Financial Institutions (Encyclopedia of Business and Finance)
A financial institution is one that facilitates allocation of financial resources from its source to potential users. There are a large number of different types of financial institutions in the United States, creating a rich mosaic in the financial system. Some institutions acquire funds and make them available to users. Others act as middlemen between deficit and surplus units. Still others invest (manage) funds as agents for their clients. The key categories of financial institutions are the following: deposit taking; finance and insurance; and investment, pension, and risk management. There are also government and government-sponsored institutions that carry out regulatory, supervisory, and financing functions. Historically, each type has performed a specialized function in financing and investment management.
Deposit-taking institutions take the form of commercial banks, which accept deposits and make commercial and other loans; savings and loan associations and mutual savings banks, which accept deposits and make mortgage and other types of loans; and credit unions, which are cooperative organizations that issue share certificates and make member (consumer) and other loans. Altogether there are more than 15,000 deposit taking institutions with more than 100,000 branches spread across the economy.
The U.S. commercial banking system practiced competition through a large number of firms in the industry from 1776 to 1976. It was designed to be a unit-banking system in which state charters of banks allowed only one-office banking. The system also encouraged thrift and use of local savings for investment in the local economy. The unit-banking system not only forced competition among existing and new banks in a given banking market; it deliberately avoided the emergence of monopolies in the industry. The founding fathers in the original thirteen states understood the harm monopolies could inflict on the economic and financial systems. In due course the U.S. Congress passed the Sherman Antitrust Act of 1890, making monopoly and monopolistic practices unacceptable and therefore illegal.
The commercial banking industry dominated the U.S. financial industry from the beginning to the 1970s, when financial product innovation and the resulting business and consumer financial choices exploded to create competition across financial services industries. The commercial banking industry and its limited product offerings on both sides of the balance sheet were the only choices available to the general public. This is because the commercial banks specialized in taking checking account deposits on the liability side and making commercial loans on the asset side. They relied for safety of their operations on maturity-based hedging of mostly short-term liabilities with short-term self-liquidating commercial loans assets. This also meant that households, farmers, students, and other groups did not have access to financial capital.
Savings and loan associations, mutual savings banks and credit unions, and money market mutual funds are other deposit-taking institutions. Savings and loan associations take savings deposits and primarily make mortgage loans throughout the country. They have provided funds to create millions of housing units in the county. Their key function is maturity intermediation when they accept short-term deposit and make long-term mortgage loans. Mutual savings banks exist mainly in the eastern part of the United States. Like savings and loan associations, they, too, accept short-maturity deposits and make long-term mortgage loans. They also issue consumer and other loans, making then some what more diversified and therefore less risky in terms of loan defaults. Credit unions specialize in member savings and loans, although they also make mortgage-type loans and other investments similar to other deposit-taking institutions.
FINANCE AND INSURANCE INSTITUTIONS
Finance (credit) companies are different from deposit-taking banking institutions in that their sources of funds are not deposits. They acquire funds in the market by issuing their own obligations, such as notes and bonds. They, however, make loans on the other side of the balance sheet in full competition with deposit-taking and other types of financial institutions, such as insurance companies. Finance companies specialize in business inventory financing, although they also make consumer loans, mostly indirectly through manufacturers and distributors of goods and ser vices. Some of the finance companies are huge and operate in domestic as well as foreign markets. Several are bigger than most of the commercial banks in the United States.
Insurance companies provide the dual ser vices of insurance protection and investment. There are two types of insurance companies: life insurance companies and casualty and property insurance companies. Insurance companies' sources of funds are primarily policy premiums. Their uses of funds range from loans (thus competing with finance companies, commercial banks, and savings and loan associations) to creation of investment products (thus competing with investment companies). Life insurance companies match their certain mortality-based needs for cash outflows with longer-term riskier investments such as stocks and bonds. Casualty and property insurance companies have more uncertainty of cash outflows and their timing. Therefore they have more conservative investment policies in terms of maturity and credit risk of their investments.
INVESTMENT, PENSION, AND RISK MANAGEMENT
Investment companies pool together funds and invest in the market to achieve goals set for various types of investments, matching liquidity, maturity, return, risk, tax, and other preferences of investors on the one hand and users of funds on the other. Investment companies are organized as open-end or closed-end mutual funds. Open-end funds accept new investments and redeem old ones, while closed-end funds accept funds at one time and then do not take in new funds. Investment companies have become very popular with investors in recent decades, and thus they have mobilized trillions of dollars.
