Non-Depository Institutions

Rajeet Guha

A.1 Non-depository institutions are institutions that do not issue checkings and savings deposits. They provide a broad array of financial services. Some of them are securities market institutions that specialize in intermediating risks in securities markets while others known as insurance companies insure individuals and firms against risks of future losses. Pension funds offer pension plans that provide retirement security income to workers. Financial institutions called finance companies make loans to individuals and firms that commercial banks, savings banks and credit unions might deem uncreditworthy. Mutual funds provide specialized portfolio management skills.
Securities market institutions : When business firms issue new shares of stock or offer to sell new bonds, these firms and those who contemplate buying their securities face two asymmetric information problems. One stems from adverse selection. Some firms that issue new securities may have an incentive to do so because they are strapped for cash and teetering on the edge of financial disaster. Those considering buying new stocks or bonds recognize this possibility and need to be able to identify creditworthy firms. The firms recognize this and need a way to signal their creditworthiness to potential purchasers of their securities. Securities market institutions such as investment banks and securities brokers and dealers provide this signal by intermediating firms’ securities.
Securities market institutions also assist in minimizing moral-hazard problems that arise when firms that are successful in raising funds via security issues might have an incentive to misuse those funds. By monitoring the performances of issuing firms, these institutions assure stock and bond holders that the firms maintain their creditworthiness. This ensures that the shares of stock or the bonds of issuing firms remain liquid instruments that retain the risk characteristics that they possessed when the firms first issued them.
Investment banks guarantee that the issuing firm will receive a specified minimum price per share of stock or per bond.
Brokers offer a range of financial services including consultations about financial instruments to buy or sell and other financial planning advice.
Some broker-dealers are members of stock exchanges that are responsible for preventing wide swings in stock prices. They do this by adding to or reducing their own holdings of stock to counteract major changes in demand or supply conditions. Investment banks by and brokers by making sensible investments save the public from channeling their funds into risky propositions. Investments in reliable companies provide people with a ready source of liquidity and provide information about which companies are likely to succeed.
Insurance companies are institutions that specialize in trying to limit adverse-selection and moral hazard problems arising from insurance against future losses. The policies that they issue are promises to repay the policyholder if such a future loss occurs. In return insurance companies receive premiums from policyholders and it is from these premiums that payments are made to policyholders who experience losses.
Insurance companies design their policies to reduce the extent of problems that they face in light of asymmetric information. That is because the people who apply for insurance know much more about their risks of loss than do insurance companies, and those who receive insurance can do the most to limit the risks of such losses.
Insurance companies seek to reduce the adverse-selection problem by restricting the availability of insurance. Insurance companies will not sell every available policy to every individual. For instance suppose, that an individual learns that he is inflicted with an illness for which there is no cure. The individual then will want to purchase life insurance for the protection of his wife and children. If the insurer would permit such a person to buy such a policy, then the insurer would be taking on a 100 percent probabability of a claim that would amount to more than the premiums it would collect from that individual. No insurance company could stay in business if it made such policies to everyone. Insurers also deal with the adverse-selection problem by limiting how much insurance an individual or firm can buy. To reduce their exposures to losses from policies taken out by applicants who may know they have life-shortening conditions, insurers typically place limits on the dollar amount of coverage that individuals may purchase. In addition insurance companies typically require policyholders who purchase large life insurance to undergo blood tests or physical exams.
Insurance policies also restrict the behavior of policyholders. These provisions are intended to reduce the extent of moral-hazard problems that insurers face. Limiting the amount of insurance can reduce the extent of moral hazard problems. For example if a company that operates agricultural grain-elevators could insure them for more than they are worth then it would have little incentive to operate the elevators safely by keeping flammable liquids away. Thus the risks would increase and so would the insurer’s chances of making payments on losses. Hence insurers typically limit policy coverages to the maximum possible losses that policyholders could incur. One key weapon against moral-hazard problems is an insurance company’s ability to cancel insurance because of bad behavior by a policyholder. Most insurance policies include a clause threatening cancellation if the policyholder develops a record of reckless behavior after the policy has been issued. Insurance companies also combat moral-hazard problems by offering policies with deductible and coinsurance features. A deductible is a fixed amount of loss that a policyholder must pay before the insurance company must provide payments. Coinsurance is a feature that requires the policyholder to pay a fixed percentage of any loss above the specified deductible. Insurance companies thus reduce or eliminate the risk of families who have lost their breadwinners spending their days as paupers. They also provide people with damage-repair liquidity.
