Chapter- Two

Financial Institutions
2.1.Depository Institution
Depository institution include commercial banks (or simply banks), saving and loan associations,
saving banks and credit union.Depository institutions are financial intermediaries that accept
deposits.These deposits represent the liabilities (debts) of the deposit accepting financial
institutions.With the fund rose through deposits and other funding sources, depository
institutions make direct loans to various entities and also invest in securities.Thus, their income
is derived from:
✓ income generated from loans they make and
✓ income generated from the securities they purchased
✓ fees income
There are some financial institutions which are highly specialized types of depository
institutions (these are called thrifts). Example, saving banks, credit unions etc.They have not
been permitted to accept deposits transferable by check or any negotiable instrument.They
have obtained funds primarily by tapping the savings of households.
Depository institutions are highly regulated because of the important role that they play in the
financial system.Because of their important role, depository institutions 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.
2.2.Assets and Liability Problem of Depository Institutions
➢ A depository institution seeks to earn a positive spread between the assets it invests in (loans and
securities) and the cost of its funds (deposits and other sources).
➢ The spread is referred to as spread income or margin.
➢ The spread income should allow the institution to meet operating expenses and earn a fair profit
on its capital.
➢ But, in generating spread income a depository institution faces the following risks:
✓ Credit risk (Default risk) refers to the risk that a borrower will default on a loan obligation or
that the issuer of the security that the DIs holds will default.

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✓ Regulatory risk: refers to the risk that regulators will change the rules so as to impact the
earnings of the institution unfavorably.
✓ Funding or interest rate risk: refers to the risk associated with the amount of interest paid for
depositors and received from borrowers.
Example of funding risk
• 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, let’s 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% 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
• 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 government
securities could vary.
Spread after the first year:
• If interest rate on investment increases, DI benefit
• If interest rate on investment declines, spread reduces
Justification:
• A rise in interest rate benefits the DIs because it can reinvest the proceeds from the maturing 1-
year government security offering a higher interest rate.
• All DIs face this funding problem. Managers of a DIs 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).
In generating spread income a depository institution faces several risks, these include, credit risk,
regulatory risk and funding (interest rate risk)

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2.3.Financial Innovations and Asset/Liability Management
Financial institutions have been used different mechanisms to control funding
(Interest rate risk) using financial instruments such as:
1. Floating –rate notes: is a debt instrument whose interest rate changes periodically according to
some interest rate benchmark. A common benchmark is the London Inter Bank Offered Rate
(LIBOR) which is an interest rate that reflects the marginal, overnight or short- term whole sale
cost of funds for the global banking system. Suppose a bank borrows$60milion by issuing five
year floating rate notes. The interest rate on these notes reset every six months on the basis of
LIBOR a the time plus a risk premium. Suppose also that the bank makes to a corporation where
the interest rate on the loan resets at LIBOR plus 2% every six months holding aside credit risk,
the bank has locked in a spread of 2%
2. Adjustable –rate mortgage: mortgage is a pledge of real estate to secure the payment of a loan.
The interest rate on the mortgage loan was fixed throughout the life of the loan typically between
15 & 30 years. Since the funds obtained to make mortgage are short –term the interest rate risk
exposure that the DI faces is substantial. Therefore, the interest rates on the mortgage loans must
be adjusted periodically –every month, six months, a year, two year or three years-according to
some benchmark interest rate.
3. Interest rate swaps: is a financial innovation to improve the asset/liability management. It is an
exchange of fixed –interest rate for floating –interest rate payments by two counter parties. In a
swap, the swap buyer agrees to make a number of fixed interest rate payments on periodic
settlement dates to swap seller. The swap seller in turn, agrees to make floating rate payments to
the swap buyer on the same periodic settlement dates. In undertaking this transaction, the FI
which is the fixed rate liability payer is seeking to transform the variable rate nature of its
liability into fixed rate liability to better match the fixed return earned on its assets meanwhile,
the FI which is the variable rate payer seeks to turn its fixed rate liability in to variable rate
liability to better match the variable return on its assets.
Liquidity concern: besides facing credit risks and interest rate risks. A depository institution
must be prepared to satisfy withdrawal and of funds by depositor and tom provide loans to
customers. There are several ways that enables a depository institution to satisfy the withdrawal
and loan demand of customers.