Another investment type of company is investment banks, which provide investment and fund-raising advice to potential users of funds, such as commercial, industrial, and financial companies. They also create venture capital funds or companies. Some of them also have brokerage and dealerships in securities. Many of them underwrite securities and then place them in the market or sell them to investors.
Pension funds in the private and the government sectors collect pension contributions and invest them according to goals of the employees for their funds. Increasingly, employees are able to indicate their personal preferences for risk and reward targets with respect to their own and sometimes their employers' contributions.
Other institutions that are significant parts of the financial system are the stock, bond, commodity, currency, futures, and options exchanges. The various types of exchanges make possible not only creation and ownership of financial claims but also management of liquidity and risk of price changes and other risks in underlying commodities in the market. They greatly expand investment opportunities for savers and access to funds by small, medium, and large business enterprises. They have deepened and broadened markets in financial products and services, helped manage price risk, and improved allocation efficiency in financial markets where every attribute desired in a financial product has a counter party to trade with. The banking and investment intermediaries have extended their services to the global saver-investor with the cross-border flow of funds and trading of financial products facilitated by cross-border investing, listing, and trading of securities in home and foreign markets in home and foreign currencies.
HISTORICAL DEVELOPMENT OF THE U.S. FINANCIAL SYSTEM
Specialization and division of labor, identified as sources of creativity and efficiency by Adam Smith, led to the creation of other specialized deposit-taking and investment-type financial institutions that began to meet the demand not fulfilled by the commercial banking industry. Similar institutions were created to finance agriculture and housing in rural areas, public works, and education. Laws and regulations recognized and strengthened the separation, and thus specialization, of the financial function different intermediaries performed in the financial system.
The system was further strengthened by establishing government and semi-government intermediaries to increase liquidity in the market, manage maturity risk, and broaden the sharing of the market (price) risk through secondary markets for mortgages, agency (government and sponsored) securities, and other asset-based securities. Examples of institutions are: Commodity Credit Corporation, Farm Credit Banks, Farm Credit Financing Assistance Corporation, Farmers Home Administration, Federal Home Loan Mortgage Corporation (FEDMAC), Federal Financing Corporation, Federal National Mortgage Association (FNMA), Federal Housing Administration (FHA), Federal Home Loan Banks, Government National Mortgage Association (GNMA), Resolution Funding Corporation, Small Business Administration, and Student Loan Marketing Association (SLMA).
THE MONETARY SYSTEM
The U.S. monetary system is based on credit. The U.S. currency is issued by its central bank, the Federal Reserve System, as a liability on itself. The value of the currency is based on its purchasing power in the economy and around the world and has not been linked to or defined in terms of any particular commodity or an index since 1968. The issuance of currency was tied to the U.S. gold holdings prior to 1968. The U.S. money supply consists of currency and coins and checkable public deposits in the banking system. The measures of money are M1, M2, M3, and L.
The Federal Reserve System, created in 1913, was established to furnish elastic currency to the economy and to supervise the banking system. Prior to 1913 there had been financial crises that were due to absence of a systematic way to provide money and credit in the economy. There had also been large bank failures due to fraud and mismanagement, as well as economic fluctuations and boom and bust in commodity prices.
The Federal Reserve System consists of the Board of Governors of the Federal Reserve and the twelve regional or district Federal Reserve banks. The Board of Governors in Washington is the central decision point organization in a decentralized system. The board has seven members who are nominated by the president and confirmed by the Senate. Each board member has a fourteen-year appointment so as to make the board immune from political influence of any administration in office. The board is set up as an independent agency; it does not report to the president, but it does report to Congress. However, it actively coordinates its research and analysis with the White House and the Treasury Secretary in formulating policy. The regional Federal Reserve banks' Board of Directors is also structured to represent banking, industry and commerce, and the general public. There is a formal statutory requirement to have three directors from the three groups in the area on the board.