Pension funds have proliferated over the years as they have become popular savings vehicles for people. Pension funds exist because of increased longevity of people and because people can’t work throughout their lives but still need a permanent source of income for old-age. Pension funds also carry tax benefits. They provide retired people with liquidity. It also saves them from the risk of spending their old age in penury. They remove the element of uncertainty.
Finance companies propel the economy forward. They lend money to individuals and business that are of insufficient size or creditworthiness and thereby moves the businesses, economy and people forward. They facilitate in the running of small businesses by extending loans to them. Finance companies specialize in offering financial services to individuals. Consumer finance companies make loans enabling individuals to purchase durable goods such as home appliances or furniture or to make improvements to existing homes. Sales finance companies make loans to individuals planning to purchase items from specific retailers or manufacturers. They provide individuals and businesses with liquidity.
Mutual funds have proliferated in recent years due to the interest rates on large-denomination financial instruments outstripping interest rates at depository institutions. Mutual funds also provide risk diversification by investments in a variety of companies. By being transparent they provide information to the public. They also provide the investors with a ready source of liquidity. They also reduce uncertainty in returns.

A.4 Financial markets are a place where financial assets are bought and sold and they play a crucial role in financing and investments. The financial system comprises those who need money and those who have money to lend. Those who have money to lend are called Surplus Spending units (SSUs) and those that need money are called Deficit Spending Units (DSUs). At a fundamental level the market needs financial intermediaries who can bring the two together by borrowing money from savers and lending to borrowers. Banks are the oldest of such financial intermediaries.
Money is what drives the world. Money is the most liquid asset of an entrepreneurial economy and as Keynes explains everybody demands money either because (a) they have expenditure plans to finance (b) are in uncertainty about what the future holds and therefore need to be reassured by the availability of money to finance any unforeseen expenditure and (c) need to engage in speculative ventures to increase earning from money. Interest is the reward that people demand for inducement to part with liquidity. It is this combination of transactions, precautionary and speculative motives that makes the demand for liquidity so strong.
Banks fulfill this essential need: they provide liquidity. Every time customers withdraw money from an automated teller machine or write a check, they rely on the bank’s liquidity provision function. In fact in terms of liquidity there is very little difference between a demand deposit that an investor holds and a line of credit extended to a firm. Both products require the bank to pay the client money on demand. Therefore it bank provides liquidity on both sides of the balance sheet — to both depositors and borrowers.
Bank intermediation also contributes towards the lowering of transaction costs involved in bringing SSUs and DSUs together. The existence of banks obviates the need to transact business moving from door to locating SSUs and DSUs. Institutional intermediation ensures this. Banks also provide through their most liquid assets, money, the media for exchange. Specialization among institutional intermediaries such as banks reduces transaction costs for both lenders and borrowers.
A major reason for the existence of banks is that they specialize in handling asymmetric information problems in the financial markets. Unlike any other market for goods and services, in this market information about potential lenders with surplus funds and potential borrowers of such funds is not readily available. This is not to say that money markets did not function before institutionalized banks came into being. Individual moneylenders and pawnshop owners possessed the information and brought the two together. However given the growing complexity of our financial needs the existence of specialized institutions willing to incur the costs of such information search and its management using economies of scale is crucial to a well functioning economy.
Banks also contribute towards the spreading of risks. At a basic level by allocating a pool of savings among a diversified portfolio of assets of loans and securities they spread the risks and in the process they reduce risks for depositors and of course as mentioned earlier increase liquidity for lenders.
