Financial Institutions in the Financial System

CHAPTER TWO
FINANCIAL INSTITUTIONS IN THE FINANCIAL SYSTEM

2.1 Financial Institutions at a Glance

Business entities include nonfinancial and financial enterprises. Non financial enterprises
manufacture products (e.g., cars, steel, and computers)and/or provide nonfinancial services (e.g.,
transportation, utilities, computer programming). Financial enterprises, more popularly referred
to as financial institutions, are those organizations, which are involved in providing various
types of financial services to their customers and are controlled and supervised by the rules
and regulations delineated by government authorities. Generally, financial
institutions provide services related to one or more of the following:

a) Transforming financial assets acquired through the market and constituting them into a
different, and more widely preferable, type of asset—which becomes their liability. This is
the function performed by financial intermediaries, the most important type of financial
institution.
b) Exchanging of financial assets on behalf of customers.
c) Exchanging of financial assets for their own accounts.
d) Assisting in the creation of financial assets for their customers, and then selling those
financial assets to other market participants.
e) Providing investment advice to other market participants.
f) Managing the portfolios of other market participants.

These institutions include depository financial institutions such as banks, savings and loan
associations, mutual savings banks, and credit union; and non-depository financial institutions
like insurance companies, pension funds, finance companies, mutual funds, asset management
firms, etc.

Financial institutions can be either private or public in nature.

As a general rule what financial intermediaries do is to create assets for savers and liabilities for
borrowers which are more attractive to each than would be the case if the parties have to deal
with each other directly.

2.2 The Role of Financial Institutions

We have stressed that financial intermediaries play the basic role of transforming financial assets
that are less desirable for a large part of the public into other financial assets—their own
liabilities—which are more widely preferred by the public. This transformation involves at least
one of four economic functions: 1) providing a payment mechanism;2) providing maturity

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intermediation; 3) reducing risk via diversification; 4) reducing the costs of contracting and
information processing. Each function is described below.

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 certain financial institutions. Financial institutions perform check clearing and
wire transfer services. A debit card differs from a credit card in that in the latter case, a bill is
sent to the credit card holder periodically (usually once a month) requiring payments for
transactions made. In the past 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. A financial institution is willing to make long-term loans, and at a lower
cost to the borrower than an individual investor would, by counting on successive deposits
providing the funds until maturity. Thus, the second implication is that the cost of long-term
borrowing is likely to be reduced.

3. Reducing Risk through Diversification

Consider the example of an investor who places funds in an investment company. Suppose that
the investment company invests the funds received in the stock of a large number of companies.
By doing so, the investment company has diversified and reduced its risk. Investors who have a
small sum to invest would find it difficult to achieve the same degree of diversification because
they don't have sufficient funds to buy shares of a large number of companies. Because financial
institutions acquire funds from large numbers of surplus units and provide funds to large
numbers of deficit units, substantial diversification is effected 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.

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4. Reducing Transaction Costs

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). An economy of scale is a concept that costs
reduction in trading and other transaction services results from increased efficiency when
financial institutions perform these services.
Such economies of scale of information production and collection tend to enhance the
advantages to investors of investing via financial institutions rather than directly investing
themselves.

2.3 Classification of Financial Institutions

Financial institutions are responsible for distributing financial resources in a planned way to the
potential users. There are a number of institutions that collect and provide funds for the
necessary sector or individual. Correspondingly, there are several institutions that act as the
middleman and join the deficit and surplus units. Investing money on behalf of the client is
another variety of functions of financial institutions. Basically, the services provided by the
various types of financial institutions may vary from one institution to another

Broadly speaking financial institutions are categorized in to two major parts, as:
a) Depository financial institutions; which include commercial banks, savings and loan
associations, mutual savings banks, credit unions
b) Non-depository financial institutions; which comprises of contractual savings institutions
(insurance companies and pension funds); investment institutions (finance companies,
mutual funds, money market mutual funds, stock brokerage firms, investment banks etc)

At the same time, there are several governmental financial institutions assigned with regulatory
and supervisory functions. These institutions have played a distinct role in fulfilling the financial
and management needs of different industries, and have also shaped the national economic
scene.

2.3.1 Depository Financial Institutions

Depository institutions are financial intermediaries that accept deposits from individuals and
institutions and make loans. These institutions include commercial banks and the so-called thrift
institutions (thrifts): savings and loan associations, mutual savings banks, and credit unions.
The primary functions of financial institutions of this nature are:

 Accepting Deposits;
 Providing Commercial Loans;
 Providing Real Estate Loans;
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 Providing Mortgage Loans; and

 Issuing Share Certificates.