The monetary policy-making body within the Federal Reserve is the Federal Open Market Committee (FOMC), which meets regularly (generally eight times a year). Its voting members are the seven governors of the Board of Governors and five presidents of the regional banks. The president of the Federal Reserve Bank of New York is a permanent member of FOMC, and the other four serve on annual rotation from among four groups formed from the remaining eleven regional banks. The regional banks are located in Boston, New York, Philadelphia, Richmond, Atlanta, Cleveland, Chicago, Dallas, St. Louis, Kansas City, Minneapolis, and San Francisco. These cities were chosen because they represented the hub of the regional economy of each area of the United States in 1913. It was thought at the time that the regional economies had different characteristics in terms of the type and level of economic activity, so they needed different accommodation with respect to supply of money and finance, rediscounting mechanisms, and interest rates. In other words, it was thought that there were twelve different money markets in the U.S. economy, so each one needed special attention for its needs. This structure of the Federal Reserve System continues to this day, but the money market has become one market due to institutional and technological advancements. Now there are truly national financial institutions, not just in terms of their national charter, with interstate deposit taking and lending of commercial and numerous other types of loans to businesses and households.
The Federal Reserve policy serves the needs of the entire economy and all its parts by taking into account economic and financial information concerning all economic segments and activities in the U.S. economy. There are many advisory committees, such as the Federal Advisory Committee representing the interests of the banking industry, the Consumer Advisory Committee representing consumer interests, and similar other committees representing interests of other segments to the Federal Reserve System. Legislative, regulatory, monetary policy, and day-to-day operations of the central bank consider relevant details in their deliberations and policy decisions, including research from a wide variety of sources, private and public, about the economy.
LEGAL AND REGULATORY STRUCTURE
The key laws governing the U.S. financial institutions are: National Bank Act of 1863; Federal Reserve Act of 1913; McFadden Act of 1927; Banking Act (Glass-Steagall) of 1933 and 1935; Securities Act of 1933; Securities Exchange Act of 1934; Federal Credit Union Act of 1934; Investment Advisors Act of 1940; Investment Company Act of 1940; Bank Holding Company Act of 1956 and Douglas Amendment of 1970; Bank Merger Act of 1966; Employment Retirement Income Security Act of 1974; Depository Institutions Deregulation and Monetary Control Act of 1980; Depository Institutions (Garn-St. Germain) Act of 1982; Competitive Equality in Banking Act of 1987; Financial Institutions Reform, Recovery, and Enforcement Act of 1989; Federal Deposit Insurance Corporation Improvement Act of 1991; Interstate Banking and Branching Efficiency Act of 1994; and Financial Modernization Act of 1999.
The federal agencies that regulate depository institutions are: Office of the Comptroller of the Currency, Federal Reserve System, Federal Deposit Insurance System, National Credit Union Administration, and Office of Thrift Supervision. The Securities and Exchange Commission, Commodity Futures Trading Commission, and the Justice Department monitor and enforce relevant laws and regulations concerning securities and futures markets. State authorities regulate, monitor, and enforce laws concerning depository, insurance, finance companies and other financial institutions. The laws and regulations on financial institutions in the United States have made them competitive, efficient, fair, safe and sound, and transparent with the use of both carrots and sticks.
FINANCIAL SERVICES MODERNIZATION ACT 1999
The U.S. financial system in the twenty-first century has evolved into the largest, most developed, most efficient, and most sophisticated financial system in the world. The financial system has grown enormously since the founding of the first insurance company by Benjamin Franklin, as Philadelphia Contributionship, in 1752. The first banks in the United States were the Bank of New York, founded by Alexander Hamilton in 1784; Bank of Boston, also founded in 1784; and the First Bank of the United States, chartered in 1791. The economic structures and forces that have made this success possible are the concepts (or the foundation stones) of competition, specialization, thrift, entrepreneurial zest, and innovation. These concepts were just as well understood and vigorously practiced in the American colonies as they were expounded on by Adam Smith in Scotland in 1776 in An Inquiry into the Nature and Causes of the Wealth of Nations, his synthesis of a competitive market system. The United States has structured its economic and financial systems on Smith's economic model since its founding in 1776.
Some of the key concepts that have been the foundation stones of this financial architecture are: competition, efficiency, entrepreneurial culture, financial capital, innovation, regulation/deregulation/liberalization, reform, risk management, savings, specialization, and thrift.