The other major function banks perform is to fund so called “complex, illiquid positions”. Historically, this has taken the form of making term loans to borrowers who are "difficult" credits. By virtue of their past relationships with client firms, banks know more about their future prospects, as well as about alternative uses for the firms’ assets. Consequently, they can lend more than other less-knowledgeable lenders. Once again this is something which only institutional intermediation, institutional memory and institutional relationships make possible. It is only institutional intermediation that can take such risks with confidence and thus meet the liquidity requirements of a wide variety of DSUs. Also, the bank’s specific lending skills and knowledge have to be brought into play when the bank wants to coax repayment. As a result, the loans are hard to sell to other potential lenders without similar skills or knowledge. Consumers turn to banks for safe and for short- and long-term credit. Large and small businesses rely on banks for payment processing, short-term credit, and backup credit lines. And governments rely on the banking system to conduct payments, distribute currency, safeguard tax receipts, and to serve as a conduit for monetary policy.
Before we conclude we also need to touch upon another type of bank which like commercial banks as described above, also fulfills some essential functions which are key to the functioning of the economy. These are the central banks. The central bank controls the money supply within the national boundaries. In Britain, the central bank is called Bank of England, in Japan is the Bank of Japan, and in the United States the Federal Reserve. The central bank regulates, supervises, and is responsible for policies concerning money. Thus, it has a central role in regulating money inflation in the domestic economy, which, also, has an enormous impact on the economy's performance. The following are the accepted tasks of a central bank: 1) controlling the money supply 2) clearing checks 3) supervising and regulating banks 4) maintaining and circulating currency 5) maintaining national reserves of gold and foreign currencies.
Finally the banking industry plays a major role as the primary vehicle in implementing monetary policies and despite the rise of non-banking institutions (such as mutual funds, housing and finance companies etc.) this role remains unchallenged in most countries. . Most central banks seek to achieve their objectives through some form of interest rate management. Control over short-term interest rates is achieved in every case by manipulating the supply of central bank reserves available to satisfy banks' demand for reserves. Banks' demand for reserves is similarly influenced by central banks either directly by setting reserve requirements or indirectly by allowing only banks to access the payment system and then setting the rules regarding the management of their central bank accounts.
In summary therefore although non banking financial institutions are today rising faster than ever and while the difference between banks and such institutions is being blurred by the latter venturing into roles earlier played by banks exclusively such as deposit offers, the basic functions of banks in making credit available, in providing safe investment choices (deposits) for households, and in processing payments remain as relevant today as ever. They are at the heart of the financial system and the economy overall no matter who performs them: banks or non-banks.

A.3 Money moves the world. In our quest to satisfy endless human demands for goods and services in the modern world, money as the universal medium of exchange is crucial for human existence. The financial market consists of those who have surplus money and those who don’t. The market needs financial intermediaries who can bring the two together by borrowing money from savers and lending to borrowers.
There are broadly two types of intermediaries: depository and non-depository. Depository institutions are those that take in deposits and make loans. As we know banks are the most important depository financial intermediary which makes liquidity available where it is needed, lowers information search costs and reduces transaction costs bringing together those who need money with those who have surplus money.
A Bank can be defined as a type of financial institution that originates loans as well as maintains deposits for account holders that are federally insured. As depository institutions banks are generally considered full-service financial institutions because they offer a wide variety of services: checking and ATM debit accounts, savings accounts, dedicated savings accounts for retirement or college tuition, credit cards, auto loans, personal loans, business loans and mortgage loans which are secured by real estate.
The most common and the earliest form of bank is the commercial bank. This started as a business bank serving the interests of business. It used its own notes and made commercial loans.
Savings unions and thrifts
A non-bank or a non-bank bank, is a financial institution that provides banking services without meeting the legal definition of a bank, i. e. one that does not hold a banking license. Operations are, regardless of this, still exercised under financial supervision. Non-bank institutions frequently acts as suppliers of loans and credit facilities, however they are typically not allowed to take deposits from the general public and have to find other means of funding their operations such as issuing debt instruments.
