Financial institutions (Pols 219)

Introduction

Financial institutions are organizations—both government-owned and privately owned—that play a central role in the financial system of an economy. They act as mobilizers and depositories of savings, as well as purveyors of credit and finance to individuals, businesses, and governments. Through these functions, financial institutions facilitate investment, promote economic growth, and ensure the smooth functioning of the monetary system.

Financial institution 

Unlike non-financial business organizations, financial institutions primarily deal in financial assets and liabilities rather than goods and services. Their activities may be specialized, focusing on a particular financial service, or they may overlap, with several institutions offering similar services within the economy.

Nature and Scope of Financial Institutions

The activities of financial institutions differ based on:

• The type of financial service they provide
• The relationship they maintain with savers and borrowers
• Their functional, sectoral, or geographic scope
• The type of ownership (government, private, cooperative, or mixed)

On this basis, financial institutions are commonly classified according to their primary activity or the degree of specialization in dealing with funds within the economy.

Classification of Financial Institutions

Financial institutions may be broadly classified into:

1. Banking and Non-Banking Institutions

2. Intermediaries and Non-Intermediaries

1. Banking and Non-Banking Institutions

According to this classification, financial institutions are divided into banking institutions and non-banking institutions.

Graphical illustration of a bank

Both categories share certain similarities, such as mobilizing funds and providing credit. However, they are distinguished mainly by the fact that banking institutions participate directly in the payment mechanism of the economy.

Key characteristics of banking institutions include:

• Their deposit liabilities form a major part of the national money supply (money in circulation).
• They have the capacity to create credit or deposits through the lending process.
• They provide payment services such as cheques, electronic transfers, and clearing facilities.

Examples include:

• Commercial banks
• Central banks
• Merchant and development banks

Non-banking financial institutions, on the other hand:

• Do not participate directly in the payment system.
• Do not create money in the same way banks do.
• Mainly provide specialized financial services such as insurance, investment, or long-term financing.

Examples include:

• Insurance companies
• Pension funds
• Finance companies
• Microfinance institutions

2. Intermediaries and Non-Intermediaries

Financial institutions may also be classified into intermediaries and non-intermediaries based on how they source and allocate funds.

Financial intermediaries are institutions that act as a link between savers and investors. They:

• Mobilize savings from surplus units (savers).
• Lend these funds to deficit units (borrowers or investors).
• Earn income through interest, commissions, or service charges.

Their assets are largely claims on borrowers, while their liabilities are claims of savers.

Examples include:

• Commercial banks
• Savings banks
• Insurance companies
• Pension funds

It is important to note that all banking institutions are financial intermediaries, and many non-banking institutions also perform intermediary functions.

Non-intermediary financial institutions, however:

• May engage in lending or financial services.
• Do not obtain their resources directly from savers.
• Often raise funds through equity, government allocations, or direct financing mechanisms.

Examples include:

• Some government credit agencies
• Development finance institutions funded directly by the state

Conclusion

In conclusion, financial institutions are vital components of every modern economy, serving as channels through which savings are mobilized and credit is allocated. Their classification into banking and non-banking institutions, as well as intermediaries and non-intermediaries, helps in understanding their distinct roles, functions, and impact on the financial system. Through their diverse activities, financial institutions contribute significantly to economic stability, investment, and development.