3 Chapter 3 Financial Institutions and Their Operations Lecture Notes

8/2/2019 3 Chapter 3 Financial Institutions and Their Operations Lecture Notes

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Introduction The term financial institutions and financial

intermediaries are often used interchangeably. The financial institutions or intermediaries are engaged

in the business of channeling money from savers to

borrowers.

This channeling process, which is known as financialintermediation, is crucial to a well functioning of

modern economy

Chapter ThreeChapter Three


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Introd

current economic activity depends heavily on credit

(most of which goes through financial

intermediaries, as with bank credit cards) and

future economic growth depends heavily onbusiness investment.

For example, a student loan for college which

increases the level of education and human capitalwill promote future economic growth of a country.


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Introd

Functions ofFinancial Institutions

With in the main functions of channeling funds from

savers to borrowers, financial institutions perform

five important functions.

1. Pooling the savings of individuals

2. Providing safekeeping, accounting and access to

payments system3. Providing liquidity

4. Reducing risk by diversifying

5. Collecting and processing information


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Introd

1. Pooling the savings of individuals

Small savers may not have enough money

individually to make large loans or buy bonds, but

through the bank they can indirectly invest in loans,

bonds, and other assets and earn better rates of

interest than they could on their own.

2. Providing safekeeping, accounting and access topayments system

Financial institutions (e.g. banks) are safe places to

deposit money, especially since bank deposits are

insured up to a certain level of money.


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Introd

3. Providing liquidity

Liquidity refers to the ability of the financial assets

to be converted in to cash.

Therefore, financial institutions facilitate liquidity.


When financial institutions pool the savings of

individuals, they invest them in a wide variety ofloans, bonds, and other assets.


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Introd


Financial institutions have a much easier time than

individuals do when it comes to screening out bad credit

risks and monitoring loans for complains. This is because financial institutions have a wealth of

information about current and past applicants, as well as

standardized procedures for evaluating creditworthiness.

In the subsequent sections we will discuss: Role and function of central banks

Depository institutions and

Non-depository institutions


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Part I: Central Banks

Nature of Central Banks: A central bank, reserve bank, ormonetary authority is a

banking institution granted the exclusive privilege to lend agovernment its currency.

A central bank is the apex bank in a country. It is called bydifferent names in different countries:

Reserve bank of India,

The bank of England

The federal Reserve System inAmerica

The Bank of France in France

National Bank of Ethiopia in Ethiopia

State Bank of

Pakistan


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Functions of Central Bank

1. Regulator of currency

2. Banker, FiscalAgent andAdvisor to the Government

3. Custodian of Cash reserve of Commercial Banks

4. Custody and Management of Foreign ExchangeReserves

5. Lender ofLast resort

6. Clearing House for transfer and settlement

7. Controller of Credit


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1. Regulator of currency

It is the bank of issue. It has monopoly of notes (legal

tender money) issue.

This monopoly of issuing notes has the following

benefits:

Uniformity in the notes issued which helps in facilitating

exchange and trade.

Enhances stability in the monetary system and creates

confidence among the public

The central bank can restrict or expand the supply of cash

according to the requirement of the economy


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2.Banker, Fiscal Agent and Advisor to the

Government

As banker to the government the central bank:

bank keeps the deposits of the government and makes

payment on behalf of the government (state and/or central)

But it does not pay interest on govt deposits

It buys and sells foreign currency on behalf of the

government

It keeps the stock of gold of the government

Thus, it is the custodian of government money and wealth.


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2. Banker, Fiscal Agent and Advisor to the

Govt .Contd

As fiscal agent of the govt Central bank:

Makes short term loans to the govt

It floats loans, pays interest on them, and finally repays

them on behalf of the govt

Thus, it manages the entire public debt


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2. Central Bank as Banker, Fiscal Agent and

Advisor to the Govt .Contd

AsAdvisor of the govt the central bank

Advises the govt on such issues as

economic and monetary matters as controlling inflation ordeflation,

devaluation or revaluation of the currency,

Deficit financing

Balance of payment etc


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3. Custodian of Cash Reserve

Requirement of Comm. Banks

Comm. Banks are required to keep reserve equal to acertain percentage of both time and demand depositswith the Central bank.

It is on the basis of these reserve that central banktransfers funds from one bank to another to facilitateclearing of checks.

The central bank acts as the custodian of the cash

reserve requirement of commercial banks and helps infacilitating their transactions.

