Chapter One: General Introduction

1.1 Meaning and nature of financial institutions

Financial institutions, as the name implies, are entities that deal in finances. They offer a wide
range of monetary or financial services to individuals and businesses. From helping individuals
save money to enabling them to invest in stocks, such institutions serve different functions
simultaneously.

There are various types of financial institutions to fulfill different requirements of customers.
They look into the customer’s financial needs, be it an individual or a company, and offer
relevant services. These entities provide customers with valuable pieces of advice while
choosing appropriate financial investment or savings options. The professionals explain the pros
and cons of each alternative for their customers to decide which investment they should spend
on.

The national and international financial institutions have a great role in ensuring a healthy
economy. With the give and take of the monetary resources, the flow of transactions remains
balanced, which keeps the economy going. Moreover, such entities in the nation make the
market liquid, triggering more economic activities in the respective countries. Therefore, any
damage to these financial entities can have a direct negative impact on the economic health of
the nation.

Financial institutions are entities that help individuals and businesses fulfill their monetary or
financial requirements, either by depositing money, investing it, or managing it. Some of the
institutions labeled under this category include – banks, investment firms, trusts, brokerage
ventures, insurance companies, etc.

Financial institutions are organizations that provide financial services to individuals and
businesses. They play a crucial role in the economy by facilitating the flow of funds between
savers and borrowers. These institutions can include banks, credit unions, insurance companies,
brokerage firms, investment banks, and other similar entities.

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The nature of financial institutions is characterized by their functions, which can include
accepting deposits, lending money, providing investment services, facilitating the purchase of
securities, and offering insurance products. They also play a key role in managing risk and
providing liquidity in the financial system.

Financial institutions are heavily regulated to ensure stability and protect consumers. They are
subject to oversight by government agencies to maintain the integrity of the financial system and
safeguard the interests of depositors and investors.

Overall, financial institutions serve as the backbone of the financial system, providing essential
services that support economic growth and development.

1.2 What is money?

The most important financial asset in the economy is money. All financial assets are valued in
terms of money and flows of funds between lenders and borrowers occur through the medium of
money. Money itself is a true financial asset, because all forms of money in use today are claims
against some institution, public or private. For example one of the largest components of the
money supply today is the checking account, which is the debt of a bank or other depository
institution. Another, currency and coin- the pocket money held by the public.

Functions of Money

Money performs a wide variety of important services. It serves as standard of value (unit of
account) for all the goods and services to trade. Without money the price of very good or service
would have to be expressed in terms of the exchange ratios with all other goods and services – a
burden for both buyers and sellers. Had it not been for money, for example, we would need to
know how many loaves of bread is required to have cup of tea. Imagine how many exchange
ratios we need to know to trade 12 items. But, the existence of money as a common standard of
value permits us to express the prices of all goods and services in terms of only one good;
birr/dollar/euro/pound etc – monetary unit.

Money also serves as a medium of exchange. It is usually the only financial asset that virtually
every business, household and government unit will accept in payment for goods and services.

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People accept it only because they know they can exchange it at a later date for goods and
services. With the medium of exchange, buyers and sellers no longer need to have an exact
coincidence of wants in terms of quantity, quality, time and location.

Money serves also as a store of value – a reserve of future purchasing power. Purchasing power
can be stored in currencies or checks etc until the time is right to buy.

Money functions as the only perfect liquid asset in the financial system. An asset is liquid if it
can be converted in to cash quickly with little or no loss of value. A liquid asset possesses three
essential characteristics: price stability, ready marketability and reversibility. An asset must be
considered liquid if its price tends to be reasonably stable over time, if it has an active resale
market, and if it is reversible so that investors can recover their original investment without loss.
All assets - real and financial – differ in their degree of liquidity. Generally, financial assets,
especially bank deposits and stocks and bonds tend to be highly liquid. Whereas, real assets such
as a home or an automobile may be of extremely difficult to sell in hurry without taking a
substantial loss. Money is the most liquid of all other assets because it needs not to be converted
in to any other form to be spent.

Inflation/deflation increases/decreases the purchasing power of money respectively.

Inflation- a rise in average price level of all goods and services

Deflation – average level of prices for goods and services actually decline. It benefits those
whose income does not also decline with prices and, therefore, can buy more goods and services
than they could in the past.

1.3 Types of financial institutions

The 9 types of financial institutions are:

i. Central Banks
ii. Retail or Commercial Banks
iii. Internet Banks
iv. Credit Unions
v. Savings and Loan Associations

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 vi. Investment Banks
vii. Brokerage Firms
viii. Insurance Companies
ix. Mortgage Companies

1. Central Banks

Central banks are primary banks that oversee and manage other banks. In Ethiopia, the central
bank is called National Bank of Ethiopia. It is responsible for setting and enacting monetary
policy, providing financial supervision, and regulating other financial institutions.

The National Bank of Ethiopia monitors the money depositing and transfer system in Ethiopia. It
provides deposit insurance for commercial banks and savings banks.

2. Commercial Banks (Retail Banks)

Commercial banks are the banks that consumers mostly interact with. Commercial banks offer
products to individual consumers and to businesses. The majority of retail/commercial banks
offer deposit accounts, lending, and some financial advice.

