The financial market is composed of a number of financial institutions that perform a variety of functions. In most contexts, financial institutions can be considered synonymous with financial intermediaries in the financial markets. In a nutshell, financial intermediaries are the financial institutions that pool resources and channel funds from savers/lenders to spenders/borrowers. Smooth functioning of these institutions is very important for an efficient financial market and for the conduct of fiscal and monetary policies. Due to their crucial importance, almost all financial intermediaries are regulated—some are subjected to very tight regulations whereas others operate under less stringent regulations.
A large number of financial institutions serve as financial intermediaries. The essential economic function of the financial markets is to channel surplus funds from individuals who have saved from their incomes to individuals who want to finance consumption or businesses that need funds to finance capital investments. There are two ways in which funds are channeled from savers/lenders to spenders/borrowers. The first is called direct finance. In direct finance, lenders lend to borrowers directly. A saver, for example, has $10,000 saved and buys a $10,000 General Motors (GM) bond maturing in ten years, paying an interest rate of 9.5 percent per annum—in this transaction, the saver has essentially directly lent $10,000 to General Motors for ten years. The second way in which funds are channeled is called indirect finance. It is in indirect finance that financial institutions called financial intermediaries are involved. In this case, a financial intermediary stands between savers/lenders and spenders/borrowers—it obtains surplus funds from savers and lends them to borrowers of its choice. A commercial bank is a common example of a financial intermediary—a commercial bank receives savings and checking deposits from individuals, and uses them, for instance, to make mortgage loans.
There are a large number of financial institutions that serve as financial intermediaries. According to Frederic Mishkin, the author of The Economics of Money, Banking and Financial Markets, financial intermediaries themselves are subdivided into three broad categories: (1) depository institutions (commonly referred to as banks); (2) contractual savings institutions; and (3) investment intermediaries. The division of financial intermediaries into these three groups is based on the primary sources of funds and how they use these funds. Based on Mishkin's book, each of these three categories and the financial institutions that fall under these categories are briefly discussed below.
Depository institutions are generally referred to as banks. The term "depository institution" originates from the fact that a banking-type financial intermediary accepts deposits from individuals and businesses, and makes loans. Depository institutions are made up of four kinds of banking institutions: commercial banks, savings and loan associations, credit unions, and mutual savings banks. The key characteristics of these four kinds of banking institutions are briefly described in what follows.
Commercial banks are financial intermediaries that raise funds primarily by issuing (1) demand and other checkable deposits (deposits by businesses or individuals on which checks can be written to make payments); (2) savings account deposits (they carry interest payments, but can not be used to write checks on and are usually maintained by households and individuals); and (3) certificates of deposit (CDs) or time deposits (they earn interest and have fixed terms to maturity and are opened by both individuals and businesses). Commercial banks use the resources so raised (within limitations imposed by the nation's central bank, the Federal Reserve Bank) to make loans to consumers (for instance, to buy durable goods, such as automobiles), to businesses (for example, to invest in a plant expansion), and to home buyers (mortgage loans). They also investment funds in U.S. Treasury bonds and in state and local government bonds (municipal bonds). Commercial banks are like other businesses—they profit from the difference between the reward for lending and the cost of borrowing.
There are approximately 10,000 commercial banks in the United States, a number that is much larger than in most other industrialized countries. As a group, they are the largest financial intermediary in the United States. Most of them, however, are very small—almost 67 percent of commercial banks in the United States have assets of less than 100 million dollars, and another 26 percent of them have assets between 100 and 500 million dollars. Only a little over 4 percent of the banks have assets over one billion dollars. Despite the large number of banks in the U.S. banking industry, larger banks do hold a giant share of the industry assets. In 1995, the top 4.3 percent of banks (with assets of $1 billion or more) hold nearly 53 percent of all bank assets.
