Chapter 2: Financial Institutions in the Financial System PDF

Chapter 2: Financial institutions in the financial system CHAPTER TWO FINANCIAL INSTITUTIONS IN THE FINANCIAL SYSTEM 2.1 Financial institutions and capital transfer A financial institution (FI) is a company engaged in the business of dealing with f...

Chapter 2: Financial institutions in the financial system CHAPTER TWO FINANCIAL INSTITUTIONS IN THE FINANCIAL SYSTEM 2.1 Financial institutions and capital transfer A financial institution (FI) is a company engaged in the business of dealing with financial and monetary transactions such as deposits, loans, investments, and currency exchange. Financial Institutions are the firms which provide access to financial markets. Financial institutions (e.g., commercial and savings banks, credit unions, insurance companies, mutual funds) perform the essential function of channeling funds from those with surplus funds (suppliers of funds) to those with shortages of funds (users of funds). In financial economics, a financial institution is an institution that provides financial services for its clients or members. It accepts deposits from consumers, and "places the money in a variety of investment vehicles," such as loans and mutual funds, to benefit both the consumers and the institution. Probably the most important financial service provided by financial institutions is acting as financial intermediaries. Generally, financial institutions provide services related to one or more of the following: ❖ Transforming financial assets acquired through the market and converting them into a different and more widely preferable type of asset. ❖ Exchanging financial assets on behalf of customers ❖ Exchanging financial assets for their own accounts ❖ Assisting in the creation of financial assets for their customers, and then selling those financial assets to other market participants ❖ Providing investment advice to other market participants; and ❖ Managing the portfolios of other market participants. Financial institutions are responsible for distributing financial resources in a planned way to the potential users. These institutions are controlled and supervised by the rules and regulations described by government authorities. With the help of their functions, financial institutions transfer Compiled By: Alemayo S. (MSc) 1  Chapter 2: Financial institutions in the financial system money or funds to various tiers of economy and thus play a significant role in acting upon the domestic and the international economic scenario. There are three different ways for transferring capital or fund from savers to borrowers in the financial system this are direct transfers of money and securities, investment banking house, and financial intermediaries. 1. Direct transfer of money and securities This is the easier way to transferring the capital or fund from both borrower and saver. The borrowers no need to go through the investment bankers or any financial institutions or intermediaries. The scenario of direct transfer of money and securities will only occur when the businesses sell the shares or bonds to the savers directly in the financial market without go through any financial institution. The securities of the company will straight away sell to the seller exchange with money to the borrower. This direct transfer of money and securities is only suitable for the small firms and procedure is raised by a small amount of capital. The concept is the business deliver the securities to savers in return it’s give the firm the money it needs. For example, a person needs capital to starting his new business but he is lack of capital. So, his uncle lends him money to raise fund in order to starting business. So, his uncle direct transfer the money to that person. 2. Investment banking house For investment banking house, if the company needs to raise up the capital faster so the company will prefer to go through the investment banking house to established new investment securities in order to help the company to obtain financing. For example, ABC company is temporary lacking in capital so ABC company need to sell the shares or bonds to the investment banking house in order to raise fund quickly. The purpose implements the investment banking house in order to exchange the securities into cash faster than the business sell the securities itself. But the investment might use the prices that lower than the market price to purchase these shares or bonds of the company. When the firms sell their securities to the investment banking house, the investment banking house will resell the securities to the savers. So, the investment banking house is the middleman between the business and the savers. However, the investment banking house will buy in bulk of the securities or the bonds from the business and slowly resell to the seller who are willing to purchase Compiled By: Alemayo S. (MSc) 2  Chapter 2: Financial institutions in the financial system those securities and bonds. The primary market transaction is corporation receives the proceeds of the sale and new securities are involved. 