3. Internet Banks

Next up are internet banks. Internet banks are newer to the financial market but they provide
many of the same services as retail banks. The biggest differentiator of internet banks is that they
do not have a brick-and-mortar location and operate largely online.

Within the category of internet banks, there are also digital banks and neobanks. Digital banks
are platforms that exist online-only but they are also affiliated with a traditional bank.
Comparatively, neobanks don’t have any affiliation with a traditional bank.

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4. Credit Unions

Credit unions are another popular choice for financial institutions. Historically, credit unions
have helped specific demographics based on union membership, such as teachers, laborers, and
members of the military.

Products in credit unions are very similar to those available at retail and commercial banks but
they are actually owned by the members themselves, with a mission to operate for the benefit of
members rather than profit.

5. Savings and Loan Associations

Another key category in the financial market is savings and loan associations. Savings and loan
associations typically offer higher interest rates on savings accounts and have lower fees for
loans. These types of financial institutions have been around for many years and are a trusted
source for saving money and taking out loans. Some of the services you’ll find here include
specialized savings accounts, loans, and personal services. These differ from traditional savings
and loans you’d find in banks by offering higher interest rates, lower fees, and personal service.

Individuals might use this type of financial institution for personal loans, mortgage lending, and
deposit accounts.

6. Investment Banks

Next, we have investment banks and other investment companies. These banks do not take any
deposits but instead raise capital for individuals, businesses, and governments through securities.
They are traditionally known as mutual fund companies and they offer pooled investment fund
accounts for individuals and institutional investors.

An investment bank is a financial institution that helps companies raise capital by issuing and
selling securities. Investment banks also help companies with mergers, acquisitions, and other
corporate finance activities.

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7. Brokerage Firms

Brokerage firms are separate entities that help individuals and institutions buy and sell securities.
You may interact with a brokerage firm when you want to place trades of stock, bonds,
exchange-traded funds and more.

8. Insurance Companies

Insurance companies are another type of financial institution that helps individuals transfers the
risk of loss. Insurance is required for homes and vehicles, and other important investments, and
by going with insurance companies, individuals and businesses can protect against financial loss
due to accidents, property damage, death, disability, and significant misfortune.

9. Mortgage Companies

A mortgage company is a financial institution that specializes in home loans. Mortgage

companies help people finance the purchase of a new home or refinance an existing home loan.
Mortgage companies typically work with borrowers to determine how much they can afford to
borrow and then help them find the best loan for their needs.

1.4 Functions of financial institutions

The major functions of Financial Institutions are:

A. Regulate monetary supply

The financial institution helps to regulate the economy's money supply. These institutions control
inflation and also maintain stability in the money supply. The National Bank of Ethiopia takes
various steps by increasing/decreasing repo rates, open market operation, cash reserve ratios to
regulate the country's liquidity. Financial institutions are taking part in buying and selling the
securities of the government which helps to regulate liquidity.

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B. Bank services

It offers credit facilities to its clients who need financial support to lead their lives. This
institution also gives reasonable interest rates for savings and other deposit accounts. They cover
loans like personal, educational, automobile, and others for its customers.

C. Insurance services

The insurance companies also come under financial institutions as they provide money through
investments to the insurer. Insurance companies provide insurance for vehicles, stocks, assets,
marine, etc. Insurance companies also offer coverage for life insurance and health insurance.
These insurance companies offer their hand in mobilizing savings and investing in productive
investments. Here, they transfer customer risks with financial support by assuring customers' life
and insured asset in times of uncertainty.

D. Formation of capital

By accepting individuals’ savings, financial institutions provide monetary services to investors

who need external funds for increasing their capital stocks. Investors may need financial services
to implement expansion plans by installing new plants, machinery, tools, equipment, building a
new plant and buying new transport vehicles, etc. Thus, financial institutions help in the
formation of capital.

E. Investment consultation

Nowadays many investment options are carried out worldwide. A company/individual must
choose wisely for investing in a specific investment option that suits their interest. Many
investors may not be acquainted with numerous investment options. Every financial institution
has investment consulting services to help their clients to adopt the best option available in the
financial markets. Based on the investor’s risk-taking and other interests, the financial institution
suggests the investment option.

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F. Brokerage service

Some financial institutions like commercial banks and non-banking companies offer a different
investment option for investors in form of brokerage. The institution serves as a broker between
investors and various companies for selling stocks, bonds, shares by getting a brokerage fee.

G. Movement of financial resources

Another function of financial institutions is the movement of financial resources from SSU to
DSU. Through financial institutions, money transfer was made easy for large funds like
investments, real estate purchases, and other huge transactions from one party to another party.

H. Managing risk

The financial institution manages the risk and uncertainties of companies and individuals.
Financial institutions manage the risk by assembling a massive pool of individuals and
businesses to share the risks and difficulties faced by businesses and people.

1.5 Role of Financial Institutions

The role of financial institutions is multifaceted and crucial in the functioning of an economy.
They act as intermediaries between those who have surplus funds (savers) and those who need
funds (borrowers). This process of financial intermediation facilitates the flow of money and
credit, thereby promoting economic growth and development.

