FINANCIAL INSTITUTSIONS AND INTERMEDATION

1. CHAPTER TWO
FINANCIAL INSTITUTSIONS AND INTERMEDATION

2. THE ROLE OF FINANCIAL INSTITUTIONS
• The term financial institutions describe a wide array of firms. The most familiar
financial institution is probably a commercial bank.
• In fact, commercial banks are the oldest financial institutions in most countries, and
they handle a significant portion of every country's financial assets. Financial
institutions include:
Commercial banks
Savings and loan associations
Credit unions
Insurance companies
Pension funds
Investment companies
 Investment bankers
Securities brokers and
dealers Finance companies

3. • Why do financial institutions exist, and why are they so
diverse?
• In fact, they share common attributes.
All have at least some contact with the general public
all accept money and provide services in return.
• The discussion of their development starts with a simple world
that assumes the existence of money and works toward the
complex system of financial markets today.

4. EXAMPLE OF A FINANCIAL TRANSACTION
Savings units
• First, assume a tiny economy, a world populated by only two people-person A
and person B. Person A works throughout the year to obtain all necessities of
life-food, shelter, and clothing.
• Person A now has $100 of excess resources. Assuming no liabilities, person A
has wealth of $100, or Wo = $100.
• When income exceeds expenditures for the year, person A becomes a surplus
savings unit.
Surplus savings unit (SSU):
• An economic entity, whose income for a particular period exceeds
expenditures.
• The amount of person A's wealth will stay the same without any productive
application for the excess resources, that is, without investment opportunities.

5. • Now consider person B, who also has worked successfully
during the year to satisfy basic needs but without accumulating
excess resources like person A. Person B's current wealth is
zero.
• Hence, the summation of wealth of the two citizens of this
small economy is'$100.
• Person B, however, has come up with a 1-year project that
promises to return 20 percent on investment.
• Yet, with no funds available for investment, B will be unable to
take advantage of the lucrative opportunity.
• All other things being equal, the wealth of this society 1 year
from now, WI, will be identical to its current wealth.

6. Direct Financing
Direct Financing
• The clear solution to this dilemma is for person A to lend person B the funds
necessary for the project. If this happens, person B becomes a deficit savings
unit.
Deficit savings unit (DSU): An economic unit, whose income for a particular
period is less than expenditures.
• When the ultimate user of funds-a DSU or an entrepreneur-obtains
necessary resources from an investor or SSU, the process is called direct
financing.
• Direct financing is the provision of funds for investment to the ultimate user
of the funds (DSU) by an ultimate investor (SSU).
• This arrangement makes it possible for a person with an idea or an
opportunity to under-take a worthwhile project what would, otherwise, have
been forgone.

7. • The benefits of direct financing reach beyond one individual,
however. They are an important source of growth in an economy.
• If we assume that person A is willing to provide financing in the
amount of $100 at an agreed-upon rate of 10 percent (probably
documented in a promissory note signed by person B), A earns N10;
total wealth 1 year from now will be $110 [$100 (1.10) = $110], or
WI = $110.
• Person B's wealth also increases. After repayment of principal and
interest, B's wealth will have increased to $10 [$100(1.20) $110 =
$10].
• On an aggregate basis then, the wealth of the economy grows to
$120, increasing by the 20 percent return on B's project.
• In the absence of financing, this growth would not have occurred.

8. • Notice that the economy grows by the rate of return available
from investment and that this rate of return is shared, in
negotiated proportions, between SSUs and DSUs.
• Direct financing works only when mutual agreement on all terms
of the arrangement is possible.
• In this example person A had confidence in the proposed project
and did not object to the required holding period.
• Person B agreed to the 10 percent interest rate.

9. FINANCIAL INTERMEDIATION
An Expanded Example
• Direct financing in a world of more than a handful of people can be an
inefficient way to allocate capital. Suppose there are 100 SSUs and 100 DSUs,
all of them as interested in financing their projects at favorable terms as the
original person B.
• If each DSU investigates a direct financing arrangement with each ultimate
investor, search and information costs become unreasonable .
• If each of the ultimate investors also looks for the "right" investment,
information costs will mount even faster.
• Enter a financial intermediary, a commercial bank. The bank, not the
individuals, can analyze each of the projects proposed by the entrepreneurs
Because no more than 100 "feasibility studies" are required, information costs
are reduced. This is indirect financing

10. Indirect financing:
• This is the process by which entrepreneurs obtain money for investment from
a financial intermediary who, accumulate the funds from ultimate investors.
• Investment dollars flow from SSUs through the intermediary to the
entrepreneurs, producing essentially the same net result as with direct
financing. The distinction is that the commercial bank holds promissory
notes.
• The ultimate investor now holds a bank deposit, a different financial
instrument. The promissory note is a primary security; the deposit is a
secondary security.
• Primary security: A financial claim issued by the ultimate user of the funds,
the DSU.
• Secondary security: A financial claim issued by a financial intermediary

11. The banking sector
A. Retail banks
• Put at its simplest, the retail banks take (small) deposits from the public
which are re- packaged and lent to businesses and households.
• This is generally high-volume and low- value business which contrasts with
wholesale banking which is low volume but each transaction is for high
value.
• The distinction between retail and wholesale banks has become blurred over
recent years as the large institutions have diversified their operations.
• The retail banks operate nationwide branch networks and a subset of banks
provide a cheques clearance system (transferring money from one account
to another) these are the clearing banks.

