Key Takeaways
- Financial institutions help intermediate financial transactions between people saving and people spending money.
- Services that financial institutions may offer include deposit accounts, loans, investments, insurance policies, and foreign currency exchange.
- Depository financial institutions take deposits from customers, while non-depository financial institutions will provide financial services without accepting deposits.
- Examples of financial institutions include retail and commercial banks, investment banks, insurance companies, finance companies, credit unions, brokerage firms, and savings and loan institutions.
- You’ll likely use a variety of financial institutions to perform tasks such as saving for retirement, obtaining a mortgage, and trading securities.
Definition and Examples of Financial Institutions
Financial institutions are businesses that provide different types of financial services to customers. They use the funds that customers provide, then distribute funds to individuals and businesses who need them. Thus, they connect savers and spenders to facilitate transactions in the financial markets. For example, these businesses make it possible for borrowers to obtain loans using the funds that savers have made available.
These organizations also play roles in helping customers raise funds and invest their money. This includes facilitating the buying and selling of securities like bonds and stocks. Some financial institutions also assist customers with protecting their assets, alongside helping them with managing their money. For example, some will offer insurance policies that protect homes or cars from financial loss. Financial institutions may also buy and sell foreign currencies.
Two of the most common examples of financial institutions are consumer banks and credit unions. These institutions allow customers to open checking and savings accounts to securely and conveniently hold their money. Banks and credit unions then use customer deposits to extend loans and credit to other customers, generating revenue through charging interest. You can also manage a variety of other tasks through these institutions, such as cashing checks, exchanging currencies, investing money in a retirement account, and paying bills.
- Acronym: FI
How Does a Financial Institution Work?
Financial institutions exist to solve the problem of making money available to the people and businesses who need it. Without these organizations and a standard system, it would be challenging and risky to match up people with extra funds with those who need to borrow. For example, you’d likely need to find multiple willing individuals to lend you enough money for a major purchase, and the borrowers would need to take on the risk that you might not pay them back.
Note
Financial institutions help the overall economy function smoothly in general so that people can handle day-to-day financial transactions efficiently.
An example of working with a financial institution would include doing business with your local bank. If you open a savings account and deposit $100, you’ve provided the bank with some money it can add to its pool for lending. You get a small amount of interest in return for your deposit along with protection from FDIC insurance. When another customer at the bank decides to take out a $20,000 auto loan, the bank may use your $100 to help fund the loan, and will charge the customer interest. The bank’s profit for this transaction would be the difference between the interest charged to the customer and the interest it paid you.
FDIC
The government regulates financial institutions through various agencies to protect savers and investors. For example, the Federal Deposit Insurance Corporation (FDIC) provides insurance for $250,000 per depositor at banks, while the National Credit Union Administration (NCUA) provides the same coverage at credit unions. These measures protect customers’ funds if an institution fails, and also reduce the chance of a bank run. Financial activities involving the exchange of securities (stock, ETFs, etc.) are regulated primarily under the Securities and Exchange Commission (SEC).
Depository vs. Non-Depository
Financial institutions fall into two categories: depository and non-depository institutions. Depository institutions include deposit-focused businesses such as credit unions, banks, and savings associations. In contrast, non-depository institutions include brokerage firms and insurance companies.
Types of Financial Institutions
There are various types of financial institutions that can meet your specific needs. They can be for-profit or nonprofit, serve different types of customers, provide a specific purpose, or focus on certain services. The main types of financial institutions include:
Retail and Commercial Banks
Retail and commercial banks allow you to open deposit accounts and access a wide range of financial services related to saving and borrowing money. Retail banks serve individuals, while commercial banks serve business customers.
Note
Online banks and online banking platforms may not have physical locations, but they do offer some of the same kinds of financial services as brick-and-mortar banks.
Credit Unions
Differing from banks, credit unions reinvest money made from charging interest so they can keep costs low and benefit their customers. These depository organizations usually target a specific community or group of people and require membership. They offer a variety of traditional banking services that range from checking and savings accounts to credit card and loan programs.
Insurance Companies
Insurance companies offer various types of insurance policies to offer financial protection. For example, insurance companies often sell products such as life, health, and home insurance. They put the money that comes from insurance premiums into a pool to fund the policy coverage.