(As the case of fed funds)


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4.Custody and Mgt of Foreign

Exchange

It keeps and manages the foreign exchange reserve of thecountry

It sells gold at fixed price to the monetary authority of other

countries

It buys and sells foreign currencies at international prices

It fixes the exchange rates within narrow limits in keeping itsobligation as a member of IMF

It manages exchange control operations by supplying foreigncurrencies to importers and persons visiting foreign countrieson business, studies, etc in keeping with the rules laid down bythe govt


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5.Central Bank

Lender ofLast resort

As lender of last resort, the central bank grantsaccommodations in the form of re-discountsand collateral advances to commercial banks, bill

brokers, dealers, or other financial institutions This facilities help such institutions in order to help

them in times of stress so as to save financialstructure of the country from collapse.


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6. Clearing House for transfer and

settlement

It acts as a clearing house for transfer and

settlement of mutual claims of commercial banks


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7. Controller of Credit

This is the most important function of central bank in

order to control inflation and deflation.

It adopts quantitative methods and qualitative

methods

Quantitative methods aim at controlling the cost and

quantity of credit by adopting:

Bank rate policy Open market operation and

By variation in reserve ratio of commercial banks


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7. Controller Of Credit. Contd

Qualitative methods control the use and direction

of credit.

These involve:

Selective credit control

Direct action


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7. Controller of Credit. Contd

Additional controlling functions of Central banks

include the supervising and controlling of

commercial banks:

Issue oflicences

The regulation ofbranch expansion

To see that every bank maintains the minimum paid up

capital and reserve as provided by law

Inspection or auditing the accounts of banks


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7.Controller of Credit. Contd

To approve the appointment of chairpersons and directors

of such banks in accordance with the rules and

qualifications

To control and recommend mergerof weak banks in orderto avoid their failures and to protect interest of depositors

To recommend nationalization of certain banks to the

government in public interest

To publish periodical reports relating to different aspects of

monetary and economic policies


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Central Bank and objectives of Credit

Control

The credit control is the means to control the lendingpolicy of Commercial banks by the central bank toachieve the following objectives

To stabilize the internal price level To stabilize the rate of foreign exchange

To protect the outflow of gold

To control business cycles

To meet business needs To have growth with stability.


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Monetary Policy (MP)

Definition of MP:

MP refers to credit control measures adopted by centralbanks of a country

MP refers to a policy employing central banks controlof the supply of money as an instrument for achievingthe objective of general economic policy.

MP= any conscious action undertaken by the monetaryauthorities to change the quantity, availability, or costof money


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Objectives of MP

The following are the Principal objectives of

Monetary Policy:

1. Price Stability

2. Economic Growth

3. Balance ofPayment

4. Full Employment


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1. Price Stability objective of Central

Banks

Price Stability means relative controlling of

inflation or deflation.

Deflationary price level raises increasing

unemployment and falling level of out put and

income. It ultimately leads to depression.

Inflation is unjust and ruins the general economic

welfare of the community


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Price Stability objective of Central

Banks (contd)

The goal of price stabilization implies that in generalthe average price level as measured by the wholesale price index or consumers price index should not

be allowed to vary beyond narrow margins.


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2. Economic Growth Objective

Economic growth can be defined as the process

whereby the real per capita income of a country

increases over a long period of time.

It is measured by the increase in the amount of

goods and services produced in a country.


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2. Economic Growth Objective

Contd

How Monetary Policy contribute to Economic

Growth?

Through:

Management ofAggregate Demand

Encouragement to saving and Investment


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3. Balance ofPayment objective

A balance of payment deficit is defined as equal to

the excess of money supply through domestic credit

creation over extra money demand for cash.

BP deficit reflects excess money supply in theeconomy. As the result people exchange their excess

holdings for foreign goods and services. (increased in

import over export; and outflow of currency will be

more than the inflow of currency).


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4. Full Employment Objective

Definition of Full Employment:

Full employment is a situation in which every body

who wants to work get work. ( Keynes).


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4.Full Employment-contd

It should be noted that full employment is not and

end in itself. It is a precondition for maximum

social welfare.

Along with the full employment of labor, other

economic resources must be used with maximum

efficiency and productivity.


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Instruments of MP

The monetary authority use different instruments to

achieve the objectives of MP of their country. They

are divided in to two categories:

1.AQuantitative, general or indirect includes: bank rate variations,

open market operations, and

changing reserve requirements.

They are meant to regulate the overall level of creditcontrols in the economy through commercial banks.


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Instruments of MPContd

2. Qualitative, selective or direct- ( include changing

margin requirement, and regulation of consumer

credit). They aim at controlling specific types of credit.


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1. Bank rate Policy: as Instrument of

MP

The bank rate is the minimum lending rate of thecentral bank at which it rediscounts first class bill ofexchange and government securities held byCommercial Banks (CBs). When there is inflation in

the economy the central bank raises the bank ratewhich affects the cost of credit: Borrowing from the Central bank becomes costly and

commercial banks borrow less from it.

