A financial institution is a company engaged in the business of dealing with monetary transactions, such as deposits, loans, investments and currency exchange.
Financial institutions can be classified as banking and non- banking institutions. [According to R.S.Sayers banking institutions are creator of credit but non-institutions are purveyors of credit. Banking institutions of India consists commercial banks, co-operative banks etc. and non-banking financial institutions are like Life insurance Corporations, Unit Trust of India etc.]
Business entities includes non financial and financial enterprises. Non financial enterprises manufacture products (eg. cars, steel, computers) and/or provide non-financial services (Eg. Transportation, utilities, computer programming). Financial services are more popularly referred to as financial institutions provides services related to one or more of the following:
- Transforming financial assets acquired through the market and constituting them into a different, and more widely preferable, type of asset – which becomes their liability. This is the function performed by financial intermediaries, the most important type of financial institution.
- Exchanging of financial assets on behalf of customers.
- Exchanging of financial assets for their own accounts.
- Assisting in the creation of financial assets for their customers then selling those financial assets to other market participants.
- Providing instrument advise to other market participants.
- Managing the portfolios of other market participants.
Financial intermediaries obtain funds by issuing financial claims against themselves to market participants, and then investing those funds. The investment made by financial intermediaries can be direct or indirect investment.
It can be illustrated with the help of an example :
Commercial bank accept deposits and may use the proceeds to lend funds to consumers and businesses. The deposit represents an IOU of the commercial bank and a financial asset owned by the depositor. The loan represents an IOU of the borrowing entity and a financial asset of the commercial bank. The commercial bank has made a direct investment in the borrowing entity; the depositor effectively has made an indirect investment in that borrowing entity.
The basic role of transforming financial assets involves at least one of the four economic functions:
- Maturity intermediation
- Reducing risk via diversification
- Reducing the cost of contracting and information processing
- Providing a payment mechanism
1) Maturity Intermediation
In our example of commercial bank, two things should be noted. First, the maturity of at least a portion of deposits accepted is typically short term. For example, certain types of deposits are payable upon demand. Others have specific maturity dates. Second, the maturity of the loans made by a commercial bank may be considerably longer then two years.
In the absence of commercial bank, the borrower would have to borrow for the shorter term but the commercial banks by issuing its own financial claims transforms short term asset into a long term by giving the borrower a loan for the length of time sought. This function of financial intermediaries is called Maturity intermediation.
2) Reducing risk via diversification
Suppose that the investment company invests funds received in the stock of a large number of companies. By doing so the investment company has diversified and reduced risk. The small investors would find it difficult to achieve same degree of diversification. The economic function of financial intermediaries i.e transforming risky assets into less risky ones is called diversification.
3) Reducing the cost of contracting and information processing
There are some skilled analysts who give consultation to the investors in their leisure time. That leisure time is short in supply, so to sacrifice it must be compensated. In addition to the opportunity cost of the time to process the information about the financial asset and its issuer, there is the cost of acquiring that information. All these costs are called the information processing costs. The costs of writing loan contracts are referred to as contracting costs.
4) Providing a payment mechanism
Although the previous three economic functions may not have been immediately obvious, this last function should be. Most transactions made today are not done with cash. Instead, payments are made using cheques, cards and electronic transfers of funds. These methods for making payments called payment mechanism are provided by certain financial intermediaries. Initially it was restricted to cash and cheques but later on they started accepting cards and other means used for transferring funds. The ability to make payment without the use of cash is critical for the function of financial market.