Financial Institution

Financial Institutions
Financial institutions are the firms that provide access to the financial markets, both to savers
who wish to purchase financial instruments directly and to borrowers who want to issue them.
Because financial institutions sit between savers and borrowers, they are also known as financial
intermediaries, and what they do is known as intermediation. Banks. insurance companies,
securities firms, and pension funds are all financial intermediaries. These institutions are essential;
any disturbance to the services they provide will have severe adverse effects on the economy.
To understand the importance of financial institutions, think what the world would be like if
they didn't exist. Without an intermediary, individuals and households wishing to save would
either have to hold their wealth in cash or figure out some way to funnel it directly to companies
or households that could put it to use. The assets of these household savers would be some
combination of government liabilities and the equity and debt issued by corporations and other
households. All finance would be direct, with borrowers obtaining funds straight from the
lenders.
Such a system would be unlikely to work very well, for a number of reasons. First, individual
transactions between saver-lenders and spender-borrowers would likely be extremely expensive.
Not only would the two sides have difficulty finding each other, but even if they did, writing the
contract to effect the transaction would be very costly. Second, lenders need to evaluate the
creditworthiness of borrowers and then monitor them to ensure that they don't abscond with the
funds. Individuals are not specialists in monitoring. Third, most borrowers want to borrow for the
long term, while lenders favor more liquid short-term loans. Lenders would surely require
compensation for the illiquidity of long-term loans, driving the price of borrowing up.
A financial market could be created in which the loans and other securities could be resold, but
that would create the risk of price fluctuations. All these problems would restrict the flow of
resources through the economy. Healthy financial institutions open up the flow, directing it to the
most productive investments and increasing the system's efficiency.
The Role of Financial Institutions

Financial institutions reduce transactions costs by specializing in the issuance of standardized
securities. They reduce the information costs of screening and monitoring borrowers to make sure
they are creditworthy and they use the proceeds of a loan or security issue properly. In other
words, financial institutions curb information asymmetries and the problems that go along with
them, helping resources flow to their most productive uses.
At the same time that they make long-term loans, financial institutions also give savers ready
access to their funds. That is, they issue short-term liabilities to lenders while making long-term
loans to borrowers. By making loans to many different borrowers at once, financial institutions can
provide savers with financial instruments that are both more liquid and less risky than the
individual stocks and bonds they would purchase directly in financial markets.
Figure 3.2 is a schematic overview of the financial system. It shows that there are two types of
financial institutions: those that provide brokerage services (top) and those that transform assets
(bottom). Broker institutions give households and corporations
The Structure of the Financial Industry
In analyzing the structure of the financial industry, we can start by dividing intermediaries into
two broad categories called depository and non-depository institutions. Depository institutions
take deposits and make loans; they are what most people think of as banks, whether they are
commercial banks, savings banks, or credit unions. Non-depository institutions include insurance
companies, securities firms, asset management firms that operate mutual funds and exchange-
traded funds, hedge funds, private equity or venture capital firms, finance companies, and
pension funds. Each of these serves a very different function from a bank. Some screen and
monitor borrowers; others transfer and reduce risk. Still others are primarily brokers. Here is a
list of the major groups of financial institutions, together with a brief description of what they
do.
1. Depository institutions (commercial banks, savings banks, and credit unions) take deposits
and make loans.
2. Insurance companies accept premiums, which they invest in securities and re al estate (their
assets) in return for promising compensation to policyholders shou ld certain events occur
(their liabilities). Life insurers protect against the risk of untimely death. Property and
casualty insurers protect against personal injury loss and losses from theft, accidents, and
fire.
3. Pension funds invest individual and company contributions in stocks, bonds, and real estate
(their assets) in order to provide payments to retired workers (their liabilities).
4. Securities firms include brokers, investment banks, underwriters, asset management firms,
private equity firms, and venture capital firms. Brokers and investment banks issue stocks
and bonds for corporate customers, trade them, and advise customers. All these activities
give customers access to the financial markets. Asset management firms pool the resources
of individuals and companies and invest them in portfolios of bonds, stocks, and real estate.
Hedge funds do the same for small groups of wealthy investors. Customers own shares of
the portfolios, so they face the risk that the assets will change in value. But portfolios are
less risky than individual securities, and individual savers can purchase smaller units than
they could if they went directly to the financial markets. Private equity and venture capital
firms also serve wealthy investors: They acquire controlling stakes in a few firms and manage
them actively to boost the return on investment before reselling them. In contrast, most
mutual funds consist of passive investors, who do not seek to influence management.
5. Finance companies raise funds directly in the financial markets in order to make loans to
individuals and firms. Finance companies tend to specialize in particular types of loans, such
as mortgage, automobile, or certain types of business equipment. While their assets are
similar to a bank's, their liabilities are debt instruments that are traded in financial markets,
not deposits.
6. Government-sponsored enterprises (GSEs) are federal credit agencies that provide loans
directly for farmers and home mortgagors. They also guarantee programs that insure loans
made by private lenders. Aside from GSEs, the government also provides retirement income
and medical insurance care to companies the elderly perform through Social Security and
Medicare. Pension funds and these functions privately.
As we continue our study of the relationship between the financial system and the real economy,
we will return to the importance of financial institutions, the conduits that channel resources from
savers to investors. These intermediaries are absolutely essential to the operation of any economy.
When they cease to function, so does everything else. Recall from Chapter 2 that the measures of
money (Ml and M2) include checking deposits, savings deposits, and certificates of deposit, among
other things. These are all important liabilities of banks. Because they are very liquid, they are
accepted as a means of payment.

Financial Institution

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Financial Institutions

The Role of Financial Institutions

The Structure of the Financial Industry

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