What is a Financial Institution?
A financial institution is an organization that provides financial services, such as accepting deposits, providing loans, facilitating investments, and offering financial products. Financial institutions play a crucial role in the financial system, serving as intermediaries between savers and borrowers, thus promoting liquidity and the efficient allocation of resources in the economy.
Different Types of Financial Institutions
- Depository Institutions: Accept deposits from the public (e.g., banks, credit unions).
- Non-depository Institutions: Provide financial services but don’t accept deposits (e.g., insurance companies, investment companies).
- Investment Banks: Facilitate the issuance of securities and advisory services.
- Insurance Companies: Provide risk management and policy underwriting.
- Pension Funds: Manage retirement savings for employees.
- Brokerage Firms: Facilitate buying and selling of securities.
- Microfinance Institutions: Provide financial services to low-income individuals or those lacking access to conventional banking.
Functions of Financial Institutions
- Intermediation: Channel funds from savers to borrowers.
- Liquidity Creation: Provide liquidity through deposits and withdrawals.
- Risk Management: Offer various financial products to manage risk.
- Payment Systems: Facilitate transactions through various payment mechanisms.
- Information Processing: Assess the creditworthiness of borrowers and provide essential market data.
- Investment Services: Offer opportunities for investment and wealth management.
Different Types of Services Provided by Banks and Financial Institutions
- Deposit Services: Savings accounts, current accounts, fixed deposits.
- Loan Services: Personal loans, home loans, business loans.
- Payment and Money Transfer Services: Wire transfers, checks, electronic fund transfers (EFT).
- Investment Services: Wealth management, stock brokerage, mutual funds.
- Insurance Services: Life and non-life insurance products.
- Foreign Exchange Services: Currency exchange and international trade financing.
- Advisory Services: Financial planning, tax advisory, and investment advice.
Rationale of Liquidity and Liability Management
- Liquidity Management: Ensures that a bank can meet its financial obligations as they come due without incurring unacceptable losses. It's essential for maintaining customer confidence and regulatory compliance.
- Liability Management: Involves managing the bank's short-term and long-term funding sources to minimize costs and risks related to lender confidence and interest rate fluctuations.
Sources of Funds of a Commercial Bank and Regulations
Sources of Funds:
- Deposits: Retail and wholesale deposits from customers.
- Borrowings: Loans from other financial institutions, central banks, or the capital market.
- Equity Capital: Funds raised from shareholders.
- Securitization: Packaging assets and selling them as securities.
- Retained Earnings: Profits reinvested in the bank.
Regulations:
- Capital Adequacy Requirements: Maintained under Basel III (minimum capital ratios).
- Reserve Requirements: A percentage of deposits held in reserve.
- Liquidity Coverage Ratio: Ensuring enough high-quality liquid assets for short-term obligations.
Define Depository Institutions and Describe Its Different Types
Depository Institutions: Financial institutions that accept deposits from individuals and businesses, providing secure storage for funds while offering various financial services.
Different Types:
- Commercial Banks: Offer a wide range of banking services, including deposits and loans.
- Savings and Loan Associations (S&Ls): Focus on accepting savings deposits and providing mortgage loans.
- Credit Unions: Member-owned institutions that provide similar services at lower rates.
- Savings Banks: Primarily focus on savings accounts and loans, often community-oriented.
Qualitative & Quantitative Credit Control Measures of Central Bank
Qualitative Measures: Tools that influence the allocation of credit rather than its volume. These include:
- Moral suasion: Persuading banks to adhere to credit guidelines.
- Credit ceilings: Limiting the amount of credit available to certain sectors.
Quantitative Measures: Tools that alter the amount of credit or money in the economy including:
- Open market operations: Buying/selling government bonds to affect money supply.
- Discount rate: Changing the interest rates at which banks can borrow from the central bank.
- Reserve requirements: Changing the percentage of deposits banks must hold in reserve.
Sources & Uses of Funds of Depository Financial Institutions
Sources of Funds:
- Customer deposits
- Borrowings (interbank and central bank loans)
- Capital (equity from shareholders)
Uses of Funds:
- Loans to individuals and businesses
- Investment in securities (government bonds, stocks)
- Cash reserves held for regulatory compliance and liquidity needs
Rank the Following Bank Assets from Most to Least Liquid:
- C. Reserves (most liquid, as they are cash or cash-equivalents stored at the central bank)
- B. Securities (can be quickly sold, hence relatively liquid)
- A. Commercial loans (not as liquid, as they are not easily convertible to cash)
- D. Physical capital (least liquid, as it requires time to convert into cash or assets)
This ranking indicates the relative ease with which an asset can be converted into cash without significant loss of value.
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