CHAPTER THREE

FINANCIAL INSTITUTIONS IN THE FINANCIAL SYSTEM

Objective
After completing this chapter the student able to describe the following
 Advantage of Financial institutions in the financial system
 Types of Financial intermediaries
 Relationship of depository, non depository and investment institution and
 Identify the difference in each title.
3.1 Need for Financial Institutions in a Financial System

 If financial markets were perfect, all information about any securities for sale in primary and secondary
markets (including the creditworthiness of the security issuer) would be continuously and freely available to
investors. In addition, all securities for sale could be broken down (unbundled) into any size desired by
investors, and security transaction costs would be nonexistent. Under these conditions, financial
intermediaries would not be necessary.
 Because markets are imperfect, securities buyers and sellers do not have full access to information.
Individuals have funds available normally do not have a means of identifying creditworthy borrowers to
whom they could lend their funds. In addition, they do not have the expertise to assess the creditworthiness
of potential borrowers.
 Financial institutions are needed to resolve the problems caused by market imperfections. They accept funds
from surplus units and channel the funds to deficit units. Without financial institutions, the information and
transaction costs of financial market transaction costs would be excessive.
3.2 Relative sizes and types of major financial institutions
Comparative sizes of key financial services providers
 Financial intermediaries and other financial intuitions differ greatly in their relative importance with in any
nation’s financial system measured by total financial assets, for example, commercial banks dominate the
United States financial systems, and most other financial systems around the globe.
 More than $9.5 million in financial assets held by U.S banks represent about one quarter of the total
resources of all U.S financial institutions. By some measures banks appear to have lost some of their market
share to some non bank financial institutions (such as mutual funds and credit unions), which may be less
regulated or offer more flexible service options. In most countries, however, banks still represent the
dominant financial institution.

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 Lagging well behind banks are savings and loans associations- another deposit type financial intermediary
active primarily in the U.S mortgage market, financing the building and purchase of new homes. Very
similar in sources and use funds to savings and loans are savings banks, which attract small savings deposits
from individuals and families and make wide variety of house hold land.
 The fourth major kind of deposit type financial intermediary, the credit union, was also created to attract
small savings deposits from individuals and families and make loans to credit members.
 When the assets of all four deposit type intermediaries’ (commercial banks, savings and loans, savings
banks and credit unions) one combined, they make up about one-third of the total financial assets of all U.S
financial institutions. The remainder of the sector’s financial assets is held by a highly diverse group of no
deposit financial institutions. Life insurance companies protect policy holders against the risks of
premature death and disability and are among the most important non deposit institution and rank fourth
hind commercial banks in total assets.
 The other type of insurance firm property casualty insurers –offers wider array policies to reduce the risk of
loss associated with climate, weather damage, and personal negligence.
 Among the most specialized financial intuitions are pension funds, which protect their customers against the
risk of outliving their sources of income in the retirement years, private pensions now rank third behind
banks and mutual funds in total assets held within the U.S finical system.
 Other important financial institutions include finance companies, investment companies (mutual funds) and
real estate investment trusts. Finance companies lend money to business and consumers to meet short term
working capital and long-term investment needs investment companies pool the funds contributed by
thousands of savers by selling shares and then investing in securities sold in the open market and are
particularly important in holding and investing the public’s retirement savings.
 A specialized type of Investment Company is the money market fund. Money market fund accepts saving
(share) accounts from businesses and individuals and places those funds in high quality, short term (money
market) securities. Another related investment companies are real estate investment trusts. They are one of
smallest members of the financial institution sector which invest mainly in commercial and residential
properties. Finally, near the bottom of the list, size wise, are mortgage banks, which facilitate the raising of
credit to construct new businesses and homes.
3.3 Classifying Financial Institution
 Financial institutions may be grouped in a variety of different ways. One of the most important distinctions
is between depository institutions (Commercial banks, savings and loan associations, saving banks and
credit unions), Contractual institutions (insurance companies and pension funds) and investment
institutions (mutual funds and real estate investment trusts).