Non-banks are ordinary intermediaries. It is an institution, which offers services similar to those of banks but not subject to the usual banking regulations. Although thy do not accept deposits the way banks do, many of them offer their customers NOW accounts which function like conventional checking accounts but because of prior notice provisions do not technically give the depositor a legal right to withdraw on demand. Others even offer conventional checking accounts, but avoid classification as banks by limiting their extension of commercial credit to the purchase of money market instruments such as certificates of deposit and commercial paper.
Non Banks also act as a conduit between those with funds to lend and those in need of funds. By pooling the funds of investors from whom they borrow, they can then lend in various amounts and periods. For their service they charge a fee, usually in the form of periodic interest payments. Their borrowing and lending increases the total credit market debt but has no direct effect on the money supply. Non-banks simply intermediate the transfer of funds from the bank accounts of the original investors to the bank accounts of the ultimate borrowers.

Bank Lending vs. Non-Bank Lending
Banks play a key role in the monetary system, yet their lending now accounts for less than 20% of the total credit market debt in the US. Most of the lending is done through non-bank financial institutions such as finance companies, mortgage companies, insurance companies, pension funds, and investment banks. Non-banks cannot accept demand deposits, and therefore play no direct role in the payment system. But they provide a variety of financial products and compete quite successfully with banks for lending opportunities.
Non-banks usually borrow short-term at low rates to lend longer term at higher rates. That means a non-bank must be able to roll over its short-term debt at favorable rates. It must also be able to borrow on short notice to manage any cash flow problem. For that reason it must maintain an excellent credit rating, or it may not be able to borrow at all.
Bank Lending
Banks are not ordinary intermediaries. Like non-banks, they also borrow, but they do not lend the deposits they acquire. They lend by crediting the borrower's account with a new deposit, and then if necessary borrowing the funds needed to meet the reserve ratio requirement. The accounts of other depositors remain intact and their deposits fully available for withdrawal. Thus a bank loan increases the total of bank deposits, which means an increase in the money supply. When the loan is paid off, the money supply decreases.
A net increase in bank lending results in a shortage of reserves needed by the banking system, which only the Fed can supply. In order to maintain control of the Fed funds rate, i.e. the interest rate on overnight loans between banks, the Fed must provide the funds as required. It does so by purchasing Treasury securities from the public.
Bank lending has no effect on a bank's own capital. But bank lending is limited by the capital ratio requirement set by the Fed. If a bank has sufficient capital, it can expand its balance sheet by issuing more loans. However if it is not holding excess reserves, it will have to acquire more in order to meet the reserve ratio requirement. Banks therefore actively seek new deposits. Of course they prefer deposits on which they pay no interest, like ordinary checking accounts. They also seek savers and investors who will buy their term deposits at a low interest rate relative to their own lending rate.

A.6 The traditional bank has an inherent susceptibility to crisis, in that it borrows short term and lends leveraged long term. The sum of deposits and the bank's capital will never equal more than a modest percentage of the loans the bank has outstanding. Even if liquidity is not a concern, if there is no run on the bank, banks can simply choose a bad portfolio of loans, or more precisely incorrectly price the interest rates of those loans, and lose more money than they have.
The fundamental rationale for regulation of banks is that banking industry, more than any other industry suffers from an inherent opaqueness is in its operations. They are like black boxes where money goes in and goes out but it is extremely difficult for the outside world to understand the risks taken in this process of intermediation between surplus spending units (SSUs) and deficit spending units (DSUs). Because banks are opaque, runs and failures of some banks can impact upon the entire banking industry. The riskier and more inefficient ones can infect all and lead to a collapse of the entire industry as past experience has shown. Conversely if banks were as transparent as other firms, runs on riskier banks would not induce failures of safe banks and the role of outside regulation would become redundant and inefficient. The market would then regulate what the regulators now try to achieve. Fully transparent banks would borrow at open market rates that fairly reflected their risks.
