What Are Financial Institutions?
In today’s financial services marketplace, a financial institution exists to provide a wide variety of deposit, lending, and investment products to individuals, businesses, or both. While some financial institutions focus on providing services and accounts for the general public, others are more likely to serve only certain consumers with more specialized offerings.
Within a capitalistic economic system, financial institutions are vital for regulating the economy, ensuring fair financial practices, and facilitating prosperity. To know which financial institution is most appropriate for serving a specific need, it is important to understand the difference among the types of institutions and the purposes that they serve.
- There are nine major types of financial institutions that provide a variety of services from mortgage loans to investment vehicles.
- Financial institutions are vital for regulating the economy, ensuring fair financial practices, and facilitating prosperity.
- As financialization continues to permeate our lives, it is increasingly likely that you will have an account or product offered by several of these types.
- Nowadays, an increasing number of financial institutions operate online, which in some instances may reduce some of their service fees.
- The major categories of financial institutions are central banks, retail and commercial banks, internet banks, credit unions, savings and loan (S&L) associations, investment banks and companies, brokerage firms, insurance companies, and mortgage companies.
- Here we take a look at these, from central banks to neighborhood banks and everything in between.
Why Financial Institutions Are Important
At the most basic level, financial institutions are important because they allow people to access the money that they need. For example, although banks do many things, their primary role is to take in funds—called deposits—from those with money, pool them, and lend them to those who need funds. Banks are intermediaries between depositors (who lend money to the bank) and borrowers (to whom the bank lends money).
This works because while some depositors need their money at any given moment, most do not. That enables banks to use shorter-term deposits to make longer-term loans. This applies to almost every entity and individual in a capitalist system: individuals and households, financial and nonfinancial firms, or national and local governments.
Domestic capital formation is the driving force behind any country’s development, and effective domestic financial institutions are one of its most important facilitators. They are the key channel between savings and investment, and their efficiency is a key determinant of a country’s economic growth.
The Function of Financial Institutions in Capital Markets
Capital markets are important for the functioning of capitalist economies. These markets are where savings and investments are channeled between suppliers and those in need. Suppliers are people or institutions with capital to lend or invest and typically include banks and investors. Those who seek capital in this market are businesses, governments, and individuals.
Financial institutions play an important role when it comes to capital markets, because they direct capital to where it is most useful. For example, a bank takes in deposits from customers and lends the money to borrowers. This ensures that capital markets function efficiently.
Regulatory Frameworks for Financial Institutions
Governments consider it imperative to oversee and regulate banks and financial institutions because they do play such an integral part in the economy. Historically, bankruptcies of financial institutions can create panic. The health of a nation’s banking system is a linchpin of economic stability. Loss of confidence in a financial institution can easily lead to a bank run.
In the United States, the Office of the Comptroller of the Currency (OCC) regulates federally chartered banks and the Federal Deposit Insurance Corp. (FDIC) insures regular deposit accounts to reassure individuals and businesses regarding the safety of their finances with financial institutions.
1. Central Banks
Central banks are the financial institutions responsible for the oversight and management of all other banks. In the United States, the central bank is the Federal Reserve Bank (Fed), which is responsible for conducting monetary policy and supervision and regulation of financial institutions.
Individual consumers do not have direct contact with a central bank; instead, large financial institutions work directly with the Fed to provide products and services to the general public.
2. Retail and Commercial Banks
Traditionally, retail banks offered products to individual consumers while commercial banks worked directly with businesses. Currently, the majority of large banks offer deposit accounts, lending, and limited financial advice to both demographics.
Products offered at retail and commercial banks include checking and savings accounts, certificates of deposit (CDs), personal and mortgage loans, credit cards, and business banking accounts.
3. Internet Banks
A newer entrant to the financial institution market is internet banks, which work similarly to retail banks. Internet banks offer the same products and services as conventional banks, but they do so through online platforms instead of brick-and-mortar locations.
Under internet banks, there are two categories: digital banks and neobanks. Digital banks are online-only platforms affiliated with traditional banks. However, neobanks are pure digital native banks with no affiliation to any bank but themselves.
4. Credit Unions
A credit union is a type of financial institution providing traditional banking services and is created, owned, and operated by its members.
In the recent past, credit unions used to serve a specific demographic per their field of membership, such as teachers or members of the military. Nowadays, however, they have loosened the restrictions on membership and are open to the general public.
