CHAPTER 3 – FINANCIAL INSTITUTIONS

Financial Markets and Institutions

Meaning of financial institution
A financial Institution is an institution (public
or private) that collects funds (from the public
or other institutions) and invests them in
financial assets.
A financial institution is an institution that
provides financial services for its clients or
members.

Financial Markets and Institutions

• The most important financial service provided
by financial institutions is acting as financial
intermediary –
– means a person that is subject to, or governed by,
a measure adopted or maintained by a Party or by
a public body that exercises regulatory or
supervisory authority delegated by law, in respect
of and by reason of the production or provision of
a financial service

Financial Markets and Institutions

• Financial Institution means, including, but
not limited to, an association, bank,
brokerage firm, credit union, industrial
savings bank, savings and loan association,
trust company, or other type of financial
institution organized under the laws of a
state of the United States and doing business
( https://apps.fldfs.com/CAP_Web/PublicDeposits/intro_definitions.aspx)

Financial Markets and Institutions

• One very popular way of defining a financial
institution is as an institution that collects
funds from the public to place in financial
assets such as stocks, bonds, money market
instruments, bank deposits, or loans.

Financial Markets and Institutions

• There is no universally accepted method of
classification where financial intermediaries
are concerned.
• It is quiet common to distinguish between
deposit taking institutions (DTI’s) and Non
Deposit taking institutions (NDTI’s).

Financial Markets and Institutions

 Reasons for this classification
• Firstly, deposit liabilities of DTI’s usually form
the bulk of a country’s money supply. The
quantity and growth of these deposits are often
subject to pressures and influences which do not
apply to NDTIs.
• Secondly, because deposit liabilities are money,
the failure of a DTI means that people lose, at
least temporarily, access to means of payment.
• Lastly, customers hold deposits for reasons which
are rather different from the reasons which cause
them to hold other types of financial products.
Financial Markets and Institutions
• In addition to the deposit taking and non
deposit taking financial institutions it is
essential to discuss the role of the central bank
in the financial system of a country.
• The central bank plays a prominent role in the
way the financial system operates in an
economy, usually being the primary regulatory
or the apex body regulating the financial
system in the country.

Financial Markets and Institutions

 Central Bank
• A central bank, reserve bank, or monetary
authority is a public institution that usually issues
the currency, regulates the money supply, and
controls the interest rates in a country.
• Central banks often also oversee the
commercial banking system within its country's
borders.
• A central bank is distinguished from a normal
commercial bank because it has a monopoly on
creating the currency of that nation, which is
usually that nation's legal tender.
Financial Markets and Institutions
• The primary function of a central bank is- to provide the
nation's money supply,
• More active duties include controlling interest rates, and
acting as a lender of last resort to the banking sector during
times of financial crisis.
• Supervisory powers, to ensure that banks and other financial
institutions do not behave recklessly or fraudulently.
• Most developed nations today have an "independent" central
bank, that is one which operates under rules designed to
prevent political interference.
• Examples include the European Central Bank (ECB) and the
Federal Reserve System in the United States, Reserve Bank of
India(RBI) or even the National Bank of Ethiopia (NBE)

Financial Markets and Institutions

 Functions of a Central Bank
1. Implementing the Monetary Policy
2. Determining Interest Rates
3. Controlling the nation's entire money supply
4. The Government's banker and the bankers' bank or the
"lender of last resort"
5. Managing the country's foreign exchange and gold
reserves
6. Regulating and supervising the banking industry
7. Setting the official interest rate – used to manage
both inflation and the country's exchange rate – and
ensuring that this rate takes effect via a variety of policy
mechanisms
Financial Markets and Institutions
 Monetary policy
Monetary policy is the process by which
the monetary authority of a country controls
the supply of money, often targeting a rate
of interest to attain a set of objectives oriented
towards the growth and stability of
the economy.

Financial Markets and Institutions

Monetary decisions today take into account a wider range of
factors, such as:
• Short term interest rates;
• Long term interest rates;
• Velocity of money through the economy;
• Exchange rates;
• Credit quality;
• Bonds and equities (corporate ownership and debt);
• Government versus private sector spending/savings;
• International capital flows of money on large scales;
• Financial derivatives such as options, swaps, futures
contracts, etc.

Financial Markets and Institutions

 The National Bank of Ethiopia has the following powers and duties:

• Prints and issues the legal tender currency, and regulates the
country's money supply.
• Regulates the applicable interest rate and other cost of money
charges.
• Formulates, implements and follows-up the country's exchange
rate policy, manages and administers the international reserves of
the country.
• Licenses, supervises and regulates the operations of banks,
insurance companies and other financial institutions.
• Sets limits on gold and foreign exchange assets, which banks, and
other financial institutions authorized to deal in foreign exchange
and hold in deposits.