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 Depository institutions derive the bulk of their loan-able funds from deposit accounts sold to the public.
Contractual institutions attract funds by offering legal contracts to protect the saver against risk (such as an
insurance policy or retirement account). Some investment institutions, particularly mutual funds, sells shares
to the public and invest the proceeds in stocks, bonds and other assets in the hope of providing returns to
their shareholders. Other investment institutions facilitate the buying and selling of securities and other
assets as in the case of brokers and dealers.
 We have seen why financial intermediaries play such an important role in the economy. Now we look at the
principal financial intermediaries themselves and how they perform the intermediation function. They fall
into three categories Depository institutions (banks), contractual saving institutions and investment
intermediaries.
3.3.1 Depository institutions
 Depository institutions (for simplicity, we refer to these as banks throughout this material) are financial
intermediaries that accept deposits from individuals and institutions and make loans. The study of money
and banking focuses special attention on this group of financial institutions, because they are involved in the
creation of deposits and are an important component of the money supply.
 They are popular financial institutions for the following reasons:
 They offer deposit accounts that can accommodate the amount and liquidity characteristics desired by
most surplus units
 They repackage funds received from deposits to provide loans of the size and maturity desired by deficit
units
 They accept the risk on loans provided
 They have more expertise than individual surplus units in evaluating the creditworthiness of deficit units
 They diversify their loans among numerous deficit units and therefore can absorb defaulted loans better
than individual surplus units could
 These institutions include commercial banks and the so called institutions savings and loan associations,
mutual savings banks and credit unions.
 A more specific description of each depository institutions follows:
A. Commercial banks
 These financial intermediaries raise funds primarily by issuing
 Checkable deposits: deposits on which cheeks can be written,
 Savings deposits: deposits that are payable on demand but do not allow their owner to write cheek and
 Time deposits: deposits with fixed terms to maturity.
 They then use these funds to make commercial consumer and mortgage loans and to buy U.S government
securities and municipal bonds.

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 There are slightly fewer than 7,500 commercial banks in the United States, and as a group, they are the
largest financial intermediary and have the most diversified portfolios (collections) of assets.
 The principal source of funds for most banks is deposit accounts-demand, savings, and time deposits.
Economically, deposit accounts are similar to other sources of funds borrowed by the bank. Legally,
however, deposits take precedence over other sources of funds in case of a bank failure.
B. Savings and loan Association and mutual saving Banks
 These depository institutions, of which there are approximately 1,500, obtain funds primarily through saving
deposits (often called shares) and time and checkable deposits.
 Like commercial banks, S&Ls offer deposit accounts to surplus units and the channel these deposits to
deficit units. Whereas commercial banks have concentrated on commercial loans, however, S&Ls have
concentrated on residential mortgage loans. In recent decades, however, deregulation has permitted S&Ls
more flexibility in allocating their funds, so their functions have become more similar to those of
commercial banks. Although S&Ls can be owned by shareholders, most are mutual (depository owned).
 In the past, these institutions were constrained in their activities and mostly made mortgages loans for
residential housing.
 Over time these restrictions have been loosened so that the distinction between these depository institutions
and commercial banks has blurred. These intermediaries have become more like and are now more
competitive with each other.
C. Credit union
 These financial institutions, numbering about 8,900, are typically very small cooperative lending institutions
organized around a particular group: union members , employees of a particular from and so forth.
 They acquire funds form deposits called shares and primarily make consumer loans.
 Credit unions differ from commercial banks and saving institutions in that they:
 Are nonprofit and
 Restrict their business to the credit union members, who share a common bond such as a common
employer or union.
 Because of the common bond characteristics, credit unions tend to be much smaller than other depository
institutions. They use most of their funds to provide loans to their members.
 Like savings institutions, credit unions were started both to provide an outlet for savers to deposit small
amounts of funds and as organizations that would provide loans on relatively lenient terms to their
members.
 Unlike savings institutions, however, credit unions were not instituted for the purpose of providing
mortgage financing for their members. Instead, credit unions tend to focus on consumer lending. Credit