In most other industrialized countries, there are far fewer banks—typically, five or fewer banks dominate the banking industry. The latter is true for countries such as Great Britain or Canada, where a small group of commercial banks accounts for most of the banking business. By contrast, in the United States, the ten-largest banks together hold only about one third of the industry assets. This characteristic of the banking industry sets it apart from other industries in the United States. The automobile industry in the United States, for example, is dominated by only three firms. Almost the same is true for mainframe computers. Does this mean that the U.S. banking industry is more competitive than, for instance, the auto industry? Surprisingly, this is not the case. The answer lies in the banking regulation embodied in the McFadden Act of 1927, which had effectively prohibited branching across state lines. Fortunately, effective I June 1997, this Act was overturned by the passage of Riegle-Neal Banking Act in 1994.
Commercial banks are very heavily regulated. They are often subject to multiple layers of regulation. They are either chartered by states or the federal government (the U.S. Department of Treasury), and they are thus regulated by the chartering institution. Many commercial banks are members of the Federal Reserve System and are regulated by the Federal Reserve. In addition, as most commercial banks buy deposit insurance (in which an account with a bank is insured up to $100,000) from the Federal Deposit Insurance Corporation (FDIC), they are also regulated by this agency. Nevertheless, the U.S. banking industry is undergoing a period of rapid transformation with the passage of deregulation legislation in the mid-1990s.
Except for some minor differences, savings and loan associations (S&Ls) look like commercial banks. The main difference lies in the way S&Ls obtain funds and use these funds to make loans. Like commercial banks, they also obtain funds by issuing checkable deposits, savings account deposits, and time deposits. Traditionally, however, savings deposits have played a greater role for savings and loan associations. The funds obtained through different kinds of deposits have traditionally been used to make mortgage loans—in contrast, business and consumer loans dominate commercial banks' loan portfolios. Also, there are some subtle differences between commercial banks and savings and loan associations. For example, savings deposits issued by S&Ls are often called shares.
Until 1980 government regulations did not allow savings and loan associations to establish checking accounts. They were also restricted to making mortgage loans. The S&Ls were allowed, however, to pay somewhat higher interest rates (compared to commercial banks) on savings deposits, so as to attract funds that could be used to make mortgage loans. This arrangement landed savings and loan associations in deep trouble. During the 1950s and early 1960s, interest rates were relatively low and S&Ls grew faster than commercial banks—they had a comfortable margin between the cost of their funds and the interest they received on mortgage loans. Interest rates, however, rose quite sharply from the late 1960s to the early 1980s. The high interest rate of these years meant that the S&Ls were raising funds at higher costs. Many of their mortgage loans, however, were made years before at very low interest rates, and these were long-term fixed-rate mortgages, with maturity exceeding over 25 years. As a result, savings and loan associations' incomes from mortgages fell short of the cost of acquiring new funds, a phenomenon known as the profit squeeze. Partly due to this reason, many savings and loans suffered large losses and had to go out of business.
Through the Banking Deregulation Act passed in 1980, restrictions on savings and loan associations' activities have been substantially eased. They were allowed to issue checkable deposits, make consumer loans, and to participate in other activities that were hitherto restricted to commercial banks. Through the 1980 act, however, S&Ls were also made subject of the same Reserve requirements that are applied to commercial banks. As the result, the distinction between commercial banks and savings and loan associations has been blurred. More and more, these two kinds of depository institutions look alike and behave in a similar fashion. To many people, it may make virtually no difference whether they bank with savings and loan associations or commercial banks.
Similar to commercial banks, savings and loan associations are also subject to multiple layers of government regulation. Federally chartered savings and loan associations are regulated by the Office of Thrift Supervision (OTS), a bureau within the federal Treasury. Federal deposit insurance for S&Ls is provided by the Savings Association Insurance Fund (SAIF), a subsidiary of the Federal Deposit Insurance Corporation.
