What do financial institutions do?
29 December 2021
Confidence in financial sectors
2 January 2022
Classification of financial institutions
The demand for financial services by households and business, as well as by governments, can be fulfilled through a wide variety of financial markets and institutions. This range of activity reflects the diverse requirements of savers for liquidity, risk and return and the alternative ways in which investment opportunities are evaluated. As it has been mentioned, in a classification financial institutes are categorized in two classes:
· Banks and Money Markets:
The foundation of a financial sector is the banking system and the money market. Banks provide basic transactions services by issuing and transferring liquid deposits. These services facilitate not only economic transactions in the real economy, but also other types of financial activity. For banks to provide transactions services there must, in turn, be a market for liquid assets with a certain value that banks can exchange to settle transactions.
Banks also mobilize savings through term deposits and allocate these resources for investment through lending activities. But there are substantial differences among banks and the type of customers on which they focus. While universal banks seek to reach a broad customer base with a wide range of products, other types of banks specialize on particular types of customers and products, such as savings banks, commercial banks and micro-finance banks. Specialization among banks reflects alternative ways of reaching customers and of meeting their particular demands for banking services.
· Non-bank Financial Institutions:
While banks are characterized primarily by their deposit and loan products, non-bank financial institutions undertake a range of specialized activities. Leasing companies provide an alternative to secured bank loans for the funding of fixed investment. Institutions such as life insurance companies and pension funds offer contractual saving instruments to households and invest in long-term debt, commercial real estate and equity. Institutions such as unit trusts and mutual funds enable retail investors to invest collectively in portfolios of marketable securities. Yet other institutions, such as private equity funds and venture capital funds, provide sophisticated investors with the opportunity to invest in portfolios of non-marketable securities.
The question that may now arise is whether, the government has to have a role to play in the management and operation of financial institutions, according to European bank documents:
Governments must play a strong but limited role in promoting confidence in the financial sector. This confidence must ultimately derive from the quality of assets that financial institutions hold and from the transparency and fairness of financial markets. High quality financial assets require a stable macroeconomic environment and an appropriate institutional framework for banks, non-bank financial institutions and securities activities. Providing this environment is a central responsibility of government.
Effective competition, however, is not sufficient to ensure efficient intermediation. There must also be independence from political interference in making operating decisions. Experience has shown that state-owned financial institutions are more susceptible to political interference in their decision process and are more likely to be bailed-out when their investments sour than are private institutions. However, sound corporate governance and effective curbs on conflicts of interest must accompany private ownership if private financial institutions are to perform well. Experience has shown, for example, that ownership of banks by industrial firms can encourage concentrated and connected lending exposures. A successful transition requires that there be neither directed credits nor connected lending.
written by the Legal Institute of tamadon kohan rey