However the reality is that to some extent opacity is almost intrinsic to banks. Given the intermediation role that banks play with limited control over how businesses to which they lend are run, points to a fundamental source of risk in the banking industry. As Guthman points out: “Probably in no other field involving such large public interests is there more uncertainty for the investors than in banking… because of the difficulty in valuing such a large and mixed lot of loans” and other assets. Primary among bank assets are loans to smaller, more opaque borrowers also referred to as the raison d etre for Banks (D. Diamond 1984, “Financial Intermediation and Delegated Monitoring: Review of economic Studies). Lending to opaque borrowers may lead to opaque banks. This makes it extremely difficult to evaluate bank loan quality and therefore the true value of its assets.
Again given the intermediary role of banks between SSUs and DSUs, the depositors are completely blind about what happens to their money and the nature of risks their money is exposed to. It is this combination of opaqueness inherent to banking and the consequent risks to depositors and the entire banking industry and the difficulties that the market faces to ensure efficiency of lending and borrowing within such opacity that underscores the need for regulation.
The other inherent need for regulation of banks arises from the nature of their assets. The typical balance sheet structure of banks features a sizable volume of highly liquid liabilities--those that can be withdrawn at par on demand such as balances in checking accounts--in combination with a portfolio of generally longer-term assets that often are difficult to sell or borrow against on short notice. It is probably fair to say that there is considerable agreement among central bankers and other economic policymakers that this unique balance sheet structure creates an inherent potential instability in the banking system. Rumors concerning an individual bank's financial condition--even if ill-founded--can spark a run by depositors and other creditors that may force the bank to unload assets at fire sale prices and, in extreme situations, suspend payment on withdrawal requests. Especially if the distressed institution is large or prominent, the panic can spread to other banks, with potentially debilitating consequences for the economy as a whole. Most countries with private banking systems have experienced episodes of bank panics to some degree, and in the United States, such panics occurred with some frequency in the late nineteenth century and was a major factor exacerbating the Great Depression of the 1930s.
Therefore while institutional regimes differ, most countries have established safeguards against banking panics that rest on three basic pillars--some form of deposit insurance (explicit or implicit), a program of banking supervision and regulation, and an institution that can act as lender of last resort.
However from every regulation comes a change in behavior and excessive bank regulations can actually harm the industry. Therefore what is important is a careful balance which does not destroy the innovation and risk taking entrepreneurial spirit of banks.
History of Regulation

A.5 Banks are clearly the oldest and most important financial market intermediary, which brings the potential borrowers and lenders together, provides liquidity that drives the economy and provides the medium of exchange. We know a bank can be defined as a type of financial institution that originates loans as well as maintains deposits for account holders that are federally insured.
Although the type of services offered by a bank depends upon the type of bank and the country, services provided usually include: directly taking deposits from the general public and issuing checking and savings accounts; lending out money to companies and individuals; cashing checks, facilitating money transactions such as wire transfers and cashiers checks; issuing credit cards, ATM, and debit cards and online banking. Clearly the one common thread which runs through all these functions is the ability of banks to make liquidity available most immediately on demand and other times as expeditiously as possible. Therefore at a basic level the continued and assured availability of deposits is a critical component of the bank’s liquidity and any uncertainty regarding deposits is necessarily of concern to banks.
A bank raises funds by attracting deposits, borrowing money in the inter-bank market, or issuing financial instruments in the money market or a securities market. The bank then lends out most of these funds to borrowers. However, it would not be prudent for a bank to lend out all of its balance sheet. It must keep a certain proportion of its funds in reserve so that it can repay depositors who withdraw their deposits. The one event which can severely impair a bank’s reputation and can therefore create a run on the bank is the bank’s inability even if temporarily to repay a depositor to withdraw his/her deposit or a portion thereof. Depositor panic psychology has been seen far too often to result in bank failures under such circumstances. That is why uncertainties related to deposit levels, even if misconceived, are danger signals that banks take very seriously.