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 unions are strictly mutual institutions. They are organized like clubs whose members pool their savings and
loan them to one another.
 To be a member of a credit union, a person must qualify under the credit union’s common bond
requirements. Most common bonds are “occupational” (e.g. Members work for the same employers or in the
same industry), some are “associational” (e.g. Members belong to the same region trade association or trade
union) and the rest are “residential” (e.g. Members live in a qualifying sparsely populated rural country in
specified low income areas).
 The common bond requirement gives credit unions several advantages that are not available to other
depository institutions.
 First like other clubs, their income is not subject to federal income tax before it is paid out as
“dividends”. Savers who own shares (which are equivalent to other institutions’ deposits) in the credit
union receive “dividends” instead of interest as a return on their savings shares (deposits).
 Second, because their common bond requirement prevents credit unions from competing for the same
customers (members), they are not subject to antitrust laws that otherwise might keep them from
engaging in cooperative ventures.
 Consequently, they have developed strong trade associations that provide them with many jointly
provided services and help them coordinate their activities. Their trade associations, cooperative
ventures and tax exemptions give them advantages that are not available to other depository
institutions.
 Thus, while the mortgage-oriented thrifts (saving associations) are becoming more like commercial
banks, credit unions are likely to remain a district form of financial institution.
D. Micro-Finance Institutions
 Micro finance is defined as the provision of financial intermediation through distribution of small loans,
acceptance of small savings and the provision of other financial products and services to the poor.
 The main focus of micro financing is on the poor through provision of small credit and acceptance of small
savings.
 Credit provision & saving mobilization are the core financial products /services provided by MFIs. But there
are other services provided by MFI. Micro financial Institutions provide the Credit provision, Saving
mobilization and other types of services:
 The Distinguishing characteristics of micro finance from Conventional Banks
The most distinguishing characteristics of MFIs from the conventional banks are:
1. Procedures are designed to be helpful to the client and therefore are user friendly. They are simple to
understand, locally provided and easily and quickly accessible.

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 2. The traditional lender's requirement for physical collateral (such as land, house and productive assets) is
usually replaced by system of collective guarantee groups whose members are mutually responsible for
ensuring individual loans are repaid. Loans are dependent not only on individual's repayment
performance, but also on that of every other group members.
3. Loan amounts especially at the first loan cycle are too small, much smaller than the traditional banks
would find it viable to provide and service.
4. Borrowers are usually also required to be savers.
5. MFI's operating costs as well as administrative cost per loan are higher than the conventional bank's.
 Objectives of the Micro finance Institutions
 The goal of MFIs as development organizations is to service the financial needs of un-served or underserved
markets (the poor) as a means of meeting development objectives. The development objectives generally
include one or more of the following:
 To reduce poverty.
 To help existing businesses grow or diversify their activities and to encourage the development of new
businesses.
 To create employment and income opportunities through the creation and expansion of micro
enterprise and ,
 To increase the productivity and income of vulnerable group, especially women and the poor.
3.3.2 Non depository of contractual saving institutions
 Contractual savings institutions, such as insurance companies and pension funds, are financial
intermediaries that acquire funds at periodic intervals on a contractual basis. Because they can predict with
reasonable accuracy how much they will have to pay out in benefits in the coming years, they do not have to
worry as much as depository institution about losing funds quickly. As a result the liquidity of assets is not
as important as consideration for them as it is for depository institutions, and they tend to invest their funds
primarily in long term securities such as corporate bonds, stocks and mortgages.
A. Insurance Companies
 Insurance companies provide individuals and firms with insurance policies that reduce the financial burden
associated with death, illness and damage to property. They charge premiums in exchange for the insurance
that they provide.
 They invest the funds that they receive in the form of premiums until the funds are needed to cover
insurance claims. Insurance companies commonly invest the funds in stocks or bonds issued by the
government. In this way, they finance the needs of deficit units and thus serve as important financial
intermediaries.
 Their overall performance is linked to the performance of the stocks and bonds in which they invest.

