Financial Institutions: Types, Roles, and Advantages

Financial Institutions: Types, Roles, and Advantages

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Chanchal
Chanchal Aggarwal
Senior Executive Content
Updated on Jun 18, 2024 17:26 IST

A financial institution is an establishment that conducts financial transactions such as investments, loans, and deposits. It plays a crucial role in the economy by channelling funds from savers to borrowers, facilitating the efficient allocation of resources, and supporting economic growth and development. Financial institutions include banks, credit unions, insurance companies, and investment firms.

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We live in an economy where individuals and organizations constantly need finance to fulfil their requirements. Financial Institutions are the places where these entities turn to when they want to do transactions, investments, savings, money exchange, or money management. Financial institutions are significant as they give the marketplace money and assets so they can be efficiently distributed as capital whenever required. For instance, a bank receives customer deposits and provides that money to borrowers.

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Let’s begin our discussion by understanding the meaning of Financial Institutions.

Table of Content

What is Financial Institution (FI)?

Financial institutions are organizations that provide financial services to their clients. These include banks, credit unions, insurance companies, brokerage firms, and asset management companies. They play a crucial economic role by facilitating monetary transactions, lending, investment, and risk management. Financial institutions act as intermediaries between savers and borrowers, mobilize savings, and channel them into productive investments, thereby fostering economic growth and financial stability. 

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Types of Financial Institutions

Financial institutions come in various forms, each serving distinct functions to support economic activities and financial stability. Here are the main types of financial institutions:

Commercial Banks

A commercial bank is a financial institution that accepts money from individuals and businesses and provides loans to those in need. It offers services such as loans, savings, certificates of deposits, bank accounts, bank overdrafts, etc., to its customers. These organizations earn money by granting loans to individuals and gaining interest on loans. Business loans, house loans, personal loans, car loans, and education loans are the different types of loans offered by commercial banks.

Investment Banks

Investment banking helps individuals, organizations, governments, and other institutions raise capital and provides financial consultancy advice. It doesn’t deal with customer deposits but rather assists with financing through securities such as bonds and stocks

They are a type of financial institution that provides services that specialize in facilitating business operations, such as financing and offerings of capital expenditure and equity, mergers and acquisitions, and new issues of initial public offerings (IPOs). They also commonly act as market makers for trading exchanges, provide brokerage services for investors, and other corporate restructurings.

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Credit Unions

A credit union is a financial institution similar to a commercial bank. However, it is a non-profit institution created, owned, and operated by its members. Credit unions provide traditional banking services only to their members, such as account opening, issuing credit cards, loans, etc. Credit unions charge interest and account fees just like a bank, but they reinvest those profits into the products they offer; however, banks provide these profits to their shareholders. 

Historically, credit unions only served a particular demographic according to their field of membership, such as military members, teachers, etc. Nowadays, they have liberated the restrictions on membership and provide their services to the general public.

Insurance Companies

Insurance companies are familiar kinds of non-bank financial institutions. They offer insurance services to both individuals and organizations. The insurance can be related to the protection against financial risk, life insurance, health, home, shop, company, products, vehicles, etc. These institutions put the money from insurance premiums into a pool to fund the policy coverage. Insurance companies can be necessary for the stability of financial systems mainly because they are significant investors in financial markets. As a result of the growing links between insurers and banks, insurers are insuring the risks of households and firms to guarantee their financial stability.

Brokerage Firms

A brokerage firm or company is a middleman who facilitates the transaction by connecting the buying and selling parties. Brokers assist in the dealing of securities such as stocks, mutual funds, shares, bonds, options, and other financial instruments. Once the transaction is completed, brokers receive both parties’ brokerage (commission). Some brokerage companies also provide financial advice and act as consultants.

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Role of Financial Institutions

Financial institutions are vital to the economy, providing essential services such as lending, investment, and risk management, facilitating economic growth and stability. Let's understand the role of financial institutions in detail. 

1. Economic Growth of the Nation

At the national level, financial institutions are subject to government regulation. They serve as government agents and develop the country’s economy. For instance, following government regulations, financial institutions may extend a selective credit line with lower interest rates to assist a struggling industry in resolving its problems.

2. Capital Formation

Financial institutions offer financial services to investors who require external cash to raise their capital stocks by accepting individual savings. Investors may want financial services to carry out development plans by setting up new machinery, tools, and equipment, constructing a new facility, and purchasing new transport vehicles, among other things. Financial institutions contribute to the creation of capital in this way.

3. Regulate Monetary Supply

The financial institution assists in controlling the amount of money in the economy. These organizations keep the money supply stable and manage inflation. The Federal Reserve Bank regulates the nation’s liquidity in several ways, including adjusting repo rates, participating in open markets, and setting cash reserve ratios. To control liquidity, financial institutions purchase and sell government assets.

4. Banking Services

Commercial banks and other financial institutions assist their clients by offering savings and deposit services. Additionally, they provide their clients with credit options, including overdraft facilities, to meet their short-term funding needs. Additionally, commercial banks offer their clients loans such as house loans, mortgages, personal loans, and loans for schooling.

5. Pension Fund Services

Financial institutions assist people in retirement planning through the different types of investment plans they offer. A pension fund is one of these investing possibilities. Employers, banks, or other institutions contribute to the investment pool on behalf of the individual, who then receives a lump sum or monthly income upon retirement.

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Functions of Financial Institution

Financial institutions perform several key functions essential to the economy and financial system. Here are the primary functions of financial institutions:

Intermediation

Financial institutions act as intermediaries between savers and borrowers. They collect funds from individuals and businesses as deposits and then lend them to borrowers who need capital for various purposes, such as starting a business or purchasing a home.

