Financial institutions are the intermediaries through which capital from one group is funneled into another. These institutions take in money from individuals, companies, and governments in the form of savings. They redirect this incoming capital to other individuals, companies, and governments in the form of loans. Although financial institutions pay interest to the people that deposit their money with them, they eventually collect a far greater amount from the people they loan the money to (Gitman, 2009).
There are different kinds of financial institutions and their effect on individual decision-making varies. Most U.S. citizens maintain at least a checking account with a commercial bank. The fractional reserve banking system requires commercial banks to maintain a certain percentage of deposited funds on hand (Black, 2002). The rest of these funds may be issued to other bank customers in the form of loans. If a commercial bank needs to increase the amount of funds it holds in reserve, whether by government requirement or its own internal fiduciary requirement, it may encourage new customers to open checking accounts, or provide incentives for existing customers to increase their holds within their checking accounts. For example, if my bank decides it will wave all fees for checking accounts with a balance over $5,000, my inclination is to maintain that $5,000 balance in order to avoid service charges.
Another financial institution that can affect individual financial decision-making is life insurance companies. Some purveyors of variable universal life insurance offer discounts for policies with certain death benefits. In this real life example, it was more cost effective to purchase a $1 million variable life insurance policy and decrease the death benefit over time, than to begin with a $500,000 policy. In this case, the financial institution was setting parameters that directly influenced the financial decisions of individuals.
Financial institutions facilitate transactions between individuals, business, and governments in two primary ways. The first method was mentioned previously and deals with customer deposits and bank loans. Since bank loans are often much larger than the amount of any individual bank account, the commercial bank acts as an intermediary by collecting money from several depositors and transferring it to one debtor. In a similar but different method, life insurance companies and pension and mutual funds manage the money of a group of investors and use the money to purchase ownership in companies. This ownership takes capital from the investors and infuses it into the companies that sell the stock. The difference between the two methods is that investors are active participants in the capital transfer process. Bank depositors have no control over the loaning of their money, and receive no direct benefit from the interest generated by the loans.
When it comes to financial matters, individuals are generally net suppliers of capital. As a group, they save more money than they receive in loans. Businesses on the other hand, are the net demanders of capital. They save less money than they borrow (Gitman, 2009). In this function of lending and borrowing money, financial institutions play a similar role for both individuals and businesses. The requirements that businesses place on financial institutions is only different because businesses tend to be on the receiving end of funds instead of the depositing end. That being said, financial institutions are still an intermediary by which capital is transferred from one group to another.
Black, J. (2002). “fractional reserve banking“. A Dictionary of Economics. Retrieved November 24, 2008.
Gitman, L. J. (2009). Principles of managerial finance (12th ed.). Boston: Pearson.