Chapter Three

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 financial intermediation, is crucial to a well functioning of modern economy

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 on business investment. For example, a student loan for college which increases the level of education and human capital will promote future economic growth of a country.

Introd
Functions of Financial Institutions With in the main functions of channeling funds from savers to borrowers, financial institutions perform five important functions.
1. 2.

3. 4. 5.

Pooling the savings of individuals Providing safekeeping, accounting and access to payments system Providing liquidity Reducing risk by diversifying Collecting and processing information

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 to payments 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.

Introd
3.

Providing liquidity

Liquidity refers to the ability of the financial assets to be converted in to cash. Therefore, financial institutions facilitate liquidity.
4.

Reducing risk by diversifying

When financial institutions pool the savings of individuals, they invest them in a wide variety of loans, bonds, and other assets.

Introd
5.

Reducing risk by diversifying 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


Part I: Central Banks

Nature of Central Banks:
A central bank, reserve bank, or monetary authority is a banking institution granted the exclusive privilege to lend a government its currency. A central bank is the apex bank in a country. It is called by different names in different countries:

 Reserve bank

of India,  The bank of England  The federal Reserve System in America  The Bank of France in France  National Bank of Ethiopia in Ethiopia  State Bank of Pakistan

Functions of Central Bank

1. Regulator of currency 2. Banker, Fiscal Agent and Advisor to the Government 3. Custodian of Cash reserve of Commercial Banks 4. Custody and Management of Foreign Exchange Reserves 5. Lender of Last resort 6. Clearing House for transfer and settlement 7. Controller of Credit

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

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.

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

2. Central Bank as Banker, Fiscal Agent and Advisor to the Govt .Contd
As Advisor of the govt the central bank
Advises


the govt on such issues as

economic and monetary matters as controlling inflation or deflation,  devaluation or revaluation of the currency,  Deficit financing  Balance of payment etc

3. Custodian of Cash Reserve Requirement of Comm. Banks

Comm. Banks are required to keep reserve equal to a certain percentage of both time and demand deposits with the Central bank. It is on the basis of these reserve that central bank transfers funds from one bank to another to facilitate clearing of checks. The central bank acts as the custodian of the cash reserve requirement of commercial banks and helps in facilitating their transactions. (As the case of fed funds)

4.Custody Exchange

and

Mgt

of

Foreign

It keeps and manages the foreign exchange reserve of the country 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 its obligation as a member of IMF It manages exchange control operations by supplying foreign currencies to importers and persons visiting foreign countries on business, studies, etc in keeping with the rules laid down by the govt

5.Central Lender of Last resort

Bank

As lender of last resort, the central bank grants accommodations in the form of re-discounts and 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 financial structure of the country from collapse.

6. Clearing House for transfer and settlement

It acts as a clearing house for transfer and settlement of mutual claims of commercial banks

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

7. Controller Of Credit. Contd

Qualitative methods control the use and direction of credit. These involve:
credit control Direct action
Selective

7. Controller of Credit. Contd

Additional controlling functions of Central banks include the supervising and controlling of commercial banks:
Issue

of licences The regulation of branch 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

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 merger of weak banks in order to 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

Central Bank and objectives of Credit Control

The credit control is the means to control the lending policy of Commercial banks by the central bank to achieve 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.

Monetary Policy (MP)

Definition of MP:
MP

refers to credit control measures adopted by central banks of a country MP refers to a policy employing central banks control of the supply of money as an instrument for achieving the objective of general economic policy. MP= any conscious action undertaken by the monetary authorities to change the quantity, availability, or cost of money

Objectives of MP
The following are the Principal objectives of Monetary Policy:
1.

Price Stability 2. Economic Growth 3. Balance of Payment 4. Full Employment

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

Price Stability objective of Central Banks (contd)

The goal of price stabilization implies that in general the average price level as measured by the whole sale price index or consumers price index should not be allowed to vary beyond narrow margins.

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.

2. Economic Growth Objective Contd

How Monetary Policy contribute to Economic Growth? Through:
Management

of Aggregate Demand Encouragement to saving and Investment

3. Balance of Payment 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 the economy. 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).

3. Balance of Payment objective (contd)

Under this situation the monetary authority will have to sell foreign exchange reserves and buy the domestic currency for eliminating excess supply of domestic currency until equilibrium is maintained

4. Full Employment Objective

Definition of Full Employment:
Full

employment is a situation in which every body who wants to work get work. ( Keynes).

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.

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. A Quantitative, general or indirect includes:  bank rate variations,  open market operations, and  changing reserve requirements.

They

are meant to regulate the overall level of credit controls in the economy through commercial banks.

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.

1. Bank rate Policy: as Instrument of MP

The bank rate is the minimum lending rate of the central bank at which it rediscounts first class bill of exchange and government securities held by Commercial Banks (CBs). When there is inflation in the economy the central bank raises the bank rate which 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 from CBs. There is contraction of credit and prices are checked from rising further

Bank rate 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.

