Chapter-One

Introduction to Financial
Institutions

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1.1. Meaning and Nature of Financial Institutions

■ Financial system in an economy provides - financial

services - by which savings are transferred in to
investments.
[The collapse of Greece financial system]
■ Financial system consists of the following,
– A variety of institutions - financial institutions (bank ,
mutual fund, insurance company etc)
– Market - financial markets
– Instruments - financial instruments - (bond, common
stock and preferred stock, etc) – financial
assets/securities/claims.
– Services
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 Segments of Financial System

The four components:

INSTITUTIONS

SERVICES

INSTRUMENTS MARKETS

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1. Financial Institution
■ Financial institutions are one of the constitutes
of the overall financial system in an economy.

■ They act as agents that provide financial services

for its clients.

■ They can be defined as mobilizers and

depositors of savings and purveyors/providers of
credit or finance.

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■ Act as financial intermediary - they act as middlemen
between savers and borrowers.

■ Funds are or /can be/ transferred either directly or

indirectly in financial system.

■ Financial institutions undertake and facilitate indirect

finance .

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 2. Financial Service(s)
■The term ‘Financial Service’ in a broad sense means
“mobilizing and allocating savings”.

■Thus it includes various activities, functions and services

provided by financial institutions in the transformation of the
savings into investment.

■Services offered include:

■ Loan service
■ Leasing
■ Deposit service/depository
■ Housing finance
■ Merger and acquisition
■ Insurance service
■ Underwriting -involves loans, insurance, or investments. ---etc.
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 3. Financial Instrument

■ Financial instrument, also called security, is a financial asset

(not real asset) that help for borrowing and lending money.

■ It is a claim on the issuer’s future income or assets.

■ It includes, for example,:

– Government or Corporate Bond – a debt security that
promises to make payments periodically for a specified
period of time (i.e. interest and principal payments).
– Shares/Stock - an equity security - preferred stock, common
stock or other equity that gives ownership right to the
holder/buyer.
– Money Market Instruments-such as commercial papers for
temporary cash surplus holders to lend to those with
temporary cash deficit, maturing in maximum one year.10
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4. Financial Markets
■ Financial markets are the centers or arrangements that provide
facilities for buying and selling of financial claims and services.

■ Corporations , financial institutions, individuals and

governments trade in financial products on these markets.

■ The participants on the demand and supply sides of these

markets are financial institutions, agents, brokers, dealers,
borrowers, lenders, savers and others who are inter-linked by
the laws, contracts, covenants (Promise), and communication
networks..

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Con’t.…
■ Financial markets perform essential economic functions
of channeling funds.

■ Generally speaking, it is not necessary to have specific

place or location to indicate a financial market.

■ Wherever a financial transaction takes place, it is

deemed to have taken place in the financial market.

■ Hence, financial markets are pervasive in nature.

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1.2. Types/Classification of Financial Institution

There are two broad categories of financial institutions. These are:

1. Regulatory Institution - (central bank) –Regulate : interest
rate, foreign currency, credit, issue license , money supply ,
liquidity etc. In Ethiopia – NBE.

2. Intermediary Institutions–facilitate and provide financial

services under the regulation of the regulatory institution.

■ They stand between borrower and lender and help to transfer

funds from one to other through indirect finance.

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■ It includes but not limited to:
– Commercial Banks
– Insurance Company
– Savings and Loan Association
– Credit Union
– Pension Fund
– Mutual Fund, etc.

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 Intermediary Financial
Institution

Contractual
Depository Investment
(saving)
Institution Institution
Institution

Commercial Insurance Finance

Bank Company Company

Saving and Loan

Association –E.g. Pension Fund Mutual Fund
ACSI and others and others

Credit Union and

others-E.G.DMU
W/S/L/A
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Con’t…
1. Depository Institution
–Accept deposit and make loan

–Includes : -Commercial banks ,Savings and Loan

Association and Credit Union etc.

A. Commercial Banks
–Perform all kinds of banking function

–Their source of fund is deposit

–Use of fund - to make loan and to purchase different

government securities. 19
B . Saving and Loan Association

■ It is depository institution established for the purpose of

pooling saving of local residents to finance the construction
and purchase of home and satisfy other financing needs.

