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Lecture 1
Introduction to Banking Systems

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Six Parts of the Financial
System
1. Money
To pay for purchases and store wealth.
2. Financial Instruments
To transfer resources from savers to investors and to transfer
risk to those best equipped to bear it.
3. Financial Markets
To buy and sell financial instruments.
4. Financial Institutions
To provide access to financial markets, collect information &
provide services.
5. Regulatory Agencies
To provide oversight for financial system.
6. Central Banks
To monitor financial Institutions and stabilize the economy.

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Six Parts of the Financial
System
1. Money
To pay for purchases and store wealth.
2. Financial Instruments
To transfer resources from savers to investors and to transfer
risk to those best equipped to bear it.
3. Financial Markets
To buy and sell financial instruments.
4. Financial Institutions
To provide access to financial markets, collect information &
provide services.
5. Regulatory Agencies
To provide oversight for financial system.
6. Central Banks
To monitor financial Institutions and stabilize the economy.

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Six Parts of the Financial
System
1. Money
– Money has changed from gold/silver coins to
paper currency to electronic funds.
– Cash can be obtained from an ATM any
where in the world.
– Bills are paid and transactions are checked
online.

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Six Parts of the Financial
System
2. Financial instruments
– Buying and selling individual stocks used to
be only for the wealthy.
– Today we have mutual funds and other
stocks available through banks or online.
– Putting together a portfolio is open to
everyone.

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Six Parts of the Financial
System
3. Financial Markets
– Once financial markets were located in
coffeehouses and taverns.
– Then organized markets were created, like
the New York Stock Exchange.
– Now transactions are mostly handled by
electronic markets.
• This has reduced the cost of processing financial
transactions.
– There is a much broader array of financial
instruments available.

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Six Parts of the Financial
System
4. Financial Institutions
– Banks began as vaults, developed into
institutions, to today’s financial supermarket.
– Offer a huge assortment of financial
products and services.

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Six Parts of the Financial
System
5. Government regulatory agencies
– Government regulatory agencies were
introduced by federal government after
the Great Depression.
– Government regulatory agencies
provide wide-ranging financial
regulation - rules and supervision.
– Government regulatory agencies
examine the systems a bank uses to
manage its risk.
– The 2007-2009 financial crises has led

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Six Parts of the Financial
System
6. Central banks
– Central banks began as large private banks
to finance wars.
– Central banks control the availability of
money and credit to ensure low inflation,
high growth and stability of financial system.
– Today’s policymakers strive for transparency
in their operations.

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Five Core Principles of
Money and Banking
1. Time has value.
2. Risk requires compensation.
3. Information is the basis for
decisions.
4. Markets determine prices and
allocation resources.
5. Stability improves welfare.

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Five Core Principles of
Money and Banking
A. Core Principle 1: Time has value
– Time affects the value of financial
instruments.
– Interest is paid to compensate the
lenders for the time the borrowers have
their money.
– Chapter 4 develops an understanding
of interest rates and how to use them.

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Five Core Principles of
Money and Banking
B. Core Principle 2: Risk requires
compensation
– In a world of uncertainty, individuals
will accept risk only if they are
compensated.
– In the financial world, compensation
comes in the form of explicit payments:
the higher the risk the bigger the
payment.

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Five Core Principles of
Money and Banking
C. Core Principle 3: Information is the
basis for decisions
– The more important the decision, the
more information we gather.
– Collection and processing of
information is the foundation of the
financial system.

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Five Core Principles of
Money and Banking
D. Core Principle 4: Markets determine
prices and allocate resources.
– Markets are the core of the economic
system.
– Markets channel resources and
minimize the cost of gathering
information and making transactions.
– The better developed the financial
markets, the faster the country will
grow.

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Five Core Principles of
Money and Banking
E. Core Principle 5: Stability improves
welfare.
– A stable economy reduces risk and
improves everyone's welfare.
– Financial instability in the autumn of
2008 triggered the worse global
downturn since the Great Depression.
– A stable economy grows faster than an
unstable one.

