Types of Financial Intermediaries
You observe different types of financial intermediaries if you walk around the big city such as Kathmandu and Pokhara. You will see some financial institutions such as banks, finance companies, development banks, and saving and credit cooperatives that are collecting deposits from individuals, government and non-government organizations. Similarly, you will see some financial institutions such as Citizen Investment Trust (CIT) and Employee Provident Funds collecting specific amounts of savings from government employees and some financial institutions such as Nepal Life Insurance Company Limited and National Life Insurance Company Limited selling their policies to individuals to protect them from possible unfavorable events. Similarly, you will see some financial intermediaries selling securities to the investors.
Broadly, financial intermediaries are of two types: 1) depository institutions, and 2) non-depository institutions. Non-depository institutions are classified into contractual saving institutions and investment intermediaries. Depository institutions are those financial institutions that accept deposits from the general public. Commercial banks, finance companies, development banks, and saving and credit cooperatives are depository institutions. Non-depository institutions do not receive deposits from the public.
Financial intermediaries such as insurance companies, pension funds, and government retirement funds are examples of contractual saving institutions. Money market funds and mutual funds are examples of investment and investment intermediaries. Both contractual saving institution’s intermediaries do not accept deposits from the general public. So, both types of financial intermediaries are non-depository financial intermediaries.
As discussed earlier, depository institutions are those institutions that accept the deposits from general public. In Nepal, commercial banks, development banks, finance companies, micro-credit development banks, and saving and credit cooperatives accept deposits in different types of accounts. So, these financial institutions are depository institutions. Nepal Rastra Bank issues licenses to commercial banks, development banks, finance companies, and micro-credit development banks. In the U.S.A., commercial banks, savings and loan associations, mutual savings banks, and credit unions are the depository institutions.
Commercial banks collect deposits and provide commercial and consumer loans. In Nepal, commercial banks are the licensed institution with a minimum paid-up capital of Rs 8 billion. They are Class A financial institutions. The number of commercial banks by Mid-July 2019 is 28 and these 28 banks occupy around 86 percent of total assets of licensed financial institutions. So, commercial banks have the dominant role in the financial sector of Nepal. They are involved in accepting and mobilizing deposits, providing different types of loans with or without collateral, issuing the guarantee, and carrying out the agency’s services.
Before the enforcement of the Bank and Financial Institutions Act, development banks were established for specific purposes. For example, the Agriculture Development Bank was established focusing on the development of agro-based industries, and the Nepal Industrial Development Corporation (NIDC) was incorporated to provide loans and promotional services to the industries. After the liberalization of the financial sector and enforcement of the Bank and Financial Institutions Act, development banks also accept deposits and grant loans to the general public. In addition, development banks carry out research, and surveys, and provide consultancy services relating to the establishment and operation of industrial projects. By mid-July 2019, the number of development banks in Nepal is 29 and these banks occupy around 11 percent of the total assets and deposits of depository institutions.
Nepal Rastra Bank has classified development banks as Class B financial institutions. Class B financial institutions are further classified into three categories according to the coverage of their services and have fixed the minimum paid-up capital. National-level development banks need a minimum paid-up capital of Rs 2.5 billion, banks covering 4-10 districts and banks covering 1-3 districts need Rs 1.2 billion and Rs 500 million of minimum paid-up capital respectively. Thus, based on paid-up capital, development banks are those banks having a minimum capital of Rs 500 million to Rs 2.5 billion.
Finance company and micro-credit development bank:
Both finance companies and micro-credit development banks carry out fundamental banking services with certain limitations in transactions especially in the collection of deposits and granting the loans. Both accept deposits from the general public. National level finance companies and finance companies covering 4-10 districts need Rs 800 million of minimum paid-up capital and companies providing their service from 1-3 districts need Rs 400 million minimum capital. So, functionally, finance companies (Class C financial institutions) are those financial institutions having paid-up capital from Rs 400 million to Rs 800 million. By mid-July 2019, the number of finance companies is 23 and they share around 3 percent of the total assets of depository financial institutions and 2 percent of total deposits.
Microcredit development banks (Class D financial institutions) are classified into national level, regional level, and banks covering 4-10 districts and 1-3 districts. National-level banks need minimum paid-up capital of Rs 100 million, regional-level banks need Rs 60 million, banks covering 4-10 districts need Rs 20 million, and banks covering 1-3 districts need Rs 10 million of minimum capital. Further, micro-credit development banks are wholesale and retail banks. Wholesale banks provide the loan to microfinance institutions and retail banks provide the loan to individuals.
Saving and credit associations and mutual saving banks:
Major sources of funds of these financial institutions are saving deposits, time, and checkable deposits. People from similar types of professions form savings and credit associations. Each member of the association deposits savings periodically and provide loan to its member only for the construction and purchase of the residential home. So, saving and credit associations receive funds from their members and provide loans to their members, especially mortgage loans. Traditionally, activities of saving and credit associations were limited to the collection of savings from members and providing loans to the members only. But nowadays, their activities are like the activities of banks. So, they have become alike commercial banks and
competitive with each other.
In the Nepalese context, this is saving and credit cooperatives. Saving and credit cooperatives collect saving deposits from their members and make consumer loans only to their members. Members of a credit union are based on a similar profession. For example, farmers may run the credit unions or employee unions may run credit unions only making the employees members of the credit unions. Though theoretically credit unions collect savings deposits from their members and make loans to their members, they are carrying on the fundamental banking services to the general public other than their genuine members.