– Source of fund – Deposit

– Use of fund – Mortgage loan and others

■ Mortgage loan means it is debt instrument used to finance the

purchase of home and other form of real estate when the
underlying real estate serve as collateral.

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C. Credit Unions

■ Small lending institutions organized around

particular group; union members ,employees of
particular firm and residents of particular region.

– Source of fund - saving deposit called share

– Use of fund - consumer loan

■ They acquire fund from deposits and make

consumers loans.

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2 . Contractual Institutions
■ Acquire funds from people at periodic intervals on a
contractual basis and they invest these funds in long
term securities such as corporate bonds, stocks and
mortgages.

A. Insurance Companies
■ Provide various types of insurance for their customers,
including life insurance, property and liability
insurance, and health insurance.

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■ They periodically receive payments (premiums)
from their policyholders, pool the payments, and
invest the proceeds until these funds are needed to
pay off claims of policyholders.

– Source of fund - premium

– Use of fund - long term securities (investments)

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Con’t…
B. Pension Funds
■ These institutions provide retirement income in the form of
annuities to employees who are covered by a pension plan –
based on contract.

■ They receive payments from employees and employers and

then invest the proceeds.
– Source of fund - contribution from employees and
employers
– Use of fund – investment in stock and bond etc.

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Con’t…
3. Investment Intermediaries/Institutions
■ This category of financial intermediaries includes

A. Finance Companies:

■ They are non-depository taking institution that acquire funds

by issuing financial asset such as commercial paper, stock,
bond and/or borrow from bank and use the proceed to make
loan often for individual and small business.

– Source of fund –selling security

– use of fund –lend to individuals and small businesses

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■ They lend these funds to consumers who make purchase of:-
- Furniture
- Automobiles and Home Improvement
- Small Business etc…

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Con’t…
B. Mutual Funds:
■ Pool funds of many small investors by selling them share
(small denominations) and use the proceed to buy security (at
high denomination ) and get income through interest, dividend
and capital appreciation.

■ The profit/losses of the mutual fund are shared by the investors

in proportion to their investment in the fund.

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Classification of Financial Institution Based on Source of Fund

■ Depository Institution
 Commercial banks
 Savings and Loan Associations
 Credit Union, etc

■ Non-Depository Institution
 Insurance company
 Pension fund
 Finance company
 Mutual fund, etc

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1.3. Functions of Financial Institutions
■The major function of financial institutions is to collect funds from
severs and direct the fund to various investment activities .

A financial institution performs the following specific functions:

1. It serves as a link between savers/lenders and
investors/borrowers.

2. It helps in utilizing the mobilized savings of scattered savers in

more efficient and effective manner.

3. It channels flow of saving into productive investment.

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Con’t…

4. It assists in the selection of the projects to be financed and also

reviews the performance of such projects periodically.

5. It provides payment mechanism for exchange of goods and

services.
 Legal tender money by central bank
 Check
 Electronic means of payment, LC etc.

6. It provides a mechanism for the transfer of resources across

geographic boundaries. E.g. western union, Dahabshiil etc…

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7. It promotes the process of capital formation to speedy
economic development.
– The process of capital formation involves three distinct but
interrelated activities. These are savings, finance and
investment.

8. Reduce transaction and information costs

9. Motivates people to save more

10. Regulate supply of money, financial system and many more

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 1.4. Role/importance of Financial Institutions
■
■ Raising capital for business-for expansion ,new product etc.

■Mobilizing saving for investment

■Facilitate growth of industry

■Development of entrepreneur- Creates investment opportunities

for small investors

■Government raise capital for development project

■Economic growth

■Provide specialized service –credit rating, counseling service,

underwriting (taking financial risks for fee) 33

Con’t…
■ Facilitate transaction at reduced costs

■ Collecting, processing and providing information at lower costs

■ Pool the savings of individuals

■ Providing safeguarding and payments system

■ Reducing risk by diversifying e.g. Pension funds

■ Enhance capital formation

■ Provide liquidity-help in conversion of financial asset to cash

early.

