Financial Intermediaries

The biggest sources of credit are the financial institutions. Financial

institutions are either intermediaries or non-intermediaries. Financial
institutions that are also intermediaries channel the savings of
individuals and business into loans and investments.
An intermediary is a go-between, the one in the middle, best illustrated
here:

Diagram 4

A.) NO INTERMEDIARY

Lender
(JOSE SANTOS) Borrower
(RAISA CORPUZ)

B.) WITH
INTERMEDIARY

J. Santos -savings deposit consumer loan= Marithy Chiong

Financial
Rey Go =time deposit Intermediary housing loan= Reese Ingala
Manny Tan =savings auto loan= Andy Garcia
In the first situation (no intermediary), the lender and the borrower are in
direct personal contact. They are probably neighbors, or former
acquaintances. With an intermediary, the providers and users of credit
do not know each other. The saving depositors could be from Vigan,
Ilocos Sur, and the borrowers, fishpond operators in Roxas City.

These financial institutions are perceived as the sources of credit. In

reality, the true sources of credit are the individuals, businesses, and
some government entities who need them.

These financial institutions provide “intermediation” by establishing

branches and offices where depositors may conveniently put their excess
funds and by using their expertise in handling these funds thru prudence
in granting loans, and with an experienced, and thus effective, collection
machinery, the profits of the providers of the funds (the depositors) in
the form of interest income are more or less guaranteed on continuing
basis.

In the first example, without an intermediary, the lender is not

guaranteed that he will be repaid. Of course, he gets all the interest
income. But if he has not done a complete background check on the
borrower, or the credit instrument used was defective, and perhaps even
difficult to enforce, the debt might well be a bad debt, and the lender
loses not just the interest income, but the principal as well.

With banks, the deposits are guaranteed for both the principal and
interest income, even if the bank is unable to collect the loans it has
granted from out of the depositor’s funds. The only very rare situation
where the deposits could be totally lost is when a bank is closed by the
Bangko Sentral. There is, however, the PDIC or Philippine Deposit
Insurance Corporation which is mandated by law to reimburse up to
P100,000 every depositor in case the bank is closed or liquidated.

Financial intermediaries provide the following:

Financial intermediaries pool funds invest them prudently by avoiding

risks and by the technique of diversification – or “not putting one’s
eggs in one basket”. Commercial banks diversify by lending to
borrowers in different geographic locations, or different economic
sectors, or simply by investing in different types of securities: stocks,
bonds, treasury bills, loans.

Financial intermediaries provide managerial competence. They have

the best manpower development programs, and they recruit the best
talents from the best campuses in the country.

They also match short-term and long-term with short-term and long-
term uses. They generally use conservative financial strategies, using
long-term funds for short-term credits. They also provide a continuing
stream of earnings. Coupon bonds provide detachable coupons that
could be encashed on a periodic basis. Insurance products provide for
annual payments. Retirement programs pay lump-sum and periodic
pensions.

Lastly, they create processes that allow all types of transactions to be

handled efficiently and cheaply for the convenience of their clients.
Without systems established and continuously maintained by these
financial institutions, the world of business and industry will be in total
chaos and confusion.

Some of these financial intermediaries are:

1. Banks
a) Commercial b) Savings Banks c) Rural Banks

2. Insurance companies

3. Pre-need companies

4. Pension/retirement funds
a) SSS b) GSIS c) RSBS d) Private pension funds

5. Investment banks, legally required not to use the word “bank” and
are now known as Investment Houses

6. Financing companies

7. Credit cooperatives

Financial institutions are either bank or non-bank. Items 2 to 7 above are

non-banks. A bank is licensed by the Bangko Sentral and is authorized
to accept deposits from the public. Non-bank financial institutions are
prohibited from accepting deposits. It is because of this strict delineation
(bank vs non-bank) that an investment bank (its official and accepted
name in the US and throughout the world) in this country must not use
the word “bank” but it must call itself, and so should the public, as an
investment houses. Only in the Philippines.
Obviously, the purpose is to avoid confusing the public; an investment
bank, or house, is not allowed to accept deposits.