The Commercial Banks in turn raise their lending to the

business communities and borrowers borrow less fromCBs.

There is contraction of credit and prices are checked fromrising further


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Bankrate Policy: as Instrument of MP

When prices are depressed, the central bank lowers the

bank rate:

It is cheap to borrow from national bank (NB) on the part

of the CBs. The latter also lower their lending rates.

Business people are encouraged to borrow more.

Investment is encouraged.

Output, employment, income and demand start rising and

the downward movement of prices is checked.


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22.. OpenOpen MarketMarket OperationOperation:: asas instrumentinstrument ofof

MPMP

Open market operation refers to sale and purchase ofsecurities in the money market by central bank.

With rising price (inflation), the NB sells securities. Thereserve of CBs are reduced and they are not in a position to

lend more to business people. Further investment isdiscouraged and the rise in prices is checked.

When recessionary forces start in the economy, the NBbuys securities. The reserves of CBs are raised. They lendmore. Investment, output, income and demand rise, and fall

in price is checked.


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33.. ChangeChange inin reservereserve ratioratio:: asas

InstrumentInstrument ofof MPMP

Every bank is required by law to keep a certain

percentage of its total deposits in the form of a

reserve fund in its vault and also a certain

percentage with the central bank (NB).

For instance, when prices are rising, the NB

raises the reserve ratio. Banks are required to

keep more with the central bank. Theirreserves are reduced and they lend less. The

volume of investment, output, and

employment are adversely affected


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Types of financial institutions

Financial institutions can be classified in many

different ways. The standard classification, however,

will be as follows:

DepositoryInstitutions

Non-DepositoryInstitutions

Commercial Banks Insurance Companies

Savings and LoanAssociations

Pension Funds

Saving Banks Investment Companies

Credit Unions Investment Banking firms


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Part II Depository Institutions (DIs)

DIs accept deposits from economic agents (liabilityto them) and then lend these funds to make directloans or invest in securities (assets)

Income of DIs: Income generated from loans

Income generated from investment in securities, and

Fee income


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Depository

Depository institutions, which are usually just called

banks, are categorized as such because their primary

source of funding is the deposits of savers.

In other words, depository institutions are financialintermediaries that accept deposits.

These deposits represent the liabilities (debts) of the

deposit accepting financial institutions.

With the fund raised through deposits and other funding

sources, they make direct loans to various entities and

invest in securities.


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Depository

In U.S.A., the Federal Deposit Insurance Corporation

(FDCI) insures the savings accounts of such institutions

up to a certain limit.

Depository institutions are further subcategorizeddepending on the market they serve, their primary

source of funding, type of ownership, how they are

regulated and the geographic extent of their market.

Thus, depository institution includes commercial banks,

saving and loan associations, saving banks and credit

union.


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Depository

Depository institutions are highly regulated

because of the important role that they play in the

financial system.

Because of their important role, they are affording

special privileges such as:

access to federal deposit insurance, and

access to a government entity that providesfunds for liquidity of emergency needs.


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Constituents of DIs

DIs include:A. Commercial Banks

B. Saving and loan associations

C. Saving Banks

D. Credit unions


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Asset/ Liability Problems of DIs

Spread Income (margined Income)=

Income from loan and Investment Less cost

of its funds (deposit and other sources)


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Asset/Asset/ LiabilityLiability ProblemsProblems ofofDIsDIs (Contd)(Contd)

DIs face the following risks:

Credit (Default) risk

Regulatory riskFunding risk (interest rate risk)


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Risks of DI

Credit risk (Default risk) refers to the risk that a

borrower will default on a loan obligation or that

the issuer of the security that the DIs holds will

default Regulatory risk is the risk that regulators will

change the rules and affect the earnings of the

institutions unfavourably

Funding risk is the risk that the interest ratemovement may move in such a manner that profits

will be adversely affected


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Example of funding rsik

Suppose a DI raise $100 million by issuing a

deposit account with a 1 year maturity and agreeing

to pay interest rate of 7%. Ignoring the reserve

requirement, lets assume that the DI can invest theentire amount, in a government security at 9%

interest rate for 15 years

Thus spread for the first year= 2%


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Example (contd)

Spread for the remaining 14 years depends on thefuture interest rate that DI pays for its newdepositors in order to raise the $100 million:

If interest rate increases, spread declines If interest rate decreases, spread increases

If the DI must pay more than 9%, the spread will benegative.

DI benefit from decline in interest rate but suffers fromincreases


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Example (contd)

Suppose the DI could borrow funds for 15 years at 7%

and invest it in a government security maturing in 1

year earning 9%:

Spread income for Year 1= 2%.