Credit unions are not publicly traded and only need to make enough money to continue daily operations. That’s why they can afford to provide better rates to their customers than commercial banks.
While members can access better rates, credit unions may provide fewer services than traditional banks and have fewer brick-and-mortar locations than most banks, which can be a drawback for clients who like in-person service.
5. Savings and Loan (S&L) Associations
Financial institutions that are mutually owned by their customers and provide no more than 20% of total lending to businesses fall under the category of savings and loan associations. They provide individual consumers with checking and accounts, personal loans, and home mortgages.
Unlike commercial banks, most of these institutions are community-based and privately owned, although some may also be publicly traded. The members pay dues that are pooled together, which allows better rates on banking products.
6. Investment Banks
Investment banks are financial institutions that provide services and act as an intermediary in complex transactions—for instance, when a startup is preparing for an initial public offering (IPO), or in mergers. They can also act as a broker or financial advisor for large institutional clients such as pension funds.
Investment banks do not take deposits; instead, they help individuals, businesses, and governments raise capital through the issuance of securities. Investment companies, traditionally known as mutual fund companies, pool funds from individuals and institutional investors to provide them access to the broader securities market.
Global investment banks include JPMorgan Chase, Goldman Sachs, Morgan Stanley, Citigroup, Bank of America, Credit Suisse, and Deutsche Bank. Robo-advisors are the new breed of such companies, enabled by mobile technology to support investment services more cost-effectively and provide broader access to investing by the public.
7. Brokerage Firms
Brokerage firms assist individuals and institutions in buying and selling securities among available investors. Customers of brokerage firms can place trades of stocks, bonds, mutual funds, exchange-traded funds (ETFs), and some alternative investments.
8. Insurance Companies
Financial institutions that help individuals transfer the risk of loss are known as insurance companies. Individuals and businesses use insurance companies to protect against financial loss due to death, disability, accidents, property damage, and other misfortunes.
9. Mortgage Companies
Financial institutions that specialize in originating or funding mortgage loans are mortgage companies. While most mortgage companies serve the individual consumer market, some specialize in lending options for commercial real estate only.
Mortgage companies focus exclusively on originating loans and seek funding from financial institutions that provide the capital for the mortgages.
Many mortgage companies today operate online or have limited branch locations, which allows for lower mortgage costs and fees.
What is the main difference between a bank and other financial institutions?
The main difference between banks and other, nonbanking financial institutions is that the latter cannot accept deposits into savings and demand deposit accounts, whereas these are the core business for the former.
What is a financial intermediary?
A financial intermediary is an entity that acts as the middleman between two parties, generally banks or funds, in a financial transaction. A financial intermediary may lower the cost of doing business.
How do banks make money?
Commercial banks make money from a variety of fees and by earning interest from loans such as mortgages, auto loans, business loans, and personal loans. Customer deposits provide banks with the capital to make these loans.
Are all financial institutions safe?
Yes, barring an economic catastrophe. Banks and credit unions are generally safe places to keep your money, because they are insured by the federal government via two agencies: the Federal Deposit Insurance Corp. (FDIC) and the National Credit Union Administration (NCUA). This insurance covers your principal and any interest you’re owed through the date of your bank’s default, up to $250,000 in combined total balances.
Are cryptocurrency exchanges considered financial institutions?
It’s complicated. Despite a large number of cryptocurrency investors and blockchain firms in the United States, the country hasn’t yet developed a clear regulatory framework for the asset class. The Securities and Exchange Commission (SEC) typically views cryptocurrency as a security, while the Commodity Futures Trading Commission (CFTC) calls Bitcoin (BTCUSD) a commodity, and the Treasury calls it a currency. Crypto exchanges in the United States fall under the regulatory scope of the Bank Secrecy Act (BSA) and must register with the Financial Crimes Enforcement Network (FinCEN). They are also required to comply with anti-money laundering (AML) and combating the financing of terrorism (CFT) obligations.
The Bottom Line
There are nine major types of financial institutions that provide a variety of services from mortgage loans to investment vehicles. Financial institutions are vital for regulating the economy, ensuring fair financial practices, and facilitating prosperity.
The major categories of financial institutions are central banks, retail and commercial banks, internet banks, credit unions, savings and loan associations, investment banks and companies, brokerage firms, insurance companies, and mortgage companies.