Overview of Financial Institutions

A financial market is a market in which financial assets (securities) such as stocks and bonds can be
purchased or sold.

Because financial markets are imperfect, securities buyers and sellers do not have full access to information
so it needs transparency. Individuals with available funds are not normally capable of identifying credit
worthy borrowers to whom they could lend those funds. In addition, they do not have the expertise to assess
the creditworthiness of potential borrowers so an effective resolution for the imperfectness is the Financial
Institution.

Financial institutions are needed to resolve the limitations caused by market imperfections Financial
Institutions have two classifications: Depository and Non-depository. Under the depository we have the
commercial banks, savings institutions, and credit unions. For the nondepository we have the finance
companies, mutual funds, securities firms, insurance companies and pension funds. Lastly, Financial
institutions have different risks, benefits and regulating Body

FINANCIAL INSTITUTIONS

Definition: Financial Institutions are companies engaged in the business of dealing with financial
and monetary transactions. It encompasses a broad range of business operations within the
financial services sector and can vary by size, scope, and geography.
ROLE OF FINANCIAL INSTITUTIONS:

“Serve as intermediaries within the financial markets”

• Meaning they act as the mediator among participants in the financial markets

WHAT They Do as Intermediaries:

1. Channel funds from surplus units to deficit units

• Meaning they accept funds from surplus units and transfer the funds to deficit
units.

· Surplus units (or investors)

- participants in the financial markets who receive more money than they spend
- provide their net savings to the financial markets to earn a return on their investment
- examples: professionals who earn more income than they receive
· Deficit units
- Participants in the financial markets who spend more money than they receive
- they access funds from the financial markets so that they can spend more money than they
receive
- examples: college students who often borrow from financial markets to support their education;
families to obtain mortgages; businesses to finance their growth; and governments to finance many
of their expenditures.

2. Offers services to provide information and easier ways of transacting to participants in the
financial markets
• Meaning financial institutions supplemented what the financial markets including
all its participants(surplus and deficit units) were lacking
• Example: (For Surplus Units) Financial institutions with all its professional people
and their expertise in this field are able to provide services to surplus units like
providing them information on how to invest surplus units’ money, or to whom to
invest, or when to invest among others.
• Example: (For Deficit units) Financial institutions help deficit units by offering them
available funds as previously invested by surplus units, also they provide deficit
units with systematic ways for easier transactions such as lending.

The second function of financial institutions as intermediaries is that they offer services to provide
information and easier ways of transacting to participants in the financial markets
As part of their various services, these institutions provide investment opportunities and help
businesses to generate funds for various purposes.

An example of this is to provide services to surplus units with information on how to invest, whom
to invest, or when to invest among others.
They could also help deficit units by offering them available funds as previously invested by
surplus units and provide them with systematic ways for easier transactions such as lending.
Financial Institutions are referred to as a company that deals in all types of finance-related
businesses and so it is known to also help in directing the payment system and the moving of the
financial resources.
This means that financial institutions are to manage payments of different units, keep the payment
system in motion through its offers and services, and allows the moving of financial resources
from one place to another.

3. Helps in directing the payment system and moving the financial resources
• Meaning financial institutions' primary function is to manage payments of different
units (surplus units and deficit units).
• They keep the payment system in motion through its offers and services like the
savings accounts, checking accounts, and credit cards.
• They also allow moving of financial resources from one place to another. They
assist with different transactions and transfers like investments, purchasing of real
estates, paying annuities, etc.
4. Through financial institutions, risks are managed and evaluated for each unit.
• Financial institutions are the one who also manages risk and evaluates each of
their users' financial capacity.
• They assess each users' financial capacity to manage the level of risk they are
dealing with and allow more people to invest and share the risk to make it easier
to be handled.
5. Financial Institutions helps in maintaining the financial market
• Through financial institutions, it allows the different sectors and individuals to invest
in different investments like the stock market.
• There are a lot of investments that financial institutions offer like the Mutual Funds,
Unit Investment Trust Fund, Stock Market Online Brokers.
• Example: BPI Trade of Bank of the Philippine Islands, BDO Nomura of Banco de
Oro, and First Metro of Metro Bank.

