Lecture # 1

Management of Financial
Institutions

 Module I: Introduction
Financial
Institutions
and
economic
development, Types of Money, Process of
Capital Formation, Technology of financial
systemsPooling,
Netting,
Credit
substitution & Delegation.

In financial economics, a financial institution

acts as an agent that provides financial
services for its clients. Financial institutions
generally fall under financial regulation from
a government authority.

Types of Financial Institutions

Common types of financial institutions
include banks, Insurance Co, Leasing Co,
Investment Co, Mutual Funds

Banks
A bank is a commercial or state institution
that provides financial services, including
issuing money in various forms, receiving
deposits of money, lending money and
processing transactions and the creating
of credit.

1. Central Bank
A central bank, reserve bank or
monetary authority, is an entity
responsible for the monetary policy of its
country or of a group of member states,
such as the European Central Bank (ECB)
in the European Union, the Federal
Reserve System in the United States of
America, State Bank in Pakistan.

1. Central Bank
Its primary responsibility is to maintain the
stability of the national currency and
money supply, but more active duties
include controlling subsidized-loan interest
rates, and acting as a lender of last
resort to the banking sector during times
of financial crisis

2. Commercial Banks
A commercial bank accepts deposits from
customers and in turn makes loans, even
in excess of the deposits; a process
known as fractional-reserve banking.
Some banks (called Banks of issue) issue
banknotes as legal tender.

3. Investment Banks
Investment banks help companies and
governments and their agencies to raise
money by issuing and selling securities in
the primary market. They assist public and
private corporations in raising funds in the
capital markets (both equity and debt), as
well as in providing strategic advisory
services for mergers, acquisitions and
other types of financial transactions.

4. Saving Banks
A savings bank is a financial institution
whose primary purpose is accepting
savings deposits. It may also perform
some other functions.

5. Micro Finance Banks

For the purpose of poverty reduction
program, such kind of banks are working
in the different countries with the
contribution of UNO or World Bank.
In Pakistan 7 Micro Finance Banks are
providing services under the SBP
prudential regulation.

6. Islamic Banks
Islamic banking refers to a system of
banking or banking activity that is
consistent with Islamic law (Sharia)
principles and guided by Islamic
economics. In particular, Islamic law
prohibits usury, the collection and payment
of interest, also commonly called riba in
Islamic discourse.

7. Specialized Banks
1. ZTBL
The Zarai Taraqiati Bank Limited It is
also
known
as
Agricultural
Development
Bank
of
Pakistan
(ADBP).
It is the premier financial institution
geared towards the development of the
agricultural sector through the provision
of financial services and technical knowhow.

7. Specialized Banks
2. IDBP
Industrial Development Bank of Pakistan
is one of Pakistan's oldest development
financing institution created with the
primary objective of extending term
finance
for
investment
in
the
manufacturing sector and SME Sector of
the economy.

7. Specialized Banks
3. SME Bank
Promote the business.
Positive impact on Financial environment.
Financing of projects.
Tell revenue generation schemes to
entrepreneurs.

8. Non-banking financial
company
Non-bank financial companies (NBFCs)
also known as a non-bank or a non-bank
bank, are financial institutions that provide
banking services without meeting the legal
definition of a bank, i.e. one that does not
hold a banking license.

8. Non-banking financial
company
Operations are, regardless of this, still
exercised under bank regulation. However
this depends on the jurisdiction, as in
some jurisdictions, such as New Zealand,
any company can do the business of
banking, and there are no banking
licenses issued.

8. Non-banking financial
company
Non-bank institutions frequently acts as
suppliers of loans and credit facilities,
supporting investments in property,
providing services relating to events within
peoples lives such as funding private
education, wealth management and
retirement planning

8. Non-banking financial
company
however they are typically not allowed to
take deposits from the general public and
have to find other means of funding their
operations
such
as
issuing
debt
instruments. In India, most NBFCs raise
capital through Chit Funds.

9. Investment company
Generally, an "investment company" is a
company (corporation, business trust,
partnership, or limited liability company)
that issues securities and is primarily
engaged in the business of investing in
securities.