Financial institutions offer various services, including:

1. Accepting deposits: They accept deposits from individuals, businesses, and governments in
various forms, such as savings accounts, checking accounts, and others.

2. Lending money: They lend money to individuals, businesses, and governments in the form
of loans, mortgages, and overdrafts.

3. Providing payment services: They facilitate the transfer of funds between individuals and
businesses through various payment methods, such as checks, debit cards, and credit cards.

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4. Managing investments: They offer investment services, such as mutual funds, stocks, and
bonds, to help individuals and businesses grow their wealth.

5. Providing financial advice: They offer financial advice and guidance to individuals and
businesses on various financial matters, such as budgeting, saving, and investing.

Overall, financial institutions play a vital role in the economy by facilitating the flow of money
and credit, providing financial services, and promoting economic growth and development.

Chapter Two

Banking System

A banking system is a network of financial institutions that provide financial services to

customers. These services include accepting deposits, making loans, and facilitating payments.
Banking systems are essential to the functioning of modern economies, as they provide the
means for individuals and businesses to manage their finances.

Banking systems are regulated by government agencies to ensure that they are safe and sound.
These agencies set rules and regulations that banks must follow, and they also monitor banks to
ensure that they are complying with the rules.

Banking systems are essential to the functioning of modern economies. They provide the means
for individuals and businesses to manage their finances, and they also facilitate the flow of
money throughout the economy.

2.1 Definition, Evolution and system of a Central Banking

Central banking refers to the financial institution or authority responsible for managing a
country's monetary system and regulating its financial institutions. Central banks play a crucial
role in maintaining economic stability, controlling inflation, and facilitating financial
transactions.

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Definition: A central bank is a financial institution that manages a country's monetary policy,
regulates banks, and provides financial services to the government and the banking system. It is
the apex of a country's financial system and acts as the lender of last resort.

Evolution: The concept of central banking has evolved over time, with the first central banks
emerging in Europe in the 17th century. The Bank of England, established in 1694, is considered
the oldest central bank in the world. Central banking gained prominence in the 20th century as
governments sought to regulate their economies and prevent financial crises.

System: The system of central banking varies from country to country, but some common
functions include:

1. Monetary Policy: Central banks control the money supply and interest rates to achieve
economic objectives such as price stability, full employment, and economic growth.

2. Financial Regulation: Central banks supervise and regulate banks and other financial
institutions to ensure their soundness and stability.

3. Government Banking: Central banks act as the government's banker, managing its
financial transactions and providing financial advice.

4. Lender of Last Resort: Central banks provide emergency loans to banks facing liquidity
problems, preventing financial crises.

Central banking is a complex and dynamic field that continues to evolve in response to changing
economic and financial conditions. Central banks play a vital role in maintaining the stability and
efficiency of the financial system, and their decisions have a significant impact on the economy
and the lives of citizens.

2.2 Central Banking Functions

Central banking functions are the duties and responsibilities carried out by central banks, which
are financial institutions that manage a country's monetary system and regulate the banking

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sector. Central banks play a crucial role in maintaining economic stability and facilitating
financial transactions within an economy.

Here are some of the key central banking functions:

1. Monetary Policy: Central banks are responsible for formulating and implementing monetary
policy, which involves managing the supply of money and credit in the economy. They use
various tools, such as interest rates, reserve requirements, and open market operations, to
influence the availability and cost of money, thereby influencing economic activity and
inflation.

2. Financial Stability: Central banks are tasked with ensuring the stability of the financial
system. They monitor and regulate financial institutions, including banks, to ensure they
operate safely and soundly. Central banks also act as lenders of last resort, providing
liquidity to banks during times of financial stress.

3. Payments System: Central banks oversee and facilitate the smooth functioning of the
payments system, which enables the transfer of funds between individuals, businesses, and
financial institutions. They ensure the security and efficiency of payment systems, including
electronic payments and real-time gross settlement systems.

4. Foreign Exchange: Central banks manage a country's foreign exchange reserves and play a
role in stabilizing the exchange rate of the domestic currency. They intervene in the foreign
exchange market by buying or selling foreign currencies to influence the value of the
domestic currency.

5. Financial Market Operations: Central banks conduct open market operations to influence the
supply of money and credit in the economy. They buy or sell government securities to inject
or withdraw liquidity from the financial system.

6. Lender of Last Resort: Central banks act as a lender of last resort to banks and other
financial institutions during times of financial crisis. They provide liquidity to banks that are
facing difficulties in obtaining funding from other sources, thereby preventing a systemic
financial crisis.

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In summary, central banking functions encompass a wide range of activities aimed at
maintaining economic stability, regulating the financial system, facilitating payments, managing
foreign exchange reserves, and ensuring the smooth functioning of financial markets.

2.3 Monetary Policy & its Objectives

Monetary policy refers to the actions taken by a central bank or other regulatory body to control
the supply of money and credit in an economy. Its primary objectives are to maintain price
stability, promote economic growth, and ensure financial stability.

Price Stability: Monetary policy aims to keep inflation within a targeted range. Inflation occurs
when the general price level of goods and services rises, reducing the purchasing power of
money. By controlling the money supply, central banks can influence inflation.