Credit unions are also depository institutions, but they are structured as cooperative lending institutions—they are organized around a particular group, such as employees of a company or an institution, members of a labor union, or members of a particular branch of armed forces. Credit unions, like commercial banks and savings and loan associations, acquire funds by issuing different kinds of deposits (often called shares) and primarily make consumer loans. The 1980 Banking Deregulation Act also eased restrictions on credit unions—this act allowed them to issue checkable deposits, as well as to make mortgage loans in addition consumer loans. For all practical purposes, members of a credit union can consider it as a bank. Membership in the credit union is not, however, as open as commercial banks—one must belong to the particular group, in some way, to qualify for the membership of the relevant credit union.
There are large number of credit unions in the United States, about 13,000. As a group, in terms of sheer numbers, they are larger than commercial banks. Most credit unions, however, are quite small and have assets of less than $10 million. As credit unions are intimately tied to a particular group (a company, an institution, or an industry), they lack the diversification of a commercial bank, making them vulnerable. If a large number of workers in an industry are laid off and thus have trouble making loan payments, this can easily endanger the credit union in that industry. Recent regulatory changes have attempted to reduce this risk of credit union failures by allowing them to cater to a more diverse group of individuals. This has induced an increase in the size of credit unions.
Like commercial banks, and savings and loan associations, deposits up to $100,000 (on a per-account basis) are insured, and they are subject to regulations. Credit unions are chartered either by state banking authorities or the federal government. Nearly half of all credit unions are federally chartered. Charters are issued by a federal agency known as the National Credit Union Administration (NCUA), which regulates federally chartered credit unions through establishment of minimum capital requirements, periodic examinations of credit unions' books, and the requirement that these institutions submit periodic reports on their activities. Federal deposit insurance is provided by a subsidiary of the NCUA called the National Credit Union Share Insurance Fund (NCUSIF). NCUSIF provides insurance both to federally chartered and state-chartered credit unions. When a state-chartered credit union buys insurance from the NCUSIF, it becomes subject to regulation by the NCUSIF, in addition to the regulation by the relevant state banking authority. Similar to commercial banks, this leads to multiple layers of regulations.
The interstate branching laws do not apply to federally chartered credit unions. A federally chartered credit union can open branches wherever its members are. In some cases, it literally leads to a worldwide branching. Members of the U.S. Navy and Marine Corps belong to the Navy Federal Credit Union. As these servicepersons are also stationed at locations outside the United States, the Navy Federal Credit Union has branches across the world.
Credit unions have not faced the problems that rocked the savings and loan industry. This is because most of the loans made by credit unions are to consumers, and consumer loans have much shorter maturity periods than mortgage loans (the primary assets of savings and loan associations).
Mutual savings banks are the smallest group of financial intermediaries among depository institutions. They are quite similar to savings and loan associations. Also, one can consider them as hybrid between a savings and loan and a credit union. Like savings and loan associations, they acquire funds by issuing different kinds of deposits and make, primarily, mortgage loans. Like credit unions, however, they are organized as cooperatives, known as mutuals, in which depositors own the bank.
Like savings and loan associations, mutual savings banks were restricted to making mortgage loans until the restrictions were relaxed by the 1980 banking act. As a result, mutual savings banks also experienced profit squeeze from the late 1960s to the early 1980s. They can now issue checking deposits and make consumer and other loans, in addition to making mortgage loans.
There are only about 500 mutual savings banks in the United States, and most of them are concentrated in New York State and New England. They can also be chartered either by states or the federal government. Nearly half of mutual savings banks are chartered by the states. A majority of them have deposit insurance from the Federal Deposit Insurance Corporation (FDIC). As in case of other categories of depository institutions, each account is insured up to $100,000. Because of buying the deposit insurance from the FDIC, most mutual funds are also subject to regulations by the FDIC.
Two acts—the Depository Institutions Deregulation and Monetary Control Act of 1980, and the Gamn-St. Germain Depository Institutions Act of 1982—blurred the distinction among the four kinds of depository institutions discussed above. These acts expanded the ability of noncommercial banks to participate in activities from which they were hitherto barred. For example, all four kinds of depository institutions were allowed to issue checking accounts.
