What is a Financial Institution?

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Definition:

A financial institution is a company or nonprofit organization that provides financial services to customers and facilitates transactions between parties.

🤔 Understanding financial institutions

Financial institutions act as middle-men for the financial services market. First, people turn to deposit institutions such as banks and credit unions to house their money. These organizations also play an important role in the capital and debt markets. They can extend credit and loans to consumers, as well as help corporations get the capital they need to do business. Financial institutions aren’t just consumer banks. These organizations also include investment banks, brokerage firms, and insurance companies. Many are corporations, but others, such as credit unions, are nonprofit organizations. Just about everyone relies on financial institutions in some way, whether it be for a place to store your money, grow your wealth, or prepare for the future.

Example

Opening an account at a financial institution is often one of the first money moves we make in our lives. Suppose you just got your first job, and want to make sure you have a checking account into which your employer can deposit your paychecks. You head to a local financial institution, either a bank or credit union, to open a checking account and savings account. Over the years, you’ll probably use this financial institution for many different services, including an auto loan when you buy your next car, a mortgage when you buy your first home, and maybe some investment accounts, such as your individual retirement account (IRA).

Takeaway

Financial institutions are like thrift stores…

Some people are visiting the thrift store because they’ve got a house full of items and need a place to take some of them. Others are visiting the thrift store to check things out, hoping to get a good deal. Financial institutions are similar, in that people visit them for different reasons. Some people might bring their money there to store in a deposit account, while others are taking money out in the form of a loan, hoping to get a good deal on the interest.

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What is a financial institution?

Financial institutions are companies and nonprofit organizations that help consumers and businesses to store their money, grow their wealth, and protect themselves from financial losses. Financial institutions act as intermediaries in the financial market, connecting people and companies with parties that can provide the debt and equity they need. Different types of financial institutions include commercial banks and credit unions.

Perhaps the most common image people have of financial institutions is the banks and credit unions where they deposit their money into checking and savings accounts. But financial institutions are so much more than that. Nondepository firms such as insurance companies, investment banks, and brokerage firms help people and companies to financially grow and prepare for the future.

What is the role of financial institutions in the financial system?

Financial institutions play a critical role in the financial system. The primary function that these firms serve is as an intermediary in the economy. They act as middle-men of the debt and equity markets. First, these companies facilitate debt transactions. When individuals and companies want to take on debt, they turn to financial institutions, which then make available the money that other customers have deposited into accounts.

Financial institutions also serve as middle-men in the equity market. They act as matchmakers for companies that want to raise capital by selling equity (e.g. by selling shares or issuing bonds) and those that want to grow their wealth by purchasing equity (e.g. investing in other companies).

Because of the important role that financial institutions play in the economy, the government has a significant amount of involvement. Agencies such as the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC) and the National Credit Union Administration (NCUA) help to regulate deposit institutions and, in the case of the FDIC and NCUA, insure the money of consumers. Other organizations such as the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) help to regulate those institutions that sell securities and insurance products.

How do financial institutions work?

There are two different categories of financial institutions that provide services. Depository institutions such as banks and credit unions serve businesses and consumers by giving them a safe place to keep their money. People deposit money into checking accounts, from which they can pay their bills and make purchases. The other primary type of deposit account is a savings account, where people can deposit money and earn a small return from interest. Deposit institutions also offer lending services for businesses and consumers.

Nondepository firms, meanwhile, provide services to help consumers and businesses protect and grow their money. Companies do this primarily by selling insurance policies (such as insurance companies that sell auto, home, or life insurance), or facilitating securities transactions (such as brokerage firms that help customers to invest in stocks and mutual funds).

What are the major types of financial institutions?

Central bank

In the United States, the Federal Reserve System is the central bank. The Federal Reserve is responsible for conducting monetary policy (meaning the policies it uses to try to manage employment and inflation), ensuring stability in the financial system, promoting the stability of financial institutions, and prioritizing consumer protection.