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1.5. Money Market and Characteristics of Developed Money
Market

Money Market - Meaning:

■ A money market is a mechanism through which short-term
funds (money market instruments) are borrowed and lent.

■ A large part of the financial transactions of a particular country

and the world is routed through this market.

Definition of money market:  

“It is the collective name given to the various firms and
institutions that deal in the various grades of near money
financial assets”.  

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Con’t…
■ 1) Money market provides short-term finance to the needy
borrowers. Normally it will be for a period up to one year.

■ 2) The money market provides for the requirements of

working capital.

■ 3) The instruments dealt with in money market are; Bill of

exchange, Treasury bills, Call loans, Short-term Government
securities, Commercial papers, Certificate of deposits, etc.

■ 4) They provide assistance to solve the liquidity problems of

commercial banks as well as the Government.

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 Characteristics of Developed Money Markets

■ Such markets can be seen in the developed countries like USA

and UK.
■ The money markets in these countries have the following
features or characteristics.

1) Existence of effective Central Bank:

■ The role of Central Bank is notable.
■ It controls the entire money market operations by making the
availability of funds depending upon the economic cycles.
■ It can be done through its open market operations.
■ Central Bank acts as a monetary authority as well as leader of
the money market, which controls the other institutions in the
money market in an effective manner.  
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2) Availability of proper credit instruments:
■ Have the necessary credit instruments such as treasury bills,
promissory notes, bills of exchange, etc.
■ They should be freely available.
■ In the absence of such credit instruments the money market
cannot function in an effective manner.
3) Flexibility and adequacy of funds:
■ In a developed money market, there must be more
resources/funds.
■ The flow of funds into the money market should also be
flexible enough, i.e., the flow of funds can be increased or
decreased depending upon the demand for funds.
■ Such a flow of funds will ensure proper functioning of the
money market.

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4) International attraction:
■ The developed money markets attract and allow funds from
foreign countries.
■ The dealers, borrowers and lenders of foreign countries eagerly
come forward to participate in the developed money market.

5) Highly developed industrial system:

■ The money market will function smoothly and can achieve
the basic purpose of its existence only when there is a highly
developed industrial system.
■ Developed money market demands for highly developed
industrial system.

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Characteristics of an Undeveloped Money Market:
■ The money markets in the majority of
underdeveloped/less developed countries are mostly
undeveloped or unorganized.

■ The developed money market consists of the central

bank, the commercial banks, brokers, discount houses,
acceptance houses, etc.

■ On the other hand, the undeveloped money market

consists of the moneylenders, the indigenous bankers,
traders, merchants, land­lords, brokers, etc.

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The main characteristics of such a market are:

1) Personal Touch:
■ The lenders have a personal touch with the borrowers.
■ The lender knows every borrower personally in the village
because the borrower resides there.

2) Flexibility in Loans:
■ There is no rigidity in loan transactions.
■ The borrower can have more or less amount of loan according
to his requirements depending upon the nature of security or
his goodwill with the moneylender.

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3) Multiplicity of Lending Activities:
■ Mostly people do not specialize in money lending alone.
■ They combine money lending with other economic
activities. A merchant may supply goods on loan instead
of money in cash.

4) Varied Interest Rates:

■ There are multiplicity of interest rates.
■ Interest rates are much higher than rates in the developed sector
of the money market.
■ The interest rates are not even uniform.
■ The rate depends on the need of the borrower, the amount of loan,
the time for which it is required and the nature of security.
■ The greater the urgency, the higher will be the interest rate.
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5) Defective System of Accounting:
■ In the unorganized sector of the money market, the system of
maintaining accounts is highly defective.
■ Proper accounts are never maintained.
■ Besides, there is utmost secrecy.
■ The accounts of the moneylenders are not liable to checking by
any higher authority.

6. Absence of Link with the Developed Money Market:

■ It is not linked with the developed sector of the money market
in such countries.
■ It is also not under the control of the developed market.
■ This has the effect of reducing the volume of monetary
transactions and savings, and prevents their use in productive
investments.
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Thank you!!!

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