Financial Markets and Institutions

• Sets limits on the net foreign exchange positions and terms and
the amount of external indebtedness of banks and other financial
institutions.
• Provides short and long term refinancing facilities to banks and
other financial institutions.
• Accepts deposit of any kind from foreign sources.
• Promotes and encourages the dissemination of banking and
insurance services throughout the country.
• Prepares periodic economic studies, together with forecasts of
the balance of payments, money supply, prices and other relevant
statistical indicators of the Ethiopian economy useful for analysis
and for the formulation and determination by the Bank of
monetary, saving and exchange policies.

Financial Markets and Institutions

• Acts as banker, fiscal agent and financial advisor
to the Government.
• Represents the country in international monetary
institutions and acts consistently with
international monetary and banking agreements
to which Ethiopia is a party.
• Exercises and performs such other powers and
activities as central banks customarily perform.

Financial Markets and Institutions

 Deposit Taking Institutions
• Typically a Deposit taking institution is an institution whose main
function is to take deposits.
• DTIs are Banks, building societies, credit unions and other
organizations which accept customers' funds, either at call or for
fixed periods, and pay interest on the amounts.
• Deposit-taking institutions are identified with 'savings' and differ in
purpose from investment institutions which actively manage their
customers' funds in the pursuit of profits, or from corporations
which 'borrow' money from the public by issuing debentures or
bonds.
• The most common deposit taking institutions are the commercial
banks

Financial Markets and Institutions

 Types of Banks
• Commercial, Banks – Commercial banks are those which
perform all kinds of banking functions such as accepting deposits,
advancing loans, credit creation and agency functions.
• Exchange Banks – Exchange banks are those banks which deal in
foreign exchange and specialize in financing foreign trade.
• They are also called foreign exchange banks. These banks also
provide information such as information about foreign customers,
providing remittance facilities etc.
• Industrial Banks–Industrial banks are those banks which provide
medium term and long term finance to industries for the
purchase of land, machinery etc.

Financial Markets and Institutions

 Cont…

• Agricultural Banks – Agricultural banks are

those banks which provide credit to farmers for
short term and medium term and long term needs.
• Co-operative Banks – Co-operative banks are
those financial institutions which are organized on
the principle of cooperation. They provide short
term and medium term loans to their members.
• Savings banks–savings banks help promote small
savings and mobilize them. They have been
successful in Japan and Germany.

Financial Markets and Institutions

 Commercial Banks
• It is a bank that provides checking accounts, savings accounts, and
money market accounts and that accepts time deposits. Commercial
banks engage in the following activities:
– Processing of payments by way of telegraphic transfer, internet
banking, or other means
– Issuing bank drafts and bank cheques
– Accepting money on term deposit
– Lending money by overdraft, installment loan, or other means
– Providing letter of credit, guarantees, underwriting commitments
– Safekeeping of documents and other items in safe deposit boxes
– Cash management and treasury services
– Merchant banking
– Traditionally, large commercial banks also underwrite bonds,
and make markets in currency, interest rates, and credit-related
securities, but today large commercial banks usually have an
investment bank arm that is involved in the mentioned activities.
Financial Markets and Institutions
 Functions of Commercial Banks
• Accepting deposits
– Banks accept three types of deposits from its customers. The
savings deposits on which the banks pay a small interest rate to
the depositors who are usually small savers.
– Similarly business men keep their money in current accounts.
They can withdraw any amount outstanding in their credit in
current deposits through cheques with out notice. Current
accounts are known as demand deposits.
– Deposits are also accepted by the bank for a fixed period.
These are also known as fixed time deposits.
– The banks pay a higher rate of interest on such deposits.

Financial markets and institutions

 Advancing Loans
• A banks lends a certain percentage of the cash lying in deposits at a rate higher than
what it offers to the depositors. A bank advances loans in the following ways

– Cash Credit – the bank advances loans to businessmen against certain specified
securities. The amount of loan is credited to the current account of the borrower.
The borrower can withdraw money through cheques according to his requirements
but pays interest on the full amount
– Call Loans – these are very short term loans advanced to the bill brokers not more
than fifteen days. They are advanced against first class bill or securities. Such loans
can be recalled at a very short notice. In normal times they can also be renewed.
– Overdraft – a bank often permits a businessman to draw cheques for a sum greater
than the balance lying in his current account. This is done by providing them
overdraft facility up to a specific amount. He is charged interest only on the amount
by which his current account is actually overdrawn and not by the full amount of the
overdraft sanctioned to him by the bank.
– Discounting bills of exchange – if a creditor holding a bill of exchange wants
money immediately, the bank provides him the money by discounting the bill of
exchange. It deposit the amount of the bill in the current account of the bill holder
after deducting its rate of interest for the period of the loan which is usually not
more than 90 days. When the bill of exchange matures, the bank gets its payment
from the banker of the debtor who accepted the bill.