Economic Growth: Monetary policy can stimulate economic growth by increasing the money
supply, making it easier for businesses to borrow and invest. This can lead to increased
production, job creation, and overall economic expansion.

Financial Stability: Monetary policy helps maintain financial stability by preventing excessive
risk-taking in the financial system. Central banks can use various tools, such as reserve
requirements and interest rates, to manage the level of risk in the financial system.

In summary, monetary policy is a crucial tool used by central banks to achieve economic
objectives such as price stability, economic growth, and financial stability. It involves managing
the money supply and credit conditions to influence inflation, economic activity, and financial
risk.

2.4 Regulation of the financial system

The regulation of the financial system refers to the various mechanisms and measures put in
place by governments and regulatory bodies to oversee and control the activities of financial
institutions and markets. It aims to ensure the stability, integrity, and efficiency of the financial
system, protect consumers and investors, and mitigate systemic risks.

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Financial system regulation typically involves:

1. Prudential Regulation: This focuses on ensuring the safety and soundness of individual
financial institutions. It includes rules on capital adequacy, liquidity, risk management, and
corporate governance.

2. Market Conduct Regulation: This aims to protect investors and ensure fair and orderly
markets. It covers areas such as insider trading, market manipulation, and disclosure
requirements.

3. Systemic Risk Regulation: This addresses risks that could affect the entire financial system,
such as financial crises. It includes measures to promote financial stability, such as stress
testing, macroprudential policies, and resolution frameworks.

4. Consumer Protection Regulation: This aims to safeguard the interests of consumers of

financial products and services. It covers areas such as fair lending, credit reporting, and
consumer data privacy.

The specific regulations and approaches may vary among countries and jurisdictions, but the
overall goal is to maintain a sound and resilient financial system that supports economic growth
and development while minimizing the potential for financial instability and harm to consumers.

2.5 The role of National bank of Ethiopia in financial regulations

The central Bank of Ethiopia is known as National Bank of Ethiopia. The National Bank of
Ethiopia was established in 1963 by proclamation 206 of 1963 and began operation in January
1964.

Prior to this proclamation, the Bank used to carry out dual activities, i.e. commercial banking and
central banking.

The National Bank of Ethiopia has the following powers and duties:

• Prints and issues the legal tender currency, and regulates the country's money supply.

• Regulates the applicable interest rate and other cost of money charges.

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• Formulates implements and follows-up the country's exchange rate policy, and manages
and administers the international reserves of the country.

• Licenses, supervises and regulates the operations of banks, insurance companies and
other financial institutions.

• Sets limits on gold and foreign exchange assets, which banks, and other financial
institutions authorized to deal in foreign exchange and hold in deposits.

• Sets limits on the net foreign exchange positions and terms, and the amount of external
indebtedness of banks and other financial institutions.

• Provides short and long term refinancing facilities to banks and other financial
institutions and also accepts deposit of any kind from foreign sources.

• Promotes and encourages the dissemination of banking and insurance services throughout
the country.

• Prepares periodic economic studies, together with forecasts of the balance of payments,
money supply, prices and other relevant statistical indicators of the Ethiopian economy
useful for analysis and for the formulation and determination by the Bank of monetary,
saving and exchange policies.

• Acts as banker, fiscal agent and financial advisor to the Government.

• Represents the country in international monetary institutions and acts consistently with
international monetary and banking agreements to which Ethiopia is a party.

• Exercises and performs such other powers and activities as central banks customarily
perform.

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 Chapter Three

FINANCIAL SYSTEM

The word "system", in the term "financial system", implies a set of complex and closely
connected or interlined institutions, agents, practices, markets, transactions, claims, and liabilities
in the economy.

3.1 Meaning of Financial System

A financial system is a system that allows the transfer of money between savers and
borrowers. It comprises of a set of complex and closely interconnected financial institutions,
markets, instruments, services, practices, and transactions.

A financial system is a network of financial institutions, financial markets, financial instruments

and financial services to facilitate the transfer of funds. The system consists of savers,
intermediaries, instruments and the ultimate user of funds. The level of economic growth largely
depends upon and is facilitated by the state of financial system prevailing in the economy.
Efficient financial system and sustainable economic growth are corollary.

The financial system allows you to place your excess money into a savings account in a bank of
your choice. Keeping your money in a bank safeguards your savings, and the bank pays you
interest based on the amount you keep in your account. Money in deposit accounts, like savings
accounts, is used to provide loans for a wide range of projects to people and businesses.
Mortgages, car loans and student loans are financed largely by deposits in banks, savings
institutions and credit unions.

Basic features and functions of a financial system

Functions of a financial system–

 Channels funds from lenders to borrowers

 Creates liquidity and money

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  Provides a payments mechanism

 Provides financial services such as insurance and pensions

3.2 Basic features of a financial system

1. Financial system provides an ideal linkage between depositors and investors, thus encouraging
both savings and investments

2. It facilitates expansion of financial markets over space and time

3. Promotes efficient allocation of financial resources for socially desirable and economically
productive purposes.

4. Influences both quality and the pace of the economic development.

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• Financial Asset

Financial Asset is an asset that derives value because of a contractual claim. A financial asset is
an intangible asset whose value is derived from a contractual claim, such as bank
deposits, bonds, and stocks. Financial assets are usually more liquid than other tangible assets,
such as commodities or real estate, and may be traded on financial markets.