Note that the deposit interest rate is fixed in this case,

while the investment in govt securities could vary.

S

pread after the first year: If interest rate on investment increases, DI benefit

If interest rate on investment declines, spread reduces


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Example (contd)

Justification:

A rise in interest rate benefits the DI b/s it can reinvest

the proceeds from the maturing 1-year government

security offering a higher interest rate.


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All DI face this funding problem. Managers of a DI

with particular expectation about future direction of

interest rate will seek to benefit from these

expectations: Those who expect rise in interest rate may pursue a

policy to borrow funds for a (long/short) and lend

funds for a (short/long).


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A. Commercial Banks

Com. Banks are those FIs which accept deposit

from the public repayable on demand and lend

them for short periods


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Bank Services

Commercial banks provide numerous services in the

financial system.

The services can be broadly classified as:1. Individual banking;

2. Institutional banking; and

3. Global banking.


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1. Individual banking:

It encompasses consumer lending, residential

mortgage lending, consumer installment loans,

credit card financing, student loan & individual

oriented financial investment service. They generate income:

Interest from loans

Fee income from credit card financing


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2. Institutional banking:

loans to non-financial corporations & financial

corporations (like insurance companies), government,

leasing companies etc.

They generate: Interest from loan to corporation & leasing

Fees from management of private assets pension funds,

custodial services.


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3. Global banking:

It concerns a broad range of activities involving

corporate financing & capital market & foreign

exchange products & services.

Most global banking generates fee income rather thaninterest income.


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BankBalance Sheet

1. BankAssets

Assets earn revenue for the bank and includes cash,

securities, loans, and property and equipment that

allows it to operate.A. Cash

One of the major services of a bank is to supply cash on

demand, whether it is a depositor withdrawing money

or writing a check or a bank customer drawing a credit.

Hence, a bank must maintain a certain level of cash

compared to its liabilities to maintain solvency.


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BankBalance Sheet

B. Securities

The primary securities that banks own are

Treasury Bills and Government Bonds.

These securities can be sold quickly in the

secondary market when a bank needs more cash.

Therefore, they are often referred to as secondary

reserves.


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BankBalance Sheet

C. Loans

Loans are the major assets for most banks. They

earn more interest than banks have to pay on

deposits, and, thus, are a major source of revenuefor a bank.

Loans include the following major types:Business loans, usually called commercial and industrial

loans.

Real estate loans, e.g., residential mortgages

Consumer loans, e.g., credit cards

Inter-bank loans, i.e., the loan given to other banks.


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BankBalance Sheet

2. BankLiabilities

Liabilities are either the deposits of customers or

money that banks borrow from other sources to

use to fund assets that earn revenue.

A. Checkable/Demand deposits

Checkable or demand deposits are deposits where

depositors can withdraw the money at will. Most checkable or demand accounts pay very little

interest or no interest.


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BankBalance Sheet

B. Saving and Time deposits

Since saving accounts are not used as a payment

system, banks are forced to pay more interest for it.

Saving deposits are mostly passbook saving accounts,where all transactions were recorded in a passbook.

C. Certificate ofDeposit (CD)

CD is a deposit where the depositor agrees to keep themoney in the account until the certificate of deposit

expires.

The bank compensates the depositor with a higher

interest rate.


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BankBalance Sheet

D. Borrowing

I. Banks usually borrow money from other banks in

what is called the central/federal funds market.

II. Banks also borrow funds from non-depositoryinstitutions, such as insurance companies, pension

fund.

However, most of these loans are collateralized in the

form of repurchase agreement, where the bank gives

the lender securities, usually Treasury bills, as

collateral for a short-term loan.


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BankBalance Sheet

III. As a last resort, banks can also borrow funds from the

central bank.

But since borrowing from the central bank shows that

banks are under financial stress and unable to getfunding elsewhere, they do this rarely.


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BankBalance Sheet

3. BankCapital

Banks can also get more funds either from the banks

owners if it is a corporation or by issuing more stocks.


