What Are The Different Financial Institutions?
Most firms are too small to raise funds by selling stocks or bonds directly to investors. When these companies need to raise funds to help pay for a capital investment, the only choice is to borrow money from a financial intermediary like a bank or insurance company.
The financial intermediary, in turn, raises funds, often in small amounts, from individual households. For example, a bank raises funds when customers deposit money into their bank accounts. The bank can then lend this money to borrowers.
The bank saves borrowers and lenders from finding and negotiating with each other directly. For example, a firm that wishes to borrow $2.5 million could in principle try to arrange loans from many individuals.
However, it is far more convenient and efficient for a bank, which has ongoing relations with thousands of depositors, to raise the funds from them, and then lend the money to the company The bank provides a service.
To cover the costs of this service, it charges borrowers a higher interest rate than it pays its depositors. Banks and their immediate relatives, such as savings and loan companies, are the most familiar financial intermediaries. But there are many others, such as insurance companies.
In the United States, insurance companies are more important than banks for the long-term financing of business. They are massive investors in corporate stocks and bonds, and they often make long-term loans directly to corporations.
Suppose a company needs a loan for 9 years, not 9 months. It could issue a bond directly to investors, or it could negotiate a 9-year loan with an insurance company.
The money to make the loan comes mainly from the sale of insurance policies. Say you buy a fire insurance policy on your home. You pay cash to the insurance company and get a financial asset (the policy) in exchange.
You receive no interest payments on this financial asset, but if a fire does strike, the company is obliged to cover the damages up to the policy limit. This is the return on your investment.
The company will issue not just one policy, but thousands. Normally the incidence of fires “averages out,” leaving the company with a predictable obligation to its policyholders as a group. Of course the insurance company must charge enough for its policies to cover selling and administrative costs, pay policyholders’ claims, and generate a profit for its stockholders.
Why is a financial intermediary different from a manufacturing corporation? First, it may raise money differently, for example, by taking deposits or selling insurance policies.
Second, it invests that money in financial assets, for example, in stocks, bonds, or loans to businesses or individuals. The manufacturing company’s main investments are in plant, equipment, and other real assets.
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