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1. Attract additional deposits
2. Use existing securities as collateral for borrowing from federal agency or other institutions like
investment banks
3. Sell securities that it owns
4. Raise short –term funds in the money market such as by issuing CPs, CDs
A. Commercial Banks
Commercial Banks are those financial institutions 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. Individual banking: encompasses customer lending residential mortgage lending,
customer installment loans, credit card financing, automobile & boat financing,
brokerage services and student loans and individual oriented investment services.Interest
income is generated form lending and fees income is produced form brokerage services.
2. Institutional banking: loans grant to financial and non-financial corporations,
government etc. this includes real estate financing leasing activities and factoring.
3. Global banking: It covers a broad range of activities involving corporate financing and
capital market and foreign exchange products and services. Most global banking
activities generate fee income rather than interest income.
Bank Funding:
How banks raise funds?
There are three sources of funds for banks.
(1)Deposit (2) non-deposit borrowing and (3) common stock and retained earnings.
Banks are highly leveraged financial institutions, which means, most of their funds come from
deposit, borrowing (non-deposit borrowing and borrowing from Federal Reserve through the
discount window facility).
Reserve Requirements and Borrowing in the Federal Fund Market
A bank cannot invest $1 for every $1 it obtains in deposit. All banks must maintain a specific
percentage of their deposits in anon-interest bearing accounts at one of the Federal Reserve
banks. These specific percentages are called reserve ratios and the dollar amount required to be

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kept on deposit at a federal reserve bank are called required reserve. The reserve ratios are
established by Federal Reserve board (Fed).
The reserve ratios differ based on the type of deposits. The Fed define two types of deposit,
transaction and non- transaction deposit. Demand deposits (current deposit) classified as
transaction deposits and saving and time deposits (CDs) are non- transaction deposit.
Reserve ratios are higher for transaction deposits relative to non-deposit transactions.
How required reserves could be determined?
To compute the required reserve, the Federal Reserve Bank has established a two –week period
called deposit computation period.
Required reserve = average amount of each type of deposit at the close of the computation
period multiplied by reserve requirement for each type of deposit.
Reserve requirements in each period are to be satisfied by actual reserves.
If actual reserves exceed required reserves the difference is referred to as excess reserves. Since
reserves are placed in a non- interest bearing accounts, there is an opportunity cost associated
with excess reserve. There are penalties imposed on banks that do not satisfy the reserve
requirements. Banks temporarily face shortage of required reserves can borrow from banks that
have excess reserves, the market where banks can borrow or lend reserves is called federal fund
market and the associated interest rate charged to borrow funds in this market is known as
federal funds rate.
Borrowing at the Fed discount window:-the Federal Reserve Bank is the banker’s bank or the
bank of last resort. Banks temporarily short –of funds can borrow from the fed at its discount
window. Collateral is necessary to borrow. The required collaterals can be including:
1. Treasury securities, federal agency or municipal securities all with maturity of less than 6
months.
2. Commercial and industrial loans with 90 days or less maturity.
The interest rate that the Fed charges to borrow funds at discount window is called discount
rate, which charges periodically to implement monetary policy.
Bank borrowing at the Fed to meet required reserve is quite limited amount. Banks borrowing at
the discount window is provided a privilege to meet short –term liquidity needs -not to increase
earnings.

