Financial Institutions and Markets: Banks, Money Market and Foreign Exchange

Money does not move itself from people who have more than they need to people who need more than they have. Financial institutions do the moving. They take in savings, lend them out, insure against loss, manage pensions and run the markets in which money, shares and foreign currency are traded.

Without them, a business could not borrow to expand, an employee could not save for retirement, and an importer could not pay a supplier abroad.

The Institute of Chartered Accountants of Nigeria (ICAN) syllabus asks you to identify and explain the types of financial institution. This topic covers the central bank, commercial and universal banks, development banks, the other institutions, the money and capital markets and the foreign exchange market, with Nigerian examples throughout.

What financial institutions do

Financial institutions are the main channels through which funds flow from sectors with surplus funds to sectors with too little, so that resources are used well and the economy can grow. They fall into two groups.

The central bank

The central bank is the highest authority in a country’s banking and monetary system. It is owned by the government but is usually run independently by a board whose members the government appoints. The Central Bank of Nigeria (CBN) is one of the earliest in West Africa.

Traditional functions

Developmental functions

• Developing financial markets by starting initiatives to raise short- and long-term funds.
• Developing financial institutions, supporting finance houses and development banks such as the Bank of Industry and the Nigeria Agricultural Co-operative and Rural Development Bank.
• Developing human capital, for example through the Chartered Institute of Bankers of Nigeria and the Financial Institutions Training Centre.
• Creating special plans and funds for small and medium enterprises, exports and agriculture, such as the Small and Medium Industries Equity Investment Scheme and the Agricultural Credit Guarantee Scheme Fund.
• Providing data on financial indicators for research.

Commercial and universal banking

Universal banking lets a deposit-taking institution offer a wide range of financial services and, in its widest sense, own and manage non-financial businesses. It removes the barriers between the money, capital and insurance markets so that one institution can provide integrated services. There is no single agreed definition, and the practice differs from country to country.

Commercial banks are profit-making businesses and also financial intermediaries through which the authorities distribute money in the economy.

Development banks

Development banks, or development finance institutions, are set up to promote growth in particular sectors such as industry, agriculture, rural areas, urban areas and housing. In low-income countries their roles include:

• giving medium- and long-term loans for investment in manufacturing, commerce and agriculture;
• identifying, promoting and developing profitable private-sector projects, with managerial, technical and financial advice;
• investing directly in mining, housing and agriculture;
• monitoring the projects they fund;
• researching the economy’s needs and advising government on policy;
• building entrepreneurship and giving take-off loans;
• channelling foreign investible capital into the local economy; and
• attracting foreign direct investment by bringing in investors as technical and management partners.

Nigerian examples are the Nigeria Agricultural Co-operative and Rural Development Bank, the Bank of Industry and the Urban Development Bank.

Other financial institutions

The money market and the capital market

An example from the money market. A company issues commercial paper with a face value of ₦100 million, due in 90 days, and sells it for ₦97.5 million. It receives ₦97.5 million now and pays ₦100 million at maturity. The ₦2.5 million discount is its cost of borrowing, which is 2.56% for 90 days (2.5 ÷ 97.5), or about 10.4% a year (2.56% × 365 ÷ 90).

The foreign exchange market in Nigeria

Foreign exchange management in Nigeria has moved from tight control to a market-based system.

Worked example: matching the need to the institution

Financial institutions in more detail

How banks create credit: a worked example

Banks lend most of what they take in as deposits and keep a fraction as reserves. Suppose a bank must keep 20% of deposits as reserves. A customer deposits ₦1,000. The bank keeps ₦200 and lends ₦800. The borrower spends it, and the seller deposits it in a bank, which keeps ₦160 and lends ₦640, and so on. In total, the original ₦1,000 can support up to 1,000 ÷ 0.20 = ₦5,000 of deposits.

The factor of 5 is the money multiplier, which is 1 divided by the reserve ratio. This is why the central bank’s control of reserve requirements affects the money supply.

The central bank as lender of last resort

If a sound bank is short of cash and cannot borrow elsewhere, the central bank lends to it or discounts its bills. The assurance prevents a run on one bank from spreading. In return the central bank supervises banks and may impose conditions.

The money market instruments explained

Primary and secondary capital markets

In the primary market a company or government sells new securities to raise money, and the issuer receives the proceeds. In the secondary market investors trade existing securities with each other, and the issuer receives nothing, but the ability to sell makes securities more attractive in the first place. A stock exchange is a secondary market and supports the primary market.

