Financial Institutions Overview

Introduction to Financial Institutions

• Economic growth depends on increasing savings and investment.
• The primary goal of a financial system is to encourage savings and channel them into investments.
• Transformation of savings into investment fuels economic growth, job creation, and higher living standards.

Components of the Financial System

• The Financial System consists of institutions, instruments, and markets.
• The system includes savers, intermediaries, markets, and those who use savings for investment.

Financial Intermediaries (FI)

• FIs include commercial banks, savings and loan associations, investment companies, insurance companies, and pension funds.
• They provide a steady and inexpensive flow of funds from savers to investors or final users.
• FIs serve individuals, households, corporations, small businesses, new businesses, and governments.

Importance of Financial Institutions

• Financial institutions change assets acquired through the market into a preferable type of asset, which becomes their liability.
• They exchange assets on behalf of customers and for their own accounts.
• Financial institutions aid in creating financial assets for customers and then sell these assets to other market participants.
• Investment advice and portfolio management are offered to other market participants.

Role of Financial Intermediaries

• Financial intermediaries gather funds by issuing financial claims to market participants.
• Gathered funds are then invested into loans or securities (direct investments).
• Market participants holding claims issued by financial intermediaries have made indirect investments.
• Financial intermediaries mobilize savings, act as depositories, and provide credit or finance.
• They also offer various financial services to the community.

Functions of Financial Institutions

• Financial institutions transform services by accepting deposits as liabilities.
• Deposits are converted into assets, like loans, a function known as liability-asset transformation.
• They provide large volumes of finance based on small deposits, which is called size transformation.
• Risk is reduced through diversification, known as risk transformation.
• FIs offer savers various deposit options based on liquidity preferences.
• FIs provide borrowers with loan maturity, a process known as maturity transformation.

Maturity Intermediation

• Banks transform short-term assets into long-term for borrowers and financial assets for the desired investment horizon of depositors.
• Maturity intermediation increases depositors' maturity choices and provides borrowers greater choice in debt obligation lengths.
• It reduces the cost of long-term borrowing.

Reducing Risk via Diversification

• Diversification is the economic function of transforming riskier assets into less risky ones through financial intermediaries.
• Investment companies diversify funds in a large number of company stocks.
• Diversification reduces risk for investors with a small sum to invest.
• Although it's possible to diversify on their own, individual investors may not achieve the same cost-effectiveness with financial intermediaries.

Reducing Costs of Contracting and Information Processing

• Information processing costs equal opportunity cost plus the cost of collecting information.
• Financial intermediaries manage large funds, which allows them to have economies of scale in contracting and information processing.
• Lower information processing costs benefit investors purchasing financial claims and issuers with lower borrowing costs.

Providing a Mechanism of Payments

• Financial intermediaries support payments through methods, such as cheques, credit cards, and electronic funds transfers.

Asset Liability Management of Financial Institutions

• Liabilities dictate the investment strategy pursued by a financial institution.
• Liabilities equal the timing and cash outlays required by contractual obligations.
• Liabilities of a financial institution are categorized into the following four types:
• Type I: Known amount and timing of cash outlay. Example is fixed rate deposit.
• Type II: Known amount and uncertain timing of cash outlay. Example is life insurance policy.
• Type III: Uncertain amount and known timing of cash outlay. Example is certificates of deposit with fluctuating interest rates.
• Type IV: Uncertain amount and timing of cash outlay. Example is automobile/home insurance policies.

Liquidity Concerns

• Uncertainty about the amount and timing of cash outlays requires preparation to satisfy obligations.
• Liquidity concerns also include possible reductions in cash inflows and inability to obtain deposits.
• Depositors may request withdrawal of funds from certificates of deposit before maturity, requiring the institution to grant withdrawal but assess penalties.

Advantages of Financial Institutions

• Reduction of information and transaction costs.
• FIs extend long-term loans.
• Provision of liquid claims and pooling of risks.
• Banks mobilize insured savings, reducing costs for borrowers/lenders.
• Banks conduct expert credit investigations, saving costs of multiple amateur assessments.

Financial Markets (FM)

• FMs are hubs for buying and selling financial claims and services.
• Corporations, FIs, individuals, and governments engage in trading financial products.
• These trades are direct or through regulated brokers/dealers.
• FMs are classified into primary and secondary markets.
• Primary Markets = New financial claims or securities are issued for the first time. They mobilize savings and supply fresh capital to business entities.
• Secondary Markets = Markets deal in existing securities. They render securities issued on the PM liquid.