9. Investment company
An investment company invests the
money it receives from investors on a
collective basis, and each investor shares
in the profits and losses in proportion to
the investors interest in the investment
company.

11. Leasing Companies

A lease or tenancy is the right to use or occupy
personal property or real property given by a
lessor to another person (usually called the
lessee or tenant) for a fixed or indefinite period
of time, whereby the lessee obtains exclusive
possession of the property in return for paying
the lessor a fixed or determinable consideration
(payment).

12. Insurances Companies

Insurance companies may be classified as
1. Life insurance companies, which
sell life insurance, annuities and pensions
products.
2. Non-life or general insurance
companies, which sell other types of
insurance.

Mutual Fund
An investment which is comprised of a
pool of funds collected from many
investors for the purpose of investing in
securities such as stocks, bonds, money
market securities and similar assets.

Mutual funds are operated by money

mangers, who invest the fund's capital and
attempt to produce capital gains and
income for the fund's investors. A mutual
fund's portfolio is structured and
maintained to match the investment
objectives stated in its prospectus.

10. Brokerage Houses

Stock brokers assist people in investing,
online only companies are called 'discount
brokerages', companies with a branch
presence
are
called
'full
service
brokerages' or 'private client services.

Financial Institution Functions

Financial institutions provide a service as
intermediaries of the capital and debt
markets. They are responsible for
transferring funds from investors to
companies, in need of those funds. The
presence of financial institutions facilitate
the flow of cash through the economy.

Financial Institution Functions

To do so, savings accounts are pooled to
mitigate the risk brought by individual
account holders in order to provide funds
for loans. Such is the primary means for
depository institutions to develop revenue.

Financial Institution Functions

Should the yield curve become inverse,
firms in this arena will offer additional feegenerating services including securities
underwriting, sales & trading, and prime
brokerage.

Misleading financial analysis

Financial analysis of an organization is
misleading when it is used to
misrepresent the organisation, its situation
or its prospects.

 This type of deceit is sometimes used to

obtain money by misdirecting people to
invest in a stock market bubble, profiting
from the increase in value, then removing
funds before the bubble collapses, for
instance in a stock market crash.

Conclusion
To review, we have looked at the
relationship between institutions and
Financial Markets. This growing field of
research may offer us a new insight into
the dynamics of economic growth within
and among various economies.

Chapter 3
What Is Money?

34

Meaning of Money
Money (money supply)anything that is
generally accepted in payment for goods or
services or in the repayment of debts; a stock
concept. Money supply is the total amount of
money available in the economy. (stock)
Wealththe total collection of pieces of
property that serve to store value (stock)
Incomeflow of earnings per unit
of time (flow)
35

Functions of Money

Medium of Exchangepromotes economic efficiency by

minimizing the time spent in exchanging goods
and services. Facilitates specialization and division of labor. A
good medium of exchange

Must be easily standardized

Must be widely accepted
Must be divisible
Must be easy to carry
Must not deteriorate quickly

Unit of Accountused to measure value in

the economy: assets, goods, services.
Store of Valueused to save purchasing power; allows
intertemporal substitution of income
most liquid of all assets but High inflation diminishes its store of value
function.
36

Evolution of the Payments System

Commodity Money: Gold, Silver, other precious metals, certain stones, Cigarettes,
etc.
Representative money that is backed 100 % by precious metals (banknotes).
Representative money is an item such as a token or piece of paper that has no
intrinsic value, but can be exchanged on demand for a commodity that does have
intrinsic value, such as gold, silver, copper, and even tobacco.
Fiat Money: No consumption or investment use: intrinsically useless pieces of
paper. Currency that a government has declared to be legal tender, but is not backed
by a physical commodity. The value of fiat money is derived from the relationship
between supply and demand rather than the value of the material that the money is
made of. Historically, most currencies were based on physical commodities such as
gold or silver, but fiat money is based solely on faith. Fiat is the Latin word for "it shall
be".