Depository Services

Financial institutions provide depository services by accepting deposits from individuals and businesses. They offer checking accounts, savings accounts, and other deposit products where customers can securely store their money. These deposits may also earn interest.

Credit Provision

Financial institutions extend credit to individuals and businesses through loans and credit lines. They evaluate the creditworthiness of borrowers, determine interest rates, and provide financial support for various needs, such as personal loans, mortgages, business loans, and working capital.

Investment Services

Financial institutions offer investment services to help individuals and businesses manage and grow wealth. They provide access to investment products such as stocks, bonds, mutual funds, and other securities. They also offer advisory services to guide clients in making informed investment decisions.

Risk Management

Financial institutions assist individuals and businesses in managing financial risks. They provide insurance products, such as life insurance, health insurance, property insurance, and liability insurance, to protect against potential losses and unforeseen events.

Payment and Settlement Services

Financial institutions facilitate payment transactions between individuals and businesses. They provide payment and settlement services such as processing electronic fund transfers, issuing credit and debit cards, and managing payment systems to enable smooth and secure transactions.

Asset Management

Financial institutions offer asset management services, where they manage investment portfolios on behalf of clients. They provide expertise in selecting investment options, diversifying portfolios, and monitoring market conditions to optimize returns and meet clients’ financial goals.

Financial Advisory

Financial institutions provide financial advisory services to individuals and businesses. They offer guidance on financial planning, retirement planning, tax planning, estate planning, and overall wealth management. They assist clients in making informed financial decisions based on their goals and risk tolerance.

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Advantages of Financial Institutions

1. Procurement of Funds

Financial institutions are crucial because they allow people to receive money when they need it. For instance, although banks do various tasks, they primarily collect deposits from those who have money, pool them, and then lend them to individuals who need money. Banks act as middlemen between depositors (who provide the bank with funds) and borrowers (to whom the bank lends money).

2. Offer Safety

Even though you can keep your money at home or in your wallet, depositing money with a financial institution guarantees its security. You also have an additional layer of protection because government laws provide some protection for your deposits in case of a bank failure. Individuals can use financial institutions to earn interest on a deposit account (cash deposits, money market, or savings). Alternatively, one can buy stocks and bonds through a brokerage. 

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3. Financial Consultation

Financial institutions provide people with finances and guide them with the right investment plans and policies. Investment banks inform businesses and individuals about the proper techniques for generating profits. They help their clients raise capital, issue new IPOs, etc. Similarly, insurance companies help individuals and businesses by suggesting the right plan for their future welfare. 

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4. Employment Creation

Starting or expanding a business requires financial resources, and bank loans are one of the easiest ways to get them. Financial institutions provide credit not only to individuals but businesses also. Startups and small businesses can start their venture by seeking long and medium-term credit from these institutions. This will lead to the opening of new employment opportunities and economic growth. The business owners also have the option to take a loan against their existing property either for a new venture opening or for the expansion and diversification of an existing one.

5. Ensure Regional Balance

The government set up financial institutes in rural and backward areas to help local people, small farmers, artisans, household workers, etc., with loans and credits. These institutions also provide government-approved schemes such as NABARD, Agricultural loans, interest at low rates to Self Health Groups (SGHs), etc., to help uplift these areas. 

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Disadvantages of Financial Institutions

1. Complex and Lengthy Process

These organizations follow strict guidelines for giving loans since they must meet government standards. The individual or company seeking financing requires a detailed examination involving many formalities and paperwork, making the process time-consuming.

2. Security Deposit

One has to keep any security and bear due to other restrictions set by them to take a loan from these financial institutions. Also, loans are given at high interest rates, which burdens individuals and businesses. This is the reason why many worthy individuals fail to receive credit.

3. Hidden Risk Involved

If the management of the financial institution defaults, then the customers will have to deal with even worse situations. They might not be able to get their invested money back. The principal amount is only sometimes guaranteed to be recovered because the government may declare a specific amount to be reimbursed in the event of default. The amount the government declares to be repaid is typically substantially lower than the principal amount of the investment.

4. Limitation on the Borrower

The financial institutions are entitled to have a representative on the borrowing company’s board of directors, which limits the company’s authority. Additionally, they may directly influence the borrowing company’s dividend distribution choice.

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Wrapping It Up

Financial institutions are the base of any strong economy. These institutions are necessary for the economy to thrive and recover. The government oversees these institutions through the central bank, insurance regulators, investment banks, pension fund regulators, etc. In earlier days, their role was limited to providing traditional banking services, but now they are an integral part of the development and growth of the economy.

FAQs

What is a financial institution?

A financial institution is an organization that provides various financial services such as banking, lending, investing, and insurance. Examples include banks, credit unions, investment firms, and insurance companies.

What services do financial institutions offer?

Financial institutions offer a wide range of services including deposit accounts, loans, mortgages, credit cards, investment products, retirement planning, insurance policies, and financial advice.

How do financial institutions make money?

Financial institutions generate revenue through various means such as interest earned on loans and credit products, fees charged for services, commissions on investment transactions, and premiums collected for insurance policies.

How are financial institutions regulated?

Financial institutions are regulated by government authorities such as central banks, financial regulatory bodies, and insurance regulatory agencies. These regulations aim to ensure the stability, integrity, and fair practices within the financial industry.

Are deposits in financial institutions safe?

Deposits in financial institutions are generally considered safe due to measures such as deposit insurance provided by governmental agencies. However, it is important to check the coverage limits and the regulatory safeguards in place to protect deposits.

About the Author
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Chanchal Aggarwal
Senior Executive Content

Chanchal is a creative and enthusiastic content creator who enjoys writing research-driven, audience-specific and engaging content. Her curiosity for learning and exploring makes her a suitable writer for a variety ... Read Full Bio