Money Markets and Capital Markets

• Money Markets and Capital Markets both transfer resources to producers and are similar.
• The distinction is based on maturity of financial assets:
• Money Markets handle short-term claims.
• Capital Markets handle long-term claims (above 1 year).

Financial Markets' Classification

• Classification by nature of claim:
• Debt Market
• Equity Market
• Classification by maturity of claim:
• Money Market
• Capital Market
• Classification by seasoning of claim:
• Primary Market
• Secondary Market
• Classification by immediate or future delivery:
• Spot Market
• Derivatives Market
• Classification by organizational structure:
• Over the Counter Market
• Standardized Market

Financial Institutions' Classification

• Financial Institutions are classified into Banking or Non-Banking institutions.
• Banking institutions participate in an economy's payments mechanism.
• They offer transactions services, and their deposit liabilities make up a large portion of the national money supply.
• Banks advance credit by creating claims against themselves.

What is a Bank?

• A bank is defined by its economic functions, services, and legal basis.
• Banks transfer funds from savers to borrowers and facilitate payments for goods and services.

Expansion of Bank Services

• Banks are offering a wide array of financial services, including accounts, savings plans, and loans.
• Services include investment banking, insurance protections, financial planning, advice for merging companies, and risk-management services.
• Banks are becoming general financial service providers and expanding beyond traditional services.
• Competitors also undergo changes within the global financial system. Financial service institutions are attempting to be more like banks in service offerings.
• Financial institutions offer:
• Payment services.
• Risk protection services.
• Liquidity services.
• Credit services.

Non-Banking Institutions

• Deposit Type Institutions:
• Savings and Loan Associations specialize in savings deposits and home mortgage loans.
• Credit Unions gather deposits from individuals and make loans to members as nonprofit associations.
• Non-depository Institutions:
• Life and Property/Casualty Insurance Companies protect against risks to property or people and manage pension plans and retirement funds.
• Other Financial Intermediaries:
• Hedge Funds market shares to upscale investors in diverse assets (commodities, real estate, loans, etc).
• Finance Companies provide loans to commercial enterprises and families using funds borrowed in the open market or from other FIs.
• Money Market Funds gather short-term liquid funds from investors, investing in high-quality short-duration securities.
• Mutual Funds sell shares representing an interest in a professionally managed asset pool.
• Investment Banks provide advice to corporations and governments raising funds in the financial marketplace.
• Security brokers and dealers buy and sell securities for their customers and their own accounts.
• Financial Holding Companies include credit card, insurance, finance, and security broker-dealer firms as diversified financial-service providers.

Financial System and Economic Development

• Efficiency: using and allocating factors to the most productive purposes
• Information Arbitrage Efficiency: indicates that prices in an efficient market reflect available information.
• Fundamental Valuation Efficiency: the market price is equal to its intrinsic value
• Full Insurance Efficiency: the extent of hedging against possible contingencies.
• Functional or operational efficiency: a market minimizes administrative and transaction costs and provides convenience to borrowers/lenders.
• Allocational Efficiency: financial markets channel investment into projects adjusted for risk.
• Innovations: introduction of new instruments/services, or new sources/processes.
• Financial Engineering: the creative formulation of finance solutions.
• Financial Revolution: conveys the magnitude, speed, and spread of financial sector changes.
• Diversification: development of various FIs, instruments, markets, services and practices.
• Disintermediation: a decline in any FI's share of aggregate financial assets.
• Markets:
• Broad Markets: attract funds from all investor types.
• Deep Markets: have sufficient orders for buying and selling at fine quotations.
• Financial Repression: Government regulatory policies that distort prices discourage savings.
• Financial Reforms: liberalization and deregulation that promote growth, viability, and profitability.
• Privatization: increases financial sector ownership, management, and control.
• Prudential Regulation: regulation aiming for transparency and accountability.
• Integration: close connections across all the sub-parts of the financial system.
• Internationalization and Globalization: extending financial system activities beyond borders.
• Securitization:
• Tapping bonds commercially as an alternative to institutional financing.
• Existing assets are removed from balance sheets by funding other investors.