FInancial Institutions

by | Jul 7, 2020

Financial Institutions

The economy cannot be run without financial institutions– companies or groups that

deal with financial and monetary transactions. There are nine major types of financial

institutions.

The central bank has power over how all other banks do business, by controlling the

money supply in an economy. In the United States, the Federal Reserve Bank is the central

bank. This bank is often tied to the government. The central bank works to keep inflation and

unemployment low by managing interest rates. Low interest rates correspond to a higher

amount of borrowing and economic activity, but may increase inflation, and vice versa. If the

economy is strained, the central bank can provide loans.

Traditional banks are the banks where most people have savings or checking accounts. Banks are private institutions, with the goal of generating income for themselves. These banks make money by providing loans to people. When a bank provides a loan, it borrows against the money that people have stored in their accounts, with the expectation that the loanwill be paid back, plus interest. When you store money in a bank account, the bank makes sure that the money does not sit idly, but uses it to provide liquidity to others via loans.

Internet banks largely provide the same services as traditional banks, but operate

without any physical locations. They can often provide higher returns on money stored in

accounts, but also lack some services offered by traditional banks.

Credit unions are similar to banks, but are owned and operated for and by the people

they serve. Their business model is similar to traditional banks, but instead of profit going to the

company, credit unions look to use their profits to benefit their communities. Often, credit unions

are based around a certain group, whether it is by profession, demographic, or geography, so

that it can better target the needs of its members. However, similar to internet banks, credit

unions also lack services that larger banks have built up, such as online tools.

Savings and loans institutions (S&Ls), provide similar services as banks and credit

unions. S&Ls tend to be owned by its members, and focus more on providing mortgages than

other types of loans.

All these institutions make money off of providing loans. In order to provide loans, they

must first have capital. This capital is sourced from the accounts of its members. This is why

banks offer interest on accounts – to incentivize you to place your money with the bank.

Additionally, this is also why banks offer higher interest on savings accounts – by limiting the

number of withdrawals you can make from the account (and then limiting the amount of money

they actually need to have on hand in case you make a withdrawal), banks are free to make

more loans with your money.

When banks make a loan, they will make their money back if the loan is paid off on time.

With a trustworthy lendee (with trustworthiness usually denoted by credit score), a bank will charge lower interest rates so that the customer doesn’t go to other banks. However, if the bank is unsure they will be paid back, they will charge higher interest rates to make up for the risk of losing the loan.

Investment banks are banks for companies. They help companies perform a variety of

actions, from going public (issuing an IPO) to merging with another company to raising money

through corporate debt. Investment banks make money by charging for these services, but they

often have subdivisions that make investments. Investment banks serve the economy by

helping ensure that companies aren’t limited by their size, and have financial options that can

help the company best serve their customers.

Brokerage firms help people buy and sell securities, like stocks, bonds, and mutual

funds. They ensure that individuals can make investments and participate in financial markets.

They make money by charging a commission for transactions, or by lending against cash stored

in their accounts (just like traditional banks).

Insurance companies provide insurance to customers. Customers will pay premiums to

the company for insurance, and the company pays for services that the customer may need at

some point in the future. Insurance companies make money by choosing low risk customers

that can pay premiums but will likely not need insurance.

These institutions all make money or services available to people who need it. They help

with making sure that money flows through the economy and is being used in a productive way.

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