2. Open Market Operation: as instrument of Operation: MP

Open market operation refers to sale and purchase of securities in the money market by central bank.
With rising price (inflation), the NB sells securities. The reserve of CBs are reduced and they are not in a position to lend more to business people. Further investment is discouraged and the rise in prices is checked. When recessionary forces start in the economy, the NB buys securities. The reserves of CBs are raised. They lend more. Investment, output, income and demand rise, and fall in price is checked.

3. Change in reserve Instrument of MP

ratio: ratio:

as

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. Their reserves are reduced and they lend less. The volume of investment, output, and employment are adversely affected

4. Selective Credit Controls

These controls are used to influence specific types of credit for particular purpose. When there is brisk speculative activity in the economy or in particular sector in certain commodity, and prices are rising, the NB raises margin loans against specified securities. The result is that the borrowers are given less money in loans against specific securities.

Types of financial institutions

Financial institutions can be classified in many different ways. The standard classification, however, will be as follows:
Depository Institutions Commercial Banks Savings and Loan Associations Saving Banks Credit Unions Non-Depository Institutions Insurance Companies Pension Funds Investment Companies Investment Banking firms

Part II 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, and Fee income

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 financial intermediaries 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.

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 subcategorized depending 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.

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 provides funds for liquidity of emergency needs.

Constituents of DIs DIs include:

A. B. C. D.

Commercial Banks Saving and loan associations Saving Banks Credit unions

Asset/ Liability Problems of DIs

Spread Income (margined Income)= Income from loan and Investment Less cost of its funds (deposit and other sources)

Asset/ Liability Problems of DIs (Contd)

DIs face the following risks: Credit (Default) risk Regulatory risk Funding risk (interest rate risk)

Risks of DI
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 profits will be adversely affected
 Credit

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 the entire amount, in a government security at 9% interest rate for 15 years Thus spread for the first year = 2%

Example (contd)
Spread for the remaining 14 years depends on the future interest rate that DI pays for its new depositors 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 be negative. DI benefit from decline in interest rate but suffers from increases

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. Spread after the first year: If interest rate on investment increases, DI benefit If interest rate on investment declines, spread reduces

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.

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).

A. Commercial Banks
Com. Banks are those FIs which accept deposit from the public repayable on demand and lend them for short periods

Bank Services
Commercial banks provide numerous services in the financial system. The services can be broadly classified as:
1. 2. 3.

Individual banking; Institutional banking; and Global banking.

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

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.

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 than interest income.

Bank Balance Sheet

1.

A.

Bank Assets Assets earn revenue for the bank and includes cash, securities, loans, and property and equipment that allows it to operate. 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.

Bank Balance 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.

Bank Balance 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 revenue for 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.

Bank Balance Sheet

2.

Bank Liabilities

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.

Bank Balance Sheet

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 of Deposit (CD) CD is a deposit where the depositor agrees to keep the money in the account until the certificate of deposit expires. The bank compensates the depositor with a higher interest rate.
B.

Bank Balance Sheet

D. I.

II.

Borrowing Banks usually borrow money from other banks in what is called the central/federal funds market. Banks also borrow funds from non-depository institutions, 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.

Bank Balance 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 get funding elsewhere, they do this rarely.

Bank Balance Sheet

3.

Bank Capital Banks can also get more funds either from the banks owners if it is a corporation or by issuing more stocks.

Functions of Commercial Banks

1. Primary Functions (Accepting deposits and lending money) 2. Secondary Functions (agency services and general utility service)

Primary Functions of Comm. Banks

1. Accepting deposits
Current

or demand deposits Saving deposits Fixed or time deposits

2. Lending Money
Overdrafts Cash

credit Loans and Advances Discounting of bill of Exchange

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

Secondary Functions: Agency service Functions: (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

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

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 and search costs.

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.

Types of Regulations of CBs

1. 2. 3. 4. 5. 6.

Safety and soundness regulation, Monetary policy regulation, Credit allocation regulation, Consumer protection regulation, Investor protection, and Entry and chartering regulation,

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 assetsIn US banks are prohibited from making loans exceeding 10% of their own equity capital fund to any one company or borrower.

1. Safety and soundness regulation (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 the protection

1. Safety and soundness regulation (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.

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 instruments)

ratio

requirements

of

MP

3. Credit Allocation 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 economy The regulator may set maximum interest rate, price or fees to subsidize certain sectors

4. Consumer Protection Regulation

This regulation is concerned about the discrimination on the basis of age, race, sex, of income-( Banks should not discriminate on such grounds). For example, the US congress passed the Home Mortgage 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 the demographic data (such as income and percentage of minority population) for that location. CBs must now report the reason that they granted or denied credit.

5. Investor Protection 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.

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 firms already 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. by restricting 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

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 very easily 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

Risks faced by Commercial Banks

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.

Risks faced by Commercial Banks

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. 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.

2.

Risks faced by Commercial Banks

In this case, the local currency declines rapidly compared to foreign currencies, and governments will often impose capital controls to prevent more capital from leaving the country. Operational risk: It arises from faulty business practices or when buildings, equipment, and other property required to run the business are damaged or destroyed.

3.