Banks. A bank is primary in the lending business. A bank starts by using

the personal fund of its owners, also called as owners’ equity. A typical
commercial bank would start with P1 B (all owners’ equity), which
would then be loaned out to qualified borrowers. However, a P1 B
starting capital, in a highly urbanized city like Cagayan de Oro, will not
go very far. The bank’s owners, through its management, would have to
solicit for deposits. It is authorized by the government, through the
Bangko Sentral, to accept deposits from the public. Technically, the
bank will have to “borrow” or “buy” deposits so they can turn around
and lend them out.

Essentially, a bank is in the buy-and-sell business, its “buys” the

deposits at low interest rates, say at 4%, and “sell” them at much higher
interest rates, for example at 24%. Its major source of income is the
spread or the difference between its lending rate and the interest rate it
pays its depositors, less its cost of operations. Of course, banks have
other income sources, most of them fee based: fees for fund transfers,
import-export fees, and commissions.

Rural Banks. A rural bank is just another bank created by law to

improve the Philippine countryside, particularly the agricultural sector.
Rural banks are governed by Republic Act No. 7353 or the New Rural
Bank Act.
To encourage the establishment of more rural banks, Republic Act No.
7353 gave special privileges:

1. Rural banks may accept as security real estate properties without

“torrens titles”

2. In the foreclosure of mortgages, rural banks are exempt from

publications in newspapers, where the amount of principal amount
of the loan does not exceed P100,000.

3. Rural banks are exempt from the payment of fees, documentary

stamps and other charges in registration of mortgages in the
Registry of Deeds up to loan amounts of P50,000.

Rural banks proliferated in the 7o’s and 80’s, but the number of
operating rural banks went down considerably in the 1990’s. Almost
every town with a sizable population had a rural bank. Most of these
banks were eventually closed and liquidated due to liquidity problems,
some because of abuses and mismanagement of the owners.

Insurance Companies. The major activity of the insurance company is

cash accumulation. Its customers, called policyowners, pay premiums
today, in exchange for a future payment in case of death or disability of
the insured or the maturity of the insurance policy. For example, a
policyowner will pay a semi-annual (every 6 months) premium of
P24,000. Incase the insured dies or is permanently disabled, the
insurance company will pay P5.0 M to the beneficiary.

To make sure that this large sum of money is available, say in 20 years,
these premium payments (after deducting the commissions of insurance
salesmen and allowing for overhead excuses) are “accumulated” , in
actuality, they are invested in stocks, bonds, or loans ( all good money-
makers) so that the income generated plus the principal will sum up to
more than the future lump-sum payments. The word “more” is
emphasized because this is to the best interest of the insurance company;
that is how they make money.

Pre-need companies operate under the same “cash accumulation”

scheme as the insurance companies. The major exceptions are from the
marketing viewpoint, pre-need companies stress the major concerns of
the people: their children’s future (educational plans) and old age
(pension plans); insurance companies are heavily regulated by the
Insurance Commission, while the pre-need companies are supervised by
the Securities and Exchange Commission. Some of the pre-need
companies are CAP, Cocoplans, Pet Plans.

Pre-need companies include in their products term life insurance that

will pay the planholder’s beneficiary in case of death, and credit
insurance, which will continue the payment for the premium, if not yet
paid up when the insured dies. These extra premiums are paid by the
pre-need company, to, usually, an affiliate or sister company.

Diagram 5
Premium Premium Premium maturity or death of insured
payment payment payment LUMP-SUM PAYMENT
__________________________________________________________________
__________________________________________________________________

TWENTY YEARS
Accumulation of Premiums
Pension funds. Pension funds collect employees’ contributions, mostly
mandatory and on a monthly basis, from employees’ paychecks. These
are invested in stocks, bonds, and loans, mostly on a long-term basis, so
that they will grow into sufficient amounts to pay off the retirement
benefits of their members. The amount of money collected by the
pension funds in the US (most of them private funds managed by
workers’ union) accumulate so quickly every month, that pension fund
officers have to be continually on the lookout for new investments.

Most of the time, the monthly collections from these contributions

exceed the available investment opportunities. Thus, pension fund
managers are more interested in long-term investments, like 5-year time
deposits, bonds, and stocks.