There is one area of regulation, branching regulations, where the old restrictions imposed by the McFadden Act of 1927 (prohibition against branching across state lines) are still in place. Due to the McFadden Act, there are a large number of commercial banks in the United States. Crises in the savings and loan industry during the 1980s induced some banks tob purchase failed savings and loan associations spread over several states, effectively implying branching across states in these instances. Technological changes (especially the widespread use of automated teller machines, ATMs) and the use of "holding companies" (where a holding company owns banks in different states) have dealt a further blow to branching restrictions imposed by the 1927 act. There was a widespread belief that the Mcfadden Act had long become obsolete. Congress finally removed the restrictions against branching across state lines in 1994.
Contractual savings institutions are financial intermediaries that acquire funds periodically on a contractual basis and invest them (lend them out) in such a way that they have financial instruments maturing when contractual obligations have to be met. In general, they can predict their liabilities fairly accurately, and thus they (unlike depository institutions) do not have to worry as much about losing funds. As a result, they mainly invest resources in longer term securities, such as, corporate stocks and bonds, and mortgages. Three major categories of contractual savings institutions—life insurance companies, fire and casualty insurance companies, and pension funds and government retirement funds—are briefly discussed below.
Life insurance companies sell life insurance policies that protect the beneficiaries of a policyholder against financial hazards that follow the death of the insured person. Life insurance companies also sell annuities in which an insurance company contracts to make annual income payments to the annuity buyer upon his or her retirement. These insurance companies acquire funds through payments of premiums by individuals who pay to keep their policies in force. Life insurance companies can calculate liabilities with a fair degree of accuracy using mortality tables. As a result, they use funds to buy longer term securities—primarily corporate bonds and mortgages. While corporate stocks are also long-term securities, life insurance companies are restricted in the amount of stocks they can hold. This government restriction is based on the perception that stocks are risky, and they may thus jeopardize the insurance companies' ability to meet liabilities. With about $2 trillion in assets, life insurance companies are the largest segment among contractual savings institutions.
Fire and casualty insurance companies (also called property and casualty insurance companies) are in the insurance business like the life insurance companies. They insure policyholders against the risk of loss from a variety of contingencies, such as fire, flood, theft, or accidents. An individual buys car or home insurance, for example, from a property and casualty insurance company. Like life insurance companies, fire and casualty insurance companies acquire funds through payments of insurance premiums from policyholders. Unlike life insurance companies, however, the property and casualty insurance companies are subject to greater uncertainty with respect to their liabilities—there is no way to pinpoint as to when major disasters may happen. Two major hurricanes, Hugo in 1989 and Andrew in 1992, hit U.S. states, which multiplied the claim payments by the property and casualty insurance companies to policyholders manifold. Due to this kind of uncertainty, these insurance companies buy more liquid assets (shorter-term securities) than life insurance companies. Municipal bonds constitute the largest fraction of total assets. They also, however, invest in corporate stocks and bonds, and Treasury securities.
Private pension funds and government retirement funds receive periodic payments of contributions from employers and/or employees that participate in the program. Employee contributions are either automatically deducted from pay or made voluntarily. The pension and retirement funds' liability is to provide retirement income, generally in the form of annuities, to individuals covered by these pension plans. As the liabilities of private pension and government retirement funds are fairly certain with respect to timing and are of a long-term nature, they invest resources in long-term financial instruments, such as corporate stocks and bonds.
The federal government has encouraged growth in pension funds through legislative actions that mandate establishment of pension plans, as well as through tax incentives to individuals that lower their costs of contributing to the pension plans. The federal 403(b) provision is an example of the federal tax incentive.
Most, though not all, investment intermediaries facilitate investments in financial assets by individuals and institutions by pooling resources and investing them according to stipulated objectives. The financial intermediaries included under this category are: mutual funds, money market mutual funds, and finance companies.
