Chapter 5

FINANCIAL INSTITUTIONS AND

INTERMEDIARIES
FINANCIAL INSTITUTIONS AND INTERMEDIARIES: AN OVERVIEW
Financial institution – a company engaged in the business of dealing with financial and
monetary transactions such as deposits, loans, investments, and currency exchange.
- Include banks, trust companies, insurance companies, brokerage firms and investment
leaders
The financial system matches savers and borrowers through two channels:
1. Financial markets, and
2. Banks and other financial intermediaries

Financial intermediaries – is a financial firm, such as a bank, that borrows funds from savers
and lends them to borrowers.

Basic Structure of Financial Institutions/Intermediaries

A. Depository Institutions
1. Commercial banks/Universal Banks
2. Savings and Loans Associations
3. Mutual Savings Bank
4. Credit Union
B. Contractual Saving Institutions
1. Insurance Companies
a. Life insurance companies
b. Property and casualty
2. Pension Funds
a. Defined contribution plan
b. Defined benefit plan
C. Investment Intermediaries
1. Investment Banks
2. Mutual Funds
a. Closed-end mutual funds
b. Open-end mutual funds
3. Hedge Funds
4. Finance Companies
a. Consumer finance companies
b. Business finance companies
c. Sales finance companies
5. Money Market Mutual Funds

PRIMARY ASSETS AND PRIMARY LIABILITIES OF FINANCIAL INTERMEDIARIES

Type of Intermediary Primary Liabilities Primary Assets

(Sources of (Uses of Funds)
Funds)
Depository Institutions
 Commercial banks  Deposits  Business and consumer loans,
mortgages, National government
securities and municipal bonds
 Savings and loan  Deposits  Mortgages
associations
  Mutual savings bank  Deposits  Mortgages
 Credit Unions  Deposits  Consumer loans
Contractual Savings Institutions
 Life insurance companies  Premium from  Corporate bonds mortgages
policies
 Fire and casualty  Premium from  Government bonds, corporate bonds
insurance companies policies and stock, National government
securities
 Pension funds  Employer and  Corporate bonds and stock
employee
contributions
Investment Intermediaries
 Mutual funds  Shares  Stocks, bonds
 Hedge funds  Shares  Stocks, bonds, derivatives
 Finance companies  Commercial  Consumer and business loans
paper, stocks,
bonds
 Money market mutual  Share  Money market instruments
funds

BASICS OF COMMERCIAL BANKING

Commercial banking is a business. Banks fill a market need by providing a service, and they
earn a profit by charging customers for that service.

Sources of
deposits
Funds
Banks

Uses of Funds loans

Key Commercial Banking Activities

1. Taking deposits from savers, and
2. Making loans to households and firms

The Bank Balance Sheet

1. Bank Assets
a. Funds received from depositors,
b. Borrowed funds
c. Funds from shareholders, and
d. Profits from operations
Most Important Bank Assets
 Reserve and other cash assets
 Securities
 Loans receivable
 Other assets
2. Bank Liabilities
 a. Demand or Current Account Deposits
b. Nondemand deposits
c. Borrowings
3. Bank Capital
- a.k.a shareholder’s equity
- a.k.a bank net worth

Basic Operations of a Commercial Bank

 When a depositor puts money in a checking account and the bank uses the money to
finance a loan, the bank has transformed a financial asset (a deposit) for a saver into a
liability (a loan) for a borrower.

Example:
Suppose you used a Php 1,000.00 to open a checking account at a Philippine Commercial Bank
(PCB). As a result,
a. PCB acquires Php 1,000.00 in vault cash which counts as part of its reserves, and
b. PCB lists your Php 1,000.00 as a liability in the form of current account (CA)
deposits.

PCB
Assets Liabilities
Cash-in- Php Current Account Php
Vault 1,000.00 Deposits 1,000.00

Suppose that PCB held no excess reserves before receiving your Php 1,000.00 deposit and that
banking regulations require banks to hold 10% of their current account deposits as reserves.
Therefore,
a. Php 100.00 of the Php 1,000.00 is required reserves, and
b. The other Php 900.00is excess reserves

PCB
Assets Liabilities
Required Php Current Account Php
Reserves 100.00 Deposits 1,000.00
Excess Reserves
900.00

Suppose that BSP uses its excess reserves to buy Treasury bills worth Php 300.00 and make a
loan worth Php 600.00.
PCB
Assets Liabilities
Reserve Php Current Account Php
s 100.00 Deposits 1,000.00
Securiti
es 300.00
Loans 600.00

 PCB has used your Php 1,000.00 deposit to provide funds to the National Treasury and
to the person or business it granted loan to.
 By using your deposit, the bank acquired interest-earning asset.
 If what the PCB earns on this asset is greater than the interest the bank pays you on
your deposit, then PCB will earn a profit on these transactions.