3. Financial intermediaries Financial intermediaries are institutions which are between savers and investors and moving funds between both of them. The types of intermediaries included banks, credit unions, insurance companies, pension funds, mutual fund, broker and building societies. Banks are one type of intermediary, it receiving money from small savers and provide loan to borrowers to purchase homes, vacations, and so on to businesses and government units. In this indirect transfer through a financial intermediary, the financial intermediaries will collect the money from the savers that wish to invest or the savers purchase the intermediary securities. After that, the financial intermediary will use this amount of money to provide financial service such as provide loans to the borrowers to start up the business. The following diagram indicate the aforementioned ways of capital transfer. 2.2 Functions of Financial Institutions Financial institutions play a crucial role in the economy by providing various financial services. The following is the basic functions of financial institutions; 1. Providing Maturity Intermediation The function of financial institutions for taking short-term maturity deposits from the surplus units and giving long term maturity loans to borrowers (deficit unit) is called maturity intermediation. Maturity intermediation arises due to short-term maturity nature of deposits and long-term Compiled By: Alemayo S. (MSc) 3  Chapter 2: Financial institutions in the financial system maturity nature of loans. For example, the commercial banks, by issuing its own financial claims, by raising deposits in essence transforms a shorter-term asset into a longer-term one by giving the borrower a loan for the length of time. Maturity intermediation has two implications for financial markets. The first is, borrowers have more choices for the length of their debt obligations. The second one is, it will require that long-term borrowers pay higher interest rate than short-term borrowers. 2. Reducing risk by 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 a chance to diversify and reduce risks. Investors who have a small sum to invest would find it difficult to achieve the same degree of diversification because they do not 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 affected 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. Economic function of financial intermediaries transforming more risky assets into less risky ones is called risk diversification. 3. Reducing the costs of contracting and information processing As financial institutions include investment professionals who are trained to analyze financial assets and manage them reduces cost of contracting and information processing. The employment of such professionals is cost-effective for financial intermediaries and less information processing costs. Or 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. Compiled By: Alemayo S. (MSc) 4  Chapter 2: Financial institutions in the financial system 4. Providing Payments Mechanisms The ability to make payments without the use of cash is critical for the functioning of a financial market. In short, depository institutions transform assets that cannot be used to make payments into other assets. Generally, functions of financial institutions are the following; 1) Pooling the savings of individuals 2) Providing safekeeping, accounting and access to payment system 3) Providing liquidity 4) Currency exchange 5) Reducing risk by diversifying 6) Collection and processing information 2.3 Classifications of Financial Institutions The services provided by financial institutions depend on its type. Services provided by the various types of financial institutions may vary from one institution to another. For example, the services offered by the commercial banks are different from insurance companies. Generally, financial institutions are classified into two as depository and non-depository financial institutions. The different types of financial institutions are discussed as follows. 2.3.1 Depository financial institutions Depository institutions are a financial institution (such as commercial bank, savings and loan associations, mutual saving banks, and credit union) that is legally allowed to accept monetary deposits from consumers. It contributes to the economy by lending much of the money saved by depositors. Depository institutions are financial firms that take deposits from households and businesses and manage, and make loans to other households and businesses. In other words, depository institutions are those institutions which accept deposits from economic agents (liability to them) and then lend these funds to make direct loans or invest in securities (assets). Compiled By: Alemayo S. (MSc) 5  Chapter 2: Financial institutions in the financial system Deposits are money placed in an account at a depository institution & constituting a claim on the depository institutions. Loans are the borrowing of a sum of money by households or businesses from the depository institutions. The deposits accepted by these institutions represent their liabilities (debts). With the fund raised through deposits and other funding sources depository institutions make direct loans to various entities and also invest in securities. Depository institutions drive their income from; interest on loans, interest on securities, and fees income. Assets and Liability Problem of Depository institutions A depository institution seeks to earn a positive spread between the assets it invests in (loans and securities) and the cost of its funds (deposits and other sources). The spread is referred to as spread income or margin. The spread income should allow the institution to meet operating expenses and earn a fair profit on its capital. Depository institution makes a profit by borrowing from depositors at a low interest rate and lending at a higher interest rate. The depository institution earns no interest on