• Financial Markets

Financial Market is any marketplace where buyers and sellers participate in the trade of assets
such as equities, bonds, currencies and derivatives. Financial markets are typically defined by
having transparent pricing, basic regulations on trading, costs and fees and market forces
determining the prices of securities that trade.

Financial market provides three important economic functions:

1. Financial market determines the prices of assets traded through the interactions between
buyers and sellers;

2. Financial market provides a liquidity of the financial assets;

3. Financial market reduces the cost of transactions by reducing explicit costs, such as money
spent to advertise the desire to buy or to sell a financial asset.

Financial markets could be classified in to two by sequence of transactions for selling and buying
securities:

_ Primary market

_ Secondary market

All securities are first traded in the primary market, and the secondary market provides liquidity
for these securities.

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Primary market is where corporate and government entities can raise capital and where the first
transactions with the new issued securities are performed. If a company’s share is traded in the
primary market for the first time this is referred to as an initial public offering (IPO).

Secondary market - where previously issued securities are traded among investors. Generally,
individual investors do not have access to secondary markets. They use security brokers to act as
intermediaries for them. The broker delivers an order received from investors in securities to a
market place, where these orders are executed. Finally, clearing and settlement processes ensure
that both sides to these transactions honor their commitment.

Financial markets could be classified in to two by term of circulation of financial assets traded in
the market:

_ Money market;

_ Capital market

Money market - in which only short-term financial instruments are traded.

Capital market - in which only long-term financial instruments are traded.

The capital markets allow firms, governments to finance spending in excess of their current
incomes.

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• Financial Institutions

Financial Institutions are private (shareholder-owned) or public (government owned)

organizations that, broadly speaking, act as a channel between savers
and borrowers of funds (suppliers and consumers of capital).

Two main types of financial institutions (with increasingly blurred dividing line) are:
(1) Depository banks and credit unions which pay interest on deposits from the interest earned on
the loans, and

(2) Non-depository insurance companies and mutual funds (unit trusts) which collect funds
by selling their policies or shares (units) to the public and provide returns in
the form periodic benefits and profit payouts.

• Foreign Exchange Market

The foreign exchange market (forex, or currency market) is a global decentralized market for the
trading of currencies. This includes all aspects of buying, selling and exchanging currencies at
current or determined prices.

• Capital Market

A capital market is one in which individuals and institutions trade financial securities.
Organizations and institutions in the public and private sectors also often sell securities on the
capital markets in order to raise funds. Thus, this type of market is composed of both the primary
and secondary markets.

Any government or corporation requires capital (funds) to finance its operations and to engage in
its own long-term investments. To do this, a company raises money through the sale of securities
- stocks and bonds in the company's name. These are bought and sold in the capital markets.

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Stock Markets/ Equity market
Stock markets allow investors to buy and sell shares in publicly traded companies. They are one
of the most vital areas of a market economy as they provide companies with access to capital and
investors with a slice of ownership in the company and the potential of gains based on the
company's future performance.

Equity markets are the meeting point for buyers and sellers of stocks. The securities traded in the
equity market can be either public stocks, which are those listed on the stock exchange, or
privately traded stocks. Often, private stocks are traded through dealers, which is the definition
of an over-the-counter market.

Stock Exchanges

The place where stocks in the equity market are traded is the stock exchange. There are many
stock exchanges around the world, and they can be either physical places or virtual gathering
spots.

• Money Market

The money market is a segment of the financial market in which financial instruments with high
liquidity and very short maturities are traded. The money market is used by participants as a
means for borrowing and lending in the short term, from several days to just under a year.

• Credit Market

Credit Market is a marketplace for the exchange of debt securities and short-term commercial
papers.

Commercial paper is an unsecured, short-term debt instrument issued by a corporation, typically

for the financing of accounts receivable, inventories and meeting short-term

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liabilities. Maturities on commercial paper rarely range any longer than 270 days. The debt is
usually issued at a discount, reflecting prevailing market interest rates.

• Primary Market

A primary market issues new securities on an exchange. Companies, governments and other
groups obtain financing through debt or equity based securities. Primary markets, also known as
"new issue markets," are facilitated by underwriting groups, which consist of investment banks
that will set a beginning price range for a given security and then oversee its sale directly to
investors.

The primary markets are where investors have their first chance to participate in a new security
issuance. The issuing company or group receives cash proceeds from the sale, which is then used
to fund operations or expand the business.

• Money Market Instruments

The money market is the arena in which financial institutions make available to a broad range of
borrowers and investors the opportunity to buy and sell various forms of short-term securities.
There is no physical "money market." Instead it is an informal network of banks and traders
linked by telephones, fax machines, and computers.

Although securities purchased on the money market carry less risk than long-term debt, they are
still not entirely risk free. After all, banks do sometimes fail, and the fortunes of companies can
change rather rapidly. The low risk is associated with lender selectivity. The lender who offers
funds with almost instant maturities ("tomorrow") cannot spend too much time qualifying
borrowers and thus selects only blue-chip borrowers. Repayment therefore is assured (unless you

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caught Enron just before it suddenly nose-dived). Borrowers with fewer credentials, of course,
have difficulty getting money from this market unless it is through well-established funds.

