The economy works best when there is money and credit available to finance business, consumer purchases, or investments. When money is limited, such as during the 2007 – 2009 Great Recession, businesses cannot finance their operations or invest in new projects, so unemployment rises, causing people to curtail their spending, which contracts business even more. Tax receipts fall, so state and local governments cut back on their spending, adding to the recession.
Most of the money and credit readily available to the economy comes from financial intermediaries. Depository institutions — banks that accept deposits — contribute to the economy by lending money saved by depositors. However, deposits do not provide all of the economy's funding, since only the wealthy save a significant amount of money, but not in low-interest paying deposits which are taxable as ordinary income. The wealthy put most of their money into assets such as stocks, real estate, and municipal bonds, which not only offer greater returns, but the returns are often taxed less than ordinary income. People who are not wealthy do not save very much, at least in the United States, because they need the money for everyday wants and needs. Although wealthy individuals have a lot more money than lower-income individuals, there are many more people in the lower-income classes; hence, the aggregate of the money held by the bottom 90% of the people matches the aggregate held by the top 10%.
This aggregate wealth of the lower-income people is made available to the economy through financial nondepository institutions, which are financial intermediaries that cannot accept deposits but do pool the payments in the form of premiums or contributions of many people and either invest it or provide credit to others. Hence, nondepository institutions form an important part of the economy. These nondepository institutions are called the shadow banking system, because they resemble banks as financial intermediaries, but they cannot legally accept deposits. Consequently, their regulation is less stringent, allowing some nondepository institutions, such as hedge funds, to take greater risks for a chance to earn higher returns. These institutions receive the public's money because they offer other services than just the payment of interest. They can spread the financial risk of individuals over a large group, or provide investment services for greater returns or for a future income.
Nondepository institutions include insurance companies, pension funds, securities firms, government-sponsored enterprises, and finance companies. There are also smaller nondepository institutions, such as pawnshops and venture capital firms, but they are much smaller sources of funds for the economy.
Insurance companies protect their customers from financial distress caused by unforeseen events, such as accidents or premature death. They pool the small premiums of the insured to pay the larger claims to those with losses. The premium payments are regular while the losses are irregular, both in timing and amount. An insurance company can profit because it can accurately estimate the payment of claims over a large group by using statistics and it can invest its surplus for greater returns, which helps to lower premiums to be competitive.
Like banks, insurance companies are confronted with the informational asymmetry problems of adverse selection and moral hazard. An insurance company solves the problem of adverse selection by screening applicants — verifying information in the application, checking the applicant's history, and by applying restrictive covenants in the insurance contract, such as not covering a pre-existing condition. Adverse selection is also reduced by grouping — placing the insurance applicant into specific classes differing in their claims history, then charging the appropriate premium. One controversial example is the use of credit scores for determining insurance premiums, since several studies have shown that people with lower credit scores file more claims than those with higher scores.
The solution to moral hazard differs, depending on the type of insurance offered. There are 2 major types of insurance: property and casualty insurance, and life insurance. How the premiums are invested depends on what type of insurance the company offers, which determines the amount of liquidity it needs.
Property and Casualty Insurance
Property and casualty insurance offers financial protection against damage or loss to either property or people, caused by accidents, natural disasters, or from the action of others. The most common type of this insurance is auto insurance, since it is legally required by every driver in most states.
Although losses can be estimated by using statistics over a large group, there is a larger standard deviation of risk because property and casualty insurance covers many more types of events, so claims vary greatly in amount. Hence, these insurance companies must maintain liquidity by investing the premiums in short-term securities, mostly safe money market securities that can be sold quickly at little cost.
Although there are several methods to reducing moral hazard, property and casualty insurers use the principle of indemnity, paying for financial losses suffered by the insured — but no more. After all, if people could profit from insurance, that would motivate them to cause losses for profits. For this same reason, insurance companies will not pay for losses covered by other insurance or other forms of compensation.
While the death of a single individual is an uncertain event, the number of deaths in a large group is predictable. Furthermore, the claim amount for any single death is certain since it is specified in the contract.
There isn't much of a moral hazard problem in life insurance because most people want to live and would not be able to benefit directly from the proceeds unless it is a whole life policy that also has a savings portion. However, this living benefit is limited by what the insured has paid in.