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Continual borrowing for long-term period and in a large amount is the indication of bank’s
financial weakness or exploitation of the interest differential for profit. If bank frequently borrow
from Fed relative to previous borrowing patters, the Fed make call to ask for an explanation for
the borrowing and if the is no subsequent improvement in the bank’s borrowing pattern, fed can
make administrative counselling to tell to stop borrowing practice.
Other non-deposit borrowing:-banks can raise short –term funds from other non-deposit
borrowing in the form of issuing obligations in the money market or medium up –to long- term
in the form of issuing securities in the bond market. Banks that raise most of their funds from
domestic and international money market relying less on depositors’ funds are called Money
Centre Banks.
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 (checking deposits):-pay no interest and can be withdrawn upon
demand using checks. Another deposit similar to demand deposit is negotiable order of
withdrawal accounts (NOW accounts). It can offer checkable deposits that pay interest when a
minimum balance is maintained on its books and withdraw able on demand.NOW accounts
require the depositor to maintain a minimum account balance let say$500 to earn interest. If the
minimum balance falls below some level (let below $500), NOW account becomes quite similar
with demand deposit since no interest is earned.
– Saving deposits:-pay interest do not have a specific maturity, and usually can be withdrawn up
on demand.
– Fixed or time deposits (certificate of deposit):-have fixed maturity date and pay either a fixed
or floating interest rates. if the depositor needs money before the maturity date, CDs can be sold
in the secondary market or by paying withdrawal penalty to the banks , it can withdraw the total
amount prior to maturity.
2. Lending Money
– Overdrafts
– Cash credit

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– Loans and Advances
– Discounting of bill of Exchange
Secondary Services of Commercial 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
– 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
2. 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
2.2.Non- Depository Institutions
These Non-depository institutions are financial institutions that do not mobilize deposits:
These include (among others):
• Insurance companies
• Pension funds
• Mutual funds
Depository institutions seek to generate income by the spread between the returns that they earn
on assets and the cost of their funds i.e. they are considered as spread business. Some of the non-
depository institutions such as life insurance companies and property –casualty insurance
companies are also considered as spread businesses. The other non-depository institutions like
pension funds are not in the spread business because they do not raise funds themselves in the
business. They seek to cover the cost of pension fund obligations at a minimum cost of that is
borne by the sponsor of the pension plan.

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A. Insurance Companies
The primary function of insurance companies is to compensate individuals and corporations
(policyholders) if perceived adverse event occur, in exchange for premium paid to the insurer by
policyholder.
• 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
1. Life insurance: deals with death, illness disablement and retirement policies. up on death of
policyholder, a life insurance company agrees to make either a lump-sum payments or a series of
payments to the beneficiaries of the policy.
Principal kinds of f life insurance policies include:
1. Term life insurance-insurance coverage for a certain number of years so that the
policyholder’s beneficiaries (nominees) receive benefit payments only if death occurs
within the period of coverage.
2. Whole life insurance- insurance protection that covers the entire lifetime of the
policyholder. Premiums built up cash values that may be borrowed by the policyholder.
3. Endowment policies-a policy with benefits payable to the living policyholder on a
specified future date or to the policyholder’s beneficiaries if death occurs before the date
specified in the policy.
4. Annuities: the insured pays a lump sum premium and the insurer pays the claims
subsequently immediately after the payment of premium or in a deferred (claims paid
more than one period later of premium payments.