Capital market instruments are responsible for generating funds for companies, corporations and
sometimes national governments. These are used by the investors to make a profit out of their
respective markets.

There are a number of capital market instruments used for market trade, including – Stock,
Bonds, Treasury-bills, Foreign Exchange, Fixed deposits, and others.

Capital market is also known as Securities Market because long term funds are raised through
trade on debt and equity securities. These activities may be conducted by both companies and
governments.

Chapter Four

Financial Institutions and its services

The various financial institutions generally act as the intermediaries between the capital market
and debt market. But the service provided by financial institution depends on its type. The
financial institutions are also responsible to transfer funds from investors to the companies.
Typically, these are the key entities that control the flow of money in the economy. The services
provided by the various types of financial institutions may vary from one institution to another.

4.1 Depository Institutions

Depository institutions are financial institutions that raise loanable funds by selling deposits to
the public or in other words they are those institutions whose funds come significantly from
customer deposits.

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The primary functions of financial institutions of this nature are:
 Accepting Deposits;
 Providing Commercial Loans;
 Providing Real Estate Loans;
 Providing Mortgage Loans; and
 Issuing Share Certificates.

Depository institutions can also be generally categorized in to commercial banks and other
depository institutions (such as saving and loan institutions, credit unions, and microfinance
institutions).

Depository institutions are popular financial institutions for the following reasons:

1. They offer deposit accounts that can accommodate the amount and liquidity
characteristics desired by most surplus units.
2. They repackage funds received from deposits to provide loans of the size & maturity
desired by deficit units.
3. They accept the risk on loans provided.
4. They have more expertise than individual surplus units in evaluating the credit worthiness
of deficit units.
5. They diversify their loans among numerous deficit units and therefore can absorb
defaulted loans better than individual surplus units could.

4.1.1 Commercial Banks

Commercial Banks are institutions that offer deposit and credit services as well as a growing list
of newer services as investment advice, security underwriting, selling insurance and financial
planning.
1. Functions of Commercial Banks
Commercial banks play an indispensable roll in the economic activities of every country.
Accordingly, the following are among the main functions of the commercial banks:

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 They process payments with the help of online banking, telegraphic transfer, debit card, and
other methods;
Acceptance of funds on term deposits;
Issuance of bank checks and bank drafts; a check drawn by a bank on its own funds
Safe custody of important documents and other valuable items in safe deposit vaults or safe
deposit boxes;
Providing loans through installment loans, overdrafts, and others; and
Foreign exchange services.

2. Importance of Commercial Banks

 Banks are principal means of making payments.

 Create money from excess reserves of public deposits.
 Use excess cash reserves to make loans and investments.
 They are principal channel for government monetary policy.

3. Classification of Commercial Banks

Commercial banks can be classified in different types depending on their activities or as
per their functions in the economy. The following classification is the common one.

I. Unit Banking
A banking business operating a single banking office
All operations housed in a single office
II. Branch Banking
A single bank that offers a full-fledged services in two or more offices across
the country, including offices abroad
Home office is the largest branch in the system
III. Correspondent Banking
An arrangement whereby a bank maintains deposit balance with other banks at a
distant place for a variety of services and assistance

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 The practice can take place within the local environment among local banks or
overseas

4. Activities and Services of Commercial Banks

Activities of commercial banks can be too much; however, the following are the main and
common activities that are crucial in the economic and commercial system of any country.

A. LOANS AND ADVANCES

Commercial Banks gives various types of loans and advances to various business sectors. The
major ones include Domestic trade, Import and export trade, Agriculture, Hotel and tourism,
Manufacturing, Construction, Transport, Services (education, health, etc), and others. Most of
these loans are extended to customers on the basis of collaterals. The commonly acceptable
collaterals are: Buildings/Houses, Motor vehicles, Bank guarantees, and Unconditional Life
Insurance at surrender value.
 Types of Credit Facilities
The main forms of credit facilities issued by the Commercial Banks are:

1. Term Loan
A term loan is a loan granted to customers to be repaid with interest within a specific period of
time. The loan can be repaid in periodic installments or in a lump sum on the due date of the
loan, as the case may be. This loan is granted in three forms, i.e., short-term, medium-term and
long-term loan.

B. OVERDRAFT

An overdraft (O/D) is a credit facility by which a customer can withdraw in excess of her/his/its
current account balance up to the limit approved by the Bank. The purpose of the loan is to
finance the day-to-day operational needs of a viable business. In order to use O/D facility,
applicants have to open a current account. The O/D account should have a proper turnover by
way of withdrawals and deposits. However, an O/D account should not be overdrawn.
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C. DEPOSITS SERVICES

Commercial Banks also provide different types of deposit services. The main ones are described
in the following section:
1. Special Demand Deposit Account
Special Demand Deposit Account (SDDA) is a non-interest bearing deposit account operated
by a saving like passbook and vouchers.
2. Saving Account
It is an interest-bearing deposit account. Saving account may be opened and operated by
individuals and organizations, resident and non-resident. Saving account is maintained for
various reasons.