Therefore there are provisions in every country for Bank reserves that are typically kept in the form of a deposit with a central bank. This is called fractional-reserve banking and it is a central issue of monetary policy. Some governments (or their central banks) restrict the proportion of a bank's balance sheet that can be lent out, and use this as a tool for controlling the money supply. Even where the reserve ratio is not controlled by the government, a minimum figure will still be set by regulatory authorities as part of banking supervision.
The traditional bank has an inherent susceptibility to crisis, in that it borrows short term and lends leveraged long term. The sum of deposits and the bank's capital will never equal more than a modest percentage of the loans the bank has outstanding. Even if liquidity is not a concern, if there is no run on the bank, banks can simply choose a bad portfolio of loans, or more precisely incorrectly price the interest rates of those loans, and lose more money than they have.
Therefore as Jan Kregel put it “banks are… profit maximizers with liquidity preferences” (Kregel, Jan, “Constraints on the expansion of output and employment: real or monetary” Journal of Post Keynesian Economics Winter 1984-85). As Keynes explained liquidity preference was a theory of choice between holding money idle (say in deposit liabilities or deposits in the central bank) and holding loans: the interest rate being the means to equalize the “attractions” of both. The interest rate is the reward for parting with liquidity. This needs some explanation. Although money is the most liquid of assets of an entrepreneurial economy, most of it is in any case constituted by banks’ own liabilities (deposits and supply of reserves by the central banks). Why then would they have a liquidity preference, viz., care about whether there is any uncertainty regarding liquidity? (On Bank’s’ Liquidity Preference: Fernando J. Cardim de Carvalho: http://www.ie.ufrj.br/moeda/pdfs/on_banks_liquidity_preference.pdf) Why then would deposit uncertainty be a big deal for banks it is they who collectively determine liquidity in the market? This is the theoretical conundrum that Gary A. Dymski seeks to explain in his work in this area.
As Dymski explains, banks are obliged to supply liquidity immediately on demand even while making loans, which are its source of profit by depleting its liquidity. As he says, “The more credit banks create to satisfy loan demand, the fewer funds are available for redistribution to meet depositor’s demand for liquidity (Dymski, G., “A Keynesian theory of bank behavior”, Journal of Post Keynesian Economics, Summer 1988). In some sense bankers are always trying to weigh between profitability and liquidity and this evaluation is profoundly affected by uncertainties on both sides, viz., deposit uncertainty and uncertainty regarding profitability. In terms of deposit uncertainty, it is not so much a problem of the entire banking industry taken as a whole because the amount of demand deposits is largely a result of the banking industry’s decision to extend loans and therefore is for the banking industry that determines the amount of liquidity available in the market. However when it comes to individual banks there are major concerns regarding deposit uncertainty because a bank could never be sure as to when and to what extent its deposits might be diverted to some other bank, thus severely eroding its ability to meet depositors liquidity demands. Realistically however, banks do not satisfy their liquidity preference only by shoring up its reserves (the only exception being the great depression) when banks showed what Friedman refers to as ‘absolute liquidity preference’. Keynes therefore explains this as not so much an issue of how much to lend and how much to keep in reserve as for banks to carefully weigh what proportion of its loans can be made in relatively less liquid forms (Some forms of loan are considered more liquid than others: example: short term consumer loans are more liquid than long term investment loans) and how to guard against deposit erosion. The individual bank’s decision as to how much liquidity it would keep, by sacrificing higher earnings (generally the more illiquid an asset is the higher the interest rate) would depend on its assessment of the risks of its depositors wanting to cash those deposits and other liquid assets.
In other words banks also engage in liability management and not just asset management, to reduce uncertainties. Thus a typical balance sheet composition of a bank would contain on the asset side different kinds like: Cash, Treasury Bills, Bills of Exchange, Inter-bank loans, Loans to customers etc., while on the liability side the portfolio would comprise Demand deposits, Time deposits and Inter Bank Borrowing. This represents a trade off between interest rates and safety on both sides, but interest rates on the liability side measure directly how much the bank is willing to pay to reduce the possibility of being surprised by an untimely demand for payment from its lenders, including depositors. This is how banks typically manage deposit uncertainty.