeds to purchase diversified portfolios of stocks and bonds.
Mutual funds allow shareholders to pool their resources so that they can take advantage of
lower transaction costs when buying large blocks of stocks or bonds. In addition, mutual
funds allow shareholders to hold on more diversified portfolios than they otherwise would.
Shareholders can sell shares at any time but the value of their shares will be determined by
the value of the mutual fund’s holdings of securities. Because these fluctuates greatly the
value of mutual fund shares will too, therefore investment in mutual funds can be risky

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