- Commercial Banks
- Credit Unions
- Savings and Loan Associations
- Mutual Saving Banks
- Mutual Funds
- Finance Companies
- Pension Funds etc.
The role of Financial Institution is to act as Financial Intermediary or to provide function of Financial Intermediation, role of go-between for savers and borrowers.
Banks are the largest financial intermediaries. Banks lend to many sectors of the economy.
However, banks and other financial institutions compete with one another and this competition has advantage for savers, borrowers and system as a whole.
Key Services Provided by Financial Institutions
In addition to matching individuals who have excess funds with chose who need them, the financial system provides three key services for savers and borrowers. These services are risk sharing, liquidity, and information. Financial markets and financial intermediaries provide these services in different ways, making various financial assets and financial liabilities more attractive to individual savers and borrowers. Many financial decisions made by savers and borrowers are shaped by the availability of these services.
Risk Sharing
One advantage of using the financial system to match individual savers and borrowers is that it allows the sharing of risks. Risk is the chance that the value of financial assets will change relative to what you expect. Most individual savers are not gamblers and would like to seek a steady return on their assets rather than erratic swings between high and low earnings. Indeed, individuals prefer stable returns on the collection of assets they hold. A collection of assets is called a portfolio. For example, you might hold some government treasury securities, some shares of stock, and some shares in a mutual fund. Although one asset or set of assets may perform well and an¬other may not perform as well, but overall returns tend to average out. This splitting of wealth into many assets is known as diversification. As long as the individual returns do not vary in the same way, the risk of severe fluctuations in a portfolio's value will be reduced. The financial system provides risk sharing by allowing savers to hold many assets. .
Liquidity
The second service, the financial system offers to savers and borrowers is liquidity, which is the ease with which an asset can be exchanged for money to purchase other assets or exchanged for goods and services. Savers view the liquidity of financial assets as a benefit. When they need their assets for their own consumption or investment, they can exchange them easily. In general, the more liquid an asset, the easier it is to exchange the asset for something else. You can easily exchange the currency notes for purchasing a book or anything else because it is highly liquid. You can also cash a check within a short period of time to buy clothes. However, selling a car would take more time because personal property is not very liquid. By holding financial claims (such as stock or bonds) on a factory, individual investors have more liquid savings than they would if they owned the machines in the factory. The reason is that the investor can more easily sell the claim than a specific machine in order to buy other assets or goods. Liquid assets allow an individual or firm to respond quickly to new opportunities or unexpected events. Financial assets created by the financial system, such as stocks, bonds, or checking accounts, are more liquid than cars, machinery, or real estate.
Financial markets and intermediaries provide trading systems for making financial assets more liquid. In addition to creating financial assets, the financial system provides mechanism for increasing the liquidity of financial assets. Investors can readily sell their holdings in government securities and stocks and bonds of large corporations, making those assets very liquid. During the past two decades, the financial system has made many other assets liquid besides stocks and bonds. One measure of the efficiency of the financial system is the extent to which it can transform illiquid assets into the liquid claims that savers want.
Information
A third service of the financial system is the collection and communication of information, or facts about borrowers and expectations about returns on financial assets. The first informational role the financial system plays is to gather information. That includes finding put about prospective borrowers and what they will do with borrowed funds. Obtaining such information would be costly and time-consuming for savers, who of course want all the facts before lending their money. Working through the financial system, a prospective investor is likely to learn more about the borrower than he would if he tried to make the investment on his own.
Another problem that exists in most transactions is asymmetric information. This means that borrowers possess information about their opportunities or activities that they don't disclose to lenders or creditors and can take advantage of this information. Sometimes, financial arrangements have to be structured so that borrowers do not take advantage of asymmetric information at the expense of lenders.
The financial system specializes in information gathering and monitoring, and arrangements exist for solving problems of asymmetric information."
The second informational role the financial system plays is communication of information.
Savers and borrowers receive the benefits of information from the financial system by looking at asset returns. As long as financial market participants are informed, the information works its way into asset returns and prices. Information is communicated to borrowers as well as to savers. The incorporation of available information in asset returns is the distinguishing feature of well-functioning financial markets.
One advantage of using the financial system to match individual savers and borrowers is that it allows the sharing of risks. Risk is the chance that the value of financial assets will change relative to what you expect. Most individual savers are not gamblers and would like to seek a steady return on their assets rather than erratic swings between high and low earnings. Indeed, individuals prefer stable returns on the collection of assets they hold. A collection of assets is called a portfolio. For example, you might hold some government treasury securities, some shares of stock, and some shares in a mutual fund. Although one asset or set of assets may perform well and an¬other may not perform as well, but overall returns tend to average out. This splitting of wealth into many assets is known as diversification. As long as the individual returns do not vary in the same way, the risk of severe fluctuations in a portfolio's value will be reduced. The financial system provides risk sharing by allowing savers to hold many assets. .
The second service, the financial system offers to savers and borrowers is liquidity, which is the ease with which an asset can be exchanged for money to purchase other assets or exchanged for goods and services. Savers view the liquidity of financial assets as a benefit. When they need their assets for their own consumption or investment, they can exchange them easily. In general, the more liquid an asset, the easier it is to exchange the asset for something else. You can easily exchange the currency notes for purchasing a book or anything else because it is highly liquid. You can also cash a check within a short period of time to buy clothes. However, selling a car would take more time because personal property is not very liquid. By holding financial claims (such as stock or bonds) on a factory, individual investors have more liquid savings than they would if they owned the machines in the factory. The reason is that the investor can more easily sell the claim than a specific machine in order to buy other assets or goods. Liquid assets allow an individual or firm to respond quickly to new opportunities or unexpected events. Financial assets created by the financial system, such as stocks, bonds, or checking accounts, are more liquid than cars, machinery, or real estate.
A third service of the financial system is the collection and communication of information, or facts about borrowers and expectations about returns on financial assets. The first informational role the financial system plays is to gather information. That includes finding put about prospective borrowers and what they will do with borrowed funds. Obtaining such information would be costly and time-consuming for savers, who of course want all the facts before lending their money. Working through the financial system, a prospective investor is likely to learn more about the borrower than he would if he tried to make the investment on his own.