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Financial Institutions
• Firms that provide access to the financial markets, both
– to savers who wish to purchase financial instruments directly and
– to borrowers who want to issue them.
• Also known as financial intermediaries.
– Examples: banks, insurance companies, securities firms, and
pension funds.
• Healthy financial institutions open the flow of resources,
increasing the system’s efficiency.

Financial institutions are businesses which
offer multiple services in banking and
finance. The services customers receive
may include savings and checking accounts,
loans, investments, and financial
counseling. The benefits consumers gain
by using financial institutions includes
convenience, cost savings, safety, and
security.

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The Role of Financial
Institutions
• To reduce transaction costs by
specializing in the issuance of
standardized securities.
• To reduce the information costs of
screening and monitoring borrowers.
– They curb asymmetries, helping resources
flow to most productive uses.
• To give savers ready access to their
funds.

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• Financial intermediation and leverage in the US
have shifted away from traditional banks and
toward other financial institutions less subject to
government regulations.
– Brokerages, insurers, hedge funds, etc.
• These have become known as shadow banks.
– Provide services that compete with banks but
do not accept deposits.
– Take on more risk than traditional banks and
are less transparent.

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• The rise of highly leveraged shadow
banks, combined with government
relaxation of rules for traditional banks,
permitted a rise of leverage in the financial
system as a whole.
– This made the financial system more
vulnerable to shocks.
• Rapid growth in some financial
instruments made it easier to conceal
leverage and risk-taking.

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• The financial crisis transformed shadow
banking.
– The largest US brokerages failed, merged, or
converted themselves into traditional banks to
gain access to funding.
• The crisis has encouraged the government
to scrutinize any financial institution that
could, by risk taking, pose a threat to the
financial system.

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The Structure of the Financial
Industry
• We can divide intermediaries into two
broad categories:
– Depository institutions,
• Take deposits and make loans
• What most people think of as banks
– Non-depository institutions.
• Include insurance companies, securities
firms, mutual fund companies, etc.

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The Structure of the Financial
Industry
1. Depository institutions take deposits and
make loans.
2. Insurance companies accept premiums,
which they invest, in return for promising
compensation to policy holders under
certain events.
3. Pension funds invest individual and
company contributions in stocks, bonds,
and real estate in order to provide
payments to retired workers.

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The Structure of the Financial
Industry
4. Securities firms include brokers, investment
banks, underwriters, and mutual fund
companies.
– Brokers and investment banks issue stocks
and bonds to corporate customers, trade
them, and advise customers.
– Mutual-fund companies pool the resources of
individuals and companies and invest them in
portfolios.
– Hedge funds do the same for small groups of
wealthy investors.

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The Structure of the Financial
Industry
5. Finance companies raise funds directly
in the financial markets in order to make
loans to individuals and firms.
– Finance companies tend to specialize in
particular types of loans, such as mortgage,
automobile, or business equipment.

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The Structure of the Financial
Industry
6. Government-sponsored enterprises are
federal credit agencies that provide loans
directly for farmers and home
mortgagors.
– Guarantee programs that insure loans made
by private lenders.
– Provides retirement income and medical
care through Social Security and Medicare.

Financial non depository
institutions
are financial intermediaries that do not
accept deposits but do pool the payments of
many people in the form of premiums or
contributions and either invest it or provide
credit to others.
Nondepository institutions include pension
funds, securities firms, government-
sponsored enterprises, and finance
companies.

Insurances Companies
• Insurance companies may be classified as
1. Life insurance companies, which
sell life insurance, annuities and pensions
products.
2. Non-life or general insurance
companies, which sell other types of
insurance.

• There are also smaller non depository
institutions, such as pawnshops that
make loans based on the value of property
such as jewelry, electronics, or other
valuable items.
• Pawnshops charge much higher fees than
other lending institutions.

Mutual Fund
An investment which is comprised of a
pool of funds collected from many
investors for the purpose of investing in
securities such as stocks, bonds, money
market securities and similar assets.

