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Different Types of Financial Institutions

Financial institutions are establishments that perform financial transactions. Such transactions include investments, deposits, and loans, among others. Nearly everybody has something to do with a financial institution, nearly on a regular basis. They can range from depositing money to taking out loans.

investors seen going inside financial institutions

In this article, we’ll provide an overview of some of the key categories of financial institutions and their roles in the financial system and the financial markets.

Commercial Banks

Commercial banks receive deposits and provide security for their clients. Of course, one of the biggest roles of banks is to provide safekeeping for their customers’ money.  Customers do not like keeping physical cash at home or in wallets. That’s because there are risks of loss (theft, accidents, et cetera). By using the services of banks, they don’t need to keep large amounts of money on hand. They can do the transactions just with checks, debit cards, or credit cards.

Commercial banks also offer loans that people and businesses use to buy products or expand operations.  This leads to more deposited funds into the banks’ vaults. If the banks lend money at higher interest rates than they pay for funds and operating expenses, they earn profits.

Further, banks also typically serve roles as payment agents within a country and between countries. Banks can issue debit cards that let users pay for goods with a simple swipe. They can also arrange wire transfers with other institutions.

Banks basically lend their rep and credibility to underwrite financial transactions. A check is merely a promissory note between two people. However, without the bank’s name and info, no merchant would accept the check.

As payment agents, banks add convenience to commercial transactions. You won’t have to carry around so much money when merchants can accept checks and debit or credit cards.

[See also: 10 High Yield Investments Risk Takers Should Consider]

Investment Banks

The stock market crash of 1929 paved the way for the Great Depression. And in turn, this compelled the government to impose stricter financial regulations. Eventually, the Glass-Steagall Act of 1933 ended up separating investment banking from commercial banking.

a rendition of a bank as a financial institution

Although investment banks are also “banks,” their operations differ distinctively from deposit-gathering commercial banks. An investment banks is an intermediary performing various services for businesses and some governments.

Such services include underwriting debt and equity offerings, serving as intermediary between issuers and investors. They are also market makers and they can facilitate mergers and other corporate reorganizations. Among many others, they can act brokers for institutional clients.

Further, these banks may also provide research and financial advisory services to businesses. In general, these banks concentrate of IPOs (initial public offerings), as well as huge public and private share offerings.

Conventionally, investment banks don’t have many things to do with the general public.  On the flip side, some of the biggest names also cooperate with commercial banks. These include JP Morgan Chase, Bank of America, and Citigroup.

In general, investment banks need to comply with fewer regulations than commercial banks. Investment banks operate under the eyes of regulatory bodies like the SEC, FINRA, and the US Treasury. However, there are fewer restrictions in terms of maintaining capital ratios and the introduction of new products.

Insurance Companies

These companies pool risk by gathering premiums from a huge group of people who want to safeguard themselves or their loved ones against losses, such accidents, fire, illness, lawsuit, disability, and death.

Insurance aids people and businesses in managing risk and preserving their wealth. By insuring a large number of people, insurance companies can operate with profits and pay for claims.

These companies make use of statistical analysis to project what their actual losses will be within a class. They know that not all people with insurance will incur losses at the same time.

Brokerages

Brokerages serve as an intermediary between buyer and sellers to make way for securities transactions. These companies can either be full service or discount.

A full service brokerage offers investment advice, portfolio management, and execution of trades. In exchange, customers pay high commissions for each trade. Meanwhile, discount brokers let investors perform their own investment research and make their own decisions.  This broker still executes the trades. However, since it doesn’t provide the other services, the commissions are much lower.

Investment Companies

Investments companies are corporations or trusts where investors invest in diversified portfolios that professionals manage. They pool their funds with those of other investors. Instead of just buying combinations of individual stocks and bonds, the investor can buy securities indirectly through a package product like a mutual fund.

There are three fundamental kinds of investment companies. These are unit investment trusts (UITs), face amount certificate companies, and managed investment companies. All of these types have some things in common.

They all have an undivided interest in the fund proportional to the number of shares they are holding. These three also have diversification in a large number of securities, as well as professional management and investment objectives.

