CHAPTER 3

Non-Depository Financial Institutions

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Non-depository Institutions

 Insurance Companies
 Securities Firms
 Brokerage firms
 Investment banks
 Mutual fund companies
 Finance Companies
 Government Sponsored Enterprises

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Insurance Companies

 Insurance companies began hundreds of

years ago with long sea voyages
 The most famous insurance company,
Lloyd’s of London, was established in 1688
 Besides insuring traditional assets like
airplane and ships, it also insures
singers’ voices, pianists’ fingers and
even food critics’ taste buds

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Insurance Companies

 Underwriting process refers to the risk

assessment and loss reimbursement
guarantee by the individual risk experts of the
relevant field joining together to form a
syndicate.
 When an insurance contract is offered, these
syndicates sign up for a certain portion of the
risk in return for a portion of the risk
premiums

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Insurance Companies

 Insurance process
 Insurance companies accept premiums in
exchange for the promise of compensation if
certain event occurs
 A home owner pays premium in return for the promise
that if the house burns down, the insurance company
will pay to rebuild it
 So for individuals, insurance is way for
transferring the risk

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Insurance Companies

 In terms of financial system as a whole,

insurance companies:
 Pool small policies and make large investments
 Diversify risks across a large population
 Screen and monitor policyholders to mitigate the
problem of asymmetric information

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Insurance Companies

 Two Types of Insurance Company:

 life insurance
 property and casualty insurance

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 Insurance Companies
 Type of Life insurance
 Term life insurance
 which makes a payment to the insured’s beneficiaries
upon the death of the insured
 Group insurance is obtained through employers

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Insurance Companies
 Whole life insurance
 Combination of term life insurance and a savings
account
 A payment of a fixed premium over lifetime in return for
a fixed benefit in case of death of policy holder
 The cash value can be refunded if the policyholder
decides to discontinue the policy
 Over the years, the emphasis shifts from insurance to
savings

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Insurance Companies

 Property and casualty Insurance

 Auto insurance is a combination of property
insurance on the car and casualty insurance on
the driver
 The policyholder pays premium in exchange for
protection

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Insurance Companies

 Balance sheet
 Liabilities
 Promises to policyholders
 Assets
 Combination of bonds and stocks
 Short term money market instruments (in case of
property and casualty insurance)

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Insurance Companies

 The Role of Insurance Companies:

 Insurance companies pool risk to generate
predictable payouts
 Adverse selection and moral hazard create
problems in the insurance market that are worse
than those in the stock and bond markets
 Cancer Patients
 Fire Insurance

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Insurance Companies
 To deal with this, insurance companies carefully
screen applicants before issuing them policies
 Medical Examination
 Driving Records
 Policies may also include restrictive covenants in
order to reduce moral hazard
 Fire extinguishing system and training
 careful

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Insurance Companies

 The future of insurance must be considered

in the light of advances in medical
technology, particularly with regard to the
decoding of the human genome.
 In the future, people with inherited tendencies
toward certain diseases may not be able to
get insurance

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Securities Firms

 The broad class of securities firms include

brokerages, investment banks, and mutual
fund companies.
 In one way or another, these are all financial
intermediaries
 The primary services of brokerage firms are
accounting and the provision of access to
secondary markets.

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Securities Firms

 They also provide loans to customers who

wish to purchase stock on margin, and they
provide liquidity by offering check-writing
privileges and by allowing investors to sell
assets quickly
 All securities firms are very much in the
business of producing information; but this is
truly at the heart of the investment banking
business

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Securities Firms

 Investment banks are the conduits through

which firms raise funds in the capital markets
 Through their underwriting services,
investment banks issue new stocks and a
variety of other debt instruments

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 Securities Firms
 In underwriting, the investment bank guarantees
the price of a new issue and then sells it to
investors at a higher price;
 However, this is not without risk, since the selling price
may not in fact be higher than the price guaranteed to
the firm issuing the security

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Securities Firms

 Information and reputation are central to the

underwriting business;
 underwriters collect information to determine the
price of the new securities and then put their
reputations on the line when they go out to sell the
issues
 In addition to underwriting, investment banks
provide advice to firms that wish to merge with
or acquire other firms, for which advice they
are paid a fee
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Finance Companies

 Finance companies raise funds in the

financial markets by issuing commercial
paper and securities and use the funds to
make loans to individuals and corporations
 These companies are largely concerned with
reducing the transactions and information
costs that are associated with intermediated
finance

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Finance Companies

 Most finance companies specialize in one of

three loan types:
 consumer loans,
 business loans,
 sales loans (for example, the financing for a
consumer to purchase a large-ticket item like an
appliance).
 Some also provide commercial and home
mortgages

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Finance Companies

 Business finance companies provide loans to

businesses, for equipment leasing
 Business finance companies also provide
short-term liquidity to firms by offering
 inventory loans (so that firms can keep the
shelves stocked)
 accounts receivable loans (which provide
immediate resources against anticipated revenue
streams)

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 Government-Sponsored Enterprises
 The government is directly involved in the financial
intermediation system through loan guarantees
and in the chartering of financial institutions to
provide specific types of financing
 Zarai Taraqiati Bank Limited (ZTBL)
 Small and Medium Enterprise (SME) Bank
 House Building Finance Corporation (HBFC)
 Khushhali Bank

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Financial Conglomerates
 Own and operate several different types of
financial intermediaries and institutions
 Alleged advantages of forming financial
conglomerates include taking advantage of
 Economies of scale - gains from size that may result
from several firms
 Streamline management
 Eliminate duplication of effort of several separate firms
 Economies of scope
 Advantages to firms being able to offer customers several
financial services under one roof
 Diversification
 Branching out of financial conglomerates into several product
lines

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Types of Pension Plans

 Contributory Plans
 Both employee and employer contribute
 Noncontributory Plans
 Only the employer contributes

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Types of Pension Plans

 Public Pension Plans

 Can be sponsored publicly (governmental units)
 U.S. retirement plan assets
 One-third assets managed by public pension
plans sponsored by:
 State and local government employees
 Federal civilian employees
 Railroad retirement
 Social Security’s Old-Age, Survivor and Disability
Insurance program

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Types of Pension Plans

 Private Pension Plans

 Sponsored by single corporation, union, small
business or individual
 Two-thirds of all pension assets sponsored
and managed by:
 Private pension funds
 Mutual funds
 Banks
 Brokerage firms
 Life insurers

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