Find out what we mean by financial institutions and financial intermediaries. Learn the two main classifications of financial institutions and understand the important distinction between depositary and non-custodial 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 to its customers or members. Probably the most important financial service provided by financial institutions is that of financial intermediary. A bank is a financial intermediary for saving, transferring, exchanging or lending money. The government to protect depositors’ money usually 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 in the form of a loan is called indirect financing. The flow is indirect because the funds the bank lends you come from people who have put money in checks or savings deposits at the bank. Therefore, the bank does not directly lend you its own funds. On the other hand, if you buy a stock that a company has just issued, the flow of funds is direct funding because the funds go directly from you to the company.
Types of financial institutions:
There are two main types of financial institutions.
1. Custodian intermediaries
They are the ones who obtain funds from the public and use them to finance their business. They are depository institutions that accept and manage deposits and make loans, including banks. Custodian intermediaries receive deposits from customers and use the money to run their business. These institutions may have other sources of income, but the daily bread of their business is managing deposits, paying interest on them, and lending money out of those deposits.
2. Non-custodial intermediaries
These are those who neither receive nor hold deposits. They make their money by selling specific services or policies. Examples are building societies, credit unions, trust companies, mortgage companies and other contractual institutions such as insurance companies, pension funds, investment institutes, banks investment companies, underwriters and brokerage firms. As their name suggests, non-custodial intermediaries do not take deposits. Instead, they provide 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 generally not supported or protected by the government.
The distinction between custodian and non-custodian:
A wide range of financial services are available through depository and non-custodial intermediaries. Most non-custodial institutions are private companies that earn money by providing specific services. You don’t make deposits, earn interest, or have checking or savings accounts with them. Noncustodial institutions are 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 part of the banking industry.
A financial market is a market in which people and entities can exchange 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 commodities. Markets work by placing many interested buyers and sellers, including households, businesses and government agencies, in one “place”, making it easier for them to find each other. Traditionally, dealers who met in person at physical markets traded stocks and bonds. Today, most securities transactions take place electronically between brokers linked by computers and are referred to as “over-the-counter” transactions.
Financial markets facilitate:
- Raising capital (on the capital markets)
- Risk transfer (in derivatives markets)
- Price Discovery
- Global transactions with financial market integration
- Liquidity transfer (in money markets)
- International trade (on foreign exchange markets)
How does the financial system work?
The financial system generally connects depositors and borrowers using two channels; the first being the banks and other financial intermediaries and the second being the financial markets. These two channels are different because of the way funds flow from depositors, or lenders, to borrowers and through the financial institutions involved.
Savers (depositors) and borrowers can be households, businesses or governments, domestic and foreign. Savers receive their returns in various forms, including dividend payments on stocks, 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 their money back.
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