Page 313 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes 14.6 Financial Institutions

The financial institutions have traditionally been the major source of long-term funds for the
economy. These institutions provide a variety of financial products and services to fulfill the
varied needs of the commercial sector. Besides, they provide assistance to new enterprises,
small and medium firms as well as to the industries established in backward areas.
14.6.1 Role of Financial Institutions

Financial institutions have been there in the world markets for a long time now. They have also
made significant contributions. The two main reasons for the existence of financial institutions
are:

1. Economic development
2. Financial stability.
If we penetrate a little, we will find that the second reason for the existence of financial institutions
leads to the first again. In the first place, banks offer deposits that claim to be capital certain. If
this promise is to be honoured, then there must be limits to the range and nature of assets that
a bank can reasonably take on to its balance sheets. More generally, financial institutions perform
a plethora of activities through their provision of liquidity, divisibility, informational efficiencies
and risk pooling services which broaden the spectrum of risks available to investors. In this
way, they encourage and improve the efficiency of investment and savings in the economy.
Through the provision of a broader range of financial instruments, they are able to foster a risk
management culture by attracting customers who are not as much able to bear risks.
Also, from the view of financial stability, in an economy in which the institutions are
comparatively less developed, banks will inevitably be required to assume risks that otherwise
might be borne by the stock market, collective investment schemes or insurance companies.
One way of minimizing financial fragility in the developing economies is to encourage a diversity
of financial institutions, where investors are able to assume a variety of risks outside the banking
system itself. Without this diversity, there is a tendency for all risks to be bundled within the
balance sheet of the banking system, which more likely may lead to severe financial crises.
The financial institutions play an important role in complementing the facilities offered by the
banks in an economy. In fact, the existence of Banking Financial Institutions (BFIs) and non
banking financial institutions (NBFIs) supported by efficient money and capital markets, keep
the financial sector complete and enhance the overall growth of the economy.

Financial institutions are the key players in the development of the capital market in any
economy. But even after their great performance, there generally remain some sectors
comparatively more challenging. For them there developed a special need for special financial
institutions. In fact, the need for establishing such financial institutions arose mainly because of
the following causes:

1. It has been difficult for industry in general to procure sufficient long- term funds in the
capital markets. There has been a lack of financial institutions to supply long-term finance
to industry. AS we know, traditionally, and more popularly, commercial banks provided
only short term finance. Thus some special financial institutions (SFIs) were established to
ensure that industry got sufficient long-term funds in the desired sectors. And that too in
accordance with the priorities determined.
2. Certain specific sections of the industry faced greater difficulties as compared with the
others in procuring long-term finance. Some such sections were:
(a) Small and medium sized organizations

308 LOVELY PROFESSIONAL UNIVERSITY