37

 Checks
Electronic Payments: EFTs, wire
transfers.
E-money: Debit cards (POS), etc.

Types of Money
Broad Money
Narrow Money
Fiat Money
Others:
a) Gold & Silver Coins (Ginni)
b) Metal Money
c) Paper Money
d) Plastic Money
e) Virtual Money

Definitions of Money
From most liquid (narrow) to the least
liquid (broad), M0, M1, M2, M2Y, M3..
M0 = paper currency and coins
M1 = M0+ Checking Accounts+ Traveler
Checks
M2 = M1 + Savings Accounts
M2Y = M2 + Forex Accounts

40

41

M2Y
1,000,000,000

100,000,000

10,000,000

1,000,000

100,000
M2Y
10,000

1,000

100

10

42

900000

800000

700000

600000

500000
M2Y (1987=100)
GDP DEFLATOR (1987=100)
400000

300000

200000

100000

0
1996

1997

1998

1999

2000

2001

2002

2003

2004

43

Dollarization and Monetary Transmission in Turkey, Erdem BAI Vice Governor Central Bank of
Turkey December 2006

Monetary Policy
90

ISE Bonds and Bills Market Benchm ark

Interest Rate (Com pound)

80
70

CBRT O/N Interest Rate (Com pound)

60
50
40
30
20

11/09/06

04/05/06

23/12/05

16/08/05

11/04/05

02/12/04

23/07/04

17/03/04

03/11/03

27/06/03

05/02/03

23/09/02

15/05/02

02/01/02

10

44

Asset Dollarization
Share of FX-Denominated Deposits in Total Deposits

43

41
39
37
35
33
31
29

Sep -0 6

Ju n - 0 6

M ar-0 6

D ec-0 5

Sep -0 5

Ju n - 0 5

M ar-0 5

D ec-0 4

Sep -0 4

Ju n - 0 4

M ar-0 4

D ec-0 3

25

Sep -0 3

27

Dollarization and Monetary Transmission in Turkey, Erdem BAI Vice Governor Central Bank of Turkey

45

Introduction
A financial system plays a vital role in the
economic growth of a country. It intermediates
with the flow of funds b/w those who save a part
of their income to those who invest in productive
assets.
It mobilizes & usefully allocates scarce resources
of a country.
A financial system is a complex, well-integrated set
of sub-systems of financial institutions, markets,
instruments, and services which facilitates the
transfer & allocation of funds, efficiently &
effectively.

INDIAN
FINANCIAL
SYS.

REGULATORS:
MoF,
SEBI, RBI,
IRDA

FIANANCIAL
INST.
(INTERMEDIARIES)

FORMAL
FINANCIAL
SYS.

INFORMAL
FINANCIAL
SYS.

FINANCIAL
MKT.

Moneylenders
Local Bankers
Traders
Landlords
Pawn Brokers

FINANCIAL
INSTRUMENTS

FINANCIAL
SERVICES

Financial
Inst.
(Intermediaries)

Banking Inst.

Scheduled
Commercial
Banks

Scheduled
Cooperative
Banks

Non-Banking
Inst.

Non-Banking
Finance
Co.

Development
Financial
Inst.

Mutual Funds

Public
Sector

Pvt.
Sector

Insurance
&
Housing
Finance co.

Scheduled
Commercial
Banks

Public
Sector
Banks

Private
Sector
Banks

Foreign
Banks
In
India

Regional
Rural
Banks

Development
Financial
Inst.

All-India Financial
Inst.: IFCI, IDBI, IIBI,
SIDBI, IDFC,
NABARD
EXIM Bank, NHB

State-level
Inst.:
SFCs, SIDCs

Other
Inst.:
ECGC, DICGC

Financial
Mkt.

Capital
Mkt.

Equity
Mkt.

Domestic
Mkt.

Debt
Mkt.

Secondary
Mkt.
NSE,BSE
OTCEI,ISE
Regional
Stock Exchanges

Primary Mkt.
-Public issues
-Private
placement

International
Mkt.

Money
Mkt.