In Nepalese financial markets, saving and credit cooperatives have a considerable role in providing banking services at the grassroots level. As per the cooperative statistics published by the Department of Cooperatives, Government of Nepal, the number of cooperatives by mid-July, 2017, is 34,592, and out of this, 13,578 cooperatives are saving and credit cooperatives. These saving and credit cooperatives are under the jurisdiction of the Department of Cooperatives, Government of Nepal. In fiscal year 2016/017, they collected Rs 217,493 million in deposits and disbursed Rs 179,880 million in loans. These data on deposits and loans show that saving and credit cooperatives have considerable roles in Nepalese financial markets.
Contractual Saving Institutions
We mentioned earlier that non-depository financial intermediaries are of two types: contractual saving institutions and investment intermediaries. Contractual saving institutions collect the funds periodically as per the contract between financial institutions and beneficiaries. For example, insurance companies collect es premiums from insured individuals periodically and pay the compensation in the case of general insurance and the insured amount in the case of life insurance.
Similarly, government retirement funds such as the Employees Provident Fund and Citizen Investment Trust collect the funds periodically and pay employees on their retirements. Similarly, pension funds also collect funds from employees and employers and pay monthly payments after retirement. Thus, contractual saving institutions collect the saving from employees as per the contract and this category of financial intermediaries include provident funds, pension funds, and insurance companies.
There are two types of firms in the insurance industry. One type of insurance is life insurance which protects people from financial hazards following their death and another type of insurance is general insurance which gives compensation for the destruction of insured properties by insured risks. Both life and general insurance companies receive insurance premiums from insured individuals and business firms as consideration for undertaking the risks as per the contract. In the case of life insurance, insurance companies pay a lump sum to the beneficiaries on the death of the insured person before the maturity of the life insurance policy and pay the insured amount to the insured person if s/he is alive even after the maturity of the policy.
Life insurance companies also sell the annuity also. In an annuity policy, insurance companies pay monthly payments or periodically as per the provision made in the policy on the retirement of an insured person. Insurance companies invest funds acquired from premiums in different types of securities such as shares, bonds, debenture, and government securities.
General insurance includes fire and casualty insurance companies. These companies insure their policyholders against the loss from fire, theft, and accidents to their properties. They collect the funds from premiums and invest in different securities. In general insurance, there is a greater possibility of a loss of funds. So, general insurance companies invest the funds in less risky and more liquid assets such as municipal bonds and government securities. They invest the funds in corporate securities but the proportion of investment in corporate securities is relatively low.
Pension funds and government retirement funds.
In developed financial markets, the private sector as well as the government establishes pension funds and retirement funds with various schemes. Pension funds receive funds from employers and employees. As per the pension scheme, employees and employers contribute to the pension funds and pension funds provide the employee pension during retired life. Financial institutions are established to manage and run the retirement funds. In Nepal, we can take the Citizen Investment Trust (CIT) as an example of a retirement fund. The government encourages the employees by giving tax incentives on the contribution to the pension funds and retirement funds. In our country, we get tax deductions on contributions to pension funds and retirement schemes. Pension funds and retirement funds invest in corporate securities and government securities.
Investment intermediaries are those financial intermediaries that sell their own securities raise the funds, and invest the funds in corporate and non-corporate securities. They include mutual funds and investment banks. Finance companies also are considered investment intermediaries only when they are not allowed to accept the deposits from general public but in our context, they are allowed to accept deposits from the general public and work as banks with some limitations. We have already discussed finance companies as the depository institution.
Mutual funds raise funds by selling their own shares to a large number of shareholders and investing the funds so raised in a large portfolio. Mutual funds are of two types: open-end mutual funds and closed-end mutual funds. The number of outstanding shares of open-end mutual funds fluctuates according to the buying and selling of shares while the number of the share of close-end funds remains constant. Investors can get the advantage of low transaction costs due to the large pooling of funds. In addition, they do not need to diversify their investment to reduce the risk because mutual funds themselves create large portfolios.
Investors can buy shares and sell their shares of mutual funds at any time to the mutual funds. In other words, mutual funds redeem the shares whenever investors want to sell their shares to the company. However, the value of a share of mutual funds depends on the market prices of securities in the portfolio of mutual funds. Thus, the value of shares also fluctuates with the fluctuation in the market price of the securities in the portfolio of mutual funds.
Money market mutual funds:
Money market mutual funds raise funds by selling their shares and investing the funds to purchase money market instruments. In general, they invest the funds in safe and liquid money market instruments. They use the interest earned on money market instruments to pay shareholders. Such funds have given the facility of checking accounts and shareholders can write the checks to withdraw the value of their shares in the mutual funds. Thus, shares in the money market mutual funds function as checking account deposits that pay interest.
An investment bank does not provide the fundamental banking functions: of accepting deposits and lending money but it helps companies to issue securities. First, it advances a company on which securities it should issue to raise the required funds from the financial markets, and then it underwrites the securities from the issuing company and sells them to investors. Investment banks purchase securities from the issuing company at an agreed price and sell them to the ultimate investors at a higher price. They work as a middleman between investors and companies.
Thus, investment banks provide the service to investors and companies. In Nepal, the Securities Board of Nepal issues a license for investment banking. It has issued investment/merchant banking licenses to 31 financial institutions by mid-July 2019. The licensed investment banks work as issue managers in initial public offerings (IPOs). For example, Himalayan Urja Bikas Company Ltd. offered 990,000 shares to the public in 2018. In this public offering, Nabil Investment Banking Limited worked as an issue manager.
What are Depository Institutions?
The Financial institutions that accept deposits from the general public.
What are Non-Depository Institutions?
The Financial intermediaries that do not accept deposits from the general public.