The fourth function of financial institutions is that they are the ones who also manage risk and
evaluate the risk for each unit. Financial institutions were able to manage the risk by distributing
the risk among its users. How? This is by allowing more people to invest in the institution so that
the risk will be divided and shared among its users so that the risk will be easier to be handled by
the institution.

Last but not the least, here's another function of Financial institution. They help in maintaining the
financial market. We already have said earlier that financial institutions serve as intermediaries
within the financial markets. How and Why? Well, Financial institutions is another way to allow
the different individuals to invest in the financial market. A lot of banks offer mutual funds, unit
investment trust fund, and there are also banks that has online brokers. Examples are BPI Trade
of Bank of the Philippine Islands, BDO Nomura of Banco de Oro, and First Metro Securities of
Metrobank Group.

Two classification of Financial Institutions:

Most of the money and credit readily available to the economy comes from financial institutions.
Financial institutions act as the middleman between two parties in a financial transaction.
Speaking of Financial Institutions, I would like to share two classifications of financial
intermediaries namely the depository institution and nondepository institution. Let’s now
differentiate the two financial institutions.

First of, depository financial institutions are intermediaries

-who accept deposits from surplus units and provide credit to deficit units through loans and
purchases of securities issued by either corporations or government.

Depository institutions has certain roles in the industry or in financial market. This includes firstly,
-They offer deposit accounts that can accommodate the amount and liquidity characteristics
desired by most surplus units
-They repackage funds received from deposits to provide loans of the size and maturity desired
by deficit units
- they accept risks on loans
- They are more expert in evaluating credit-worthiness of deficit units knowing that financial
markets are imperfect and that they don’t have the full access to information regarding their
borrowers or clients. Thus, with the help of depository institutions, it will be easier to identify and
assess the creditworthiness of potential borrowers.
- Lastly, they diversify loans that makes them better than individual surplus units.

Depository institutions include commercial banks,savings institutions and credit unions. These
are institutions who accept deposits- contribute to the economy by lending money saved by
depositors.

1.Commercial banks are the most dominant depositary institution and they serve surplus units by
offering a wide variety of deposit accounts, and they transfer deposited funds to deficit units by
providing direct loans or purchasing debt securities. They are greatly exposed to risk since most
of their investments are subject to the risk default by the borrower.They serve both private and
public sector hence focuses on commercial or business loans.Moreover commercial banks are
subject to regulations that are intended to limit their exposure to the risk of failure. An example of
which is the maintained minimum level of capital required in the bank in order to determine
possible losses from the investments made. Some example of commercial banks includes AUB,
BDO Unibank, BPI, and many more.

2. Next, is the saving institutions, which is good for people who wish to save and be thrifty. Another
term for Saving Institution is Thrift Institution. Some institutions like saving institutions are called
thrift institutions to distinguish them from commercial banks. Furthermore, Saving Institutions
offers deposit accounts to surplus units and then channels these deposits to deficit units.Savings
institutions can be owned by shareholders, but most are mutual or owned by depositors.One
similarity with commercial banks is that they also rely on the federal funds market to lend their
excess funds or to borrow funds on a short-term basis.But unlike from commercial banks saving
institution focuses on residential mortgage loans, which gives lower risk rate.

3. Last example of a depository institution is the credit union which is a non profit organization
whose transactions are limited to its members unlike the first two institutions who serve the whole
public.The same with saving institutions credit unions are also classified as thrift institutions.
Credit unions are more likely smaller compared to the other two depository institutions since it
offers investment only to their members.Some examples of credit unions are Metrobank, Eastwest
Bank, and many more.
Another financial intermediary who helps us with our financial needs are the nondepository
institutions.