Private Corporate debt

PSU Bond Market
Government Securities
Market

Treasury Bills,
Call Money mkt.
Commercial Bills,
Commercial papers,
Certificates of Deposit
Term Money

Capital Formation
Capital Formation The "capital stock" is one of
the basic determinants of an economy's ability to
produce income for its members. Composed of
equipment, buildings and intermediate goods not
themselves directly consumed.
"Capital formation" is simply the enlargement of
the capital stock. The higher the rate of capital
formation, the more rapid is the growth of the
economy's productive capacity and, hence, the
more rapid the growth of aggregate income.

 A
term
used
to
describe
net capital
accumulation during
an accounting
period.
Capital formation refers to net additions of capital
stock such as equipment, buildings and other
intermediate goods. A nation uses capital stock
in combination with labour to provide services
and produce goods; an increase in this capital
stock is known as capital formation.

Process of Capital Formation:

The process of capital formation involves three steps:
(1) Increase in the volume of real savings;
(2) Mobilisation of savings through financial and credit
institutions; and
(3) Investment of savings.
Thus the problem of capital formation becomes two-fold:
one, how to save more; and two, how to utilise the
current savings of the community for capital formation.
We discuss the factors on which capital accumulation
depends.

(1) Increasing Savings:

(a) Power and Will to Save:
Savings depend upon two factors: the power to save
and the will to save.
The power to save of the community depends upon
the size of the average income, the size of the
average family, and the standard of living of the
people. Other things being equal, if the income of the
people increases, or the size of the family is small, or
people get accustomed to a particular standard of
living which does not lean towards conspicuous
consumption, the power to save increases.

 The power to save also depends upon the level of

employment in the country. If employment opportunities
increase, and existing techniques and resources are
employed fully and efficiently, incomes increase, and so
do the propensity of the people to save.
Savings also depend upon the will to save. People may
themselves forego consumption in the present and save.
They may do so to meet emergencies, for family
purposes, or for social status. But they will save only if
certain facilities or inducements are available.

 People save if the government is stable and there is peace

and security in the country. People do not save when there
is lawlessness and disorder, and there is no security of life,
property and business. The existence of banking and
financial institutions paying high rates of interest on different
term-deposits also induces people to save more.
The taxation policy of the government also affects the
savings habits of the people. Highly progressive income and
property taxes reduce the incentive to save. But low rates of
taxation with due concessions for savings in provident fund,
life insurance, health insurance, etc. encourage savings.

(b) Perpetuation of Income Inequalities:

Perpetuation of income inequalities had been one of the
major sources of capital formation in 18th century England
and early 20th century Japan. In most communities, it is the
higher income groups with a high marginal propensity to
save that do the majority of savings. If there is unequal
distribution of income, the societys upper level incomes
accrue to the businessmen, the traders and the landlords
who save more and hence invest more on capital formation.
But this policy of deliberately creating inequalities is not
favored now either in developed or developing economics
when all countries aim at reducing income inequalities.

(c) Increasing Profits:

Professor Lewis is of the view that the ratio
of profits to national income should be
increased by expanding the capitalist sector
of the economy, by providing various
incentives and protecting enterprises from
foreign competition. The essential point is
that profits of business enterprises should
increase because they know how to use
them in productive investment.

(d) Government Measures:

Like private households and enterprises, the
government also saves by adopting a number of fiscal
and monetary measures. These measures may be in
the form of a budgetary surplus through increase in
taxation (mostly indirect), reduction in government
expenditure, expansion of the export sector, raising
money by public loans, etc. If people are not saving
voluntarily, inflation is the most effective weapon. It is
regarded as hidden or invisible tax.

 When
prices
rise,
they
reduce consumption and
thus
divert
resources from current consumption to
investment. Besides, the government
can increase savings by establishing and
running
public
undertakings
more
efficiently so that they earn larger profits
which are utilised for capital formation.

 (2) Mobilisation of Savings:

The next step for capital formation is the
mobilisation of savings through banks,
investment trusts, deposit societies,
insurance
companies,
and
capital
markets. The Kernal of Keyness theory is
that decisions to save and decisions to
invest are made largely by different people
and for different reasons.

