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Major types of financial institutions include credit unions and savings-and-loan associations, which act as banks when they make loans based on accounts that are, effectively, demand deposits. Insurance companies and stock exchanges also facilitate efficient allocations of capital in a market economy. Important economic roles performed by financial institutions include (a) channeling funds from savers to investors, (b) providing secure places for savers to keep their deposits, and (c) facilitating flows and payments of funds---most payments are made through checking accounts. Financial Intermediation
Channeling savings to investors is the single most important macroeconomic function of our financial system. Households allocate their after-tax incomes between consumption and saving. Rather than let your savings sit idle, you are probably willing to let other people use them if they pay you interest so that you ultimately receive more than they borrow. Financial institutions find borrowers willing to pay higher interest rates than must be paid to savers. Financial intermediation occurs when financial institutions make the savings of households whose incomes exceed their spending available to investors, or to other households that wish to spend more on consumer goods than their incomes allow. Differences between interest paid by borrowers and that paid to savers generate income to the owners of financial institutions. Imagine how chaotic it would be if all savers had to seek out their own borrowers, and vice versa. Transaction costs might be insurmountable. How could borrowers find savers willing to entrust them with loans? If you were a saver, how would you locate people who wanted to borrow? How would you screen loan applicants to ensure a high probability of repayment?
Financial institutions specialize in evaluating the "credit-worthiness" of loan applicants, and then they monitor borrowers. By "spreading the risk" of default across large numbers of loans, financial intermediaries are able to pay interest rates that will attract deposits from savers.
The Diversity of Financial Institutions
Different financial institutions use different methods to secure the savings of individuals, which then can be either loaned or invested directly. Since people have different ideas about the best way to save (or borrow) and firms differ in the types of debt they are willing to incur, it seems natural that various types of financial intermediaries have developed to meet these diverse needs. A second reason for the diversity of financial institutions is the mix of federal and state laws and regulation governing them. Because of major banking deregulation that began in 1980, many of these institutions are growing less distinct.
Commercial Banks
"Full service" commercial banks provide more services to their depositors than simple maintenance of checking and savings accounts. Most banks offer a variety of personal and commercial loan services, issue bank credit cards such as MasterCard and Visa, and have trust departments available to administer wills and estates.
Thrift Institutions
Savings-and-loan associations, mutual savings banks, and credit unions are all called thrift institutions. The major difference between thrift institutions and commercial banks used to be that commercial banks offered checking accounts while thrift institutions could not. However, a major revision of our banking laws in 1980 made it possible for thrift institutions to offer accounts that are almost identical to bank checking accounts.
Most of the loans made by savings-and-loan associations and mutual savings banks are used to finance housing, although S & Ls are broadening the types of loans they make. Membership in a credit union is normally limited to the employees of a particular firm or members of a particular labor union or profession, although in some rural areas a geographic boundary determines eligibility for membership. Credit unions offer their members loans for many consumer purchases, including housing.
Insurance Companies
Many people will bet a small amount of money on the outcome of the flip of a coin. However, only a few high rollers are willing to bet thousands of dollars with no better than even odds of winning. Most of us want the probable outcome of risky activities to favor us substantially, or we just don't want to play. Risk aversion occurs when people are willing to pay a premium to avoid risk. Most of us are willing to pay money to avoid some of the financial consequences of taking risks, so insurance companies can sell us a guarantee against risk for a fee that is large enough to cover their claims and operating costs and still permit a profit. No one can predict whose house will burn down next---yours or your neighbor's. Thus, all insurance policy buyers make small contributions toward a fund that can be used to compensate the person whose house goes up in flames.
Insurance companies can provide this service and expect to make profits as long as the fee (premium) is greater than the amount they might have to pay, multiplied by the probability of payment. Vast amounts of money are paid to insurance companies as premiums for life, auto, and health insurance, or as contributions to pension funds, many of which are administered by insurance companies. These funds are made available for loans to business firms or are invested directly by the insurance companies.
Securities Markets
Brokers who buy and sell financial securities also provide financial intermediation. Securities include paper assets such as stocks and bonds. A bond is simply an IOU issued by a corporation or government agency that pays interest to the lender. A share of stock is a claim to partial ownership of a corporation. Most corporations and government agencies do not solicit you directly for funds that you might be willing to lend. Instead, they typically leave this specialized sort of solicitation to brokers, who communicate offers to buy or sell securities through stock exchanges. Although the New York Stock Exchange (also known as Wall Street) is the best known, there are a number of smaller regional stock exchanges.
Table 12 summarizes the different roles played by important financial intermediaries. Be aware, however, that differences among these institutions are increasingly blurred because of deregulation. These trends are somewhat controversial because lessening of regulation may have helped set the stage for a wave of financial collapse (e.g., 1980s savings-and-loan boondoggles). This deregulation was accompanied by a shift of regulatory authority from numerous smaller regulatory agencies into the hands of the world's most influential financial regulator---our central bank, the Federal Reserve System.
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