Financial Institutions

Learn what we mean by financial institutions and financial intermediaries. Learn the two main classifications of financial institutions and understand the significant distinction between depository and non-depository financial institutions. Learn how the financial system works and understand the concept of financial markets.

What is a Financial Institution?

A financial institution is an institution that provides financial services for its clients or members. Probably the most important financial service provided by financial institutions is acting as financial intermediaries. A bank is a financial intermediary for the safeguarding, transferring, exchanging, or lending of money. The government to safeguard depositor’s money generally heavily regulates most financial institutions.

What are the Financial Intermediaries?

Funds flow from lenders to borrowers indirectly through financial intermediaries, such as banks, or directly through financial markets, such as the New York Stock Exchange. If you get a loan from a bank the flow of funds to you as a loan is known as indirect finance. The flow is indirect because the funds that the bank lends you came from people who have put money in checking or savings deposits in the bank. Hence, the bank is not lending its own funds directly to you. On the other hand, if you buy a stock that a firm has just issued, the flow of funds is direct finance because the funds are flowing directly from you to the firm.

Types of Financial Institutions:

There are two primary types of financial institutions.

1. Depository Intermediaries

They are those that get funds from the public and use them to finance their business. These are deposit-taking institutions that accept and manage deposits and make loans, including banks. Depository intermediaries receive deposits from customers and use the money to run their businesses. These institutions may have other sources of income, but the bread and butter of their business are handling deposits, paying interest on them, and lending money based on those deposits.

2. Non-depository Intermediaries

They are those that do not take or hold deposits. They earn their money selling specific services or policies. Examples are building societies, credit unions, trust companies, mortgage loan companies, and other contractual institutions like insurance companies, pension funds, investment institutes, investment banks, underwriters and brokerage firms. As the name suggests, non-depository intermediaries do not take deposits. Instead, they perform other financial services and collect fees for them as their primary means of business. In many cases, these institutions are private companies. Although the government may regulate them, they are usually not backed or protected by the government.

The distinction between Depository and Non-Depository:

A wide range of financial services is available from both depository and non-depository intermediaries. Most of the non-depository institutions are private companies earning money by performing specific services. You do not make deposits, earn interest, or have checking or savings accounts with them. Non-depository institutions are a part of the financial world and help move money through the economy. However, they are not part of the banking system and may not really be considered to be in the business of banking.

Financial Markets:

A financial market is a market in which people and entities can trade financial securities, commodities, and other financial assets at prices that reflect supply and demand. Financial markets are places or channels for buying and selling stocks, bonds, and other securities.

Securities include stocks and bonds, and commodities include precious metals or agricultural goods. Markets work by placing many interested buyers and sellers, including households, firms, and government agencies, in one "place", thus making it easier for them to find each other. Traditionally dealers who would meet face-to-face in the physical markets traded stocks and bonds. Today, most securities trading takes place electronically between dealers linked by computers and is referred to as “over-the-counter” trading.

Financial markets facilitate:

The raising of capital (in the capital markets)
The transfer of risk (in the derivatives markets)
Price discovery
Global transactions with the integration of financial markets
The transfer of liquidity (in the money markets)
International trade (in the currency markets)

How the Financial System Works?

The financial system matches depositors and borrowers broadly by using two channels; first being the banks & other financial intermediaries and the second being the financial markets. These two channels are different because of the way the funds flow from depositors, or lenders, to borrowers and by the financial institutions involved.

Both Savers (Depositors) and borrowers can be households, firms, or governments, both domestic and foreign. Savers receive their returns in various forms, including dividend payments on stock, coupon payments on bonds, and interest payments on loans. Financial markets facilitate the buying and selling of financial assets and maintain liquidity in the market when depositors or savers want to have their money back.