The only real moral hazard to life insurance is the possibility that the insurance applicant is buying insurance to provide for his beneficiaries after he commits suicide. This moral hazard is reduced by a suicide clause — not paying for suicides within the 1st 2 years of the policy, or 1 year in some policies. The reasoning behind this is that most people who commit suicide are mentally ill, so they should be covered, but the waiting period prevents someone from taking out a policy just before committing suicide.
Because claim payments are more predictable, life insurance companies invest mostly in long-term bonds, which pay a higher yield, and some stocks. Their portfolios have a smaller stock portion because the reduction in liquidity caused by a stock market decline can last for years.
Pension funds receive contributions from individuals and/or employers during their employment to provide a retirement income for the individuals. Most pension funds are provided by employers for employees. The employer may also pay part or all the contribution, but an employee must work a minimum number of years to be vested — qualified to receive the benefits of the pension. Self-employed people can also set up a pension fund for themselves through individual retirement accounts (IRAs) or other types of programs sanctioned by the federal government.
While an individual has many options to save for retirement, the main benefit of government-sanctioned pension plans is tax savings. Pension plans allow either contributions or withdrawals that are tax-free. For instance, for regular IRAs, contributions are tax-free, but withdrawals are taxed, while for Roth IRAs, contributions are taxed, but withdrawals are tax-free.
As a consequence of the regular contributions and the tax savings, pension funds have enormous amounts of money to invest. And because their payments are predictable, pension funds invest in long-term bonds and stocks, with more emphasis on stocks for greater profits.
Securities firms are companies that provide institutional support for the buying and selling of securities. Investment companies, brokerages, and investment banks are the major types of securities firms. Investment companies pool the investments of many people into a single portfolio managed by professional managers. Investment companies, such as mutual funds, provide expertise and economies of scale that small individual investors would not be able to afford otherwise. Brokerages provide an institutional framework that allows retail investors to invest in stocks, bonds, options, futures, and other financial instruments directly. Brokers provide trading software that allows traders to select their trades, and settlement and clearing services to effect the transactions. Investment banks help businesses and other organizations to sell their own stocks and bonds to the investing public. Investment banks offer advice to the issuer, register the securities with the Securities and Exchange Commission, and sell the securities to their customers.
Federal Government-Sponsored Enterprises (GSEs)
Some government agencies or private corporations chartered by the federal government also act as financial intermediaries. These agencies were created ad hoc by Congress to provide credit to specific constituencies that Congress considered not being addressed adequately by the free market. The largest of these include the Government National Mortgage Corporation (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), the Student Loan Marketing Association (Sallie Mae), and the Farm Credit System. These agencies provide credit to buy homes or farms, except for Sallie Mae, which provides student loans.
Most of these agencies buy loans from private lenders, then they securitize the loans into asset-backed securities and sell them to the public. These agency securities are exempt from state and local taxes, and they were considered very safe, at least before 2008, since most investors believed that they had the implicit backing of the federal government, which has been demonstrated in September, 2008, when the federal government placed Fannie Mae and Freddie Mac under conservatorship, ousting its executives and turning over their loan portfolios to the Federal Housing Finance Agency. Both GSE's became insolvent because they were overleveraged and guaranteed securities based on subprime loans, which started defaulting in large numbers in 2007.
Finance companies provide loans to people or businesses using the issuance of short-term securities, especially commercial paper, as a source of funds. Consumer finance companies provide consumer loans and sometimes mortgages. They also provide the instant credit offered by so many retail stores, where the customer receives the item but doesn't have to pay for a stipulated amount of time.
Business finance companies provide loans to businesses but are especially prominent in the equipment leasing business, where the finance company will buy equipment that a particular business wants, and lease it to the business. This saves the business the upfront purchase cost, and allows it to treat the equipment as a current deduction for taxes rather than as a capital expense that must be depreciated over a number of years.
Business finance companies also provide businesses with short-term liquidity by financing inventory until it is sold and with accounts receivable loans, which are short-term loans backed by accounts receivable.
Sales finance companies finance specific types of major purchases or finance the purchases of a specific retailer. For instance, most of the financing provided by automobile dealers is provided by these companies, so that the potential buyer can buy right away.