 Saving accounts may be classified in to various categories. The major ones are discussed
below:
a. Private saving account: Such account is opened by individual Person

b. Joint Accounts:

 And Account
 And/or Accounts.
c. Company Accounts

d. Accounts of Churches, Mosques, Missions, etc.

e. Earmarked Accounts: This includes Club Accounts, Private Accounts, and the like.

f. Special Accounts

 Tutor account: Tutor accounts are opened in the name or names of minors followed
by the word “minor” or “minors.”
 Liquidator account: Liquidators’ account is opened in the name of a person or
company but appointed by court as liquidator in bankruptcy.
 Interdicted accounts: Interdicted accounts are saving accounts opened in the name
of the interdicted/Sanctioned person.

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  Staff accounts: Staff accounts are saving accounts like the individual accounts
opened for the employee of the Bank.

3. Fixed (time) Deposit

A time-deposit account is a deposit account that bears interest based on the duration of the
deposit. Parties who can open such account include individuals, sole-proprietorship, and
partnership.
4. Current Account
Current account, also called demand deposit or checking account, is a non-interest-bearing
deposit account that is operated by checks.
The unique features of current account are: A non-interest-bearing deposit account with a check
book facility and Overdraft facility permitted in connection with checking account. Current
account may be opened by individuals and organizations, resident and non-resident, and Non-
literates and minors. Current or Demand Deposits may be classified under the following
categories:
5. Diaspora Account

These types of accounts are opened for people living abroad (who live more than one year
abroad) and citizens by origin but with different nationalities that are referred as eligible citizen.

D. MONEY TRANSFERS

It is a means of transferring funds through banks to individuals or organizations. Users of money

transfer include individuals, workers, students, members, travelers, organizations, private
organizations, cooperatives, public enterprises, and government.

The main features of money transfers include:

 Transfers are made between branches of the bank
 Transfers are made between branches of different cities or towns.
 Availability of telecommunication and local post offices enhances the smooth flow of
transfers between branches.

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E. FOREIGN CURRENCY

It involves buying and selling foreign currency, cash notes, traveler's checks, and drafts for the
following purposes:
 Holiday travel expenses,
 Business travel allowances,
 Medical expenses,
 Educational expenses, and
 Seminars, workshops, symposium, conference, and training fees, etc

F.GUARANTEE SERVICES

A guarantee is a promise to answer ' for the debt, default or miscarriage of another' if that person
fails to meet the obligation in a contractual agreement. Primary liability for the debt is incurred
by the principal debtor. The guarantor incurs secondary liabilities (becomes liable if the principal
debtor fails to pay or perform). A guarantee is evidenced by a written document signed by the
guarantor. There are various types of guarantees.

Some of them are discussed below:

1. Bid bond guarantee. It is issued by the bank upon the request by the
bidder expressing the bank's commitment to meet the claims of the beneficiary in case the
bidder withdraws from the bid during the bid period or fails to accept the award when
s/he becomes a winner.
2. Performance bond guarantee It is issued by the bank in favor of a bid
organizer (beneficiary) at the request of the bid winner to meet any claims to be made by
the beneficiary in case the bid winner fails to deliver the goods or perform the service as
per their agreement.
3. Advance payment guarantee: It is issued by the bank in favor of the buyer
who makes the advance, at the request of the seller or contractor who received the
advance payment, representing the bank's commitment to repay the sum in the event that
the seller fails to honor the contract terms in their entirety or in part.

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4.1.2 Other Depository Institutions

Stable financial institutions are an important component of well-functioning financial Systems,

as it has been vividly demonstrated by recent developments around the globe. When banking or,
other depository financial institutions temporarily break down or operate ineffectively, the ability
of firms to obtain funds necessary for continuing existing projects and pursuing new endeavors is
curtailed. Severe disruptions in the intermediation process can even lead to financial crises and,
in some cases, undo years of economic and social progress.

The following are among the other depository institutions (in addition to banks) which play
significant role in the economic and financial system of every country.

1. Savings and Loans Associations

A savings and loan association is a financial institution that specializes in accepting savings
deposits and making mortgage loans. They are often mutually held (often called mutual savings
banks), meaning that the depositors and borrowers are members with voting rights and have the
ability to direct the financial and managerial goals of the organization

2. Credit Unions
Credit Unions are house hold oriented intermediaries, offering deposit and credit services to
individuals and families. They are cooperative, self-help association of individuals rather than
profit motivated institutions accepting deposits from and making loans to their members, all of
whom have a common bond, such as working for the same employer. They offer low loan rates
and high deposit interest rates and have relatively low operating costs. The members of a credit
union are owners receiving dividends and sharing in any losses that occur. Credit Unions
usually report low default and delinquency rates and organized around a common affiliate.

The major difference between the credit unions and banks is that
the credit unions are owned by the members having accounts in it.

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 3. Micro-Finance Institutions
Micro finance is defined as the provision of financial intermediation through distribution of
small loans acceptance of small savings and the provision of other financial products and
services to the poor. A micro finance institution (MFI) is an organization that offers financial
services to the very poor. They are making small loans available to the poor through schemes
specially designed to meet the Poor’s particular needs and circumstances. The main focus of
micro financing is on the poor through provision of small credit and acceptance of small savings.