The difference between the average interest rate banks receives on their assets
and the average interest rate they pay on their liabilities is called the bank’s
spread.
Management of Bank Assets
1. Banks try to find borrowers who will pay high interest rates and will most likely settle
their loans on time. BY adopting conservative loan policies, banks avoid high default
rate but may miss out on attractive lending opportunities that earn high interest rates.
2. Bank try to purchase securities with high returns and low risk. By diversifying and
purchasing many different type of assets (short-term and long-term, treasury bills)
banks can lower risk associated with investments.
3. Banks manage the liquidity of the assets so that its reserve requirements can be met
without incurring huge costs. This implies that liquid securities must be held even if they
earn a somewhat lower return than other assets. The bank must balance its desire for
liquidity against the increased earnings that can be obtained from less liquid assets
such as loans.

Management of Bank Liabilities

 Banks aggressively set target goals for their asset growth and tried to acquire funds (by
issuing liabilities) as they were needed.

Management of Bank Capital

 In determining the among of capital, managers must decide how much of the increased
safety that comes with high capital (the benefit) they are willing to trade off against the
lower return on equity that comes with higher capital (the cost).
 Because of the high cost of holding capital to satisfy the requirement set by regulatory
authorities, bank managers often want to hold less capital than is required.

Bank Capital and Bank Profit

Bank Revenues
a. Interest on securities and loans
b. Fees and charges for credit and debit cards
c. Servicing deposit accounts
d. Providing financial advice and wealth management services
e. Originating and collecting payments on securitized loans
f. Carrying out foreign transactions
Bank Costs
a. Interest paid to depositors
b. Interest paid on loans and other debt
c. Cost of providing services

Formulas:

Interest received on deposits and - Interest paid on deposits and

Net Interest Margin
loans debt
=
Total Value of Earnings Assets

After-tax
ROA
profit
=
Bank Assets

After-tax
ROE
profit
=
Bank Capital

*ROA – return on assets

ROE – return on equity.
 The ratio of assets to capital is one measure of bank leverage.
  The ratio of capital to assets is called a bank’s leverage ratio.
Leverage – a measure of how much debt an investor assumes in making an investment.
Managing Bank Risk
A. Managing Liquidity Risk
Liquidity risk – the possibility that a bank may not be able to meet its cash needs by
selling assets or raising funds at a reasonable cost.
 Asset management
 Liquidity management

B. Managing Credit Risk

Credit risk – the risk that borrowers might default on their loans
 Diversification of investors
 Credit-risk analysis
 Collateral
 Credit rationing
 Monitoring and restrictive covenant
 Long-term business relationships

C. Managing Interest-Rate Risk

 A rise in the market interest rate will lower the present value of a bank’s assets
and liabilities.
 A fall in the market interest rate will raise the present value of bank assets and
liabilities.
 Floating-rate loans
 Interest-rate swaps

EXPANDING THE BOUNDARIES OF BANKING

Between 1960 and 2018, banks
i. Increased the amount of funds they raise from time deposits and negotiable certificate
of deposits,
ii. Increased their borrowings from repurchase agreements,
iii. Reduced their reliance on commercial and industrial loans and on consumer loans,
iv. Increased their reliance on real estate loans, and
v. Expanded into nontraditional lending activities and into activities where their revenue is
generated from fees rather than from interest.

Off-Balance-Sheet Activities
1. Loan commitments – in a loan commitment, a bank agrees to provide a borrower with a
stated amount of funds during a specified period of time. The fee is usually split into two
positions:
a. Upfront fee when the commitment is written, and
b. Non-usage fee on the unused portion of the loan

2. Standby letters of credit – the bank commits to lend funds to the borrower – the seller of
the commercial paper- to pay off its maturing commercial paper.
This is also availed of in connection with importation of goods by the businessmen.

3. Loan sales – a financial contract in which bank agrees to sell the expected future returns
from an underlying bank loan to a third party.
- Also called secondary loan participations involve sale of loan contract without
recourse.

4. Trading activities – banks earn fees from trading in the multi-billion-dollar markets for
futures, options, and interest-rate swaps.
Investment Banks
 a. Investment banks – assist in the initial sale of securities in the primary market.
b. Securities brokers and dealers – assist in the trading of securities in the secondary
market.
c. Venture capital firms – provide funds to companies not yet ready to sell securities to the
public.
Role of Investment Banks
Investment banks work with large companies, other financial institutions such as investment
houses, insurance companies, pension funds, hedge funds, governments, and individuals who
are very wealthy and have private funds to invest.

1. Corporate advising – they help companies take part in merger and acquisitions, create
financial products to sell, and bring new companies to market.
2. Brokerage division – provides mediation between those who want to buy shares and
those who want to sell shares
Typical Divisions within Investment Banks
1. Industry coverage groups, and
2. Financial products groups

Types of Firms Engaged in Investment Banking

a. Bulge Bracket Banks
i. Trading, all types of financing, asset management services
ii. Equity research and insurance
iii. M&A services
b. Middle-Market Banks
i. Equity and debt capital market services
ii. Financing and asset management services
iii. M&A and restructuring deals
c. Boutique Banks
 Regional boutique banks
 Elite boutique banks

Areas of Business
A. Brokerage
1. Proprietary trading
2. Acting as a broker
3. Research
B. Corporate Advising
1. Bringing companies to market
2. Bringing companies together
3. Structuring products