This aggregate wealth of the lower-income people that is made available to the economy through
financial nondepository institutions, which are financial intermediaries that cannot accept deposits
but do pool the payments in the form of premiums or contributions of many people and either
invest it or provide credit to others.Hence, nondepository institutions form an important part of the
economy. These nondepository institutions are also called the shadow banking system, because
they resemble banks as financial intermediaries, but they cannot legally accept deposits.These
include finance companies,mutual funds,securities firms,insurance companies and pension
funds.

First is the finance companies

• They are institutions who Obtain funds by issuing securities and then lend the funds to
individuals and small businesses. Aside from this, one important information we should put in
mind is that Finance Companies and Depository Institutions overlap, however, they all have their
corresponding specifics in concern to investments and as to who are their potential investors,
which is also based on their purpose or function.

Second is the Mutual funds,

• it sells shares to surplus units and uses the funds received to purchase a portfolio of
securities. Mutual funds focus on offering investment in capital market securities, like stocks and
bonds, and money market securities.

Next in line is the Securities firms

These are firms who provide a wide variety of functions in financial markets , Investment
companies, brokerages, and investment banks are the major types of securities firms. Security
firms that act as brokers provide investment or transactions between two parties or what we
basically call as they buy and sell stocks of their clients to another individual or institution. They
got their fee on the markups or between the bid quote and ask quote. An example of a security
firm that acts as brokers is Fidelity Investments in the US.
On the side of the dealers or security firms that act as dealers, they are focused on maintaining
an inventory of securities. Unlike brokers, the dealers buy and sell securities for their own account
and their fee does not depend on the prices between the transactions but it is concerned with the
performance of the security of the portfolio maintained.
Aside from brokers and dealers, security firms also provide services in regards to underwriting
and advising or often called investment banking. Security firms that offers underwriting and
advising services differ from other activities offered since it involves the public market, wherein
there is a public offering of underwriting or advising services pertaining issued securities to the
public market.

Fourth is the Insurance companies

This institution provides insurance policies that reduce the financial burden associated with death,
illness and damage to property, charge premiums and invest in financial markets concerning
stocks or bonds either issued by a corporation or the government.
· Insurance companies protect their customers from financial distress caused by
unforeseen events, such as accidents or premature death. They pool the small premiums of the
insured to pay the larger claims to those with losses. They receive funds from an individual or
institution, which will be helpful in the long run. An example of insurance companies are as follows:
Pru Life Insurance, Liberty Manual, Sun Life of canada, and many more.
Last but not the least is the Pension funds
· Pension funds are commonly provided or offered by an employer to their employee/s, in
which both employer and employee contribute funds to the plan, which will later on be received
or enjoyed during the retirement of an employee. Pension funds companies or corporations
receive contributions from individuals and/or employers during their employment to provide a
retirement income for the individuals or in other words to save for their retirement. The contribution
of an individual to a pension fund is invested in securities issued by either corporations or
government. For the meantime, pension funds are the one managing the funds of an individual
unless it is withdrawn. An example for pension funds are Social Security Trust Fund, Government
Pension Investment Fund, and many more.

DEPOSITORY
Definition: Financial institutions that deposit from surplus units and provide credit to deficit units.

ROLES OF DEPOSITORY
• Offers deposit accounts
• Repackage funds received from deposits
• Accept risks on loans
• More expert in evaluating credit-worthiness of deficit units.
• Diversify loans that makes them better than individual surplus units

1. Commercial Banks
2. Savings Institutions
3. Credit Unions
NON-DEPOSITORY
Definition: They are financial institutions that generate funds from different sources other than
deposits.