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Functions of Commercial Banks

1. Primary Functions (Accepting deposits and lending

money)

2. Secondary Functions (agency services and general

utility service)


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Primary Functions of Comm. Banks

1.Accepting deposits

Current or demand deposits

Saving deposits

Fixed or time deposits2. Lending Money

Overdrafts

Cash credit

Loans andAdvancesDiscounting of bill of Exchange


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Secondary Services of Comm. Banks

1. Agency services: as an agent banker renders

the following services

Collection of cheques, drafts, and bill for

their customers

The collection of standing orders, e.g.,

payment of commercial bills, collection of

dividend warrants and interest coupons,payment of insurance premiums, rents, etc


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SecondarySecondary FunctionsFunctions:: AgencyAgency serviceservice

(Contd)(Contd)

Conduct of stock exchange transaction such as

purchase and sale of securities for the

customers,

Acting as executor and trustee,

Providing income tax services,

Conduct of foreign exchange business


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SecondarySecondary FunctionsFunctions ::GeneralGeneral UtilityUtility serviceservice

Safe keeping of valuables

Issue of Commercial letters of credit and travellers

cheque,

Collecting trade information from foreign countries

for their customers

Arrange business tours

etc


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Regulation of Commercial Banks

Financial Institutions provide various services:

the provisions of a payments mechanism;

maturity transformations;risk transformations;

liquidity provisions; and

reduction of transaction, information andsearch costs.


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Regulation

Failure to provide these services or a breakdown

in their efficient provision can be costly to both

the ultimate providers (households) and users

(firms) of funds. Because of the vital nature of he services they

provide, Commercial Banks (CmBs) are

regulated to protect against a disruption in the provision of these services and the cost this

would impose on the economy and society at

large.


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Types of Regulations of CBs

1. Safety and soundness regulation,

2. Monetary policy regulation,

3. Credit allocation regulation,4. Consumer protection regulation,

5. Investor protection, and

6. Entry and chartering regulation,


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1. Safety and soundness regulation,

Objective of this regulation is to protect

depositors and borrowers against the risk of

commercial banks failure. These regulation

include:Layer 1 protection: Commercial banks should

diversify their assets-

In US banks are prohibited from makingloans exceeding 10% of their own equity

capital fund to any one company or

borrower.


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11.. SafetySafety andand soundnesssoundness regulationregulation (contd)(contd)

Layer 2 protection:

Stockholders contribution (equity) to the

total fund of the banks should be adequate

in such a way that it protects liability claim

holders against insolvency risk.

The higher the proportion of capital

contributed by owners the greater theprotection


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11.. SafetySafety andand soundnesssoundness regulationregulation (contd)(contd)

Layers 3 protection: Provision of guarantee

fund (such as Bank insurance Fund in US)

Deposit insurance mitigates a rational

incentive depositors otherwise have to

withdraw their funds at the first hint of

trouble.


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2. Monetary Policy Regulation

In most countries, regulators commonly impose a

minimum level of required cash reserve to be held

against deposits

(see cash reserve ratio requirements of MPinstruments)


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3. CreditAllocation Regulation

Credit allocation regulation supports the

commercial banks lending to socially

important sectors as housing, farming etc. For

example;

a commercial bank may be required to hold

a minimum amount of assets (loan) in one

particular sector of the economyThe regulator may set maximum interest

rate, price or fees to subsidize certain sectors


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4. ConsumerProtection Regulation This regulation is concerned about the discrimination on

the basis of age, race, sex, of income-( Banks should notdiscriminate on such grounds).

For example, the US congress passed the HomeMortgage Disclosure Act (MHDA) in 1975 to prevent

discrimination by lending institutions. Since 1992, CBs have had to submit reports to

regulators summarizing their lending on a geographic basis, showing the relationship between the

demographic area to which they are lending and thedemographic data (such as income and percentage ofminority population) for that location.

CBs must now report the reason that they granted ordenied credit.


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5. InvestorProtection Regulation

In US a considerable laws protect investors who use

CBs directly to purchase securities and/or indirectly

to access securities markets through investing in

mutual banks or pension funds managed by CBs. Various laws protect investors against abuse such as

insider trading, lack of disclosure, outright , and

breach of fiduciary responsibilities.


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6. Entry and Chartering Regulation

The entry of CBs is regulated, as the their activities

once they have been established.

Increasing or decreasing the cost of entry into a

financial sector affects the profitability of firmsalready competing in that industry.

Thus, the industries heavily protected against new

entries by high direct costs (e.g. through capital

requirements) and high indirect costs (e.g. byrestricting the type of individuals who can establish

CBs) of entry, produce larger profits for existing firms

than those in which entry is relatively is easy


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Risks faced by Commercial Banks

A depository institution has many risks that must be

managed carefully, especially since a bank uses a large

amount of leverage.

Without effective management of its risks, it could veryeasily become insolvent.

In addition to the previously mentioned risks faced by

depository institutions, commercial banks face the

following risks.1. foreign exchange risk

2. sovereign risk and

3. operational risk


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1. foreign exchange risk

International banks trade large amounts of currencies,

which introduces foreign exchange risk, when the value

of a currency falls with respect to another. A bank may hold assets denominated in a foreign

currency while holding liabilities in their own currency.