3.2 NON DEPOSITARY INSTITUTIONS

Unlike depository institutions, non-depository institutions do not accept checkable deposits.

Non-depository institutions serve various functions in financial markets, ranging from financial
intermediation to selling insurance against risk.

Chapter Five

Non-Bank Finance

5.1 Insurance

Insurance can be defined from the view points of the individual and the society. From an
individual point of view insurance is an economic device whereby the individual substitutes a
small certain cost (the premium) for a large uncertain financial loss (the contingency insured
against) that would exist if it were not for the insurance.

Insurance is the protection against financial loss. The creation of the counterpart of risk is the
primary function of insurance. Insurance doesn’t evade the uncertainty for the individual as to
whether the event will occur, nor does it alter the probability of occurrence, but it does reduce
the probability of financial loss concerned with the event.

From the viewpoint of the society, insurance is an economic device for reducing and eliminating
risk through the process of combining a sufficient number of homogenous exposures into a group
to make the losses predictable for the group as a whole. From the viewpoint of the insured,

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 insurance is a transfer device. From the viewpoint of the insurer, insurance is a retention and
combination device.

 Major Classes of Insurance Companies

Insurance companies create insurance policies by grouping risks according to their focus. This
provides a measure of uniformity in the risks that are covered by a type of policy, which in turn
allows insurers to anticipate their potential losses and set premiums accordingly. Insurance
Companies may be classified in to life insurance companies and Non-life (Property-casualty)
insurance companies.

I. Life Insurance Companies

There are four major perils that can destroy, wholly or partially, the economic value of a human
life. These include premature death, loss of health, old age, and unemployment which are
categorized under personal risk. Every person faces two basic contingencies concerning life.

financial compensation amounting to the sum assured if the insured faces premature death while
the policy is in force. It gives the family financial security for a certain period.

In general, there are many different types of life insurance, but the standard arrangement is a
contact specifying that upon death of the person whose life is insured, a stated sum of money (the
policy's face amount) is paid to the person designated in the policy as he beneficiary.

Life insurance is a risk-pooling plan, which is an economic plan through which the risk of
premature death is transferred from the individual to the group.

Not all people need exactly the same kind of protection from life insurance. It is so because there
are differences in ages; incomes and financial obligations; the number of their dependents; and
other related variables. To provide all the different types of protection that are needed, insurance
companies offer a variety of policies.

II. Non-life Insurance

Non-life insurance is also called property-casualty insurance and can be divided in to property
insurance and casualty (liability) insurance. Property insurance involves coverage related to loss,

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damage or destruction of real and personal property. Properties to be covered, range from
personal jewelry to industrial plant and machinery. Property insurance is intended to indemnify
the loss suffered by the insured. Indemnity may be in the form of payment of money, repair,
replacement or re-instatement. Casualty insurance, on the other hand, provides protection
against legal liability exposure resulting from negligence. Payment is made to the injured third
party by the insurance company.
 Reinsurance
Reinsurance is the shifting of part or all of the insurance originally written by one insurance to
another insurer.

5.2 Pension Fund

A Pension fund is a pool of assets forming an independent legal entity that are bought with the
contributions to a pension plan for the exclusive purpose of financing pension plan benefits.
Pension funds are savings plan through which fund participants accumulate savings during their
working days so that they withdraw the fund during their retirement years.

A pension plan is a promise by a pension plan sponsor to a plan member to provide a pension
upon retirement. The sponsor may be a company, an employer, a union or a jointly trusteed plan
where both management and unions in an industry appoint trustees to a board which manages the
plan. This promise is legally stated in the "pension plan document" which states the provisions
for the plan. Pension plans may be regulated by governments or financial institutions.

A trustee is appointed to hold the assets in trust for the benefit of the plan members. Usually the
trustee is also the custodian, which holds the plan investments. Pension plans usually hire an
outside investment manager to invest the plan assets. The sponsor may also appoint an
"investment consultant" to advice on investment issues and help select and assess the
performance of investment managers.

5.3 Mutual Funds

A mutual fund is a type of investment that pools money from many people to invest in a variety
of assets like stocks, bonds, or other securities. Mutual funds are investment vehicles that pool

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 money from many investors and invest it in a variety of assets, such as stocks, bonds, and money
market instruments. They are managed by professional money managers who make investment
decisions on behalf of the fund's shareholders.

Mutual funds offer several advantages to investors, including:

 Diversification: Mutual funds provide investors with exposure to a wide range of investments,
which can help to reduce risk.
 Professional management: Mutual funds are managed by experienced investment professionals
who have the knowledge and expertise to make sound investment decisions.
 Liquidity: Mutual funds can be easily bought and sold, making them a liquid investment.
 Affordability: Mutual funds are available to investors of all income levels.
Mutual funds also have some disadvantages, including:

 Fees: Mutual funds charge fees for their management and operating expenses.
 Risk: Mutual funds are subject to market risk, which means that their value can fluctuate.
 Lack of control: Investors do not have control over the investment decisions made by the fund's
manager.
Overall, mutual funds can be a good investment for those who are looking for a diversified,
professionally managed, and liquid investment. However, it is important to understand the fees
and risks involved before investing in a mutual fund.

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