1.

Introduction to Financial
Institutions

By

Getaneh M. (PhD)

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Main contents

1. An overview of the financial system

2. Definition of Financial Institutions
3. Categories of financial institutions
4. Roles of financial institutions
5. Functions of financial institutions
6. Money and Characteristics of a developed
market

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1. An overview of the financial system
Finance the framework for making decisions for how to get
the money and what to be done with it.
The role of financial system is to facilitate the flow and
efficient allocation of funds in an economy.
In a well functioning economy, capital flows efficiently from
those who supply capital to those who demand it.
The financial system of an economy consists 3 components:
Financial markets
Financial intermediaries
Financial regulators
Funds flow in the financial system in two ways:
Direct finance: using the financial markets
Indirect finance: via investment banks and financial intermediaries.
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Fig 1.1: Flow of Funds through the financial system

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 2. What are financial institutions (FIs)?

is an institution that provides financial services for its

clients or members.
is a company engaged in the business of dealing with
monetary transactions, i.e. deposits, loans, invts
Private or public owned organizations act as channel
between savers and borrowers of funds.

Two main types of FI:

deposit taking (banks, credit unions) and
non-deposit taking (e.g. insurance companies, mutual
funds)

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3. Categories of financial institutions
1. Investment Banking houses: underwrites and distributes
new investment securities and help businesses obtain
financing.
Buy securities designed by corporations, and resell them to
savers.
2. Commercial banks: Traditional department store of finance.
Provide wide range of services- including stock brokerage services
and insurance.
3. Financial services corporations: are large conglomerates
that combine many different financial institutions within a
single corporation.
4. Savings and loan associations (S&Ls): serves individual
savers and mortgage borrowers.
taking the funds of many small savers and then lending to home
buyers and other types of borrowers. 6
Categories of Financial institutions (contd)
5. Credit unions: are cooperative associations whose members
have common bond, e.g. being employees of the same firm.
Members savings are loaned only to other members
Cheapest source of funds available to individuals.
6. Pension funds: are retirement plans funded by corporations
or government agencies for their workers.
7. Life insurance companies: take savings in the form of annual
premiums
8. Mutual funds: are corporations that accept money from
savers and then invest in stocks or debt securities.
pool funds and thus reduce risks by diversification.

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4. Role of Financial Institutions
Creates more favorable transaction terms to both
lenders/investors and borrowers than they could
realize by dealing directly with each other in the
financial markets.
i.e. Financial intermediation

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Role of Financial Institutions (Contd)
Intermediation acting as a go-between among two
parties, i.e. surplus units(lenders) and deficit units (borrowers)
It involves more than just introducing the parties each
other, i.e. brokerage service
Financial intermediaries:
Create best assets for savers and liabilities for borrowers
transforms financial assets or claims to instruments that
are desirable for both lenders and borrowers.
Through asset transformation, FIs provides the following
economic functions:
1. Maturity transformation or flexibility, e.g. commercial banks
Covert funds lent for short period into loans of longer duration
Offers different ranges of maturities for both borrowers and lenders
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Role of Financial Institutions (Contd)

2. Risk reduction via diversification, e.g. mutual funds

transforming more risky assets into less risky ones.
3. Cost reduction for contracting and information
processing:
Investors purchasing financial assets must develop skills necessary to
evaluate their risk and return.
Information-processing costs - cost of acquiring information and the
opportunity cost of the time to process the information
Contracting costs - costs for writing and enforcing loan agreements

Economists refer to this uneven possession of

information as asymmetric information.

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Role of Financial Institutions (Contd)
4. Liquidity:- give borrowers and lenders d/t choices about
when, to what extent, and for how long to commit to financial
relationships.
5. Denomination Divisibility: pool savings of many small
lenders into large investments.
other services by FIs:
Facilitating the trading of financial assets for their
customers through brokering arrangements.
Assist in the creation of financial assets for its customers,
and then distribute to other market participants.
Providing investment advice to customers.
Manage the financial assets of customers.
Providing a payment mechanism.
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Comparison of roles among financial Institutions

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5. Money and Characteristics of a developed money
market

Money
Medium of exchange
Solves the divisibility problem, i.e. where medium
of exchange does not represent equal value for
the parties to the transaction
Facilitates saving
Store of wealth

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Characteristics of a Developed Money Market

Existence of Central Bank: controls the entire money market

operations by making the availability of funds depending
upon the economic cycles.
Highly organized Banking System: the commercial banks are
considered as nervous system of the money market.
Existence of sub-markets: such as bill market, call money
market, acceptance market, discount market, etc.
Prevalence of healthy competition: a large number of
borrowers, lenders and dealers.
Integration of sub-markets: Their functioning is inter-
dependent as funds flow into another market.
Availability of proper credit instruments: such as treasury
bills, promissory notes, bills of exchange should be freely
available. 14
 Contd
Flexibility and adequacy of funds: the flow of funds can be
increased or decreased depending upon the demand for
funds.
International attraction: foreign dealers, borrowers and
lenders are eagerly coming forward to participate.
Uniformity of interest rates: in different parts of the country
Stability of prices: is will be an outcome of the effective
functioning of a developed money market.
Highly developed industrial system: For smooth functioning
of the money market to achieve the basic purpose of its
existence, highly developed industrial system is required.

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Thank You!

The End!!!

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