reserves, but it must hold enough reserves to meet withdrawals. So, the depository institution must perform a balancing act to balance the risk of loans (profits for stockholders) against the safety of reserves (the security for depositors). Liquidity concerns Liquidity concerns for commercial banks arises due to short-term maturity nature of deposits. Besides facing credit risk & interest rate risk, Depository institutions should always be ready to satisfy withdrawal needs of depositors and meet loan demand of borrowers. Depository institutions use the following ways to accommodate withdrawal and loan demands: Attract additional deposit; Borrow using existing securities as a collateral (from a federal agency or financial institutions); Sell securities it owns; Raise short-term funds in the money market. Types of depository institutions Depository financial Institutions include: 1. Commercial banks, Compiled By: Alemayo S. (MSc) 6  Chapter 2: Financial institutions in the financial system 2. Savings and loan associations, and 3. Credit unions 4. Microfinance institutions 1. Commercial Banks Commercial banks are the largest and most diversified intermediaries on the basis of range of assets held and liabilities issued. Commercial banks provide numerous services in the financial system. Commercial banks accumulate deposits from savers and use the proceeds to provide credit to firms, individuals, and government agencies. Thus, they serve investors who wish to “invest” funds in the form of deposits. Commercial banks use the deposited funds to provide commercial loans to firms and personal loans to individuals and to purchase debt securities issued by firms or government agencies. They serve as a key source of credit to support expansion by firms. Historically, commercial banks were the dominant direct lender to firms. In recent years, however, other types of financial institutions have begun to provide more loans to firms. Commercial banks Collect funds from different sources, & put them in to different uses. In addition, they have also concerned in foreign exchange products and services and agency services (such as collection of cheques, draft, and bill for their customers, etc). 2. Savings and loan associations Savings and loan associations (S&Ls) are old institutions established to provide finance for acquisitions of homes. They can be mutually owned or have corporate stock ownerships. NB: Mutually owned means depositors are the owners. They have traditionally served individual savers, residential and commercial mortgage borrowers, take the funds of many small savers and then lend this money to home buyers and other types of borrowers. The collateral for the loan would be the home being financed. These institutions were to aggregate depositors’ funds and use the money to make long term mortgage loans. The institutions were not to take in demand deposits but instead were authorized to offer savings accounts that paid slightly higher interest than offered by commercial banks (they issue NOW (Negotiable Order of Withdrawal–pays interest) account to commercial customers. Which are traditionally reserved for commercial banks). In function, Savings and loan associations are similar to commercial banks, and in recent years the distinction between commercial banks and savings and loan institutions has become blurred as the Compiled By: Alemayo S. (MSc) 7  Chapter 2: Financial institutions in the financial system financial services industry has become more homogeneous. In the past, savings institutions were legally required to engage primarily in home mortgage finance, and even though they now may hold other types of assets, their traditional emphasis continues to be a major difference between savings institutions and commercial banks. 3. Credit unions Credit unions are the smallest and the newest of the depository institutions owned by a social or economic group that accepts saving deposits and makes mostly consumer loans. They established by people with a common bond. They are mutually owned established to satisfy saving and borrowing needs of their members. Credit unions, called by various names around the world, are member-owned, not-for-profit financial cooperatives that provide savings, credit and other financial services to their members. Credit union membership is based on a common bond, a linkage shared by savers and borrowers who belong to a specific community, organization, religion or place of employment such as employees of a given firm or union. Credit unions pool their members' savings deposits and shares to finance their own loan portfolios rather than rely on outside capital. Members benefit from higher returns on savings, lower rates on loans and fewer fees on average. Credit unions worldwide offer members from all walks of life much more than financial services. Their investment is primarily devoted to short term installment consumer loans. They provide members the chance to own their own financial institution and help them create opportunities such as starting small businesses, growing farms, building family homes and educating their children. Regardless of account size in the credit union, each member may run for the volunteer board of directors and cast a vote in elections. In some countries, members encounter their first taste of democratic decision making through their credit unions. 