 To bring the savers and investors together

there must be well-developed capital and
money markets in the country. In order to
mobilise savings, attention should be paid to
the starting of investment trusts, life
insurance, provident fund, banks, and
cooperative societies. Such agencies will
not only permit small amounts of savings to
be handled and invested conveniently but
will allow the owners of savings to retain
liquidity individually but finance long-term
investment collectively.

 (3) Investment of Savings:

The third step in the process of capital formation
is the investment of savings in creating real
assets. The profit-making classes are an
important source of capital formation in the
agricultural and industrial sectors of a country.
They have an ambition for power and save in the
form of distributed and undistributed profits and
thus invest in productive enterprises.

 Besides, there must be a regular supply of entrepreneurs who

are capable, honest and dependable. To perform his economic
function, the entrepreneur requires two things, according to
Professor Schumpeter, first, the existence of technical
knowledge to produce new products; second, the power of
disposal over the factors of production in the form of bank credit.
To these may he added, the existence of such infrastructure as
well-developed means of transport, communications, power,
water, educated and trained personnel, etc. Further, the social,
political and economic climatic conditions in the country must be
conducive for the emergence of a growing supply of
entrepreneurs.

Pool
In capital budgeting, the concept that investment
projects are financed out of a pool of bonds,
preferred stock, and common stock, and a
weighted-average cost of capital must be used
to calculate investment returns.
In insurance, a group of insurers who share
premiums and losses in order to spread risk.
In investments, the combination of funds for the
benefit of a common project, or a group of
investors who use their combined influence to
manipulate prices.
Cont

A temporary affiliation of two or more people

in an attempt to manipulate a security's
price and/or volume.
The pool is necessary in order to acquire the
capital needed to manipulate a stock
having a large market value.
Pools were especially popular in the 1920s
and early 1930s but now have been
regulated out of existence

Netting
Reducing transfers of funds between subsidiaries
or separate companies to a net amount.
Netting is a process the National Securities
Clearing Corporation (NSCC) uses to streamline
securities transactions.
To net, the NSCC compares all the buy and sell
orders for each individual security and matches
purchases by clients of one brokerage firm with
corresponding sales by other clients of the firm.

Cash flows before netting

100m
40m

U.K.
parent
100m

60m
200m

German
U.S.
100m
subsidiary
subsidiary

Cash flows after netting

60m

German
subsidiary

U.K.
parent

140m

U.S.
subsidiary

Leading and lagging

Refers to altering the timing of cash flows
within the corporation to offset foreign
exchange exposures
Leading - If a parent firm is short euros,
it can accelerate euro payments from its
subsidiaries
Lagging - If a parent firm is long euros,
it can accelerate euro payments to its
subsidiaries

The Technology of Financial

System:h
Delegation

Netting

Basic
Technology
Techniques of
Financial
System

Credit
Substitution

Pooling

Delegation: Delegation is the process of appointment of

someone to act for other.
Delegation helps to reduces transaction cost for
following reasons;
1. Delegation allows specialization.
2. The delegate is in a stronger position.
3. Revealing information.

Pooling:Pooling is the combination of assets and liabilities

in ways that reduce risk and maintain liabilities.

Credit Substitution: Credit substitution refers to liability transfer

between one party to another party.
For example: a bank substitutes its own credit
for the credit of the borrower.

Netting:Netting is offset of one transaction against to

reduce the number of transaction that actually
need be executed.
Example: Clearing house.

Financial Systems Basic

Technology
Financial Systems Basic Technology
Includes

Delegation
Credit Substitution
Pooling
Netting

Delegation
Rather than doing the things oneself, one can
assign some one else to the work on his behalf
This is being done mostly to reduce costs and
make the operations more efficient.
Examples: indirect lending
* Consumer lending through dealers / suppliers
* Lenders delegating to underwriter task of
setting up a loan & documentation
* In forward trx, traders delegate to Futures EX.