Mutual funds are financial intermediaries that raise funds through sale of shares to many individuals and institutions, and pool these to buy a diversified portfolio of stocks, bonds, or a combination of stocks and bonds. The number of mutual funds in the United States has grown rapidly. Now, there are more mutual funds than the number of stocks on the New York Stock Exchange. With the growth in the mutual fund industry, characteristics of mutual funds have also undergone changes. At the present time, a specific mutual fund is organized around an investment philosophy. In selling shares to perspective participants, the mutual fund is expected to state its investment philosophy, and follow it (generally) in investing pooled resources. A mutual fund, for example, may be a broadly diversified stock fund that picks stocks from among all available domestic stocks. A stock fund may also, however, concentrate on a narrow range of stocks, such as small capitalization stocks, over-the-counter stocks, blue-chip stocks, depressed stocks, stocks that pay high dividends, or stocks of a particular sector of the economy. Thus, one must carefully interpret a mutual fund's investment into a diversified portfolio of, for instance, stocks—the diversified investment is subject to the investment philosophy of the relevant mutual fund. Also, different investment philosophies and levels of diversification carry different levels of investment risk. Even when a mutual fund specifies an investment philosophy, it may not be fully invested—it may keep, for example, some cash on hand for investment opportunities that may open in the future or to meet redemptions.
Similar to stock mutual funds, there are bond mutual funds. Once again, a bond mutual fund follows an investment philosophy—it may invest its funds in, for example, a diversified portfolio of bonds, in long-term Treasury bonds, higher-quality corporate bonds, lower-quality corporate bonds (the so-called junk bonds), or bonds of state and local governments (called municipal bonds or munis). Bond mutual funds are generally considered less risky than stock mutual funds. As mentioned earlier, some mutual funds also invest funds in a combination of stocks and bonds.
In general, mutual funds permit an individual to participate in a more diversified portfolio of financial instruments than would have been possible if the individual tried to make the investment on his or her own—the use of a mutual fund reduces the transaction costs for the individual. In addition, as mutual funds are expected to be managed by experts, the individual participating in a mutual fund can expect better returns. In addition to these benefits, mutual funds provide liquidity to individuals participating in these funds—they can redeem or sell their shares at any time. The value of their shares, however, will depend on the value of the mutual fund's portfolio (which, in turn, will depend on the conditions in the markets for the securities in which the mutual fund is invested). This obviously implies that an individual is not guaranteed to receive the principal amount back. Also, mutual fund shares, unlike deposits at a depository institution, are not insured by a federal agency.
Money market mutual funds are like ordinary mutual funds with some added characteristics. The most important difference between mutual funds and money market mutual funds is that the latter invest in money market financial instruments (securities that have maturities of less than a year). Because of the kind of securities they invest in, assets of a money market fund are considered very liquid and are unlikely to generate losses to those that participate in these funds. Shareholders in a money market mutual fund receive investment income based on the earnings of the security holdings of the fund. A key characteristic of a money market mutual fund is that participants in these funds have limited check-writing privileges on their shareholdings—frequently, checks cannot be written for less than $500.
Finance companies acquire funds by issuing commercial papers (short-term corporate debt instruments), stocks, and bonds. They use these funds to make loans to consumers to finance home improvements or to purchase a consumer durable (such as cars or furniture), and to small businesses for various purposes. Sometimes, a finance company helps to sell a particular product. GMAC or Ford Motor Credit company are examples of finance companies that perform such a function.
SEE ALSO : Banks and Banking
[ Anandi P. Sahu , Ph.D. ]
Mishkin, Frederic S. The Economics of Money, Banking and Financial Markets. 5th ed. Addison-Wesley, 1998.
Ritter, Lawrence S., William L. Silber and Gregory F. Udell. Principles of Money, Banking and Financial Markets. 9th ed. Addison-Wesley, 1997.