The Financial Services Modernization Act, signed into law by the president on October 12, 1999, removes many of the restrictions on the banking and securities institutions imposed in the 1920s and 1930s. For example, financial conglomerates will again be able to organize commercial banking, insurance business, investment banking, securities underwriting, and other financial services under the umbrella of a holding/parent company. The McFadden Act and the Glass-Steagall Act are now in the history books. Financial innovation made possible by computer and communications technologies and spawned by competition and deregulation has brought U.S. financial institutions and the entire financial system to the exciting financial structure of the twenty-first century.
Blackwell, David W., Kidwell, D., and Peterson, R. L. (2000). Financial Institutions, Markets, and Money, 7th ed. Fort Worth, TX: Dryden Press, Harcourt College Publishers.
Dymski, Gary A., Epstein, G., and Pollin, R. (1993). Transforming the U.S. Financial System: Equity and Efficiency for the 21st Century. Armonk, NY: M.E. Sharpe.
Federal Deposit Insurance Corporation, Division of Research and Statistics. (1998). Statistics on Banking: A Statistical Profile of the United States Banking Industry. Washington, DC: Federal Deposit Insurance Corporation.
Federal Reserve System. (1994). Purposes and Functions, 8th ed. Washington, DC: Board of Governors of the Federal Reserve System.
Hayes, III, Samuel L., ed. (1993). Financial Services: Perspectives and Challenges. Boston: Harvard Business School Press.
Kaufman, George G. (1995). The U.S. Financial Systems: Money, Markets and Institutions, 6th ed. Engelwood Cliffs, NJ: Prentice Hall.
Meerschwam, David M. (1991). Breaking Financial Boundaries: Global Capital, National Deregulation, and Financial Services Firms. Boston: Harvard Business School Press.
Financial Institutions (Encyclopedia of Business)
- DEPOSITORY INSTITUTIONS
- CONTRACTUAL SAVINGS INSTITUTIONS
- PRIVATE PENSION FUNDS AND GOVERNMENT RETIREMENT FUNDS
- FURTHER READING:
The financial market is composed of a number of financial institutions that perform a variety of functions. In most contexts, financial institutions can be considered synonymous with financial intermediaries in the financial markets. In a nutshell, financial intermediaries are the financial institutions that pool resources and channel funds from savers/lenders to spenders/borrowers. Smooth functioning of these institutions is very important for an efficient financial market and for the conduct of fiscal and monetary policies. Due to their crucial importance, almost all financial intermediaries are regulatedome are subjected to very tight regulations whereas others operate under less stringent regulations.
A large number of financial institutions serve as financial intermediaries. The essential economic function of the financial markets is to channel surplus funds from individuals who have saved from their incomes to individuals who want to finance consumption or businesses that need funds to finance capital investments. There are two ways in which funds are channeled from savers/lenders to spenders/borrowers. The first is called direct finance. In direct finance, lenders lend to borrowers directly. A saver, for example, has $10,000 saved and buys a $10,000 General Motors (GM) bond maturing in ten years, paying an interest rate of 9.5 percent per annumn this transaction, the saver has essentially directly lent $10,000 to General Motors for ten years. The second way in which funds are channeled is called indirect finance. It is in indirect finance that financial institutions called financial intermediaries are involved. In this case, a financial intermediary stands between savers/lenders and spenders/borrowerst obtains surplus funds from savers and lends them to borrowers of its choice. A commercial bank is a common example of a financial intermediary commercial bank receives savings and checking deposits from individuals, and uses them, for instance, to make mortgage loans.
There are a large number of financial institutions that serve as financial intermediaries. According to Frederic Mishkin, the author of The Economics of Money, Banking and Financial Markets, financial intermediaries themselves are subdivided into three broad categories: (1) depository institutions (commonly referred to as banks); (2) contractual savings institutions; and (3) investment intermediaries. The division of financial intermediaries into these three groups is based on the primary sources of funds and how they use these funds. Based on Mishkin's book, each of these three categories and the financial institutions that fall under these categories are briefly discussed below.
Depository institutions are generally referred to as banks. The term "depository institution" originates from the fact that a banking-type financial intermediary accepts deposits from individuals and businesses, and makes loans. Depository institutions are made up of four kinds of banking institutions: commercial banks, savings and loan associations, credit unions, and mutual savings banks. The key characteristics of these four kinds of banking institutions are briefly described in what follows.