4. Microfinance institutions (MFIs) The active poor require a full set of micro finance services mainly in the form of saving and credit facilities. These services help the poor: ❖ Start new business or expand existing ones ❖ Improve productivity of farmers and micro enterprises. ❖ Improve human and social capital throughout their life Compiled By: Alemayo S. (MSc) 8  Chapter 2: Financial institutions in the financial system ❖ Deal with vulnerabilities and poverty reduction However, the active poor, both in the urban and rural areas, are neglected by formal bank and non- bank financial institutions because of different reasons. Such as: Collateral requirement of formal bank, High transactions cost (mini transaction) and High perceived risk (such as difficulty in contract enforcement and harvest failure). Therefore, the microfinance institutions can play invaluable contributions to narrow the gap between the demand for and supply of financial products. Micro finance is the provision of a broad range of financial services to the poor and low-income households, for their micro enterprises and small business. Objectives of MFIs includes; ❖ To reduce poverty ❖ To empower women and other disadvantaged population group ❖ To create employment ❖ To help existing business grow or diversity their activities ❖ To encourage the development of new business 2.3.2 Non-depository institutions Non-depository institutions are financial intermediaries that do not accept deposits but do pool the payments of many people in the form of premiums or contributions and either invest it or provide credit to others. Hence, non-depository institutions form an important part of the economy. 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. Non depository institutions include: Insurance companies, Investment Banking Firms, finance companies, Pension Funds, mutual funds, etc. 1, Insurance Companies Insurance companies provide various types of insurance for their customers, including life insurance, property insurance, and health insurance. They offer insurance policies to the public and make payments, for a price, when a certain event occurs. They provide social security and promotes individual welfare. Insurance companies distribute/spread risks to individuals, through the “Rule of large number” and they act as risk bearers. Compiled By: Alemayo S. (MSc) 9  Chapter 2: Financial institutions in the financial system Insurance companies periodically receive payments (premiums) from their policyholders, pool the payments, and invest the proceeds until these funds are needed to pay off claims of policyholders. They commonly use the funds to invest in debt securities issued by firms or by government agencies. They also invest heavily in stocks issued by firms. Thus, they help finance corporate expansion. Like mutual funds, insurance companies tend to purchase securities in large blocks, and they typically have a large stake in several firms. Thus, they closely monitor the performance of these firms. They may attempt to influence the management of a firm to improve the firm’s performance and therefore enhance the performance of the securities in which they have invested. Like banks, insurance companies are also challenged by the information asymmetry problems of adverse selection and moral hazard. Insurance companies can solve an adverse selection by screening applicants. That is, verifying information in the application, checking the applicant’s history and by applying restrictive covenant in the insurance contract. However, the solution of moral hazard is depending on the type of insurance offered. Types of Insurance Companies Mainly there are two types of insurance companies. These are Property and casualty insurance company, and Life Insurance Company. 1, Property and Causality Insurance They provide financial protection against: loss, damage, or destruction of property caused by accidents natural disasters or from the action of others loss from injury or death due to occupational accidents P&C insurance is normally divided into two: personal line and commercial line insurance companies. Personal line includes automobile insurance and home owner insurance and commercial line insurance includes product liability and commercial property insurance. The costs of the policies underwritten by a P&C insurance company consists of; Claims for loss that have been incurred and reported during the year Estimated claims on policies written during the year that will not be paid until later years. Compiled By: Alemayo S. (MSc) 10  Chapter 2: Financial institutions in the financial system P&C companies must establish reserves to satisfy the actuarially estimated claims by law. Reserves can be increased or decreased depending on whether actual claims are above or below those actuarially estimates. ii, Life Insurance Life Insurance Companies: deal with death, illness disablement and retirement policies. It is insurance against death or retirement. Up on death of policyholder, a life insurance company agrees to make either a lump-sum payments or a series of payments to the beneficiaries of the policy. 2, Pension Funds A pension fund is a fund that is established for the payment of retirement benefits. Most pension fund assets are in employer-sponsored plans. The entities that establish pension plans are called the plan sponsors. pension plans can be established by both governmental & private organizations on behalf of their employees. Pension funds receive payments (called contributions) from employees, and/or their employers on behalf of the employees, and then invest the proceeds for the benefit of the employees. They typically invest in debt securities issued by firms or government agencies and in equity securit ies issued by firms. Pension funds employ portfolio managers to invest funds that result from pooling the employee/employer contributions. They have bond portfolio managers who purchase bonds and stock portfolio managers who purchase stocks. Because of their large investments in debt securities or in stocks issued by firms, pension funds closely monitor the firms in which they invest. Like mutual funds and insurance companies, they may periodically attempt to influence the management of those firms to improve performance. 