Brokerage Houses
• Stock brokers assist people in investing,
online only companies are called 'discount
brokerages', companies with a branch
presence are called 'full service
brokerages' or 'private client services.

Investment company
• Generally, an "investment company" is a
company (corporation, business trust,
partnership, or limited liability company)
that issues securities and is primarily
engaged in the business of investing in
securities.

Depository institutions
Figure 13.3. Where Our Money Is
Deposited

Banks
• A bank is a commercial or state institution
that provides financial services, including
issuing money in various forms, receiving
deposits of money, lending money and
processing transactions and the creating
of credit.

1. Central Bank
• A central bank, reserve bank or
monetary authority, is an entity
responsible for the monetary policy of its
country or of a group of member states,
such as the European Central Bank (ECB)
in the European Union, the Federal
Reserve System in the United States of
America,

1. Central Bank
• Its primary responsibility is to maintain the
stability of the national currency and
money supply, but more active duties
include controlling subsidized-loan interest
rates, and acting as a “ lender of last
resort” to the banking sector during times
of financial crisis

2. Commercial Banks
• A commercial bank accepts deposits from
customers and in turn makes loans, even
in excess of the deposits; a process
known as fractional-reserve banking.
Some banks (called Banks of issue) issue
banknotes as legal tender.

Size, structure and composition
• From1985 to 2016 the number of
banks decreased as a result of
merges and acquisitions.

Selected Indicators for
U.S.commercial Banks
2016 2005 2003 2001 1997
Number of
institutions
23,192 7,541 7,769 8,079 9,143

Small banks make fewer
commercial and industrial loans
and more real estate loans than do
big banks

Small banks
1,5
0,1
0,6
0,5
7,3
Sales
C.i
credit cart
consumer
other
real estate

Large banks
5,3
2
1,1
0,7
0,9
Sales
REAL ESTATE 53%
C&I
OTHER
CREDIT CARD
CONSUMER

3. Different types of Banks
• Investment banks help companies and
governments and their agencies to raise
money by issuing and selling securities in
the primary market. They assist public and
private corporations in raising funds in the
capital markets (both equity and debt), as
well as in providing strategic advisory
services for mergers, acquisitions and
other types of financial transactions.

4. Saving Banks
• A saving bank is a financial institution
whose primary purpose is accepting
savings deposits. It may also perform
some other functions.

5. Micro Finance Banks
• For the purpose of poverty reduction
program, such kind of banks are working
in the different countries with the
contribution of UNO or World Bank.

6. Islamic Banks
• Islamic banking refers to a system of
banking or banking activity that is
consistent with Islamic law (Sharia)
principles and guided by Islamic
economics. In particular, Islamic law
prohibits usury, the collection and payment
of interest, also commonly called riba in
Islamic discourse.

9. Leasing Companies
• A lease or tenancy is the right to use or occupy
personal property or real property given by a
lessor to another person (usually called the
lessee or tenant) for a fixed or indefinite period
of time, whereby the lessee obtains exclusive
possession of the property in return for paying
the lessor a fixed or determinable consideration
(payment).

Federal Reserve System
• Established to supervise and regulate
member banks
• All national banks are required to join the
Federal Reserve System
• Banks that join the system are called
“member banks”

The functions of the Federal
Reserve
• Cashes checks for banks
• Makes loans to banks
• Wires money
• Collect checks for banks
• Supervise all national banks
• Supervises other members of the system
• Raises and lowers interest rates
• Attempts to control inflation

FED-Central Bank
• Monetary Policy
-Open Market Operation
-Discount Rate
-Required reserve ratio

• A bank holds on to only a fraction of the
money that it takes in—an amount called
its reserves—and lends the rest out to
individuals, businesses, and governments.
In turn, borrowers put some of these funds
back into the banking system, where they
become available to other borrowers. The
money multiplier effect ensures that the
cycle expands

Conclusion
• Financial institutions serve as financial
intermediaries between savers and
borrowers and direct the flow of funds
between the two groups.