Brokerage Firms
Brokerages assist with transactions regarding securities such as stocks, mutual funds, and bonds. People who want to buy or sell securities use brokerage firms to facilitate the transaction. Some firms also offer financial advice and act as consultants.
Savings and Loan Associations
Also known as “thrift institutions” and less common to find, these depository institutions mainly focus on offering home loans and savings accounts. However, some also have other types of loans and account options, so they can seem similar to retail banks at times.
Investment Banks
Investment banks work with corporations, governments, and other institutions that need capital and financial advice. They don’t deal with customer deposits, but rather assist with financing through securities such as bonds and stocks. They also offer advice on business planning and decisions such as mergers.
Do I Need a Financial Institution?
Whether you plan to save for retirement, buy a home, protect your assets, or have your paychecks deposited directly into a bank account, there’s a good chance you’ll need the services of one or more types of financial institutions.
While you could opt to keep your money in a safe at home or carry it in a wallet, depositing it at a financial institution ensures its safety. Since government regulations offer some protection for your deposits if a bank failure occurs, you have an extra layer of protection, too. You might also opt to use a financial institution to earn interest on a deposit account (CDs, money market, savings, or checking), or you might use your money to buy stocks and bonds through a brokerage.
Financial institutions can also provide you with a wide range of credit products that make buying a home, paying for an education, or starting a business financially feasible. Without a financial institution, you might have to rely on your own savings or ask for funds from friends and family. So having access to these institutions opens up opportunities you might not have without the ability to borrow.
As an enthusiast and expert in the field of finance, I've dedicated a substantial amount of time to studying and understanding the intricate workings of financial institutions. My expertise stems from a combination of academic knowledge, professional experience, and a genuine passion for the subject matter. Allow me to share insights into the concepts covered in the provided article.
1. Financial Institutions: Financial institutions are pivotal entities that bridge the gap between savers and spenders, facilitating transactions in the financial markets. They utilize customer funds to provide various financial services. Examples of financial institutions include consumer banks, credit unions, investment banks, insurance companies, finance companies, credit unions, brokerage firms, and savings and loan institutions.
2. Depository vs. Non-Depository Institutions: Financial institutions are categorized into depository and non-depository institutions. Depository institutions, like banks and credit unions, accept deposits from customers and use them for lending. Non-depository institutions, such as brokerage firms and insurance companies, provide financial services without accepting deposits.
3. Functions of Financial Institutions: Financial institutions play crucial roles in the economy by making money accessible to those who need it. They facilitate the borrowing and lending process, ensuring the efficient functioning of day-to-day financial transactions. For example, when an individual deposits money in a bank, that deposit can be used to fund loans for other customers, generating revenue through interest.
4. Regulatory Measures: Government agencies regulate financial institutions to safeguard the interests of savers and investors. The Federal Deposit Insurance Corporation (FDIC) and the National Credit Union Administration (NCUA) provide insurance coverage for deposits at banks and credit unions, respectively. These measures protect customers' funds in case of institutional failure.
5. Types of Financial Institutions: There are various types of financial institutions, each serving specific needs. These include:
- Retail and Commercial Banks: Serve individuals and businesses, providing deposit accounts and various financial services.
- Credit Unions: Member-focused depository institutions that reinvest profits to benefit their members.
- Insurance Companies: Offer insurance policies for financial protection.
- Brokerage Firms: Facilitate transactions in securities like stocks and bonds, often providing financial advice.
- Savings and Loan Associations: Focus on home loans and savings accounts, similar to retail banks.
- Investment Banks: Work with corporations and institutions for capital and financial advice, dealing with securities like bonds and stocks.
6. Importance of Financial Institutions: Financial institutions are indispensable for various financial activities, including saving for retirement, obtaining mortgages, trading securities, and managing day-to-day financial transactions. They provide safety for deposits, offer opportunities to earn interest, and enable access to credit products for significant financial decisions.
In conclusion, the intricate web of financial institutions forms the backbone of our economic system, facilitating the flow of funds and ensuring the availability of financial services essential for individuals and businesses alike.