Commercial banks are financial intermediaries that raise funds primarily by issuing (1) demand and other checkable deposits (deposits by businesses or individuals on which checks can be written to make payments); (2) savings account deposits (they carry interest payments, but can not be used to write checks on and are usually maintained by households and individuals); and (3) certificates of deposit (CDs) or time deposits (they earn interest and have fixed terms to maturity and are opened by both individuals and businesses). Commercial banks use the resources so raised (within limitations imposed by the nation's central bank, the Federal Reserve Bank) to make loans to consumers (for instance, to buy durable goods, such as automobiles), to businesses (for example, to invest in a plant expansion), and to home buyers (mortgage loans). They also investment funds in U.S. Treasury bonds and in state and local government bonds (municipal bonds). Commercial banks are like other businesseshey profit from the difference between the reward for lending and the cost of borrowing.
There are approximately 10,000 commercial banks in the United States, a number that is much larger than in most other industrialized countries. As a group, they are the largest financial intermediary in the United States. Most of them, however, are very smalllmost 67 percent of commercial banks in the United States have assets of less than 100 million dollars, and another 26 percent of them have assets between 100 and 500 million dollars. Only a little over 4 percent of the banks have assets over one billion dollars. Despite the large number of banks in the U.S. banking industry, larger banks do hold a giant share of the industry assets. In 1995, the top 4.3 percent of banks (with assets of $1 billion or more) hold nearly 53 percent of all bank assets.
In most other industrialized countries, there are far fewer banksypically, five or fewer banks dominate the banking industry. The latter is true for countries such as Great Britain or Canada, where a small group of commercial banks accounts for most of the banking business. By contrast, in the United States, the ten-largest banks together hold only about one third of the industry assets. This characteristic of the banking industry sets it apart from other industries in the United States. The automobile industry in the United States, for example, is dominated by only three firms. Almost the same is true for mainframe computers. Does this mean that the U.S. banking industry is more competitive than, for instance, the auto industry? Surprisingly, this is not the case. The answer lies in the banking regulation embodied in the McFadden Act of 1927, which had effectively prohibited branching across state lines. Fortunately, effective I June 1997, this Act was overturned by the passage of Riegle-Neal Banking Act in 1994.
Commercial banks are very heavily regulated. They are often subject to multiple layers of regulation. They are either chartered by states or the federal government (the U.S. Department of Treasury), and they are thus regulated by the chartering institution. Many commercial banks are members of the Federal Reserve System and are regulated by the Federal Reserve. In addition, as most commercial banks buy deposit insurance (in which an account with a bank is insured up to $100,000) from the Federal Deposit Insurance Corporation (FDIC), they are also regulated by this agency. Nevertheless, the U.S. banking industry is undergoing a period of rapid transformation with the passage of deregulation legislation in the mid-1990s.
SAVINGS AND LOAN ASSOCIATIONS (S&LS).
Except for some minor differences, savings and loan associations (S&Ls) look like commercial banks. The main difference lies in the way S&Ls obtain funds and use these funds to make loans. Like commercial banks, they also obtain funds by issuing checkable deposits, savings account deposits, and time deposits. Traditionally, however, savings deposits have played a greater role for savings and loan associations. The funds obtained through different kinds of deposits have traditionally been used to make mortgage loansn contrast, business and consumer loans dominate commercial banks' loan portfolios. Also, there are some subtle differences between commercial banks and savings and loan associations. For example, savings deposits issued by S&Ls are often called shares.
Until 1980 government regulations did not allow savings and loan associations to establish checking accounts. They were also restricted to making mortgage loans. The S&Ls were allowed, however, to pay somewhat higher interest rates (compared to commercial banks) on savings deposits, so as to attract funds that could be used to make mortgage loans. This arrangement landed savings and loan associations in deep trouble. During the 1950s and early 1960s, interest rates were relatively low and S&Ls grew faster than commercial bankshey had a comfortable margin between the cost of their funds and the interest they received on mortgage loans. Interest rates, however, rose quite sharply from the late 1960s to the early 1980s. The high interest rate of these years meant that the S&Ls were raising funds at higher costs. Many of their mortgage loans, however, were made years before at very low interest rates, and these were long-term fixed-rate mortgages, with maturity exceeding over 25 years. As a result, savings and loan associations' incomes from mortgages fell short of the cost of acquiring new funds, a phenomenon known as the profit squeeze. Partly due to this reason, many savings and loans suffered large losses and had to go out of business.