If the exchange rate of the foreign currency falls, then

both the interest payments and the principal repayment

will be worthless than when the loan was given, which

reduces a banks profits.


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Banks can reduce this risk by hedging the risk with

forward contract, future contract or swaps which will

guarantee an exchange rate at some future date.

2. Sovereign risk: Many foreign loans are paid in U.S. dollars and repaid

with dollars.

Some of these foreign loans are to countries with

unstable governments.

If political problems arise in the country that threatens

investments, investors will pull their money out to

prevent losses arising from sovereign risk.


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In this case, the local currency declines rapidly

compared to foreign currencies, and governments will

often impose capital controls to prevent more capitalfrom leaving the country.

3. Operational risk:

It arises from faulty business practices or when

buildings, equipment, and other property required to

run the business are damaged or destroyed.


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Many types of operational risk, such as the destruction

of property, are covered by insurance.

However, good management is required to preventlosses due to faulty business practices, since such losses

are not insurable.


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B.Saving & loanAssociation

The basic purpose of establishing saving and loans

associations was pooling the savings of local residents

for financing the construction and purchase of a homes.

The collateral for the loan would be the home beingfinanced.

Saving and loans are either mutually owned (means

there is no stock outstanding) or have corporate stock

ownership, so technically the depositors are the owners.


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Assets ofSaving and LoanAssociations

Traditionally, the only assets in which saving and

loans associations were allowed to invest have

been:Mortgages (Loans secured by a property).

Mortgage backed securities

Government securities Saving and Loans Associations invest in short-term

assets for operational (liquidity) and regulatory

purpose.


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Funding ofSaving and LoanAssociations

The principal source of funds for Saving and Loans

Associations consisted of passbook savings accounts

and time deposits. Then it was expanded to negotiable order of withdrawal

(NOW) account, which is similar with demand account.


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C.Saving banks

Saving banks are institutions similar to saving and

loans associations even though they are much

older than S & Ls.

Originally, they were established to provide ameans for small depositors and earn a return on

their deposits.

They can be either mutually owned (i.e., mutuallysaving banks) or stockholder owned.

However, most saving banks are of the mutual

form.


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Asset structure of saving banks and S & Ls are almost

similar.

The principal assets of saving banks are residential

mortgages. The principal source of funds for saving banks is

deposits which is very similar with S & Ls.

They have obtained funds primarily by tapping the

savings of households.

D C di U i


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D.Credit Unions

They are the smallest & nonprofit depository

institution.

They can obtain either a state or federal charter.

Their unique aspect is the common bondrequirement for membership, such as:

the employees of a particular company,

unions,

religious affiliations or wholive in a specific area etc.

They are governed by a board of volunteers.


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Credit Unions are either cooperatives or mutually

owned.

There is no corporate stock ownership.

Since they are nonprofit and owned by theircustomers, they charge lower loan rates and pay

higher interest rates on savings.

Therefore, the dual purpose of credit unions is toserve their members saving and borrowing needs.

PART III. NON DEPOSITORYPART III. NON DEPOSITORY


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PART III.NONDEPOSITORYPART III.NONDEPOSITORY

INSTITUTIONSINSTITUTIONS

These Non-depository institutions are financial

institutions that do not mobilize deposits:

These include (among others):Insurance companies

Mutual funds

Pension funds

Investment Banking Firms

A I C i


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A. Insurance Companies

The primary function of insurance companies is to

compensate individuals and corporations

(policyholders) if perceived adverse event occur, in

exchange for premium paid to the insurer bypolicyholder.

I C i


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Insurance Companies

Insurance companies provide (sell and service)insurance policies, which are legally bindingcontracts.

Insurance companies promise to pay specified sumcontingent on the occurrence of future events, such asdeath or an automobile accident.

Insurance companies are risk bearer. They accept orunderwrite the risk for an insurance premium paid bythe policyholder or owner of the policy.

T f I B i


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Types of Insurance Business

Insurance industry is classified in to two

Life insurance

General orProperty-causality insurance

T f I B i


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Types of Insurance Business

1. Life insurance: deals with death, illnessdisablement and retirement policies. Products of life insurance companies include:

1. Term insurance

2. Whole of life insurance

3. Endowment policies

4. Annuities

2. General insurance: deals with theft, property,

house, car and general accident insurance. Propertyinsurance is normally divided into two: personaland commercial

I C i


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Insurance Companies

Income of Insurance Companies:

Initial underwriting income (insurance premium)

Investment income that occur over time

The profit of the insurance companies = insurance

premium + investment income operating expense +

insurance payment or benefits

T f I b i C td


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Types of Insurance business-Contd

According to Fabozzi, insurance

products and contracts are classified as:

1. Life insurance

2. Health insurance

3. Property and causality insurance

4. Liability insurance

T f I b i C td


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Types of Insurance business-Contd

5.Disability insurance

6. Long-term care insurance

7. Structured settlements

8. Investment-Oriented Products

Students are advised to read about types of

insurance and other insurance related topics

B M t l F d


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B. Mutual Funds

Nature of Mutual Fund

A mutual fund (in US) or unit trust (in UK and India)

raise funds from the pubic and invests the funds in a

variety financial asset, mostly equity both domesticand overseas and also in liquid money and capital

market. (Keith)

N t f M t l F d


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Mutual funds are investment companies that pool

money from investors at large and offer to sell and

buy back its shares on a continuous basis and use

the capital thus raised to invest in securities ofdifferent companies

Nat re of M t al F nd ctd


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Nature of Mutual Fund-ctd

The stocks these mutual funds are very fluid and

are used for buying or redeeming and/or selling

shares at a net asset value.

Mutual funds posses shares of several companiesand receive dividends in lieu of them and the

earnings are distributed among the share holders



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Mutual funds sell shares (units) to investors andredeem outstanding shares on demand at their fairmarket value.

T

hus, they provide opportunity of small investors toinvest in a diversified portfolio of financialsecurities.

Mutual funds are also able to enjoy economies of

scale by incurring lower transaction costs andcommission.

Advantage of Mutual Funds


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Advantage of Mutual Funds

1. Mobilizing small saving

2. Professional management

3. Diversified investment/ reduced risks

4. Better liquidity5. Investment protection

6. Low transaction cost (economy of scale)

7. Economic Development


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Types of Mutual Funds


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Types of Mutual Funds

1. Open-ended mutual funds

2. Closed-ended mutual funds

OO d dd d t lt l f df d Ch t i tiCh t i ti


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OpenOpen--endedended mutualmutual fundsfunds--CharacteristicsCharacteristics

New investors can join the funds at any time

A fund (unit) is accepted and liquidated on a continuous

basis by mutual fund manager

The fund manager buys and sells units constantly ondemand by investors-it is always open for the investors

to sell or buy their share units

It provides an excellent liquidity facility to investors,

although the units of such are not listed. No intermediaries are required.

There is a certainty in purchase price, which takes place

in accordance with the declared NAV.

OpenOpen--endedended mutualmutual fundsfunds--


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CharacteristicsCharacteristics

Investors in Mutual fund own a pro rata share of

the overall portfolio, which is managed by an

investment manager of the fund who buys some

securities and sells others The value or price of each share of the portfolio

is called net asset value (NAV)

NAV equals the market value of the portfoliominus the liability of the MF divided by the No

of shares owned by the NF investors

Open-ended:


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NAV

NAV= Mkt V ofPortfolio-Liabilities

No of shares outstanding

The NAV is determined only once each day, at the

close of the day. For e.g. the NAV for a stock MF isdetermined from closing stock price for the day.

Business publications provide the NAV each day in

their MF.

All new investments into the fund or withdrawal fromthe fund during a day are priced at the closing NAV

(investment after the end of the day or a non-business

day are priced at the next days closing NAV)

Open-ended:


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NAV

The total No of shares in the fund increases ifmore investments than withdrawals are madeduring the day, and vice versa.

If the price of the securities in the portfoliochange, both the total size of the portfolio andtherefore, the NVAwill change.


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Open-ended:


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NAV

Examples 1:

Suppose today a MF contains 1000 shares ofABC

which are traded at $37.75 each, 2,000 shares of

Exxon (currently traded at $43.70) and 1,500 shares ofCitigroup currently trading at $46.67. The MF has

15,000 shares outstanding held by investors. Thus,

todays NAV is calculated:

(1000x 37.75) + (2,000x43.7) +1,500 x 46.67 =13.01

15,000

Open-ended:


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NAV

If tomorrow ABCs shares increase to $45,

Exxons shares increase to $48, and

Citigroups shares increase to $50, the NAV

(assuming the No of shares outstandingremains the same) would increase to:

1000x45 + 2000 x 48 + 1500x 50 = 14.40

15,000

Open-ended:


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NAV

Example2:

Suppose that today 1,000 additional investors buy

one share each of the mutual fund (MF) at the NAV

of $13.01. This means the MF mgr has $13,010additional funds to invest.

Suppose that the fund mgr decides to use these

additional funds to buy additional shares in

ABC.

Open-ended:


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NAV

At todays mkt price, the mgr could buy 344

($13,010/$37.75 = 344) shares of ABC additional

shares: Thus,

its new portfolio of shares has 1344 in ABC, 2000 inExxon, and 1,500 in Citigroup.