Depository institutions are popular financial institutions for the following reasons:
 They offer deposit accounts
 They provide loan facilities
 They accept the risk on loans provided
 They have more expertise
 They diversify their loans among numerous deficit units

A. Commercial Banks
These financial intermediaries raise funds primarily by issuing checkable deposits (deposits on
which checks can be written), savings deposits (deposits that are payable on demand but do not
allow their owner to write checks), and time deposits (deposits with fixed terms to maturity).
They then use these funds to make commercial, consumer, and mortgage loans and to buy
government securities and municipal bonds. They are the largest financial intermediary and have
the most diversified portfolios (collections) of assets.

B. Saving institutions
These depository institutions include saving and loan associations and mutual saving banks and
they obtain funds primarily through savings deposits (often called shares) and time and
checkable deposits.

The basic motivation behind the creation of S&Ls was provision of funds for financing the
purchase of home. The collateral for the loans would be the homes being financed. S&Ls are
either mutually owned or have corporate stock owner ship. Mutually owned means there is no
stock outstanding, so technically the depositors are the owners. To increase the ability of S&Ls
to expand the sources of funding available to bolster/strengthen their capital, legislation
facilitated the conversion of mutually-owned companies in to a corporate stock ownership
structure. To sum up, S&Ls offer deposit accounts to surplus units and channel these deposits to
deficit units and unlike commercial banks, they concentrated on residential mortgage loans to
the owners(shareholders) of the institutions.

Saving banks are institutions similar to, although much older than, S&Ls. they can be either
mutually owned in which case they are called mutual savings banks or stock holder owned. Most
savings banks are of the mutual form. While the total deposits at savings banks are less than
S&Ls, savings banks are typically larger institutions. Asset structures of savings banks and S&Ls
are similar. The principal source of funds for savings banks is deposits.

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C. Credit Unions
Credit unions are the smallest and the newest of the depository institutions. They are varying
small co-operative lending institutions organized around a particular group and owned by their
members, member deposits are called shares. The distribution paid to members is therefore in
the form of dividends, not interest. Examples of credit unions can be union members, employees
of a particular firm. Credit unions are different from other depository institutions because they:
 Are non- profit
 Restrict their funds to provide loans to their members only

2. Non-Depository institutions
Non-depository financial institutions are intermediaries that cannot accept deposits but do pool
the payments in the form of premiums or contributions of many people and either invest it or
provide credit to others. Hence, non-depository institutions form an important part of the
economy. These non-depository institutions are sometimes referred to as the shadow banking
system, because they resemble banks as financial intermediaries, but they cannot legally accept
deposits. Consequently, their regulation is less stringent, which allows some non-depository
institutions, such as hedge funds, to take greater risks for a chance to earn higher returns. These
institutions receive the public's money because they offer other services than just the payment of
interest. They can spread the financial risk of individuals over a large group, or provide
investment services for greater returns or for a future income.

The basic non-depository financial institutions include insurance companies, pension funds,
mutual funds, finance companies, money market mutual funds etc
A. Insurance Companies
• The primary function of insurance companies is to compensate individuals and
corporations (policyholders) if perceived adverse event occur, in exchange for premium
paid to the insurer by policyholder.
• Insurance companies provide (sell) insurance policies, which are legally binding
contracts.
• Insurance companies promise to pay specified sum contingent on the occurrence of future
events, such as death or an automobile accident.
• Insurance companies are risk bearers. They accept or underwrite the risk for an insurance
premium paid by the policyholder or owner of the policy.
• Income of Insurance companies:
– Initial underwriting income (insurance premium)
– Investment income that occur over time

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Therefore, profit of insurance companies =( insurance premium + investment income) –

(operating expense + insurance payment or benefits.)

Insurance companies can be classified in to life insurance and general (Property-causality)

insurance

Life insurance Companies; Life insurance companies insure people against financial
insecurities following a death and sell annuities (annual income payments upon retirement).They
acquire funds from the premiums that people pay to keep their policies in force and use them
mainly to buy corporate bonds and mortgages. Because claim payments are more predictable,
life insurance companies invest mostly in long-term bonds, which pay a higher yield, and some
stocks.