Through the Banking Deregulation Act passed in 1980, restrictions on savings and loan associations' activities have been substantially eased. They were allowed to issue checkable deposits, make consumer loans, and to participate in other activities that were hitherto restricted to commercial banks. Through the 1980 act, however, S&Ls were also made subject of the same Reserve requirements that are applied to commercial banks. As the result, the distinction between commercial banks and savings and loan associations has been blurred. More and more, these two kinds of depository institutions look alike and behave in a similar fashion. To many people, it may make virtually no difference whether they bank with savings and loan associations or commercial banks.
Similar to commercial banks, savings and loan associations are also subject to multiple layers of government regulation. Federally chartered savings and loan associations are regulated by the Office of Thrift Supervision (OTS), a bureau within the federal Treasury. Federal deposit insurance for S&Ls is provided by the Savings Association Insurance Fund (SAIF), a subsidiary of the Federal Deposit Insurance Corporation.
Credit unions are also depository institutions, but they are structured as cooperative lending institutionshey are organized around a particular group, such as employees of a company or an institution, members of a labor union, or members of a particular branch of armed forces. Credit unions, like commercial banks and savings and loan associations, acquire funds by issuing different kinds of deposits (often called shares) and primarily make consumer loans. The 1980 Banking Deregulation Act also eased restrictions on credit unionshis act allowed them to issue checkable deposits, as well as to make mortgage loans in addition consumer loans. For all practical purposes, members of a credit union can consider it as a bank. Membership in the credit union is not, however, as open as commercial banksne must belong to the particular group, in some way, to qualify for the membership of the relevant credit union.
There are large number of credit unions in the United States, about 13,000. As a group, in terms of sheer numbers, they are larger than commercial banks. Most credit unions, however, are quite small and have assets of less than $10 million. As credit unions are intimately tied to a particular group (a company, an institution, or an industry), they lack the diversification of a commercial bank, making them vulnerable. If a large number of workers in an industry are laid off and thus have trouble making loan payments, this can easily endanger the credit union in that industry. Recent regulatory changes have attempted to reduce this risk of credit union failures by allowing them to cater to a more diverse group of individuals. This has induced an increase in the size of credit unions.
Like commercial banks, and savings and loan associations, deposits up to $100,000 (on a per-account basis) are insured, and they are subject to regulations. Credit unions are chartered either by state banking authorities or the federal government. Nearly half of all credit unions are federally chartered. Charters are issued by a federal agency known as the National Credit Union Administration (NCUA), which regulates federally chartered credit unions through establishment of minimum capital requirements, periodic examinations of credit unions' books, and the requirement that these institutions submit periodic reports on their activities. Federal deposit insurance is provided by a subsidiary of the NCUA called the National Credit Union Share Insurance Fund (NCUSIF). NCUSIF provides insurance both to federally chartered and state-chartered credit unions. When a state-chartered credit union buys insurance from the NCUSIF, it becomes subject to regulation by the NCUSIF, in addition to the regulation by the relevant state banking authority. Similar to commercial banks, this leads to multiple layers of regulations.
The interstate branching laws do not apply to federally chartered credit unions. A federally chartered credit union can open branches wherever its members are. In some cases, it literally leads to a worldwide branching. Members of the U.S. Navy and Marine Corps belong to the Navy Federal Credit Union. As these servicepersons are also stationed at locations outside the United States, the Navy Federal Credit Union has branches across the world.
Credit unions have not faced the problems that rocked the savings and loan industry. This is because most of the loans made by credit unions are to consumers, and consumer loans have much shorter maturity periods than mortgage loans (the primary assets of savings and loan associations).
MUTUAL SAVINGS BANKS.
Mutual savings banks are the smallest group of financial intermediaries among depository institutions. They are quite similar to savings and loan associations. Also, one can consider them as hybrid between a savings and loan and a credit union. Like savings and loan associations, they acquire funds by issuing different kinds of deposits and make, primarily, mortgage loans. Like credit unions, however, they are organized as cooperatives, known as mutuals, in which depositors own the bank.
Like savings and loan associations, mutual savings banks were restricted to making mortgage loans until the restrictions were relaxed by the 1980 banking act. As a result, mutual savings banks also experienced profit squeeze from the late 1960s to the early 1980s. They can now issue checking deposits and make consumer and other loans, in addition to making mortgage loans.
