A financial institution is an organization that deals in a variety of monetary transactions, such as cash deposits, loans, exchanging securities, and raising capital. It intermediates transactions between the people who deposit or invest money and the people who need to borrow or raise money.
Learn about how a financial institution works, which types there are, and why you may need one to complete daily financial transactions.
Definition and Examples of Financial Institutions
Financial institutions are businesses that provide different types of financial services to customers. They use the funds that customers provide, then distribute funds to individuals and businesses who need them. Thus, they connect savers and spenders to facilitate transactions in the financial markets. For example, these businesses make it possible for borrowers to obtain loans using the funds that savers have made available.
These organizations also play roles in helping customers raise funds and invest their money. This includes facilitating the buying and selling of securities like bonds and stocks. Some financial institutions also assist customers with protecting their assets, alongside helping them with managing their money. For example, some will offer insurance policies that protect homes or cars from financial loss. Financial institutions may also buy and sell foreign currencies.
Two of the most common examples of financial institutions are consumer banks and credit unions. These institutions allow customers to open checking and savings accounts to securely and conveniently hold their money. Banks and credit unions then use customer deposits to extend loans and credit to other customers, generating revenue through charging interest. You can also manage a variety of other tasks through these institutions, such as cashing checks, exchanging currencies, investing money in a retirement account, and paying bills.
- Acronym: FI
How Does a Financial Institution Work?
Financial institutions exist to solve the problem of making money available to the people and businesses who need it. Without these organizations and a standard system, it would be challenging and risky to match up people with extra funds with those who need to borrow. For example, you’d likely need to find multiple willing individuals to lend you enough money for a major purchase, and the borrowers would need to take on the risk that you might not pay them back.
Financial institutions help the overall economy function smoothly in general so that people can handle day-to-day financial transactions efficiently.
An example of working with a financial institution would include doing business with your local bank. If you open a savings account and deposit $100, you’ve provided the bank with some money it can add to its pool for lending. You get a small amount of interest in return for your deposit along with protection from FDIC insurance. When another customer at the bank decides to take out a $20,000 auto loan, the bank may use your $100 to help fund the loan, and will charge the customer interest. The bank’s profit for this transaction would be the difference between the interest charged to the customer and the interest it paid you.
The government regulates financial institutions through various agencies to protect savers and investors. For example, the Federal Deposit Insurance Corporation (FDIC) provides insurance for $250,000 per depositor at banks, while the National Credit Union Administration (NCUA) provides the same coverage at credit unions. These measures protect customers’ funds if an institution fails, and also reduce the chance of a bank run. Financial activities involving the exchange of securities (stock, ETFs, etc.) are regulated primarily under the Securities and Exchange Commission (SEC).
Depository vs. Non-Depository
Financial institutions fall into two categories: depository and non-depository institutions. Depository institutions include deposit-focused businesses such as credit unions, banks, and savings associations. In contrast, non-depository institutions include brokerage firms and insurance companies.
Types of Financial Institutions
There are various types of financial institutions that can meet your specific needs. They can be for-profit or nonprofit, serve different types of customers, provide a specific purpose, or focus on certain services. The main types of financial institutions include:
Retail and Commercial Banks
Retail and commercial banks allow you to open deposit accounts and access a wide range of financial services related to saving and borrowing money. Retail banks serve individuals, while commercial banks serve business customers.
Online banks and online banking platforms may not have physical locations, but they do offer some of the same kinds of financial services as brick-and-mortar banks.
Differing from banks, credit unions reinvest money made from charging interest so they can keep costs low and benefit their customers. These depository organizations usually target a specific community or group of people and require membership. They offer a variety of traditional banking services that range from checking and savings accounts to credit card and loan programs.
Insurance companies offer various types of insurance policies to offer financial protection. For example, insurance companies often sell products such as life, health, and home insurance. They put the money that comes from insurance premiums into a pool to fund the policy coverage.
Brokerages assist with transactions regarding securities such as stocks, mutual funds, and bonds. People who want to buy or sell securities use brokerage firms to facilitate the transaction. Some firms also offer financial advice and act as consultants.
Savings and Loan Associations
Also known as “thrift institutions” and less common to find, these depository institutions mainly focus on offering home loans and savings accounts. However, some also have other types of loans and account options, so they can seem similar to retail banks at times.
Investment banks work with corporations, governments, and other institutions that need capital and financial advice. They don’t deal with customer deposits, but rather assist with financing through securities such as bonds and stocks. They also offer advice on business planning and decisions such as mergers.
Do I Need a Financial Institution?
Whether you plan to save for retirement, buy a home, protect your assets, or have your paychecks deposited directly into a bank account, there’s a good chance you’ll need the services of one or more types of financial institutions.
While you could opt to keep your money in a safe at home or carry it in a wallet, depositing it at a financial institution ensures its safety. Since government regulations offer some protection for your deposits if a bank failure occurs, you have an extra layer of protection, too. You might also opt to use a financial institution to earn interest on a deposit account (CDs, money market, savings, or checking), or you might use your money to buy stocks and bonds through a brokerage.
Financial institutions can also provide you with a wide range of credit products that make buying a home, paying for an education, or starting a business financially feasible. Without a financial institution, you might have to rely on your own savings or ask for funds from friends and family. So having access to these institutions opens up opportunities you might not have without the ability to borrow.
- Financial institutions help intermediate financial transactions between people saving and people spending money.
- Services that financial institutions may offer include deposit accounts, loans, investments, insurance policies, and foreign currency exchange.
- Depository financial institutions take deposits from customers, while non-depository financial institutions will provide financial services without accepting deposits.
- Examples of financial institutions include retail and commercial banks, investment banks, insurance companies, finance companies, credit unions, brokerage firms, and savings and loan institutions.
- You’ll likely use a variety of financial institutions to perform tasks such as saving for retirement, obtaining a mortgage, and trading securities.