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 The Insurance Mechanism: Insurance is the transfer of pure risk to an entity that pools the risk of loss and
provides payment if a loss occurs.
 Risk transfer means shifting the responsibility of bearing the risk from one party to another party.
 Pooling means that losses suffered by a small number of insured are spread over the entire group so
insurance purchaser substitute the average loss (a small amount) in place of the uncertainty that they might
suffer a large loss.
 Pure risks are situations in which two outcomes are possible, loss or no loss. Examples: the risk of poor
health, the risk of premature death, the risk of legal liability, and the risk of damage to property.
 Speculative risks provide three possible outcomes, loss, no loss, or gain.
 Insurance benefits society in several important ways.
1. It reduces fear and wear because if a loss occurs, the insurer provides a payment to mitigate the loss.
2. It also provides an incentive for loss control because insurance premiums are determined by the
chance of loss, and loss control reduces the chance of loss.
3. It helps to facilitate credit by protecting collateral pledged to secure loans. This benefit is especially
important in commerce because it helps to facilitate the shipment of raw materials and finished goods.
4. The insurance industry plays an important role in capital formation. Insurance companies collect small
amounts of money from many insurance purchasers. They pool these funds and then make large
blocks of funds available in the capital markets.
i. Life Insurance Companies
 Life insurance companies insure people against financial hazards following a death and sell annuities
(annual income pigments up on retirement).
 They acquire funds from the premiums that people pay to keep their policies in force and use them mainly
to buy corporate bonds and mortgages.
 They also purchase stocks, but are restricted in the amount that they can hold.
 Currently, with $4.4 trillion in assets, they are among the largest of the contractual savings institutions.
ii. Fire and Casualty Insurance Companies
 These companies insure their policy holders against loss from theft, fire and accidents.
 They are very much like life insurance companies receiving funds through premiums for their policies, but
they have a greater possibility of loss of funds if major disasters occur. For this reason, they use their funds
to buy more liquid assets than life insurance companies do.
 Their largest holding of assets is municipal bonds, they also hold corporate bonds and stocks and U.S.
government securities.

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 B. Pension funds and government Retirement Funds
 Privet pension funds and state and local retirement funds provide retirement income in the form of annuities
to employs who are covered by a pension plan.
 Funds are acquired by contributions from employers and from employees, who either have a contribution
automatically deducted from their paychecks or contribute voluntarily.
 In this way, pension funds finance the needs of deficit units and thus serve as important financial
intermediaries.
 Like insurance companies, pension plans collect small contributions from many employees or larger
contributions from employers. The plan pools these available to purchase stocks, bonds, real estate related
investments, and other securities. The pension fund uses the funds plus investment income to make
retirement benefits available.
 The largest asset holdings of pension funds are corporate bonds and stocks. The establishment of pension
funds has been actively encouraged by the federal government, both through legislation requiring pension
plans and through tax incentives to encourage contributions.
3.3.3 Investment Intermediaries
 This category of financial intermediaries includes finance companies, mutual funds and money market
mutual funds.
A. Finance Companies
 Finance companies raise funds by selling commercial paper (as short –term debt instrument) and by issuing
stocks and bonds.
 Compared to thrift institution, which tend to specialize in making certain type of loans (mortgages for
savings institutions and consumer loans for credit unions), finance companies are more diverse. Many
specialize in consumer finance, particularly small loans; others specialize in business loans, purchasing
business A/R (factoring), or leasing.
 Finance companies are sometimes referred to as department stores of consumer and business credit. These
institutions grant credit to businesses and consumers for a wide variety of purposes, including the purchase
of business equipment, automobiles, vacations and home appliances. Most authorities divide firms in the
industry into one of three groups- consumer finance companies, sales finance companies, and commercial
finance companies.
 Consumer Finance Companies-make personal cash loans to individuals. The majority of their loans are
home equity loans and loans to support the purchase of passenger cars, home appliances, and mobile
homes. However, a growing proportion of consumer-finance-company loans centers on aiding
customers with medical and hospital expense, educational costs, vacations and household expenses.

