Financial institutions perform the essential function of channeling funds from those with surplus funds to those with shortages of funds. Financial institutions provide a variety of services to sectors of the economy. Failure to provide these services or a breakdown in their efficient provision can be costly to both the ultimate suppliers of funds and users of funds as well as to the economy overall. For instance, bank failures may destroy household savings and at the same time restrict a firm’s access to credit. Insurance company failures may leave household members totally exposed in old age to the cost of catastrophic illnesses and to sudden drops in income on retirement. In addition individual financial institution failures may create doubts in savers ’minds regarding the stability and solvency of financial institutions and the financial system in general and cause panics and even withdrawal runs on sound institutions. Financial institutions are regulated in an attempt to prevent these types of market failures and the costs they would impose on the economy and society at large.
DEFINING FINANCIAL INSTITUTIONS
In financial economics, a financial institution is an institution that provides financial services for its clients or members. Financial institutions provide service as intermediaries of financial markets. They are responsible for transferring funds from investors to companies in need of those funds. Financial institutions facilitate the flow of money through the economy. Financial institutions include banks, credit unions, asset management firms, building societies, and stock brokerages, among others. These institutions are responsible for distributing financial resources in a planned way to the potential users.
There are a number of institutions that collect and provide funds for the necessary sector or individual. On the other hand, there are several institutions that act as the middleman and join the deficit and surplus units. Investing money on behalf of the client is another of the variety of functions of financial institutions.
Financial intermediation is the routing of savings to investments through financial intermediaries. It is a process through which an economy’s savings are transformed into capital investments. There are two types of Financial Intermediations:
Traditional Financial Intermediation
In this case, the savers/suppliers of funds deposit their money with the financial intermediaries (for example: banks, financial institutions, non-banking financial companies etc.) and the financial intermediaries lend the money in the way they like (subject to some government regulations). In other words, the savers/suppliers of funds have no say or role in the lending the financial intermediaries. The risk arising out of lending is borne the intermediaries, i.e. there is no financial risk for the savers/suppliers of the funds (except in case of bankruptcy of the intermediary).
The main drawback of this approach is that the difference between cost to the borrower and return to the supplier of funds is substantial, i.e. while the borrower has to pay a quite high interest for the funds borrowed; the suppliers of funds generally get only a fraction of it.
Contemporary Financial Intermediation
Contemporary Financial intermediation is aimed at overcoming the limitation of the traditional intermediation. In other words, on the one hand it aims at providing higher return to the suppliers of funds, and on the other, at making funds available to productive investors at minimum cost. The difference between the borrower’s cost and lender’s return is the fees (and sometimes expenses also) of the intermediary who simply negotiates the deal. Though the risk is borne the suppliers of funds, it is minimized/optimized through professional competency of the intermediaries.