ROLES OF NON-DEPOSITORY

1. Finance Companies
2. Mutual Funds
3. Securities Firms
4. Insurance Companies
5. Pension Funds
Benefits of Financial Institutions

1. They provide secure favourable fees and financial interest to the money deposit
accounts
1. Discounts are often available for people who purchase multiple insurance policies
from the same company, a practice known as bundling. The same financial
advantages hold true for people who choose one place for all their loans and
accounts. When you become a regular client of a financial institution to address
your financial needs, they are likely to give you a premium membership for
customer loyalty that can help you make your borrowing easier for the future.
2. The money you get to deposit to a specific institution will eventually increase and
grow.
2. They provide economic loans to various persons or organizations
1. Financial Institutions serves as vital role to the economy and to the individual as
they look for advantageous ways regarding financial matters.
3. Customer service can be tailored to your specific needs
1. Putting all of your accounts in one place makes it easier to navigate such
complexities, since customer service representatives can look at your entire suite
of accounts and provide assistance that’s tailored to your particular situation. It’s
invaluable to have access to a financial expert who can pull up all of your accounts
and help answer any questions.
4. They will ensure the security of your account
1. A financial institution will not only ensure that your loaned amount is kept securely
in an account but will also make it certain that the instalments you pay back for
your loan reach the designated authority safely. This security acts as a relief for
the customer to get out of the vibe of pressure that seems to surround the world
‘loan’.
5. Financial Future.
1. Financial institutions aim to make this procedure of paying back the money as less
harmful to your financial position as possible. It will offer a long term plan and
incentivize you to do business with them by using premium tools such as no
 taxation on cash withdrawals for the duration of the time in which the loan has to
be paid back.

Risks

Financial institutions are faced with a number of risks of which some include:

• Credit risks- are risks that the promised cash flows from loans and securities held by FIs
may not be paid in full.
• Liquidity risks- are risks that a sudden and unexpected increase in liability withdrawals
may require an FI to liquidate assets in a very short period of time and at low prices.
• Interest rate risks- are risks incurred by an FI when the maturities of its assets and
liabilities are mismatched and interest rates are volatile.
• Foreign exchange risks- are risks that exchange rate changes can affect the value of an
FI’s assets and liabilities denominated in foreign currencies.
• Operational risks- the risks that existing technology or support systems may malfunction
or breakdown, (mistakes and fraud committed by staff).
• Technological risks- the risks incurred by an FI when its technological investments do
not produce anticipated cost savings, (power and equipment failures that lead to data
loss).
• Systematic (undiversifiable) risk- this risk type is caused by changes associated with
systemic factors. As such, this risk type can only be hedged but cannot be diversified. This
risk type comes in many different forms, for example, changes in interest rates and
government policies.

Note!
The two most important risks are the interest rate and the credit risks. Problems in these areas
often lead to liquidity crises and bank failures. Thus, if an institution happens to face an increase
in the interest rates on its liabilities and at the same time, fails to increase its interest rate charged
on loans to its clients due to competition, then the said institution can become compromised.
Similarly, if an institution results in a series of bad loans that cannot be recovered, its viability can
be threatened.
Risk is defined in financial terms as the chance that an outcome or investment's actual gains will
differ from expected outcome or return. Risk also includes the possibility of losing some or all of
an original investment.

In simple words, risk in finance is the possibility of an unfavorable outcome.

1. Credit risk - The possibility of loss due to a borrower's inability to pay its loan. Since financial
institutions shoulder the risk of default when it sends a loan to its client. This risk is very common
among them. This is the reason why creditworthiness must be established prior to renting loans.

2. Liquidity risk- This is the risk that the firm may run out of cash needed to pay its bills and keep
the firm operating. It refers to how an institution's inability to meet its obligations threatens its
financial position or existence.
3. Interest rate risk- refers to the risks that an asset will decline in value in response to interest
rate movements. Suppose you have a 10-year bond that you acquire at a 3 percent interest rate.
If the interest rate increases you would have already lost the opportunity to earn more because
your 10 - yr bond comes with a fixed income and a fixed interest rate.