Given the same rise in share value as assumed

above, tomorrows NAV will be:

1,344 x $45 + 2,000 x $48 + 1,500 x $50 = 14.47

16,000


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Closed End Fund


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The shares of a closed-end fund are similar to theshares of common stock of a corporation. The newshares of a closed-end fund are initially issued by anunderwriter for the fund.

And after the new issue, the No of shares remainsconstant.

After the initial issue, no sale or purchase of fundshares are made by the fund company as in open-end

funds. Instead, the shares are traded on a secondary market,

either on an exchange or in the over-the-countermarket

Closed End Fund


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Closed End Fund

Since the number of shares available for purchase, at

any moment in time, is fixed, the NAV of the fund is

determined by the underlying shares.

The return for holders of the funds shares isdetermined by the underlying shares as well as by the

demand for the investment companys shares

themselves.

Closed End Fund


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Closed End Fund

When demand for the investment companysshares is high, because the supply of shares inthe fund is fixed the shares can trade for more

than the NA

V of he securities held in the fundsassets portfolio.

In this case the shares said to be trading at apremium.

If demand is low, the shares are sold fordiscount.

DifferenceDifference b/nb/n OpenOpen--endend andand ClosedClosed--endend


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MFMF

1. The No of shares of an open-end fund varies becausethe fund sponsor sells new shares to investors and buysexisting shares from shareholders.

By doing so the share price is always the NAV of thefund.

2. In contrast, closed-end fund have a constant number ofshares outstanding because the fund sponsor does notredeem shares and sell new shares to investors except

at the time of a new underwriting.Thus, supply and demand in the market determines theprice of the fund shares, which may be above or belowNAV, as previously discussed.

C Pension Funds


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C. Pension Funds

Pension funds are major institutional investorsand participants in the financial markets.

Pension plan is established for the eventualpayment of retirement benefits

The entities that establish pension plans-calledplan sponsors- may be private business entitiesacting for their employees, federal, state, andlocal entities on behalf of their employees.

Pension funds are financed by contribution fromemployer and/or employees

Pension Funds


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Pension Funds

The key factor explaining pension fund

growth is that the employers contribution and

a specified amount of the employees

contribution, as well as the earnings of thefunds assets, are tax exempt.

In essence, a pension is a form of employee

remuneration for which the employee is nottaxed until funds are withdrawn.


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D. Investment Banking Firms


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D. Investment Banking Firms

It is a financial institution engaged in securities business.

They perform activities related to the issuing of new

securities and the arrangement of financial transactions.

They mainly involve in primary markets, the market inwhich new issues are sold and bought for the first time.

They advice issuers on how best to raise funds, and then

they help to sell the securities.

They are also involved in planning and executing other

types of financial transactions such as merger,

acquisition and restructuring.


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Thus, they perform two general functions:

1. They assist both government and

nongovernmental companies in obtaining

funds by selling securities, i.e., raise funds forclients.

2. They act as brokers or dealers in the buying

and selling of securities in secondary markets,i.e., assisting clients in the sale or purchase of

securities.

Activities of investment banking firms


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g

1. Public offering (underwriting of securities)

Investment bankers performing one or more of the

following three functions:

Advising the issuer on the terms and the timing of theoffering.

Buying the securities from the issuers.

Distributing the issue to the public.



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g

2. Private Placement ofSecurities

In addition to underwriting securities for

distribution to the public, investment banking

firms place securities with a limited number ofinstitutional investors like insurance companies,

pension fund etc.

3. Securitization of

Assets

Securitization of Assets refers to the issuance of

securities that have a pool of assets as collateral.



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g

4. Merger andAcquisition

They may participate in merger and acquisition

activity in one of the following ways:

Finding merger and acquisition candidates.Adjusting acquiring companies or target companies

with respect to price and non price terms of exchanges

or helping companies fend off (defend) an unfriendly

takeover.

Assisting acquiring companies in obtaining the

necessary funds to finance a purchase.



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g

5. Merchant Banking

When an investment banking firm commits its

own fund by either taking an equity interest or

credit position in companies, this activityreferred to as merchant banking.



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g

6. Trading and Creation ofDerivative Instruments

derivative instruments and they allow an investment

banking firms to realize revenue in the following ways:

Customers generate commissions from the exchangetraded instruments they buy and sell. That is,

commission generated by the brokerage service

performed for customers when they are bought and

sold. There are certain derivative instruments that an

investment banking firm creates for its clients. Eg.

Swap.



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g

7. Money Management

Investment banking firms have created subsidiaries that

manage funds for individual investors or institutional

investors such as pension funds.

Documents

3 Chapter 3 Financial Institutions and Their Operations Lecture Notes