Chapter four

Financial Institutions in the

Financial System
1
Introduction

FINANCIAL INSTITUTIONS
• Financial institutions serve as intermediaries by
channeling the savings of individuals, businesses, and
governments into loans or investments

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Major Role of Financial
Intermediaries

1. Transaction Costs and Economies of Scale

Transaction costs = the time and money spent in carrying out
financial transactions.
• Financial intermediaries help reduce transaction costs by
taking advantage of economies of scale
Example: a bank can use the same loan contract again and again,
thereby reducing the costs of making each individual loan.
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Major Role of Financial
Intermediaries

2. Risk Sharing and Diversification

Risk = uncertainty about the returns investors will

receive on any particular asset.
•By purchasing a large number of different assets
issued by a wide range of borrowers, financial
intermediaries use diversification to help with risk
sharing.
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• Example: by lending to a large number of different businesses,
a bank might see a few of its loans go bad; but most of the
loans will be repaid, making the overall return less risky.
• Here, again, the bank is taking advantage of economies of
scale, since it would be difficult for a smaller investor to make
a large number of loans.

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Major Role of Financial
Intermediaries
3. Asymmetric Information: Adverse Selection and Moral Hazard
• One party often does not know enough about another party to make accurate
decisions. This inequality is called information asymmetry.
• Financial intermediaries use their expertise to screen out bad credit risks and
monitor borrowers.
• They thereby help solve two problems related to imperfect information in
financial markets.
Adverse Selection = refers to the problem that arises before a loan is made because
borrowers who are bad credit risks tend to be those who most actively seek out
loans.
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• Financial intermediaries can help solve this problem by
gathering information about potential borrowers and screening
out bad credit risks.
Moral Hazard = refers to the problem that arises after a loan is
made because borrowers may use their funds irresponsibly.
• Financial intermediaries can help solve this problem by
monitoring borrowers’ activities.

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Depository Institutions (DIs)

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 Depository Institutions (DIs)
• DIs accept deposits from economic agents (liability to them)
and then lend these funds to make direct loans or invest in
securities (assets)
• Income of DIs:
•Income generated from loans
•Income generated from investment in securities, &
•Fee income

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Constituents of DIs

• DIs include:
• Commercial Banks
• Microfinance Institutions (MFIs)
• Saving Banks
• 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/ Liability Problems of DIs

• DIs face the following risks:

• Credit (Default) risk
• Regulatory risk
• Funding 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 rate
movement may move in such a manner that 13

profits will be adversely affected

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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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 deposits
2. Lending Money
• Overdrafts
• Loans and Advances
• Discounting 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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• 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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 Secondary Functions : General Utility
service

• 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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Investment Banking
20
Introduction

• An investment bank helps an organization, which may be

a company, or a government or one of its agencies, in the
issuance and sale of new securities.
• Investment banks are experts at calculating what a
business is worth: to price a securities offering or to set
the value of a merger or acquisition.

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Introduction

• In this sense, Investment banks are intermediaries

between the issuers of securities and the investing public.
• IBs serve as brokers intermediating between fund
suppliers and users.
• Investment banking also offers advice for a wide range
of transactions a company might engage in

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 Core activities of investment
banking firms

• Specifically these activities can be classified as follows:

• Public offering (underwriting) of securities
• Trading of securities
• Merger and acquisitions

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 1. Public Offering (Underwriting) of
Securities
• The function of buying the securities from the issuer is called
underwriting.
• Traditional process in the US for issuing new securities
involves investment bankers perform one or more of the
following three functions.
– Advising the issuer on the terms and the timing of the offering
– Buying the securities from the issuer
– Distributing the issue to the public

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1. Public Offering (Underwriting) of
Securities

• In public offering, the securities may be underwritten on

• a firm commitment basis or
• best effort, and the securities may be offered to the public at
large.

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(i). Pub offering: Firm Commitment underwriting

• Here the investment bankers act as principal, purchasing

the securities from the issuer at one price and seeking to
place them with the public investors at a slightly higher
price.
• Here the bank guarantees the issuing body a price for
newly issued securities by buying the whole issue at a
fixed price from the issuer (the bid price).
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(i). Pub offering: Firm Commitment underwriting

• The investment bank then seeks to resell securities to

suppliers of funds (investors) at a higher price (the offer
price).
• As a result, the investment bank takes a risk that it may
not be able to resell the securities to investors at higher
prices.
• If IB could not sell the securities, it incurs a loss.
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(i). Pub offering: Firm Commitment underwriting

• Income of IB= Resale price – Purchase price

• This difference is called the gross spread, or the
underwriting discount.
• Gross spread = reoffer price – purchase price

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ii. Pub offering: Best-efforts offering

• The investment bank does not guarantee a price to the

issuer (as with a firm commitment offering) and acts
more as a placing or distribution agent on a fee basis
related to its success in placing the issue.
• IB agrees only to use its expertise to sell the securities; it
does not buy the entire securities from the issuer.