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Source of funds for life Insurance Company
The primary income source of life insurance companies is premium receipts from sale of various
kinds of insurance policies. How do life insurance companies decided how much premium to
charge?
There are three basic factors that influence premium determinations in life insurance.
I. Expected mortality rate
II. Investment income earned by insurers on premium income
III. Expenses to be incurred in running the business.
Example, suppose s life insurer has 100,000 policyholders each 40 years age with $1million
life insurance policy. The company must set annual premium so it will have sufficient cash to
pay off the beneficiary of any policyholders who die this year, the insurer must do
a. Determine the expected number of deaths of this year (from mortality table that shows
how many individuals of any of every 1000 persons. If the expected death rate for 40 years
old is 4per 1000 persons, the expected number of death from the group of 100000
policyholders.
Expected death = number of policyholder × expected mortality rate
= 100×4=400
b. Expected claims, if each policyholder has $1million policy
Expected claims=Expected death ×policy amount promised
= 400×1million=400million
How much should the insurance company charge each policyholderin premium? Further
things to be considered
I. Expected rate of returns when the premium invests on stocks, bonds or other financial
assets, let say 8%Therefore, to have available$400million at years end the company needs
the following amount from the policyholder at the beginning of the year.
=$400/(1.08)1=$370.4million
II. Estimated operating costs and normal profits to earn. Let say total operating costs and
required profits be $2.6million.
Gross premium = $370.4million+2.6 million
Charged from each policyholder 100,000 policyholders
=$3730 per policyholder

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2. General (property-casualty) insurance: deals with theft, property, house, car and general
accident insurance. P&C insurance companies provide broad range of insurance protections
against;
1. Losses, damages or destruction of property
2. Losses or impairment of income –producing capacity
3. Claims for damages by third party because of negligence
4. Loss resulting from injury, or death due to occupational accidents.
P&C insurance is normally divided into two: personal line and commercial line
Insurance Companies. Personal line includes automobile insurance and home owner insurance
and commercial line insurance includes product liability insurance commercial property
insurance.
The costs of the policies underwritten by a P&C insurance company consists of :
a. Claims for loss that have been incurred and reported during the year.
b. Actuarially/estimated claims on policies written during the year that will not be
paid until later years.
P&C companies must establish reserves to satisfy the actuarially estimated claims by law.
Reserves can be increased or decreased depending on whether actual claims are above or below
those actuarially estimates.
Source of funds for P&C insurance companies
Obviously, the primary source of fund is premium from the policyholder. P&C Company
generates revenues fro two sources:
I. Initially underwriting income ( insurance premium)
II. Investment income that occur over time. The profit of P&C company is calculated by
subtracting the following costs from the revenues;
 Funds that must be added to reserves for new claims for policies written during the
year called (claim expenses).
 Funds that must be added to reserve because of underestimates of actuarially
projected claims from previous years (claim adjustment expense.
 Taxes
 Administrative and marketing expenses related with issuing policies.

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If revenues for the year exceed the total expenses, then the difference is surplus and the surplus
of the P&C Company is increased; it is decreased if the reverse occurs. Surplus also changes
when funds are distributed to shareholders.
The growth of surplus of a P&C company will determine how much future business it can
underwrite. The ability of P&C Company to take on risk is measured by the ratio of the annual
premium to the capital plus surplus. Usually, this ratio is kept at between 2: 1 and 3: 1
consequently, $3 in annual premium can be supported for each $1 increase in surplus. If annual
premium exceeds the sum of claim expenses, claim adjustment expenses and administrative and
marketing expenses, the difference is said to be the underwriting profit. And if the sum of all
expenses exceed annual premium the difference is underwriting loss.
B. Pension Fund
Pension plan is a fund that established for the payment of retirement benefits. Pension funds
offer savings plans through which fund participant accumulate tax deferred savings during their
working years. The entities that establish pension plans are called plan sponsors. Pension plan
sponsors can be private businesses acting for their employees or public organizations -on behalf
of their employees, unions on behalf of their members or individuals for themselves.
Pension funds are financed by contributions by employers and employees. In some fund plans
employers contribution are matched in some measure by employees.
Pension plan assets are legally illiquid. It cannot be used before retirement even as collateral.
Pension fund is the most growing financial institution currently. The key factors for the pension
fund growth are;
❖ The employees’ and employers’ contribution are tax exempt.
❖ As well as the earnings of the fund’s assets are also tax exempt.
In essence, a pension fund is a form of employer remuneration for which the employee is not
taxed until funds are withdrawn.
The pension fund company comprises two distinct sectors.
1. Private pension funds:-are those funds administered by private corporations (insurance
companies, mutual funds etc).
2. Public pension funds:-are those funds administered by federal, state, or local government
(social security).

