Financial institutions are the businesses and organizations involved in the collection and distribution of money. They develop the methods and procedures that allow them to collect money from depositors and lend it out to borrowers. They develop the financial securities and provide the financial markets where lenders, borrowers, investors, speculators, and hedgers can exchange money for future payments in the form of interest, for ownership interests, such as stocks, for the payment of future contingent claims, such as with options and derivatives, and for sharing risk, such as the pooling of insurance premiums for financial protection. This pooled money is then given as loans or as an investment to businesses and other organizations to finance specific projects or to provide financing for other needs.
Businesses make money by supplying products and services that are desirable, and the more desirable the product or service, the more money that the business can earn, and, thus, the greater are the returns on the investments in the business. In their desire to earn greater returns, financial institutions help to funnel money to the most successful businesses, which allows them to grow faster and supply even more of the desirable goods and services. This is how financial institutions greatly contribute to the efficient allocation of economic resources. Hence, financial institutions are also financial intermediaries.
Financial intermediaries profit by earning higher returns on their investments than they pay for their sources of money. The assets of a financial intermediary are the loans, stocks, bonds, and real estate that are the company's investments and its liabilities are its obligations to its customers, including deposits, insurance policies, and pension payouts.
Depository institutions, such as banks and credit unions, collect money from depositors and lend the money out to borrowers. Lending has risks, because of information asymmetry between the lender and the borrower. Borrowers know a lot more about their ability and willing to pay than lenders do, which is why it is risky for people to lend out money directly to others. Depository institutions mitigate this risk by assessing the creditworthiness of borrowers for possible loans, monitoring the borrowers after the loan, and collecting on delinquent accounts. They also convert the short-time deposits that most savers prefer to the long-term loans that businesses desire.
Another major service offered by depository institutions is a convenient payment system. Money can be transferred by check, electronic funds transfer, or by credit or debit card. This eliminates the need for people to have a large amount of cash on hand, which is very risky, and it provides a proof of payment.
International banks provide foreign exchange services, converting the currency of one country for those of another. They also provide exporters and importers with services, such as letters of credit, that facilitate international trade.
Nondepository institutions collect money as premiums, contributions, or by selling securities for specific purposes, and then invest the money for higher returns. Nondepository institutions include insurance companies, pension funds, securities firms, and finance companies.
Insurance companies pool the premiums of many people and businesses to protect each from financial disaster resulting from rare events.
Pension funds collect contributions from workers and businesses to invest so that workers can retire with an income provided from the invested funds. Pension funds are set up by businesses, labor unions, or governments for their employees. Employers and employees make contributions from payrolls into the fund. The fund manager then invests the money to earn a return that will allow it to pay out benefits according to a prescribed schedule based actuarial estimates. Contributions to the fund and the returns earned by the fund are usually tax deferred.
Securities firms, such as stock brokers or future merchant commissions, provide the institutional foundation that allows investors to invest their money in the various financial markets by providing current market information, and allowing the investors to select market or limit orders to buy or sell securities through their computer system. Securities firms also provide clearing and settlement systems so that investors can easily clear and settle trades.
Finance companies get money by selling securities, mostly commercial paper, in the money market to other businesses, including banks, and then lend the money out to individuals or businesses at a higher interest rate than what they pay on their securities. There are 3 basic types of finance companies. Small loan companies (aka direct loan companies) lend money to individuals. Sales finance companies (aka acceptance companies) buy retail and wholesale commercial paper of consumer and capital goods dealers. Commercial finance companies (aka commercial credit companies) loan money to manufacturers and wholesalers that is secured by the borrowers' account receivables, inventory, or equipment.
Some financial institutions, such as financial supermarkets, offer several types of products and services that traditionally have been served by separate financial institutions.
Financial Institution Regulation
A characteristic of all financial institutions that accept public funds is that they are heavily regulated, not only because of their central importance to modern economies, but because most people would be unwilling to put their money in a financial institution if they did not believe it was safe to do so. If people kept their money instead of saving or investing it, then the allocation of economic resources would be much less efficient.
In the United States, financial institutions are regulated by government agencies that promulgate rules and regulations for the industry, and who also monitor those institutions for compliance. The Federal Reserve regulates depository institutions and the Federal Deposit Insurance Corporation (FDIC) insures the savings of depositors, up to a specified maximum, depending on the type of account. The Securities and Exchange Commission (SEC) regulates the securities industry and the Securities Investor Protection Corporation (SIPC) insures both securities and cash in customers' accounts of securities firms within an overall limit of $500,000 and a limit of $100,000 for cash. The Pension Benefit Guaranty Corporation (PBGC) guarantees basic pension funds of companies that become insolvent and takes steps to correct serious underfunding of pension liabilities. Insurance companies are mostly regulated by state law and guarantees by the states vary widely. All states have solvency laws to maintain the solvency of its insurers by requiring a minimum capital and guaranty funds to help failing insurers, or, to at least maintain coverage and pay the claims of customers of insolvent insurers.
Central banks are financial institutions with the most influence over their economies, since they determine the money supply and key interest rates, and they regulate and monitor other financial institutions, especially depository institutions.
As regulators and overseers of the financial institutions, central banks issue and implement many banking regulations and require institutions to have a minimum of capital compared to their liabilities. They may audit financial institutions to ensure that the proper procedures are being followed and that they are not taking excessive risk. Central banks also provide services to financial institutions, such as clearing and settlement services, especially for checks and electronic money transfers.
However, the main function of central banks is to regulate the money supply. The money supply must grow proportionately with the economy.
The quantity of money in an economy must be stable. If it grows too rapidly, then the resulting inflation causes people to lose faith in the currency, causing them to save less and to buy more. People on fixed incomes are hurt. Businesses can't plan effectively because of the uncertainty about the future value of money.
If the money supply decreases relative to the size of the economy, then the resulting deflation causes people to hold onto their money, since it will be more valuable in the future. Decreased spending causes businesses to lose income, which then results in unemployment. Increases in unemployment causes demand to fall even more, causing a spiral of deflation.
Central banks control the money supply either by setting key interest rates or by the creation and destruction of money, usually in the form of buying or selling government securities.
Central banks are also the fiscal agents of their countries, providing banking services for the government. They collect tax receipts and provide payment services for the government. They also issue and retire government securities.
Economic Importance of Financial Institutions
The Great Recession of 2008 and 2009 underscores the importance of financial institutions to the economy. Businesses, for instance, depend on financial institutions for money. When they can't get it, unemployment rises, mortgage and other credit defaults increase, people and businesses stop spending money, which reduces income for other people and businesses, and reduces tax revenue for governments, which causes them to cut spending, which causes more unemployment, etc. This is why governments around the world injected trillions of dollars into their financial institutions during the Great Recession to prevent their collapse and the subsequent collapse of the economy.