Depository institutions

Depository institutions are those that allow customers to make deposits into savings and checking accounts. These institutions borrow money for businesses, mortgages, and other purposes, and invest in products such as certificates of deposit (CDs) and money market accounts. There are several types of depository institutions.

  • Commercial banks: Commercial banks are for-profit companies that allow customers to deposit money into checking and savings accounts, borrow money, and more. The Federal Deposit Insurance Corporation (FDIC) regulates commercial banks and insures deposits up to $250,000 per account-holder per bank.
  • Internet banks: Online banks are another type of commercial bank, as they operate on a for-profit basis. However, they’re a bit different from a traditional bank since they don’t have physical branches. All of their business is online. Consumers can still take advantage of services such as checking and savings accounts, loans, and credit cards. Because they don’t have the overhead costs of traditional banks, internet banks can often offer customers perks such as high-interest savings accounts and lower-interest loans.
  • Credit unions: Credit unions are similar to commercial banks, but with a different business model. Credit unions are nonprofit organizations owned by the members (aka the account holders). Anyone with an account at the credit union also gets voting rights. Unlike for-profit banks, the FDIC does not insure the funds in credit unions. Instead, the National Credit Union Administration regulates credit unions and insures deposits up to $250,000.
  • Savings and loan association: A savings and loan association (also referred to as a thrift institution) specializes in real estate lending. They now offer many of the same services as traditional banks, but originally offered only savings accounts and loans. The Office of Thrift Supervision within the U.S. Treasury Department regulates savings and loan associations.

Investment banks

An investment bank is a for-profit business that helps companies, governments, and other entities to raise capital. Investment banks help their clients with services such as underwriting new debt and equity, facilitating mergers and acquisitions, executing the sale of securities, and managing assets.

Brokerage firms

A brokerage firm is a company that helps customers with their trading needs. First, brokerage firms can make investment recommendations to clients. Brokerage firms also buy and sell securities on behalf of clients, often either for a commission or a fee. Brokerage firms are either discount or full-services brokers. A discount broker is cheaper but requires that you do a lot of the hands-on work of researching and investing on your own. A full-service broker is more expensive, but does most of the work for you.

Insurance companies

Insurance companies sell insurance products to consumers and to other companies. Insurance companies provide policies such as property insurance, life insurance, auto insurance and more to help shield customers from financial loss.

What are the functions of financial institutions?

First, financial institutions such as commercial banks and credit unions serve as a place for consumers to safely hold their money in checking accounts and savings accounts. These firms also allow people to grow their money with a relatively low amount of risk (when compared to investing in the stock market) through interest-bearing accounts such as certificates of deposit and money market accounts.

Financial institutions also help to make debt and credit available to consumers and businesses. People might borrow money from financial institutions for purposes such as buying a house, buying a car, or growing a business.

Next, financial institutions help people to grow their wealth. While companies such as banks and credit unions help people to store their money, other financial institutions, such as brokerage firms, help people to grow their money. People might use a financial institution to invest in interest-bearing accounts at a bank such as certificates of deposit and money market accounts, or a brokerage firm to purchase equity in a company through the purchase of stock shares.

Another function of financial institutions is to help businesses. Though many companies have bank accounts and credit cards just like consumers do, they also have unique needs that require a different type of financial institution. Investment banks can help companies finalize business deals and raise capital by taking on additional debt or selling equity.

Finally, financial institutions help to create stability in the financial system. Insurance companies play an important role here, as they sell insurance policies that help to protect consumers and businesses from excessive financial loss. Banks and brokerage firms also help consumers to create stability in their own lives through savings and retirement accounts.

What is the importance of financial institutions?

Financial institutions serve a critical role in the economy on a local, national, and global level. These companies keep the economy moving by acting as intermediaries in the market, getting the money from the people who have it to the people and firms who need it.

Well-run financial institutions are what allow consumers to easily open a credit card or bank account with their local commercial bank, or to start growing their wealth by investing in the stock market. Similarly, these middle-men allow companies to reach the investors and capital to help them grow their businesses, further serving the economy.

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