There are only about 500 mutual savings banks in the United States, and most of them are concentrated in New York State and New England. They can also be chartered either by states or the federal government. Nearly half of mutual savings banks are chartered by the states. A majority of them have deposit insurance from the Federal Deposit Insurance Corporation (FDIC). As in case of other categories of depository institutions, each account is insured up to $100,000. Because of buying the deposit insurance from the FDIC, most mutual funds are also subject to regulations by the FDIC.
THE BLURRING OF DISTINCTIONS AMONG DEPOSITORY INSTITUTIONS
Two actshe Depository Institutions Deregulation and Monetary Control Act of 1980, and the Gamn-St. Germain Depository Institutions Act of 1982lurred the distinction among the four kinds of depository institutions discussed above. These acts expanded the ability of noncommercial banks to participate in activities from which they were hitherto barred. For example, all four kinds of depository institutions were allowed to issue checking accounts.
There is one area of regulation, branching regulations, where the old restrictions imposed by the McFadden Act of 1927 (prohibition against branching across state lines) are still in place. Due to the McFadden Act, there are a large number of commercial banks in the United States. Crises in the savings and loan industry during the 1980s induced some banks tob purchase failed savings and loan associations spread over several states, effectively implying branching across states in these instances. Technological changes (especially the widespread use of automated teller machines, ATMs) and the use of "holding companies" (where a holding company owns banks in different states) have dealt a further blow to branching restrictions imposed by the 1927 act. There was a widespread belief that the Mcfadden Act had long become obsolete. Congress finally removed the restrictions against branching across state lines in 1994.
CONTRACTUAL SAVINGS INSTITUTIONS
Contractual savings institutions are financial intermediaries that acquire funds periodically on a contractual basis and invest them (lend them out) in such a way that they have financial instruments maturing when contractual obligations have to be met. In general, they can predict their liabilities fairly accurately, and thus they (unlike depository institutions) do not have to worry as much about losing funds. As a result, they mainly invest resources in longer term securities, such as, corporate stocks and bonds, and mortgages. Three major categories of contractual savings institutionsife insurance companies, fire and casualty insurance companies, and pension funds and government retirement fundsre briefly discussed below.
LIFE INSURANCE COMPANIES.
Life insurance companies sell life insurance policies that protect the beneficiaries of a policyholder against financial hazards that follow the death of the insured person. Life insurance companies also sell annuities in which an insurance company contracts to make annual income payments to the annuity buyer upon his or her retirement. These insurance companies acquire funds through payments of premiums by individuals who pay to keep their policies in force. Life insurance companies can calculate liabilities with a fair degree of accuracy using mortality tables. As a result, they use funds to buy longer term securitiesrimarily corporate bonds and mortgages. While corporate stocks are also long-term securities, life insurance companies are restricted in the amount of stocks they can hold. This government restriction is based on the perception that stocks are risky, and they may thus jeopardize the insurance companies' ability to meet liabilities. With about $2 trillion in assets, life insurance companies are the largest segment among contractual savings institutions.
FIRE AND CASUALTY INSURANCE COMPANIES
Fire and casualty insurance companies (also called property and casualty insurance companies) are in the insurance business like the life insurance companies. They insure policyholders against the risk of loss from a variety of contingencies, such as fire, flood, theft, or accidents. An individual buys car or home insurance, for example, from a property and casualty insurance company. Like life insurance companies, fire and casualty insurance companies acquire funds through payments of insurance premiums from policyholders. Unlike life insurance companies, however, the property and casualty insurance companies are subject to greater uncertainty with respect to their liabilitieshere is no way to pinpoint as to when major disasters may happen. Two major hurricanes, Hugo in 1989 and Andrew in 1992, hit U.S. states, which multiplied the claim payments by the property and casualty insurance companies to policyholders manifold. Due to this kind of uncertainty, these insurance companies buy more liquid assets (shorter-term securities) than life insurance companies. Municipal bonds constitute the largest fraction of total assets. They also, however, invest in corporate stocks and bonds, and Treasury securities.