4. Foreign Exchange Risk- This refers to the potential loss because the exchange rate of a
particular currency moves unfavorably against a financial institution. For example, if a financial
institution invested in US Dollars predicting that the exchange rate will increase, if the foreign
exchange rate decreases instead, then the financial institution has suffered a loss.

5. Operational Risk- it recognizes the risks that occur from conducting day to day operations. This
might refer to the risk of losses as a result of inadequate management of controls breakdown frok
internal procedures, employee problems, systems problems etc., anything has got something to
do with conducting your day to day operations.

6. Technological or technology Risk- you know its stating the obvious but technology risk is the
risk that ecology will not work according to how it was designed or technology failures disrupt the
financial institutions operations such as a system malfunction or information security breach. This
is becoming more prevalent now as financial institutions migrate to online platforms.

7. Insolvency risk- In accounting, we all know that when liabilities are greater than assets, the
business is insolvent. Therefore, this is the risk that the financial institution will not be able to
satisfy its debts and have negative equity or not having enough assets to pay off its liabilities.

8. Country or Sovereign risk- This is the risk that reflects how a government can affect the financial
system of its country. This refers to how a country's political landscape including but not limited
to security and stability as well as economic policies including tax regulations affect financial
institutions and it's activities.

Considering the complex nature of financial systems and the important role that financial
institutions play in it. It is expected that they have to be regulated in order to protect the public. A
country cannot afford to have a failure of financial institutions as a failure in financial institutions
would lead to a failure of financial markets and eventually to the entire financial system.

Regulations/Regulating Body:

Financial regulation is the supervision of financial markets and institutions. Financial regulations
necessitate financial institutions to certain requirements, restrictions and guidelines.
The primary purpose of a financial regulation is to maintain the integrity and stability of the
financial system. Financial regulation protects investors, customers, clients and maintains orderly
markets and promotes financial stability.
· Financial regulations aims to :
· Enforce applicable laws; - laws that will govern and that will keep the financial institutions
in orderly manner
· prosecute cases of market misconduct; :
· license providers of financial services; :
· protect clients; :
· investigate complaints; and :
· maintain confidence in the financial system.

https://definitions.uslegal.com/f/financial-regulation/
Let’s discuss some of the regulations and regulating body for Financial Institutions:
• Several agencies regulate the various types of financial institutions, and the various
regulations may give some financial institutions a comparative advantage over others.

• Commercial banks are subject to regulations that are intended to limit their exposure to
the risk of failure. Particularly, banks are required to maintain a minimum level of capital,
relative to their size, so that they have a cushion to absorb possible losses from defaults
on some loans provided to households or businesses. The Federal Reserve (“the Fed”)
serves as a regulator of banks and the SEC.

• One of the law used to regulate the Financial institutions is The Financial Reform Act
called for the creation of the Financial Stability Oversight Council, which is responsible for
identifying risks to financial stability in the United States and makes regulatory
recommendations that could reduce any risks to the financial system.

This act established the Consumer Financial Protection Bureau (housed within the Federal
Reserve) to regulate specific financial services for consumers, including online banking, checking
accounts, credit cards, and student loans. This bureau can set rules to ensure that information
regarding endorsements of specific financial products is accurate and to prevent deceptive
practices.

In order to help financial systems operate smoothly and to reduce the likelihood of financial crises,
most modern nations have regulating bodies like a central bank. in our country we have the BSP
bangko Sentral ng Pilipinas
1. To protect the public, such as the providing and enforcing on adequate standards
2. To promote stability of the financial system
3. To conduct monetary policy

Before we end, Here are some of the Key takeaways

Regulatory bodies are established by governments or other organizations to oversee the
functioning and fairness of financial markets and the firms that engage in financial activity.
• The goal of regulation is to prevent and investigate fraud, keep markets efficient and
transparent, and make sure customers and clients are treated fairly and honestly.
• Several different regulatory bodies exist from the Federal Reserve Board which oversees
the commercial banking sector and the SEC which monitor brokers and stock exchanges.