12. CONT.
• Loans, overdrafts and mortgages are the main forms of retail bank
lending.
• The trend has been for retail banks to reduce their reliance on retail
deposits and raise more wholesale funds from the money markets.
• They also get together with other banks if a large loan is required by a
borrower rather than provide the full amount themselves as this
would create an excessive exposure to one customer - this is called
syndicate lending.

14. B. Wholesale banks
• The terms wholesale bank, merchant bank and investment bank are often
used inter- changeably.
• There are subtle differences but for most practical purposes they can be
regarded as the same. These institutions tend to deal in large sums of
money other large organizations, corporations, institutional investors and
governments.
• While they undertake some lending their main focus is on generating
commission income by providing advice and facilitating deals. There are
five main areas of activity:
1. Raising external finance for companies: These banks provide advice and
arrange finance for corporate clients. Sometimes they provide loans
themselves, but often they assist the setting up of a bank syndicate or make
arrangements with other institutions.

15. • They will advise and assist a firm issuing a bond, they have
expertise in helping firms float on the Stock Exchange and make
rights issues.
• They may 'underwrite' a bond or share issue. This means that
they will buy any part of the issue not taken up by other investors.
This assures the corporation that it will receive the funds it needs
for its investment program.
2. Broking and dealing: They act as agents for the buying and selling of
securities on the financial markets, including shares and bonds .
• Some also have market- making arms which assist the operation
of secondary markets.
• They also trade in the markets on their own account and assist
companies with export finance.

16. 3. Fund management (asset management): The investment banks offer
services to rich individuals who lack the time or expertise to deal with
their own investment strategies.
• They also manage unit and investment trusts as well as the portfolios of
some pension funds and insurance companies.
• In addition corporations often have short-term cash flows which need
managing efficiently (treasury management).
4. Assistance in corporate restructuring: Merchant banks earn large fees from
advising acquirers on mergers and assisting with the merger process.
• They also gain by helping target firms avoid being taken over too
cheaply.
• Advising governments on privatizations has become an important
source of fee income

17. C. International banks
• The major part of international banking these days is borrowing and lending in
foreign currencies.
• Their initial function was mainly to provide services for their own nationals, for
example for export and import transactions, but nowadays their main emphasis
is in the Eurocurrency market and international securities (shares, bonds, etc.)
trading.
D. Building societies
• Building societies collect funds from millions of savers by enticing them to put
their money in interest-bearing accounts.
• The vast majority of that deposited money is then lent to people wishing to buy
a home - in the form of a mortgage. Thus, they take short-term deposits and
they lend money for long periods, usually for 25 years.
• Recently building societies have diversified their sources of finance (e.g. using d
wholesale financial markets) and increased the range of services they offer.

18. Other Financial Intermediaries-Briefly
•Banks are but one of several financial institutions that
perform intermediation functions and serves an industrial
economy.
Other financial intermediaries are:
savings and loan associations
 mutual savings banks
credit unions
 investment companies
 pension funds
 insurance companies
 and finance companies.

19. Depository Institutions
• Commercial banks, savings and loan associations, mutual savings banks, and
credit unions are depository institutions.
• That is, they all issue secondary securities in the form of the customer's
deposit, money that can be withdrawn upon demand or according to terms
of the deposit agreement.
• Mutual savings and loan associations, mutual savings banks, and credit
unions technically issue ownership shares, not deposits.
• Savings and loan associations (S&Ls) were established to provide real estate
finance by accepting small savers' deposits and investing in residential
mortgages.
• To this traditional function have been added consumer and commercial loans.
Savings and loan associations now also accept checking and large-
denomination deposits.

20. • Mutual savings banks were also originally geared to the small investor. These
institutions made mortgage loans and accepted primarily savings deposits.
Their activities have grown in ways similar to S&Ls.
• Like S&Ls and mutual savings banks, credit unions provide a savings vehicle
for the small investor. They invest these funds in small consumer loans for
purposes other than residential housing.
• Members of credit unions share some form of common bond, frequently
employment or occupation. As credit unions have evolved, they, too, have
begun to offer a full range of consumer services.

21. Non-depository Financial Institutions
• Investment companies, pension funds, insurance companies, and finance
companies are financial intermediaries that are not depository institutions. Thus,
the secondary securities that they issue are different.
• Investment companies pool money in small denominations to make large
purchases of corporate and government securities. To this extent, they are similar
to commercial banks, but investment companies issue ownership shares, not
deposits, to their investors.
• The rate of return from an investment company share depends on the rate of
return of the securities in which the company invests, with no guarantee or
insurance for the investor.

22. • Pension funds offer the secondary security of deferred income. Contributors to
pension funds receive the promise of lump-sum or periodic payments at or during
retirement from employment.
• Contributions into pension funds are made by both employers and employees.
Pension funds are major providers of money for industrial expansion.
• Insurance companies promise protection from a variety of specified risks in exchange
for investor funds. This promised protection is documented in an insurance policy.
• The two major types of insurance companies are life insurers and property and
casualty insurers. Life insurers protect investors from death and disability during the
term of the policy.

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