Delegation- Reducing costs

Many costs of a trx. are indivisible eg.
Syndication of loans.
Delegation allows specialization. The
delegate representing many lenders and
lending more often acquires expertise.
The delegate can negotiate better terms.
Revealing information to one delegate
would be more acceptable to the borrower.

Delegation- Fundamental issue

How the delegate to be trusted?
Two possible solutions to this are:
1.Bonding: putting up of assets to guarantee
performance
2.Reputation:General estimation in which
someone is held by the public

Credit Substitution
Replacement of credit of one party to a transaction with the
(superior) credit of a financial institution.
In many cases delegation combined with credit substitution.
eg. A bank substitutes its own credit for the credit of the
borrower: depositors lend to the bank rather than to the
ultimate borrower.
Credit substitution works because the promise of bank,
insurance company or future exchange is more acceptable
than the promise of the ultimate trading partner. This is due
to following two reasons:
* Reputation of FI
* FIs resources and capabilities in fulfilling the promise.

Delegation & Credit substitution

Delegation & credit substitution may not
always go together.
Underwriters don't guarantee the issues
they float : there is a delegation but not
credit substitution.
When bank money is used in payment,
the bank substitutes its own credit for the
credit of the buyer: there is credit
substitution but no delegation.

POOLING
Pooling is a resource management term that refers to the
grouping together of resources (assets, equipment,
personnel, effort, etc.) for the purposes of maximizing
advantage and/or minimizing risk to the users. The term is
used in many disciplines.
Pooling is combination of assets & liabilities in ways that
reduce risk or improve liquidity.
Pooling makes the liabilities of an FI (the promises it
makes) safer and more liquid than its assets (the promises
to it). Eg. pooling makes bank depositors safer and more
liquid than assets.
One reason pooling works is diversification, other is netting.

 Pooling is the grouping together of assets, and

related strategies for minimizing risk. Debt
instruments with similar characteristics, such as
mortgages, can be pooled into a new security, for
example:
Asset-backed securities (ABS)
Mortgage-backed securities (MBS)
Collateralized debt obligations (CDO)
Collateralized mortgage obligations (CMO)
Structured finance

Collective investment schemes for pooling in

relation to investment.

 Securitization
Intergovernmental risk pool
Pooling of interests is a mergeraccounting method that was taken out of
the market in the United States by
the Financial
Accounting
Standards
Board on June 30, 2001.

NETTING
Netting is offset of one trx. against another, to
reduce the number of trx.s that actually need to
be executed.
Executing a trx. is costly. Netting lowers costs by
offsetting one trx. against another.
Example: clearing of checks, by netting banks
obligations to one another reduces the need for
physical transfer and thereby reduces costs.

 DEFINITION of 'Netting'
Consolidating the value of two or more transactions,
payments or positions in order to create a single value.
Netting entails offsetting the value of multiple positions,
and can be used to determine which party is owed
remuneration in a multiparty agreement.
Netting is a general concept that has a number of more
specific uses. In a case in which a company is filing for
bankruptcy, parties that do business with the defaulting
company will offset any money owed to the defaulting
company with any money owed by the defaulting company.

The remainder represents the total amount owed to the

defaulting company or money owed by it, and can be used in
bankruptcy proceedings.
Companies can also use netting to simplify third-party invoices,
ultimately reducing multiple invoices into a single one. For
example, several divisions in a large transport corporation
purchase paper supplies from a single supplier, but the paper
supplier also uses the same transport company to ship its
products to others. By netting how much each party owes the
other, a single invoice can be created for the company that has
the outstanding bill. This technique can also be used when
transferring funds between subsidiaries.

 Netting is also used in trading. An investor

can offset a position in one security or
currency with another position either in the
same security or another one. The goal in
netting is to offset gains in one position
with losses in another.

Netting
Netting also creates liquidity eg. Bank can
hold relatively illiquid assets because it
can meet withdrawals out of new deposits,
without having to liquidate the underlying
assets. By netting new deposits and
withdrawals, it reduces the need to buy
and sell the underlying assets.
Secondary markets work in much the
same way.