The current system of financial institutions or intermediaries in the United States, like the monetary system, has evolved to meet the needs of the nation’s citizens and facilitate the process of saving and investing. Individuals can save and grow their savings with the help of financial institutions.
While individuals can invest directly in the securities of companies and government entities, most individuals invest indirectly through financial institutions that provide lending and investment services on their behalf. Financial intermediation is the process by which individuals’ savings are accumulated with financial institutions, which in turn lend or invest them.
The main types of financial intermediaries are classified into four categories: Depository Institutions, Contractual Savings Organizations, Securities Firms, and Financial Corporations. Depository institutions accept deposits or savings from individuals and then lend these pooled savings to businesses, governments, and individuals.
Depository institutions include commercial banks, savings and loan associations (S&Ls), savings banks, and credit unions.
Contractual savings institutions collect premiums for insurance policies and employee/employer contributions from participants in pension funds and provide retirement benefits and insurance against major financial losses. Insurance companies and pension funds are the two main forms of contractual savings organizations.
Investment firms accept and invest individual savings and also facilitate the sale and transfer of securities between investors. Securities firms not only pool individual savings and investments but also receive funds from other financial intermediaries. Investment companies (mutual funds), investment banks, and brokerage firms are the main types of securities firms we will cover.
Financial firms lend directly to consumers and businesses and help borrowers obtain mortgage loans for real estate.
During the American colonial period, few of today’s financial intermediaries existed. Only commercial banks and insurance companies (life and property) can be traced back to before 1800. Savings banks and S&Ls began to develop in the early 1800s.
Investment banking firms (and organized securities exchanges) can also be traced back to the first half of the 1800s. No new large financial intermediaries emerged in the last half of the nineteenth century.
Credit unions, pension funds, mutual funds, and finance companies emerged in the first half of the 1900s. Thus, during the second half of the nineteenth century and into the twenty-first century, the focus was on redefining and restructuring existing financial intermediaries rather than introducing new ones.
When we speak of banks and the banking system in the United States, we think primarily of commercial banking. Commercial banks are deposit-taking institutions that accept deposits, issue checking accounts, and make loans to businesses and individuals.
In addition to commercial banks, deposit-taking institutions include three savings institutions. Savings banks are noncommercial deposit-taking institutions called savings and loan associations (S&Ls), savings banks, and credit unions that collect savings from individuals and lend them primarily to other individuals.
S&Ls make some loans to businesses but focus mainly on loans to individuals. Savings banks and credit unions focus on making consumer and mortgage loans to individuals who want to buy things like cars and houses.
Savings banks first appeared in 1812 and emphasized individual thrift and the safety of principal. Savings banks accept savings from individuals and lend the accumulated savings to individuals, primarily in the form of mortgage loans.
Very often, the trustees of these banks were prominent local citizens who worked without pay and considered their service an important civic duty. Today, savings banks operate almost exclusively in New England, New York, and New Jersey, with the majority of their assets still invested in mortgage loans.
Savings and Loan Associations (S&Ls), also known as Savings and Loans or S&Ls, came on the scene in 1831. The basic mission of these institutions, known first as Building Societies and later as Building and Loan Associations, was to make mortgage loans.
In distinguishing between savings societies and S&Ls, one could say that the original focus of savings societies was on thrift and the security of savings, while the focus of S&Ls was on construction financing.
Today, S&Ls accept individual savings and lend pooled savings to businesses and individuals, primarily in the form of mortgage loans. In contrast to the limited geographic scope of the savings and loan system, the savings and loan business spread throughout the United States.
Credit unions came onto the American scene much later than the other savings institutions. Credit unions are cooperative, nonprofit organizations that exist primarily to provide consumer credit to their members, including financing for automobiles and home purchases.
Credit Unions are composed of individuals who have common ties such as occupation, residence, or church affiliation. These institutions are funded almost entirely from the savings of their members. The first official credit union was established in the United States in 1909, but it was not until the 1920s that credit unions gained prominence as a distinct form of deposit-taking institution.