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ii. Pub offering: Best-efforts
offering

• The investment bank incurs no risk of mispricing the

securities since it seeks to sell the securities at the price it
can get in the market.
• In return the investment bank receives a fee.

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2. Core Activity- Trading of
Securities

• It would be a mistake to think that once the securities are

all sold the investment banking firm ties with the deal are
ended.
• In the case of bonds, for example, those who bought the
securities will look to the investment banking firm to
make a market in the issue.

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2. Core Activity- Trading of
Securities

• Market making involves the creation of a secondary

market in an asset by a security firm or investment bank.
• Thus, in addition to being primary dealers of government
securities and underwriters of corporate bonds and
equities, investment bankers make a secondary market in
these instruments.

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2. Core Activity- Trading of
Securities

• Revenues from this activity is generated through

(1) the difference between the price at which the investment
banking firm sells the securities and the price paid for the
securities (called bid ask spread), and
(2) appreciations of the price of the securities held in inventory.

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2. Core Activity- Trading of
Securities

• To protect against a loss, investment banks engage in

hedging strategies.
• Various strategies are employed by traders to generate
revenue from positions in one or more securities

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3. Core Activity: Merger and
Acquisitions
• Investment banking firms are active in merger and
acquisitions (M&A).
• Investment bankers may participate in M&A activity in
one of several ways:
• Finding M&A candidates
• Underwriting any new securities to be issued by the merged
firms

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3. Core Activity: Merger and
Acquisitions

• Advising acquiring companies or target

companies with respect to price (e.g. value of
target firms) and non-price terms of an
exchange, or helping target companies fend
off an unfriendly takeover attempt

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3. Core Activity: Merger and
Acquisitions

• Assisting acquiring companies in obtaining the

necessary funds to finance a purchase,
• Recommend terms of the merger agreement, and
even assisting target firms in preventing a merger

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Commercial banks and Investment
Banks
• Commercial banks make loans to borrowers
from the funds provided by the other side of their
business—taking deposits from individuals and
firms.
• An investment bank does not have an inventory
of cash deposits to lend as a commercial bank
does
• IBs raise funds for borrowers by acting as
intermediaries for them in the financial markets 38
 Commercial banks and Investment
Banks

• If a company needs capital, it may get a

loan from a bank, or it may ask an
investment bank to sell equity or debt
(stocks or bonds).

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Non-depository Financial
Institutions
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• These Non-depository institutions are
financial institutions that do not mobilize
deposits:
• These include (among others):
• Insurance companies
• Mutual funds
• Pension funds
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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 by policyholder.

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Types of Insurance Business

• Insurance industry is classified in to two

• Life insurance
• General or Property-causality insurance

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 Types of Insurance Business
1. Life insurance: deals with death, illness disablement
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. Property insurance is
normally divided into two: personal and commercial
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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)

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Types of Insurance business

According to Fabozzi, insurance products and contracts are

classified as:
1. Life insurance
2. Health insurance
3. Property and causality insurance
4. Liability insurance

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Types of Insurance business

5.Disability insurance
6. Lon-term care insurance
7. Structured settlements
8. Investment-Oriented Products

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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 of financial assets,
mostly equity both domestic and overseas and
also in liquid money and capital market.

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Nature of Mutual Fund

• 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
of different companies

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Nature of Mutual Fund

• The stocks of these mutual funds are very liquid and are
used for buying or redeeming and/or selling shares at a
net asset value.
• Mutual funds posses shares of several companies and
receive dividends from them and the earnings are
distributed among the shareholders.

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Nature of Mutual Fund

• Mutual funds sell shares (units) to investors and

redeem outstanding shares on demand at their fair
market value. Thus, they provide opportunity of
small investors to invest in a diversified portfolio of
financial securities.
• Mutual funds are also able to enjoy economies of
scale by incurring lower transaction costs and
commission.
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Advantage of Mutual Funds

1. Mobilizing small saving

2. Professional management
3. Diversified investment/ reduced risks
4. Better liquidity
5. Investment protection
6. Low transaction cost (economies of scale)
7. Economic Development

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Return to Investors in the Mutual
Fund

• Investors in the mutual fund have the potential to gain

b/c:
• They are entitled to a share in the capital appreciation of the
underlying assets,
• They have a claim on the income generated by the underlying
assets of the fund

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Types of Mutual Funds

1. Open-ended mutual funds

2. Closed-ended mutual funds

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Open-ended mutual funds-Characteristics

• 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 on
demand 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.
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 Open-ended mutual funds-
Characteristics
• 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 portfolio minus the
liability of the MF divided by the number of shares owned
by the MF investors
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Open-ended: NAV

• NAV= Mkt V of Portfolio-Liabilities

No. of shares outstanding

• The NAV is determined only once each day, at the close of the day. For
example, the NAV for a stock of MF is determined 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 from the 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 day’s closing NAV)

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Open-ended: NAV

• The total No of shares in the fund increase if more

investments than withdrawals are made during the day,
and vice versa.
• If the price of the securities in the portfolio change, both
the total size of the portfolio and therefore, the NVA will
change.