Unit Investment Trusts (UITs)

UITs are companies that are established via an indenture or similar agreement. It sports the following traits:

  • A trustee supervises the management of the trust.
  • Unit investment trusts sell a specific number of shares to unit holders, who receive a proportionate share of net income from the trust.
  • The UIT security is redeemable. It also represents an interest in a specific portfolio of securities.
  • Personnel supervise, not manage, the portfolio since it remains fixed for the life of the trust. Simply put, there exists no day-to-day management of the trust.

Face Amount Certificate

A face amount certificate company provides debt certificate at a predetermined interest rate. Certificate holders may redeem their certificates for an amount on a certain date. They can also do so for a specific surrender value before maturity.

You can buy certificates either in periodic installments or all at once with a lump sum payment. Face amount certificate companies are almost zero or non-existent today.

Management Investment Companies

The most common type of investment companies is the management investment company. This type of company actively manages a portfolio of securities to attain its objectives.  You can find two types of management investment companies: closed-end and open-end.

The main differences between these two boil down to where investors buy and sell their shares. That means whether they buy or sell in the primary or secondary markets. They also have to consider the types of securities they are buying or selling.

Closed-End Investment Companies

A closed-ended investment company issues shares in a one-time public offering. It doesn’t continually offer new shares. It also doesn’t redeem its shares like its open-end counterpart.

Once the company has issued the shares, the investor may purchase them on the open market and sell them. The market value of the closed-end fund shares will rely on supply and demand like other securities. Rather than selling at the net asset value, the shares can sell at a premium or at a discount to the net asset value.

Open-End Companies

Open-end investment companies, which you can also call mutual funds, continuously offer new shares. You can buy these shares from the investment company and sell them back to it. Mutual funds are quite more popular that closed-end mutual funds.

Non-bank Financial Institutions

These are institutions out there that are not technically banks but still provide the same services. Here are some of them.

Savings and Loans

Savings and loans associations are like banks in many respects. This is partly the reason why many clients can’t tell commercial banks and S&Ls apart. By law, S&L companies must have 65 percent or high of their lending in residential mortgages. However, they can still do other types of lending.

S&Ls came out largely as a rejoinder to the exclusivity of commercial banks. There has been a time when banks only accepted deposits from people with high net worth or references. They wouldn’t lend to ordinary workers.

Savings and loans usually offered lower borrowing rates than commercial banks and higher interest rates on deposits. The slimmer profit margin was a result of the fact that most S&Ls were private.

Credit Unions

Credit unions are another response to commercial banks. They almost always organize as not-for-profit cooperatives. Like banks and S&Ls, one can charter credit unions at the federal or state levels. Similar to S&Ls, credit unions usually offer higher rates on the deposits and charge lower rates on loans.

In exchange for the wiggle room, there’s one special restriction: the membership is not open to the public. Rather, they are restricted to a certain group. Before, this referred to members of certain companies, churches, and so on. They were the only ones who can join such unions. However, in recent years, these restrictions have become lax considerably.

Shadow Banks

The housing bubble and the credit crisis called attention to what participants call the “shadow banking system.” This is a consolidation of investment banks, hedge funds, insurers, and other nonbank financial institutions. They replicate some of the schemes of regulated banks, though they don’t run in the same regulatory environment.

The shadow banking system funneled a great amount of money in the US residential mortgage market during the bubble. Insurance companies bought mortgage bonds from investment banks. The banks would use the proceeds to buy more mortgages so they could issue more mortgage bonds. The banks would use the money to write still more mortgages.

According to many estimates of the size of this system, it has grown to match the size of the US banking system by 2008.

There’s no regulation and reporting requirements. Thus, the nature of the transactions within this system spawned several problems. Particularly, many of these institutions borrowed short and lend long.

That means they funded long-term commitments using short-term debts. They became vulnerable to increases in short-term rates. And when the rates rose, it compelled many of them to rush-liquidate  and make margin calls. Further, since these entities didn’t belong to the formal banking system, they didn’t  have any access to emergency funding facilities.

 

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