Property and Casualty Insurance; These companies insure policyholders against loss from
theft, fire, and accidents. They are very much like life insurance companies, receiving funds
through premiums for their policies, but they have a greater possibility of loss of funds if major
disasters occur. For this reason, they use their funds to buy more liquid assets than life insurance
companies
B. Mutual Funds
A mutual fund (in US) or unit trust (in UK and India) raise funds from the public and invests the
funds in a variety of financial assets, mostly equity, both domestic and overseas and also in
liquid money and capital market.They are investment companies that pool money from investors
at large and offer to sell and buy back its shares on a continuous basis and use the capital thus
raised to invest in securities of different companies

Mutual funds possess shares of several companies and receive dividends in lieu of them and the
earnings are distributed among the shareholders on a pro rata basis.

Mutual funds sell shares (units) to investors and redeem outstanding shares on demand at their
fair market value. Thus, they provide opportunity of small investors to invest in a diversified
portfolio of financial securities. Mutual funds are also able to enjoy economies of scale by
incurring lower transaction costs and commission.
Advantage of Mutual Funds

1. Mobilizing small saving

 Direct participation in securities is not attractive to small investors because of some
requirements which are difficult for them.
 MF mobilizes funds by selling their own shares, known as units. These funds are invested in
shares of different institution, government securities, etc

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 To an investor, a unit in a mutual fund means ownership of a proportionate share of

securities in the portfolio of a mutual fund.
2. Professional management
 Mutual funds employ professional experts who manage the investment portfolio efficiently
and profitably.
 Investors are relieved of the emotional stress in buying and selling securities since MF take
care of this function.
 The Professional managers act scientifically at the right time to buy and sell for their client,
and automatic reinvestment of dividends and capital gains, etc
3 Diversified investment/ reduced risks
 Funds mobilized from investors are invested in various industries spread across the
country/globe.
 This is advantage to the small investors b/s they cannot afford to assess the profitability and
viability of different investment opportunities
 MF provide small investors the access to a reduced investment risk resulting from
diversification, economies of scale in transaction cost and professional financial
management
4. Better liquidity
 There is always a ready market for the mutual fund units- it is possible for the investors to
disinvest holdings any time during the year at the Net Asset Value (NAV)
 Securities held by the fund could be converted into cash at any time.

Thus, mutual funds could not face problem of liquidity to satisfy the redemption demand
of unit holders.

5. Investment protection
 Mutual funds are legally regulated by guidelines and legislative provisions of regulatory
bodies (such as SEC in US, SEBI in India etc)
6. Low transaction cost (economy of scale)
 The cost of purchase and sale of mutual funds is relatively lower because of the large
volume of money being handled by MF in the capital market (economies of Scale)
 Brokerage fees, trading commission, etc are lower
 This enhances the quantum of distributable income available for investors
7. Economic Developments
 Mutual funds mobilize more savings and channel them to the more productive sectors of
the economy
 The efficient functioning of mutual funds contributes to an efficient financial system.

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 This in turn paves ways for the efficient allocation of the financial resources of the country
which in turn contributes to the economic development.

The investors’ return in the mutual fund includes capital appreciation (capital gain from price
appreciation of the underlying assets), and the income generated by the assets of the fund.

Types of Mutual Funds

Mutual funds can be categorized in to two; open-ended mutual funds and closed-ended mutual
funds
1. Open-ended Mutual Funds
Characteristics
• New investors can join the funds at any time
• A fund (unit) is accepted and liquidated on a continuous basis by mutual fund manager
• The fund manager buys and sells units constantly on demand by investors-it is always
open for the investors to sell or buy their share units
• It provides an excellent liquidity facility to investors, although the units of such are not
listed. No intermediaries are required. There is a certainty in purchase price, which takes
place in accordance with the declared NAV.
• Investors in Mutual fund own a pro rata share of the overall portfolio, which is managed
by an investment manager of the fund who buys some securities and sells others
• The value or price of each share of the portfolio is called net asset value (NAV)
• NAV equals the market value of the portfolio minus the liability of the mutual fund
divided by the number of shares owned by the mutual fund investors

Market Valueof Portfolio−Liabilities

NAV=
Number of shares outstanding

 The NAV is determined only once each day, at the close of the day. For example the
NAV for a stock of a mutual fund is determined from closing stock price for the day.
Business publications provide the NAV each day in their mutual fund
 All new investments into the fund or withdrawal from the fund during a day are priced at
the closing NAV (investment after the end of the day) and a non-business day are priced
at the next day’s closing NAV)
 The total number of shares in the fund increases if more investments than withdrawals are
made during the day, and vice versa.
 The NAV of a mutual fund may increase or decrease due to an increase or decrease in the
price of the securities in the portfolio