Contractual Savings Organizations
Contractual savings organizations in the form of insurance companies and pension funds play an important role by collecting premiums and contributions and using these pooled funds to purchase corporate debt and equity securities.
Of course, contractual savings institutions also actively purchase debt securities issued by government agencies. Insurance companies provide financial protection to individuals and businesses for life, property, liability, and health uncertainties.
Policyholders pay premiums to insurance companies, which invest these funds until insured claims must be paid. Life insurance provides economic security for dependents in the event of the insured person’s premature death. Health insurance provides protection against potentially catastrophic medical expenses if the insured person falls ill or suffers an accident.
Property insurance protects the policyholder from potential financial loss due to fire, theft, and other insured perils. Liability insurance protects the policyholder from possible financial loss if he or she is accused of negligence by another person.
Pension funds receive contributions from employees and/or their employers and invest the proceeds on behalf of the employees. The purpose of a pension plan is to provide an income during a person’s retirement years.
Pension funds are either private pension plans or government-sponsored plans. Many companies offer private pension plans for their employees. A private pension plan can be either insured or uninsured.
A contracted plan with a life insurance company is an insured plan. In an uninsured plan, a trustee, often a commercial bank or trust company, is appointed to manage, invest, and distribute the benefits according to the trust agreement.
Government-sponsored plans may involve either the federal government or state and local governments. Social Security is the largest government-sponsored pension plan.
The Social Security plan is funded by current working individuals who pay Social Security taxes. Social Security is designed to provide only minimum retirement benefits, so most individuals must accumulate additional funds before retirement.
The federal government also offers pension plans for its employees, known as civil servants, and for military personnel. State and local government pension plans are typically established for teachers, police and fire employees, and other civil servants.
Investment firms perform several financial functions. Some securities firms engage in the savings and investment process, while others focus primarily on marketing new securities and facilitating the transfer of existing securities between investors.
Investment companies sell shares in their firms to individuals and others and invest the pooled proceeds in corporate and government securities. An investment company may be either a closed-end fund or an open-end fund.
A closed-end fund issues a fixed number of shares to investors and invests the pooled funds in securities. Shares in a closed-end fund are bought and sold in the secondary markets after their initial issuance.
Open-end funds usually referred to as mutual funds, may issue an unlimited number of shares to their investors and use the pooled proceeds to purchase corporate and government securities. Unlike closed-end funds, however, investors buy new shares or redeem old shares directly from their mutual fund, rather than buying and selling shares in a secondary market.
Mutual funds grow by investing their existing investors’ money in securities that will deposit or withdraw cash and increase in value. Successful mutual funds attract more investor money and in turn invest in more securities.
Investment banking firms, also called investment banks, sell or market new securities issued by companies to retail and institutional investors.
Brokerage firms assist individuals who want to buy new or existing securities or sell securities they have already purchased. Investment banking and brokerage activities are often combined in the same firms.
However, unlike mutual funds, investment banking and brokerage firms do not collect savings from individuals, but market or sell securities issued by companies directly to individuals. Investment banking and brokerage firms raise the financial capital for their activities from their own funds or from other financial institutions.
Financial firms focus largely on lending to individuals to meet credit needs and to purchase durable goods and homes. Finance companies lend directly to consumers and businesses or help individuals obtain financing.
Sales and consumer finance companies make loans to individuals. Sales finance companies finance installment loans for the purchase of automobiles and other durable goods such as washers, dryers, and refrigerators.
Consumer finance companies make small loans to individuals and households. Commercial finance companies make loans to businesses that cannot obtain financing from commercial banks.
Mortgage banks or mortgage companies help individuals obtain mortgage loans by matching borrowers with institutional investors. A mortgage loan is a loan on real property, such as a home, in which the borrower pledges the property as collateral to guarantee repayment of the loan.
The primary mortgage market in which home loans and other real estate loans are “originated” is very important to the success of the financial system. Traditionally, once a mortgage loan was originated, it was held by the lender until maturity or until the loan was repaid.
However, as individual mortgage loans have become more standardized, secondary mortgage markets have emerged in which existing real estate mortgages are bought and sold.