A financial institution is an establishment that conducts financial transactions such as investments, loans and deposits. Almost everyone deals with financial institutions on a regular basis. Everything from depositing money to taking out loans and exchanging currencies must be done through financial institutions. Here is an overview of some of the major categories of financial institutions and their roles in the financial system.
Commercial banks accept deposits and provide security and convenience to their customers. Part of the original purpose of banks was to offer customers safe keeping for their money. By keeping physical cash at home or in a wallet, there are risks of loss due to theft and accidents, not to mention the loss of possible income from interest. With banks, consumers no longer need to keep large amounts of currency on hand; transactions can be handled with checks, debit cards or credit cards, instead.
Commercial banks also make loans that individuals and businesses use to buy goods or expand business operations, which in turn leads to more deposited funds that make their way to banks. If banks can lend money at a higher interest rate than they have to pay for funds and operating costs, they make money.
Banks also serve often under-appreciated roles as payment agents within a country and between nations. Not only do banks issue debit cards that allow account holders to pay for goods with the swipe of a card, they can also arrange wire transfers with other institutions. Banks essentially underwrite financial transactions by lending their reputation and credibility to the transaction; a check is basically just a promissory note between two people, but without a bank’s name and information on that note, no merchant would accept it. As payment agents, banks make commercial transactions much more convenient; it is not necessary to carry around large amounts of physical currency when merchants will accept the checks, debit cards or credit cards that banks provide.
The stock market crash of 1929 and ensuing Great Depression caused the United States government to increase financial market regulation. The Glass-Steagall Act of 1933 resulted in the separation of investment banking from commercial banking.
While investment banks may be called “banks,” their operations are far different than deposit-gathering commercial banks. An investment bank is a financial intermediary that performs a variety of services for businesses and some governments. These services include underwriting debt and equity offerings, acting as an intermediary between an issuer of securities and the investing public, making markets, facilitating mergers and other corporate reorganizations, and acting as a broker for institutional clients. They may also provide research and financial advisory services to companies. As a general rule, investment banks focus on initial public offerings (IPOs) and large public and private share offerings. Traditionally, investment banks do not deal with the general public. However, some of the big names in investment banking, such as JP Morgan Chase, Bank of America and Citigroup, also operate commercial banks. Other past and present investment banks you may have heard of include Morgan Stanley, Goldman Sachs, Lehman Brothers and First Boston.
Generally speaking, investment banks are subject to less regulation than commercial banks. While investment banks operate under the supervision of regulatory bodies, like the Securities and Exchange Commission, FINRA, and the U.S. Treasury, there are typically fewer restrictions when it comes to maintaining capital ratios or introducing new products.
Insurance companies pool risk by collecting premiums from a large group of people who want to protect themselves and/or their loved ones against a particular loss, such as a fire, car accident, illness, lawsuit, disability or death. Insurance helps individuals and companies manage risk and preserve wealth. By insuring a large number of people, insurance companies can operate profitably and at the same time pay for claims that may arise. Insurance companies use statistical analysis to project what their actual losses will be within a given class. They know that not all insured individuals will suffer losses at the same time or at all.
A brokerage acts as an intermediary between buyers and sellers to facilitate securities transactions. Brokerage companies are compensated via commission after the transaction has been successfully completed. For example, when a trade order for a stock is carried out, an individual often pays a transaction fee for the brokerage company’s efforts to execute the trade.
A brokerage can be either full service or discount. A full service brokerage provides investment advice, portfolio management and trade execution. In exchange for this high level of service, customers pay significant commissions on each trade. Discount brokers allow investors to perform their own investment research and make their own decisions. The brokerage still executes the investor’s trades, but since it doesn’t provide the other services of a full-service brokerage, its trade commissions are much smaller.
An investment company is a corporation or a trust through which individuals invest in diversified, professionally managed portfolios of securities by pooling their funds with those of other investors. Rather than purchasing combinations of individual stocks and bonds for a portfolio, an investor can purchase securities indirectly through a package product like a mutual fund.
There are three fundamental types of investment companies: unit investment trusts (UITs), face amount certificate companies and managed investment companies. All three types have the following things in common:
- An undivided interest in the fund proportional to the number of shares held
- Diversification in a large number of securities
- Professional management
- Specific investment objectives
Let’s take a closer look at each type of investment company.
Unit Investment Trusts (UITs)
A unit investment trust, or UIT, is a company established under an indenture or similar agreement. It has the following characteristics:
- The management of the trust is supervised by a trustee.
- Unit investment trusts sell a fixed number of shares to unit holders, who receive a proportionate share of net income from the underlying trust.
- The UIT security is redeemable and represents an undivided interest in a specific portfolio of securities.
- The portfolio is merely supervised, not managed, as it remains fixed for the life of the trust. In other words, there is no day-to-day management of the portfolio.
Face Amount Certificates
A face amount certificate company issues debt certificates at a predetermined rate of interest. Additional characteristics include:
- Certificate holders may redeem their certificates for a fixed amount on a specified date, or for a specific surrender value, before maturity.
- Certificates can be purchased either in periodic installments or all at once with a lump-sum payment.
- Face amount certificate companies are almost nonexistent today.
Management Investment Companies
The most common type of investment company is the management investment company, which actively manages a portfolio of securities to achieve its investment objective. There are two types of management investment company: closed-end and open-end. The primary differences between the two come down to where investors buy and sell their shares – in the primary or secondary markets – and the type of securities the investment company sells.
- Closed-End Investment Companies: A closed-end investment company issues shares in a one-time public offering. It does not continually offer new shares, nor does it redeem its shares like an open-end investment company. Once shares are issued, an investor may purchase them on the open market and sell them in the same way. The market value of the closed-end fund’s shares will be based on supply and demand, much like other securities. Instead of selling at net asset value, the shares can sell at a premium or at a discount to the net asset value.
- Open-End Investment Companies: Open-end investment companies, also known as mutual funds, continuously issue new shares. These shares may only be purchased from the investment company and sold back to the investment company. Mutual funds are discussed in more detail in the Variable Contracts section.