Financial Markets and Institutions

• Credit Creation – Like other financial institutions, CBs aim at earning
profits. For this purpose they accept deposits and advance loans by keeping a
small cash in reserve for day to day transactions. When a bank advances a loan
it opens an account in the name of the customer and does not pay him in cash
but allows him to draw money by Cheque according to his needs. By granting a
loan the bank creates credit or deposit
• Financing foreign trade – a commercial bank finances foreign trade of its
customers by accepting foreign bills of exchange and collecting them from
foreign banks. It also transacts other foreign exchange business and buys and
sells foreign currency
• Agency services – a bank acts as an agent of its customers in collecting and
paying cheques, bills of exchange, drafts, dividends etc. it also buys and sells
shares and debentures. Further it pays subscription, insurance premium, rent,
electric and water bills and other similar charges on behalf of the clients.
• Miscellaneous services – besides the above noted services, the commercial
banks performs a number of other services. It acts as the custodian of the
valuables of its customers by providing them lockers where they can keep their
jewellery and valuable documents. It also under writes shares and debentures
of companies and helps in collection of funds from the public.

Financial Markets and Institutions

 Role of commercial banks in developing countries –

• Mobilizing savings for capital formation

• Financing Industry
• Financing Trade
• Financing agriculture
• Financing consumer activities
• Financing employment generating activities
• Help in Monetary policy

Financial Markets and Institutions

 Deposit taking institutions of Ethiopia

• Commercial Banks are the major deposit taking

institutions in Ethiopia apart from the micro
finance institutions which perform some of the
similar activities of banking.
• The following is the list of commercial banks
in Ethiopia(Currently, including Abay Bank and
Enat bank which recently joined the market, a
total of 19 banks are operating in the country out
of which 16 are private).

Financial Markets and Institutions

1. Awash International Bank
2. Bank of Abyssinia
3. Berhan International Bank
4. Buna International Bank
5. Commercial Bank of Ethiopia
6. Construction and Business Bank
7. Cooperative Bank of Oromia
8. Dashen Bank
9. Development Bank of Ethiopia
10. Lion International Bank
11. Nib International Bank
12. Oromia International Bank
13. United Bank (Ethiopia)
14. Wegagen Bank
15. Zemen Bank
16. Abay Bank
17. Debub Global Bank S.C
18. Addis International Bank S.C
19. Enat Bank S.C
20. Amhara Bank
21. Omo Bank and others which were recently estabilished.

Financial Markets and Institutions

 Some important features of banking in Ethiopia are

• Primarily the financial sector comprises of Banks, Insurance Companies and

Micro Finance Institutions. ( typically Insurance companies are the Non
Deposit Taking Institutions)

• The primary regulatory authority of the financial sector is the National bank
of Ethiopia

• The biggest player of the Banking sector is the commercial bank of Ethiopia.

• Recent statistics of the banking sector performance of the country shows that
the state-owned Commercial Bank of Ethiopia (CBE) has a share of 48.1
percent from the total lending of the country with 57.8 percent of reserve.
• A total of 19 banks are operating in the country out of which 16 are private.
• Other banks like Sidama, Damota bank, Debub, and Noh banks are offering
shares to the public to join the infant private bank industry of Ethiopia

Financial Markets and Institutions

 NDTIs – Non Deposit Taking Institutions

The most common Non Deposit Taking Institutions

include the Insurance companies, Pension funds,
Investment trusts etc.

Financial Markets and Institutions

 Insurance Companies

1.Insurance is a form of risk management primarily used to hedge against

the risk of a contingent, uncertain loss.

2. Insurance is defined as the equitable transfer of the risk of a loss, from one
entity to another, in exchange for payment.

3.An insurer is a company selling the insurance; an insured, or policyholder, is

the person or entity buying the insurance policy. The insurance rate is a
factor used to determine the amount to be charged for a certain amount of
insurance coverage, called the premium.

