What are financial institutions?
Financial institutions are the organizations or the companies which deal with financial and monetary transactions such as deposits, loans, investments, and currency exchange. They are the organizations or companies that manage money supply through the collection and distribution of money. Financial institutions are the intermediary between the consumers and the capital. In other words, financial institutions transfer funds from those who save money to those who borrow money.
Bank and Financial act, 2073 of Nepal Rastra Bank, has defined financial institutions as a corporate body incorporated to carry on banking and financial transactions. The term also includes a branch office of a development bank, finance company, microfinance institution, or branch office of a foreign finance company located in Nepal or a branch office opened abroad by a financial institution incorporated in Nepal.
Financial institutions contribute a lot towards the socio-economic development of the society as they manage the money supply, provide employment opportunities, and sponsor many educational, cultural, and social programs. They have become an essential part of our lives as they deal with monetary and financial transactions and it is almost impossible to imagine our daily life without dealing with financial transactions. With the changing time, growing economic sector, and developing information technology financial institutions have become more advanced, more convenient, and more important for households and entities.
How do financial institutions work?
Financial institutions are the organizations which control the flow of money in the market and help consumers to meet their interest. They develop the channels and procedures that allow them to collect money from depositors and lend it out to borrowers. Different types of financial institutions use a variety of methods, promotional tools, and distribution channels to attract and to provide services to their respective target customers. They develop financial securities and provide to the financial markets where lenders, borrowers, investors, speculators, and hedgers can exchange money for future payments. Financial institutions supply money to the market through the transfer of funds from investors to the companies in the form of loans, deposits, and investments.
Financial institutions are a very important part of the economy. They contribute a lot to the growth as well as smooth running of the economy. They provide vital services for both individuals and organizations. For example; as financial services providers, banks provide us a safe place to store our cash through a variety of account types such as checking and saving accounts. It provides facilities like withdrawals, bill payments through online or bricks and mortar channels, and also provides interest on our investments. They also provide credit facilities in different forms such as loans as per our demand from the deposits they have received. They create liquidity through the collection and distribution process and keep the smooth flow of money in the market.
In Nepal, the central bank, Nepal Rastra Bank formulates monetary policy and also directs and regulates the activities of other financial institutions. It is mandatory for all the financial institutions to work within the framework of rules and regulations formulated by the central bank. For example, the cash reserve ratio to be maintained by the Bank and Financial Institutions (BFIs) is 4 percent. BFIs have to spend at least 10 percent of corporate social responsibility (CSR) funds in each province.
Similarly, in the United States, there are 12 Federal Reserve Banks (Central Banks), each of which is responsible for member banks located in its district. The Federal Deposit Insurance Corporation (FDIC) insures regular deposit accounts to reassure individuals and businesses regarding the safety of their finances with financial institutions.
These organizations can be broadly classified into two types as depository and non-depository. Banks, credit unions are some of the examples of depository institutions while insurance companies, finance companies, and pension funds are some of the non-depository institutions. To know in detail about the functioning of financial institutions, let’s have a look at some of the major types of financial institutions and their operating mechanism.
The central bank is a financial institution authorized and responsible for the production and distribution of money and credit for a nation or a group of nations. The central bank controls the money supply and all other banks and financial institutions. According to modern economics, the central bank is usually responsible for the regulation of all other financial institutions through the formulation of monetary policy. Individual customers do not have direct contact with the central bank; it is the bank of the banks.
Most of the central banks are nationalized and many of them are non-government agencies. However, even if a central bank is not legally owned by the government, its privileges are established and protected by law.
The central bank, through monetary policy, increases liquidity by using expansionary monetary tools such as decreasing discount rate, reducing the reserve ratio and purchasing government securities that increase the money supply and enhances economic growth. Similarly, the Central bank decreases liquidity by using contractionary monetary tools such as increasing the discount rate and increasing the reserve ratio that decreases the money supply and controls inflation.
A commercial bank is a financial institution that provides services such as accepting deposits, offering loans, and offering basic investment products with the aim of earning profit.
Commercial banks accept deposits and use the deposits to provide loan facilities. It also provides various services to the customers and charges fees on some of the services. Commercial banks work on the basis of the rules and regulations formulated by the central bank. Banks are legally required to keep a certain minimum percentage of all deposit claims as liquid cash. This is called the reserve ratio.
The credit union is a non-profit making member-owned financial cooperative that is created, operated and controlled by its members. Members are its shareholders and the board of directors is formed on the basis of a one-person-one-vote system, regardless of their amount invested. If a credit union generates any profit it goes back to its members. It provides a higher amount of interest on savings and charges a lower rate of interest on loans. Similarly, charge fewer fees on its services. Credit unions provide services only to its members. Credit unions are exempt from paying corporate income tax.
Investment Banks and Companies
Investment banks and companies are the financial intermediaries between security issuers and investors that help individuals and organizations to raise capital and provide financial consultancy services to them. They get a commission for their services. The bigger the deal size, the more commission the bank will earn.
A brokerage firm is a financial institution that acts as a middleman between buyers and sellers to facilitate transactions. A brokerage company conducts transactions on behalf of a client. Some brokerage firms only conduct transactions, while others also offer different types of investment advisory services. Brokerage firms earn profit from commissions on orders given. That is, they usually collect a percentage of the value of each transaction, though some charge flat fees. Clients may give orders in a variety of ways such as one may meet with a broker, call on the telephone, or give orders over the Internet. We can take the real estate brokers as an example of brokerage.
It is a type of financial institution that offers various types of insurance policies to individuals and entities to protect them against financial risks in return for regular payment of premium. Individuals and organizations receive financial protection against losses. Insurance companies assess risk and charge premiums for insurance coverage. If an insured event occurs the insurance company pays up to the agreed amount of the insurance policy. These companies make money by investing the premiums. The excess amount of premium over the payment is also a source of money. Life insurance policy, health insurance policy, property insurance, and fire insurance are some of the examples of insurance policies.
How Financial Institution make money?
Just like any other business, the goal of most of the financial institutions is to earn a profit. It is also required for the functioning as well as the smooth running of every organization. Financial institutions earn profit by charging more interest on the loans and other debt they issue to borrowers than what they pay to people who use their savings. Using a simple example, a bank that pays 2% interest on savings accounts and charges 6% interest for loans earns a profit of 4% for its owners.
Financial intermediaries earn profit by earning higher returns on their investments than they pay for their sources of money. The assets of a financial intermediary are the loans, stocks, bonds, and real estate that are the company’s investments and its liabilities are its obligations to its customers, which includes deposits, insurance policies, and pension payouts.
Organizations related to monetary transactions like deposit, withdrawal, and investment bounded by the mandatory rules and regulations of the government are financial institutions. Financial institutions encompass a broad range of business operations within the financial services sector including banks, trust companies, insurance companies, brokerage firms, and investment dealers.
The central organization to regulate and manage the market conditions and the functions carried out by the institutions is the central bank. Financial institutions can operate at several scales from local community credit unions to international investment banks. Financial institutions use the money received in different forms such as deposits, premiums at the bank, insurance company, and other financial institutions to lend to others for short-term and long-term debt such as loans, credit cards, and mortgages.
This process helps to create liquidity, which creates money and keeps the smooth supply of money in the market. These organizations gain by charging the service charge to their consumers or by the investment of liquidity deposited by their consumers in different sectors.