3, Mutual Funds Mutual funds are corporations that accept money from savers and then use these funds to buy stocks, long-term bonds, or short-term debt instruments issued by businesses or government units. Mutual funds sell shares to individuals, pool these funds, and use them to invest in securities. In other words a mutual fund pools the funds of many people and managers invest the money in a diversified portfolio of securities to achieve some stated objective. These organizations pool funds and thus reduce risks by diversification. They also achieve economies of scale in analyzing securities, managing portfolios, and buying and selling securities. They continually stands ready Compiled By: Alemayo S. (MSc) 11  Chapter 2: Financial institutions in the financial system to sell new shares to the public and to redeem its outstanding shares on demand at a price equal to an appropriate share of the value of its portfolio which is computed daily at the close of the market. Mutual funds are owned by investment companies. Many of these companies have created several types of money market mutual funds, bond mutual funds, and stock mutual funds so that they can satisfy many different preferences of investors. Different funds are designed to meet the objectives of different types of savers. Hence, there are bond funds for those who desire safety, stock funds for savers who are willing to accept significant risks in the hope of higher returns, and still other funds that are used as interest-bearing checking accounts (the money market funds). Thus, mutual funds are classified into three broad types. These are: ▪ Money market mutual funds pool the proceeds received from individual investors to invest in money market (short-term) securities issued by firms and other financial institutions. ▪ Bond mutual funds pool the proceeds received from individual investors to invest in bonds, and ▪ Stock mutual funds pool the proceeds received from investors to invest in stocks. Mutual funds are regulated by the Securities and Exchange Commission (SEC). Primary objective of regulation is the enforcement of reporting and disclosure requirements to protect the investor. Such Institutional investors include mutual funds, pension funds, and insurance companies—are a growing force in developed markets. 4, Investment Banking Firms Investment bank is a financial institution engaged in securities business. Investment banking firms perform activities related to the issuing of new securities and the arrangement of financial transactions. They mainly involved in primary markets, the market in which new issues are sold and bought for the first time. They advise issuers on how best raise funds, and then they help sell the securities. Investment banking is a type of financial service that focuses on helping companies acquire funds and grow their portfolios. Investment banking firms assist client companies in obtaining funds by selling securities, i.e., raise funds for clients and act as brokers or dealers in the buying and selling securities in secondary markets, i.e., assisting clients in the sale or purchase of securities. Much of this comes in the form of stock and bonds transfer, but investment capital and wholesale corporate acquisitions are also part of the equation. Compiled By: Alemayo S. (MSc) 12  Chapter 2: Financial institutions in the financial system 5, 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. In other words, finance companies are non-bank financial institutions that tend to meet various kinds of consumer credit needs. They involve in leasing, project financing, housing and other kind of real estate financing. 2.4 Risks in Financial Industry In generally financial institutions faces the following risks; 1. Credit risk: - is also called default risk, is the risk associated with a borrower going into default (not making payments as promised to the depository institution. i.e., default by borrower or by issuer of security). Investor (financial institutions) losses include lost principal and interest, decreased cash flow, and increased collection costs. 2. Interest rate risk: - is the risk of fluctuations in a security's price or reinvestment income caused by changes in market interest rates. 3. Liquidity risk: - is the risk that the financial institution will be unable to generate sufficient cash flow to meet required cash outflows. Moreover, because of the asset transformation function of financial institutions maturity mismatches between assets and liabilities can occur. 4. Foreign exchange risk: - is the risk that foreign exchange rates will vary in the future affecting the profit of the financial institution. Mismatches between the amount of foreign currency denominated assets and liabilities can lead to foreign exchange losses or gains depending on the relative movement of the two currencies involved. 5. Political risk: - is the cost or variation in returns caused by actions of sovereign governments or regulators. Compiled By: Alemayo S. (MSc) 13