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C. Mutual Funds
Nature of Mutual Funds
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.
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. 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.
• 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. Mobilizing small saving
2. Professional management
3. Diversified investment/ reduced risks
4. Better liquidity
5. Investment protection
6. Low transaction cost (economy of scale)
7. Economic Development
1. Mobilizing small saving
– Direct participation in securities is not attractive to small investors b/s of some
requirements which is difficult for them
– MF mobilizes funds by selling their own shares, known as units. This funds are invested
in shares of different institution, gov’t securities, etc
– To an investor, a unit in a mutual fund means ownership of a proportionate share of
securities in the portfolio of a mutual fund.

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2. Professional management
• Mutual funds employ professional experts who manage the investment portfolio efficiently and
profitably.
• Investors are relived of the emotional stress in buying and selling securities since MF take care
of this function.
• The Prof mgrs act scientifically with
– the right timing to buy and sell of shares for their clients,
– Automatic reinvestment of dividends and capital gains, etc.
3.Diversified investment/ reduced risks
– Funds mobilized from investors are invested in various industries spread across the
country/globe.
– This is advantage to the small investors b/s they cannot afford to assess the profitability
and viability of different investment opportunities
– MF provide small investors the access to a reduced investment risk resulting from
diversification, economies of scale in transaction cost and professional financial mgt
4. Better liquidity
– There is always a ready market for the mutual fund units- it is possible for the investors
to divest holdings any time during the year at the Net Asset Value (NAV)
– Securities held by the fund could be converted into cash at any time.
– Thus, mutual funds could not face problem of liquidity to satisfy the redemption demand
of unit holders.
5. Investment protection
– Mutual funds are legally regulated by guidelines and legislative provisions of regulatory
bodies (such as SEC in US, SEBI in India etc)
6. Low transaction cost (economy of scale)
– The cost of purchase and sale of mutual funds is relatively lower b/s of the large volume
of money being handled by MF in the capital market (economies of Scale)
– Brokerage fees, trading commission, etc are lower
– This enhances the quantum of distributable income available for investors

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7. Economic Development
– Mutual funds mobilize more savings and channel them to the more productive sectors of
the economy
– The efficient functioning of mutual funds contributes to an efficient financial system.
– This in turn paves ways for the efficient allocation of the financial resources of the
country which in turn contributes to the economic development.
2.3.Nature of Liabilities:
Based on the amount and timing of cash outlays, any financial institutions’ liability can be
classified under the following groups.
1. Type –I Liabilities: both the amount and timing of liabilities are known with certainty.
Example-liability financial institution that knows to be paid $50000 after six months. Banks and
thrifts have type –I liabilities, they know the amount that they are committed to pay (principal
plus interest) on the maturity date of fixed deposit. Life insurance companies shall have also
type-I liability if it issues guaranteed investment contract (GIC). The obligation of life insurance
under this contract is for sum of money (called premium) and of will guarantee an interest rate
up to some specific maturity date. Example, suppose a life insurance company for a premium of
$10million issues a five year GIC agreeing to pay 10%copmonded annually. The life insurance
company knows that it must pay $16,105,100 = ((1.1)5*10,000,000).
2. Type-II liabilities: The amount of cash outlay is known but the timing of cash outlay is
uncertain. The most obvious example of type- II liability is life insurance policy which agrees to
make a specific dollar amount to policy beneficiaries up on the death of the insured.
3. Type-III liability: the timing of cash outlay is known but the amount of cash outlay is uncertain.
Example, Floating rate GIC falls into the type-III liability category.
4. Type-IV liabilities: there are numerous insurance products and pension obligation where there is
uncertainty to both the amount and timing of the cash outlays. Most of the property-casualty
insurance companies have such type of liabilities.

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