Non-bank institutions: what each contributes

Discount houses deal in short-term securities and link banks with the central bank. Insurance companies pool risk and invest premiums long term. Pension fund administrators invest retirement savings. Finance companies provide factoring, leasing and hire purchase. Together with banks they channel savings to people and firms that need funds, spread risk and make payments possible.

Exam focus: development banks, other institutions and foreign exchange management

Development banks

Development banks, or development finance institutions, support the growth of sectors such as commerce, industry, agriculture, rural and urban development and housing. Their roles, mainly in low-income countries, are:

1. Providing medium- and long-term loans for investment.
2. Identifying, promoting and developing profitable private-sector projects, with managerial, technical and financial guidance.
3. Making direct investments in sectors such as mining, housing and agriculture.
4. Monitoring the projects they fund.
5. Commissioning or conducting research on economic and social needs to advise government.
6. Fostering entrepreneurship and giving take-off loans.
7. Acting as a channel for foreign investible capital.
8. Encouraging foreign direct investment by nominating foreign investors as technical and management partners.

Nigerian examples are the Nigerian Agricultural Cooperative and Rural Development Bank (NACRDB), the Bank of Industry (BOI) and the Urban Development Bank (UDB).

Other financial institutions

• Finance companies are short-term, non-bank intermediaries. They raise funds from the public and offer debt factoring, equipment leasing, hire purchase, project financing and LPO financing, and give corporate finance advice.
• Discount houses link the Central Bank, licensed banks and other institutions. They invest in short-term securities such as treasury securities, help institutions manage idle cash by bringing surplus and deficit units together, and underwrite treasury securities.
• Insurance companies collect long-term funds from premiums, invest them in bonds, stocks, mortgages and government securities, and pay claims when a policyholder suffers a loss.
• Pension fund administrators (PFAs) are licensed by PenCom under the Pension Reform Act 2014 to open and manage retirement savings accounts and invest pension funds. Pension fund custodians hold the assets on trust, keeping them separate from the PFA’s investment function. PenCom sets limits on how much PFAs may invest in each asset class.

Money and capital markets

The money market trades short-term funds. Participants include the Central Bank, commercial banks and discount houses, and instruments include treasury securities, commercial paper, call money and bankers’ acceptances. The capital market raises medium- and long-term funds through stocks, bonds, debentures and equities, with the stock exchange, issuing houses and stockbrokers as the main institutions.

Foreign exchange management in Nigeria

• Before 1986: tightly controlled by the CBN and the Federal Ministry of Finance, with licences for importers and exporters.
• 1986 to 2002: liberalisation under the Structural Adjustment Programme, with the Second-tier Foreign Exchange Market (SFEM) and later the Inter-Bank Foreign Exchange Market (IFEM).
• 2002 to 2015: auction systems, the Retail and Wholesale Dutch Auction Systems (RDAS and WDAS). In 2015 the interbank rate system was introduced.
• 2016 to 2022: a managed floating regime, with special windows such as the Investors’ and Exporters’ windows.
• From 14 June 2023: a “willing buyer, willing seller” approach. Market segments were merged into the Nigerian Foreign Exchange Market (NFEM) and trades are cleared through a Central Counter Party, with two-way quotes restored.

Common mistakes in the exam

• Calling a development bank a commercial bank. Development banks give medium- and long-term finance for particular sectors.
• Mixing the money and capital markets. Money market funds are short-term.
• Forgetting that the central bank is a lender of last resort and banker to the government as well as the issuer of currency.
• Listing functions without describing what each involves.
• Treating discount houses and finance companies as banks. They are non-bank institutions.
• Describing the present foreign exchange system as fixed or fully controlled.

Quick revision

• Banking institutions: central bank, development banks, commercial and merchant banks. Non-banking: discount houses, finance companies, insurance companies, pension fund administrators and others.
• Central bank: six traditional functions and five developmental functions.
• Commercial banks: nine functions. Universal banking has merits and demerits.
• Development banks give medium- and long-term finance to particular sectors.
• Money market: short term. Capital market: medium and long term.
• Foreign exchange: controlled before 1986, liberalised after, auctions to 2015, managed float to 2022, and a willing buyer, willing seller market from June 2023.

Practice questions

These are original questions written in the style of the ICAN exam. Try each one before you open the answer.

Section A style: multiple choice

Section B style: written questions

A further written question

Model answers

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