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  Sales Finance Companies-make indirect loans to consumers by purchasing installment paper from
dealers selling automobiles and other consumer durables. Many of these firms are captive finance
companies controlled by a dealer or manufacturer. Their principal function is to promote sales of the
sponsoring firm’s products by providing credit.
 Commercial finance companies- focus principally on extending credit to business firms. Most of these
companies provide account receivable financing or factoring services to small or medium sized
manufacturers and wholesalers.
 They tend these funds to consumers, who make purchases of such items as furniture, automobile and home
improvements, and to small businesses. Some finance companies are organized by a parent corporation to
help sell its product. For example, ford motor credit company makes loans to consumers who purchase ford
automobiles.
B. Mutual Funds
 These financial intermediaries acquire funds by selling shares to many individuals and use the proceeds to
purchase diversified portfolios of stocks and bonds.
 Mutual funds sell shares to surplus units and use the funds received to purchase a portfolio of securities.
Some mutual funds concentrate their investment in capital market securities, such as stocks or bonds.
Others, known as money market mutual funds, concentrate in money market securities. Typically, mutual
funds purchase securities in minimum denominations that are larger than the savings of an individual
surplus unit. By purchasing shares of mutual funds and money market mutual funds, small savers are able to
invest in a diversified portfolio of securities with a relatively small amount of funds.
 Mutual funds allow share holders to pool their resources so that they can take advantage of lower
transaction costs where buying large blocks of stocks or bonds.
 In addition, mutual funds allow share holders to hold more diversified portfolios than they otherwise would
shareholders can hold.
 The fact that their market price can vary widely from their net asset values is a drawback. An investor never
knows for sure what price he or she will receive when the investor sells shares in the fund, because the
market price received would depend on both market conditions and the fund’s premium or discount from
NAV (net asset value) on the day the shares were sold.
 Therefore investments in mutual funds can be risky.
C. Investment banks
 Despite its name, an investment bank is not a bank or a financial intermediary in the ordinary sense, that is,
it does not take in deposits and then lend them out. Instead, an investment bank, is a different type of
intermediary that helps a corporation issue securities.

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 First, it advises the corporation on which type of securities to issue (stocks or bonds) then it helps sell (under
write) the securities by purchasing them from the corporation at a predetermined price and reselling. In
addition to that, in the market investment bank also act as deal makers and earn enormous fees by helping
corporations acquire other companies through mergers or acquisitions.
 Investment banks are firms that specialize in helping businesses and governments sell their new security
issues (debt or equity) in the primary markets to finance capital expenditures. In addition, after the securities
are sold, investment bankers make secondary markets for the securities as brokers and dealers. The term
“investment bank” is somewhat misleading, because those involved have little to do with commercial
banking (accepting deposits and making commercial loans).
3.4 Summary
Table 1. Primary assets and liability of financial intermediaries
Types of Intermediary Primary liabilities Primary Assets
( source of funds ) ( Uses of funds )
1 Depository institutions ( banks)
 Commercial banks Deposit -Business and consumer loans, mortgage U.S
government securities and municipal bonds.
 Savings and loans association Deposits - Mortgage
 Mutual savings banks Deposits - Mortgage
 Credit unions - Consumer loan
2 Contractual savings
institutions
 Life insurance companies Premiums from policies Corporate bonds and mortgages
Fire and casualty insurance premiums from Municipal bonds corporate bonds and stock ,
 companies Policies U.S government securities
Pension funds and government Employer and employee - Corporate bonds and stock
 retirement funds. contributions
3 Investment Intermediaries
 Finance companies Commercial Paper, Consumer and business Loans.
stocks, bonds
 Mutual funds Shares Stocks , bonds
 Money market Mutual ( funds) Shares Money market instrument

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