Financial Institutions in Economy | All About Business

Imagine that you had $100 for which you had no immediate need. If you tried it all by yourself, you might run into some problems. First, $100 may not be enough to justify shopping around for someone in need pf funds. Second, you may not even know whereto look. Third, how would you handle the legal matters? Fourth, you might want some assurance that you wouldn?t lose your money. There are many other obstacles that could interfere with your efforts to invest your $100. There are also lots of other people who have the same needs.

When there is a need, there are firms that make a business of serving that need. The economic system has a need for the efficient movement of funds among the various participants in the system. These include individuals, business, and government. Financial institutions serve that need.

There are a large number of financial institutions in our economy. While they compete in some areas, each type of institutions offers a different combination of financial services. The basic financial function of all the institutions is to collect funds those with money and to invest funds in those in need financing. Financial institutions blend together all of the funds deposited by their customers and invest those fund in the name of the institution. This process is called intermediation. The major financial institutions include commercial banks, life insurance companies, savings and loan associations, private pension funds, and credit unions.

Commercial Banks

In that they provide such a variety of financial service, commercial banks have been called the department stores of finance. Commercial banks serve both consumers and businesses. They accept deposits from some customers, and lend funds to other customers. Most of those funds are deposited into two types of accounts: savings and demand accounts, which are commonly called checking accounts.

Commercial banks are in business to make a profit. They borrow funds from depositors in exchange for interest. They rent funds to their borrowers by charging interest. (see figure 12-4). They offer their depositors interest, security, and convenience. Banks are private firms, but they are heavily regulated by government agencies. These regulations restrict bank investments to debt securities. Banks are the largest single suppliers of long and short-term loans to businesses, governments, and consumers.

Figure 12-4

Life Insurance Companies

It is easy to imagine that life insurance companies collect premiums just to pay them out to the beneficiaries of their policyholders in the form of death benefits. But the collection of premiums and the payment of benefits do not match perfectly. Life insurance companies invest the funds that would otherwise be idle (see figure 12-5). If they invest wisely, their policyholders benefit. If they can earn money on your premiums, those premiums need not be as high.

Figure 12-5

Life insurance companies are able to predict their inflows and out-flow of funds quite accurately. This allows them to commit funds to longer-term investments. By law they can invest only a small portion of their assets in common stock because of the risk involved.

Savings and loan associations

Many people do not distinguish between banks and savings and loans, but the differences are important. Savings and loans are much more specialized. Just as their name suggests, they collect savings and they make loans (see figure 12-6). They do not offer checking accounts, although they have tried to develop systems to allow for fast and easy withdrawals from savings accounts.

Figure 12-6

Savings and loans specialize in home mortgage loans. When the demand for housing is strong, savings and loans prosper. But since mortgages are for as long as 30 years, savings and loans are not able to adjust quickly to meet changes in demand.

Private pension funds

Most people are covered by some pension fund. A pension fund is a group savings plan for the purpose of providing retirement or survivors income. Private pension funds are set up to collect regular contributions from employees and their employers.

You might expect that pension fund investments would be similar to those of the insurance companies. But pension fund managers are not restricted by law to limit their investments inequities. In fact, private pension funds invest heavily in equities that can offer much greater returns on investments.

Credit union

A credit union is a cooperative thrift and loan society. It is composed of people who have a specified shared interest. Usually this is a common employer or membership in a church or union.

Members of credit unions deposit their money by purchasing ownership shares. In turn, each member may borrow from the association (see figure 12-7). Credit unions do not make loans to nonmembers. Income from loans and other investments is used to pay dividends to the members.

Figure 12-7

Credit unions are owned, operated, and controlled by their members subject to government regulation. While most of their loans are to consumers, credit unions can invest in government securities, high-grade bonds, and even time deposits in commercial banks.

Some of your money may help finance long or short-term business assets through any of these financial institutions. But once you turn your money over to an institution in return for interest, insurance coverage, or other promised future benefits, you have very little control over how that money is invested. You assume little risk and you are allowed little control. In the intermediation process, the institution stands between the suppliers and the users of funds. If you go to bank for an auto loan, your contract is with the bank. You don?t know and don?t even care how the bank obtains the funds.

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Source: http://holytrinitycec.org/financial-institutions-in-economy/

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