PRIVATE PENSION FUNDS AND GOVERNMENT RETIREMENT FUNDS
Private pension funds and government retirement funds receive periodic payments of contributions from employers and/or employees that participate in the program. Employee contributions are either automatically deducted from pay or made voluntarily. The pension and retirement funds' liability is to provide retirement income, generally in the form of annuities, to individuals covered by these pension plans. As the liabilities of private pension and government retirement funds are fairly certain with respect to timing and are of a long-term nature, they invest resources in long-term financial instruments, such as corporate stocks and bonds.
The federal government has encouraged growth in pension funds through legislative actions that mandate establishment of pension plans, as well as through tax incentives to individuals that lower their costs of contributing to the pension plans. The federal 403(b) provision is an example of the federal tax incentive.
Most, though not all, investment intermediaries facilitate investments in financial assets by individuals and institutions by pooling resources and investing them according to stipulated objectives. The financial intermediaries included under this category are: mutual funds, money market mutual funds, and finance companies.
Mutual funds are financial intermediaries that raise funds through sale of shares to many individuals and institutions, and pool these to buy a diversified portfolio of stocks, bonds, or a combination of stocks and bonds. The number of mutual funds in the United States has grown rapidly. Now, there are more mutual funds than the number of stocks on the New York Stock Exchange. With the growth in the mutual fund industry, characteristics of mutual funds have also undergone changes. At the present time, a specific mutual fund is organized around an investment philosophy. In selling shares to perspective participants, the mutual fund is expected to state its investment philosophy, and follow it (generally) in investing pooled resources. A mutual fund, for example, may be a broadly diversified stock fund that picks stocks from among all available domestic stocks. A stock fund may also, however, concentrate on a narrow range of stocks, such as small capitalization stocks, over-the-counter stocks, blue-chip stocks, depressed stocks, stocks that pay high dividends, or stocks of a particular sector of the economy. Thus, one must carefully interpret a mutual fund's investment into a diversified portfolio of, for instance, stockshe diversified investment is subject to the investment philosophy of the relevant mutual fund. Also, different investment philosophies and levels of diversification carry different levels of investment risk. Even when a mutual fund specifies an investment philosophy, it may not be fully investedt may keep, for example, some cash on hand for investment opportunities that may open in the future or to meet redemptions.
Similar to stock mutual funds, there are bond mutual funds. Once again, a bond mutual fund follows an investment philosophyt may invest its funds in, for example, a diversified portfolio of bonds, in long-term Treasury bonds, higher-quality corporate bonds, lower-quality corporate bonds (the so-called junk bonds), or bonds of state and local governments (called municipal bonds or munis). Bond mutual funds are generally considered less risky than stock mutual funds. As mentioned earlier, some mutual funds also invest funds in a combination of stocks and bonds.
In general, mutual funds permit an individual to participate in a more diversified portfolio of financial instruments than would have been possible if the individual tried to make the investment on his or her ownhe use of a mutual fund reduces the transaction costs for the individual. In addition, as mutual funds are expected to be managed by experts, the individual participating in a mutual fund can expect better returns. In addition to these benefits, mutual funds provide liquidity to individuals participating in these fundshey can redeem or sell their shares at any time. The value of their shares, however, will depend on the value of the mutual fund's portfolio (which, in turn, will depend on the conditions in the markets for the securities in which the mutual fund is invested). This obviously implies that an individual is not guaranteed to receive the principal amount back. Also, mutual fund shares, unlike deposits at a depository institution, are not insured by a federal agency.
MONEY MARKET MUTUAL FUNDS.
Money market mutual funds are like ordinary mutual funds with some added characteristics. The most important difference between mutual funds and money market mutual funds is that the latter invest in money market financial instruments (securities that have maturities of less than a year). Because of the kind of securities they invest in, assets of a money market fund are considered very liquid and are unlikely to generate losses to those that participate in these funds. Shareholders in a money market mutual fund receive investment income based on the earnings of the security holdings of the fund. A key characteristic of a money market mutual fund is that participants in these funds have limited check-writing privileges on their shareholdingsrequently, checks cannot be written for less than $500.
Finance companies acquire funds by issuing commercial papers (short-term corporate debt instruments), stocks, and bonds. They use these funds to make loans to consumers to finance home improvements or to purchase a consumer durable (such as cars or furniture), and to small businesses for various purposes. Sometimes, a finance company helps to sell a particular product. GMAC or Ford Motor Credit company are examples of finance companies that perform such a function.
SEE ALSO: Banks and Banking
[Anandi P. Sahu, Ph.D.]