4.The transaction involves the insured assuming a guaranteed and known

relatively small loss in the form of payment to the insurer in exchange for
the insurer's promise to compensate (indemnify) the insured in the case of
a loss.
5. The insured receives a contract, called the insurance policy, which details
the conditions and circumstances under which the insured will be
compensated. Financial Markets and Institutions
Types of insurance
• Auto insurance-Auto insurance protects the policyholder against financial loss in the event of an
incident involving a vehicle they own, such as in a traffic collision.
• Home insurance provides coverage for damage or destruction of the policyholder's home
• Health insurance policies issued by publicly-funded health programs, such as the UK's
National Health Service will cover the cost of medical treatments. Dental insurance, like medical
insurance, protects policyholders for dental costs.
• Disability insurance policies provide financial support in the event of the policyholder becoming
unable to work because of disabling illness or injury.
• Crime insurance is a form of casualty insurance that covers the policyholder against losses
arising from the criminal acts of third parties.
• Life insurance provides a monetary benefit to a descendant's family or other designated
beneficiary, and may specifically provide for income to an insured person's family, burial, funeral
and other final expenses.
• Crop insurance may be purchased by farmers to reduce or manage various risks associated with
growing crops. Such risks include crop loss or damage caused by weather, hail, drought, frost
damage, insects, or disease.
• Earthquake insurance is a form of property insurance that pays the policyholder in the event of
an earthquake that causes damage to the property.
• Flood insurance protects against property loss due to flooding.

Financial Markets and Institutions

 Insurance in Ethiopia –
According to the National Bank of Ethiopia there are some major insurance
companies operating in the country-
1. Africa Insurance Company S.C
2. Awash Insurance Company S.C
3. Global Insurance Company S.C.
4. Lion Insurance Company S.C
5. NIB Insurance Company
6. Nile Insurance Company S.C
7. Nyala Insurance Company S.C
8. The United Insurance S.C
9. Ethiopian Insurance Corporation
10. Abay Insurance Company
11. Berhan Insurance S.C.
12. National Insurance Company of Ethiopia S.C.
13. Oromia Insurance Company S.C.
14. Ethio-Life and General Insurance S.C
15. Tsehay Insurance S.C.
Financial Markets and Institutions
• According to the National Bank of Ethiopia (2009) Ethiopia has
merely ten insurance companies with a total of 175 branches – the
country therefore suffers from an appalling branch to people ratio
of 1 to 437,161 more over, over 52% of the branches are located in
Addis Ababa.

• Of the ten insurance companies, in the 2006/07 financial year, six

had composite insurance licenses; enabling them to write life and
general insurance.
• Two new companies are in the process of being licensed, of which
one is reported to be a life insurance- only company, the first such
company in Ethiopia.
• Figures indicate that Ethiopia’s insurance sector is skewed towards
corporate clients who insure their assets (motor vehicle, fire),
business (aviation, engineering) and staff member (accident, health,
workmen’s compensation).
Financial Markets and Institutions
• General insurance dominates the sector, with motor vehicle
insurance forming the largest category of general insurance –
constituting 43% of total insurance premiums.
• On the other hand life insurance constituted merely 6% of total
premiums. Private insurers are small and account for a diminutive
portion of overall profit, which leaves little room for product
development focused on individual insurance schemes or market
exploration geared at low-income households.
• The insurance sector is dependent on the banking sector for much
of its new business.
• Most Ethiopian insurance companies have sister banks and its
common for these banks to refer their clients to their sister
insurance companies

Financial Markets and Institutions

• A World Bank project appraisal document suggested that the
balance sheets of Ethiopian insurance companies are
overexposed to and over-concentrated in the banking sector, with
over 40% of assets exposed to the banking sector.
• The financial statements of Ethiopian insurance companies
reveal that a very limited amount of the sectors’ returns are
reinvested in the industry.
• Ethiopia’s insurance industry is relatively undeveloped which is
exemplified by the sectors low penetration levels – there are an
estimated 0.3 million formal insurance clients in Ethiopia.
• The Centre for Financial Regulation and Inclusion reports that
insurance premiums, including life and general insurance, totaled
US $105 million in the 2006/07 financial year, represented
merely 0.2% of GDP in 2007 - while in Kenya and Namibia
premiums represent 2.5% and 8.1% of GDP respectively
Financial Markets and Institutions
 Pension Funds-

• After their retirement from work most people world

wide and especially in the developed countries can
expect some form of pension. This comes in one of the
three forms :
– a flat rate of pension paid by the state to every one above a
certain age,
– an occupational pension provided from a fund to which
the employer and the employee have contributed;
– a personal pension paid from a fund to which the individual
has made contributions.
– Only the second and the third forms strictly involve
financial intermediation.
Financial Markets and Institutions
End of Chapter 3