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Open-ended: NAV

• In the open-ended MF investors buy and sell shares from

and to the MF company. Thus, the demand for shares
determines the No of shares Outstanding, and the market
value of underlying securities held in the MF divided by
the No of shareholders outstanding determines the NAV
of shares.

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 Open-ended: NAV

• Overall, the NAV of a mutual fund increase or decrease due to

an increase, or decrease in the price of the securities in the
portfolo.
• The No of shares in the fund increase or decrease due to the net
deposits or withdrawal from the fund.
• And the total value of the fund increases or decreases for both
reasons.

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Open-ended: NAV

• Examples 1:
• Suppose today a MF contains 1000 shares of ABC which are traded at
$37.75 each, 2,000 shares of Exxon (currently traded at $43.70) and
1,500 shares of Citigroup currently trading at $46.67. The MF has
15,000 shares outstanding held by investors. Thus, today’s NAV is
calculated:
(1000x 37.75) + (2,000x43.7) +1,500 x 46.67 =13.01
15,000

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Open-ended: NAV

• If tomorrow ABC’s shares increase to $45, Exxon’s

shares increase to $48, and Citigroup’s shares increase to
$50, the NAV (assuming the No of shares outstanding
remains the same) would increase to:
1000x45 + 2000 x 48 + 1500x 50 = 14.40
15,000

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Open-ended: 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 $13,010 additional funds to invest.

• Suppose that the fund mgr decides to use these additional

funds to buy additional shares in ABC.

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Open-ended: NAV

• At today’s 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 in Exxon, and 1,500 in
Citigroup.
• Given the same rise in share value as assumed above, tomorrow’s NAV will
be:
1,344 x $45 + 2,000 x $48 + 1,500 x $50 = 14.47
16,000

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 Open-ended: NAV

• The additional shares and the profitable investment made

with the new funds from these resulted in a slight higher
NAV than had the No of shares remained static ($14.47
versus $14.40)

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Closed End Fund

• The shares of a closed-end fund are similar to the shares of

common stock of a corporation. The new shares of a closed-
end fund are initially issued by an underwriter for the fund.
• And after the new issue, the No of shares remains constant.
• After the initial issue, no sale or purchase of fund shares 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-counter market
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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’s shares is
determined by the underlying shares as well as by the
demand for the investment company’s shares themselves.

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Closed End Fund

• When demand for the investment company’s shares is

high, because the supply of shares in the fund is fixed the
shares can trade for more than the NAV of the securities
held in the fund’s assets portfolio. In this case the shares
said to be trading at a premium.
• If demand is low, the shares are sold for discount.

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Difference b/n Open-end and
Closed-end MF
1. The No of shares of an open-end fund varies because the fund
sponsor sells new shares to investors and buys existing shares
from shareholders. By doing so the share price is always the
NAV of the fund.
2. In contrast, closed-end fund have a constant number of shares
outstanding because the fund sponsors do not redeem shares
and sell new shares to investors except at the time of a new
underwriting. Thus, supply and demand in the market
determines the price of the fund shares, which may be above or
below NAV.
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C. Pension Funds

• Pension funds are major institutional investors and participants in

the financial markets.
• Pension plan is established for the eventual payment of
retirement benefits
• The entities that establish pension plans-called plan sponsors-
may be private business entities acting for their employees,
federal, state, and local entities on behalf of their employees.
• Pension funds are financed by contribution from employer and/or
employees

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 Pension Funds

• The key factor explaining pension fund growth is

that the employer’s contribution and a specified
amount of the employee’s contribution, as well as
the earnings of the fund’s assets, are tax exempt.
• In essence, a pension is a form of employee
remuneration for which the employee is not taxed
until funds are withdrawn.
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 Types of pension Plans

• Two basic and widely used types of pension plans are:

• Defined benefit plans- sponsor agrees to make specified (or
defined) payment to qualifying employees at retirement and
• Defined contribution plans- sponsor is responsible only for
making specified (or defined) contribution into the plan on
behalf of qualifying employees, but does not guarantee any
specified amount at retirement.
• In addition a hybrid of plans, called a cash plan, combination
features of both pension plan types

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