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Examples 1:Suppose today a mutual fund contains 1000 shares of ABC which are traded at
$37.75 each, 2,000 shares of Exxon currently traded at $43.70 and 1,500 shares of Citigroup
currently trading at $46.67. The mutual fund has 15,000 shares outstanding held by investors.
Thus, today’s NAV is calculated as:

(1000x 37.75) + (2,000x43.7) +1,500 x 46.67 =13.01

15,000
If tomorrow ABC’s shares increase to $45, Exxon’s shares increase to $48, and Citigroup’s
shares increase to $50, the NAV (assuming the number of shares outstanding remains the same)
would increase to:

1000x45 + 2000 x 48 + 1500x 50 = 14.40

15,000

Example2: Suppose that today 1,000 additional investors buy one share each of the mutual fund
(MF) at the NAV of $13.01. This means the MF manager has $13,010 additional funds to invest.

Suppose that the fund manager decides to use these additional funds to buy additional shares in
ABC.

At today’s market price, the manager could buy 344 ($13,010/$37.75 = 344) shares of ABC
additional shares: Thus,

 Its new portfolio of shares has 1344 in ABC, 2000 in Exxon, and 1,500 in Citigroup.
 Given the same rise in share value as assumed above, tomorrow’s NAV will be:

1,344 x $45 + 2,000 x $48 + 1,500 x $50 = 14.47

16,000
The additional shares and the profitable investment made with the new funds from these resulted
in a slight higher NAV than had the number of shares remained static ($14.47 versus $14.40)

2. Closed-ended Fund

• The shares of a closed-end fund are similar to the shares of common stock of a
corporation. The new shares of a closed-end fund are initially issued by an underwriter
for the fund and after the new issue the number of shares remains constant.
• After the initial issue, no sale or purchase of shares are made by the fund company as in
open-end funds. Instead, the shares are traded on a secondary market, either in an
exchange or in the over-the-counter market

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• Since the number of shares available for purchase, at any moment in time, is fixed, the
NAV of the fund’s shares is determined by the underlying shares as well as by the
demand for the investment company’s shares themselves.
• When demand for the investment company’s shares is high, because the supply of shares
in the fund is fixed, the shares can be traded for more than the NAV of the securities held
in the fund’s assets portfolio. In this case the shares said to be trading at a premium; if
demand is low, the shares are sold for discount.

The main difference between an open-ended and a closed-ended mutual fund is;the number of
shares of an open-end fund varies because the fund sponsor sells new shares to investors and
buys existing shares from shareholders. By doing so the share price is always the NAV of the
fund. In contrast, closed-ended funds have a constant number of shares outstanding because the
fund sponsor does not redeem shares and sell new shares to investors except at the time of a new
underwriting. Thus, supply and demand in the market determines the price of the fund shares,
which may be above or below NAV, as previously discussed.
C. Pension Funds
Pension funds receive contributions from individuals and/or employers during their employment
to provide a retirement income for the individuals. Most pension funds are provided by
employers for employees. The employer may also pay part or all of the contribution, but an
employee must work a minimum number of years to be vested—qualified to receive the benefits
of the pension. Self-employed people can also set up a pension fund for themselves through
individual retirement accounts or other types of programs.

While an individual has many options to save for retirement, the main benefit of government-
sanctioned pension plans is tax savings. Pension plans allow either contributions or withdrawals
that are tax-free.

As a consequence of the regular contributions and the tax savings, pension funds have enormous
amounts of money to invest. And because their payments are predictable, pension funds invest in
long-term bonds and stocks, with more emphasis on stocks for greater profits.

D Finance Companies
Finance companies raise funds by selling commercial paper (a short-term debt instrument) and
by issuing stocks and bonds. They lend these funds to consumers, who make purchases of such
items as furniture, automobiles, and home improvements, and to small businesses. Some finance
companies are organized by a parent corporation to help sell its product. For example, Ford
Motor Credit Company makes loans to consumers who purchase Ford automobiles.

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E. Money Market Mutual Funds

These relatively new financial institutions have the characteristics of a mutual fund but also
function to some extent as a depository institution because they offer deposit-type accounts. Like
most mutual funds, they sell shares to acquire funds that are then used to buy money market
instruments that are both safe and very liquid. The interest on these assets is then paid out to the
shareholders.

A key feature of these funds is that shareholders can write checks against the value of their
shareholdings. In effect, shares in a money market mutual fund function like checking account
deposits that pay interest.

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