Investment house. An investment house main function is the

channeling (actually, obtaining or pooling together) of private funds
from various individuals and business for investment, as capital stock, in
public corporations. A public (not to be confused with the government)
corporation sell shares of stock to the public; private (or closed)
corporations do not. Oftentimes, these public corporations that sell
shares of stock through the investment house are listed in the Philippine
Stock Exchange.
Diagram 6
Investor A===== fresh capital ABC corp

Investor B ===== Financial

Intermediary

Investor C =====

fresh capital XYZ corp

An issuing corporation (it issues or sells new shares of stocks to the
public, in exchange for cash, of course) would be either start-up or
newly established venture, or an existing corporation need of funds. An
issuing corporation who wants to sell new shares can, in fact, do it on its
own, without using facilities of an investment house; however, it is
better to engage, to hire, the services of an investment house. An
investment house has the expertise and the network of contacts
necessary in the successful selling of new shares of stock. They will
underwrite or package the proposal and sell the new shares in what they
call IPO –or Initial Public Offering. For this service, it gets a fee. A
guaranteed offering, wherein the investment house guarantees all the
new shares are sold (if they’re not, the investment house will buy the
unsold shares), the fee is higher, if the sales is on a “best effort basis”,
the fee is lower.

New issues of stock have been shown to be historically profitable to

those who invest in them. The frequent buyers and pension funds,
insurance companies, other large corporations who want to speculate on
new issues, and very wealthy individuals, who are interested in making
fantastic profits. Occasionally, investment houses will also sell bonds.

The investment house performs an important role in enterprise

development, which in turn is essential to the economic development of
our country. New enterprises have higher potentials in the creation of
new employment opportunities, and the generation of taxes for
government projects.

Investment houses provide “underwriting” services, however, an

opportunity to “underwrite” newly-issued shares of stocks does not
happen everyday. Thus, investment houses engage in other
undertakings: they also act as a financial consultants, investment adviser
and brokers, and they sign pension and retirement programs, among
other things.

Financing Companies were defined by the “Financing Company Act”

or R.A. No. 5980 as corporations or partnerships (except those regulated
by the Central Bank, Insurance Commissioner and the Cooperative
Development Authority) which are primarily organized for the purpose
of extending credit facilities to consumers and to industrial, commercial,
or agricultural enterprises, either by discounting or factoring commercial
papers or accounts receivables, or by buying and selling contracts,
leases, chattel mortgages, or other evidences of indebtedness, or by
leasing motor vehicles, heavy equipment and industrial machinery,
business and office machines and equipment, appliances and other
movable property.

With this sweeping or all-encompassing definition, finance companies

have engaged in various types of financing. They are heavily involved in
car financing, and in the financing of inventory and equipment. Finance
companies do a lot of trading in the money market (buying and selling
all types of short-term securities, like commercial papers, T-bills, which
will be explained in the next section). They have also popularized the
usage of repos, or repurchase agreements (also in the next section).

One type of car financing that they engage in is car leasing, which is
different from the regular plan offered by banks. A bank, in financing a
car, transfers ownership thereof to the buyers, using the same vehicles as
security through a chattel mortgage.

In a lease with option to purchase, the ownership of the car remains with
the financing company, and is transferred to the buyer only upon full
payment of all monthly installments and a token amount to exercise the
option. This arrangement strengthens the lender’s hold on the vehicle by
virtue of its ownership. Also, to the buyer, all lease payments are tax-
deductible. If the ownership is transferred to the buyer, the depreciation
charges would probably be distributed over a 5-year depreciation period.
In a lease arrangement, if the term of the lease is 24 months, all of these
can be charged within 2 years as deduction against income for tax
purposes.

There is another advantage to the financing company which is not

commonly known. Since the car is owned by the finance company, it
can actually get a loan from a friendly bank and get fund both ways:
from the loan, using the car as collateral, and from the installments
payments of the buyers of the car.

Credit cooperatives. This is a true financial intermediary. It channels

the contribution of its members into loans, mostly for farm inputs like
fertilizers and farm chemicals. Some larger cooperatives are able to
provide funds for post-harvest facilities payable on a medium-term
basis.

In the last decade, government lending institutions have been

encouraging the formation of cooperatives, even to the point of making
loans available only to cooperatives.