Risks faced by Commercial Banks

Many types of operational risk, such as the destruction of property, are covered by insurance. However, good management is required to prevent losses due to faulty business practices, since such losses are not insurable.

B.Saving & loan Association

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 being financed. 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.

Assets of Saving and Loan Associations Traditionally, the only assets in which saving and loans associations were allowed to invest have been:
secured by a property).  Mortgage backed securities  Government securities Saving and Loans Associations invest in short-term assets for operational (liquidity) and regulatory purpose.
 Mortgages (Loans

Funding of Saving and Loan Associations 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.

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 a means for small depositors and earn a return on their deposits. They can be either mutually owned (i.e., mutually saving banks) or stockholder owned. However, most saving banks are of the mutual form.

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.Credit Unions
They are the smallest & nonprofit depository institution. They can obtain either a state or federal charter. Their unique aspect is the common bond requirement for membership, such as:
 the

employees of a particular company,  unions,  religious affiliations or who  live in a specific area etc.

They are governed by a board of volunteers.

Credit Unions are either cooperatives or mutually owned. There is no corporate stock ownership. Since they are nonprofit and owned by their customers, they charge lower loan rates and pay higher interest rates on savings. Therefore, the dual purpose of credit unions is to serve their members saving and borrowing needs.

PART III. NON DEPOSITORY INSTITUTIONS

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. 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.

Insurance Companies
Insurance companies provide (sell and service) insurance policies, which are legally binding contracts. Insurance companies promise to pay specified sum contingent on the occurrence of future events, such as death or an automobile accident. Insurance companies are risk bearer. They accept or underwrite the risk for an insurance premium paid by the policyholder or owner of the policy.

Types of Insurance Business

Insurance industry is classified in to two
Life

insurance General or Property-causality insurance

Types of Insurance Business

1.

Life insurance: deals with death, illness disablement and retirement policies. Products of life insurance companies include:
1. 2. 3. 4.

Term insurance Whole of life insurance Endowment policies Annuities

2.

General insurance: deals with theft, property, house, car and general accident insurance. Property insurance is normally divided into two: personal and commercial

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

Types of Insurance business-Contd

According to Fabozzi, insurance products and contracts are classified as:
1. 2. 3. 4.

Life insurance Health insurance Property and causality insurance Liability insurance

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. 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 domestic and overseas and also in liquid money and capital market. (Keith)

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

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 companies and receive dividends in lieu of them and the earnings are distributed among the share holders

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.

Advantage of Mutual Funds

1. 2. 3. 4. 5. 6. 7.

Mobilizing small saving Professional management Diversified investment/ reduced risks Better liquidity Investment protection Low transaction cost (economy of scale) Economic Development

Return to Investors in the Mutual Fund

Investors in the mutual fund have the potential to gain: 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

Types of Mutual Funds

1. 2.

Open-ended mutual funds Closed-ended mutual funds

Open-ended mutual funds-Characteristics OpenfundsNew 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.

OpenOpen-ended Characteristics

mutual

fundsfunds-

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 No of shares owned by the NF investors

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 e.g. the NAV for a stock 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 days closing NAV)

Open-ended: NAV
The total No of shares in the fund increases 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.

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.

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, todays NAV is calculated: (1000x 37.75) + (2,000x43.7) +1,500 x 46.67 =13.01 15,000

Open-ended: 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 outstanding remains the same) would increase to:
1000x45 + 2000 x 48 + 1500x 50 15,000 = 14.40

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.

Open-ended: 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 in Exxon, 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

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)

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

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 is determined by the underlying shares as well as by the demand for the investment companys shares themselves.

Closed End Fund

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

Difference b/n Open-end and Closed-end OpenClosedMF

1.

2.

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. In contrast, closed-end fund have a constant number of shares outstanding because the fund sponsor does 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, as previously discussed.

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

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 the funds 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.

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 on 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 may be used.

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 in which 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.

Thus, they perform two general functions: 1. They assist both government and nongovernmental companies in obtaining funds by selling securities, i.e., raise funds for clients. 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

Public offering (underwriting of securities) Investment bankers performing one or more of the following three functions:
1.
Advising

the issuer on the terms and the timing of the

offering. Buying the securities from the issuers.

Distributing

the issue to the public.

Activities of investment banking firms

Private Placement of Securities In addition to underwriting securities for distribution to the public, investment banking firms place securities with a limited number of institutional investors like insurance companies, pension fund etc. 3. Securitization of Assets
2.

Securitization of Assets refers to the issuance of securities that have a pool of assets as collateral.

Activities of investment banking firms

Merger and Acquisition They may participate in merger and acquisition activity in one of the following ways:
4.
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.

Activities of investment banking firms

Merchant Banking When an investment banking firm commits its own fund by either taking an equity interest or credit position in companies, this activity referred to as merchant banking.
5.

Activities of investment banking firms

Trading and Creation of Derivative Instruments derivative instruments and they allow an investment banking firms to realize revenue in the following ways:  Customers generate commissions from the exchange traded 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.
6.

Activities of investment banking firms

7.

Money Management

Investment banking firms have created subsidiaries that manage funds for individual investors or institutional investors such as pension funds.