What is Financial Institutions? Components, Classification, Role in Economic Development

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What is Financial Institutions?

Financial institutions are companies that offer a variety of financial services to their clients. They take the money that customers give them and lend it to people and businesses that require it. In this way, they act as a bridge between savers and spenders to make financial transactions easier. These companies, for example, enable borrowers to get loans using the funds that savers have deposited in it.

Financial institutions also assist customers in raising finance and investing their funds. This involves making it easier to acquire and sell securities such as bonds and stocks. Along with helping consumers manage their money, certain financial organisations also aid them in protecting their assets.

A financial institution is a business that engages in a wide range of monetary operations such as cash deposits, loans, stock exchanges and raising capital. It acts as a middleman between those who want to deposit or invest money and those who need to take credit or raise funds. Financial institutions are commercial companies that function as middlemen in many forms of financial monetary dealings.

A financial institution serves as a conduit between consumers and capital or debt markets, offering banking and investment services. A financial institution is in charge of providing money to the market by transferring funds from investors to businesses in the form of loans, deposits and investments. Large financial firms such as JP Morgan Chase, HSBC, Goldman Sachs and Morgan Stanley have the ability to influence the flow of money in a country’s economy.

Components of Indian Financial System

The financial system is made up of four key components. This includes the following:

Financial institutions

Financial institutions serve as a go-be- tween for the investor and the borrower. The financial markets are used to mobilise the investor’s funds, either directly or indi- rectly.

The main functions of the financial institutions are as follows:

  • It is possible to transform a short-term burden into a long-term investment.

  • It aids in the transformation of a hazardous investment into a risk-free one.

  • It also serves as a medium of convenience denomination, allowing a tiny deposit to be matched with big loans and a large deposit to be matched with little loans.

A bank is the greatest illustration of a financial institution. People who have extra money put it in savings accounts, while oth- ers who are short on cash take out loans. The bank serves as a link between the two.

Financial institutions are further classified into two categories:

  • Banking Institutions or Depository Institutions: This category comprises banks and credit unions that accept money from the public in exchange for interest on deposits and then lend it to those in need.

  • Non-Banking Institutions or Non-Depository Institutions: Insurance, mutual funds and brokerage firms are examples of non-banking institutions or non-depository institutions. They are unable to request monetary deposits, but they can market financial goods to their clients.

Financial Institutions are further divided into three categories:

  • Regulatory: Financial market regulators such as the RBI, IRDA and SEBI, among others. ‰ Intermediates: SBI, BOB, PNB and other commercial banks that give loans and other financial assistance are examples of intermediates.

  • Non-Intermediates: Institutions that give financial assistance to corporate customers are known as non-intermediaries. NABARD, SIBDI and other organisations are included.

Financial Assets

Financial assets are the items that are exchanged on the financial markets. The securities in the market differ from one another based on the distinct criteria and demands of the loan applicant. The following are some major financial assets that have been briefly discussed:

  • Call Money: Call money is a term used to describe a loan that is given for one day and then repaid the next day. This type of transaction does not necessitate the use of collateral securities.

  • Notice money: Notice money is a term used to describe a loan that is provided for more than a day but less than 14 days. This type of transaction does not necessitate the use of collateral securities.

  • Term money: Term money refers to a deposit that has a maturity time longer than 14 days.

  • Treasury bills: Treasury Bills, or T-Bills, are short-term government bonds or debt instruments that mature in less than a year. Purchasing a T-Bill entails making a loan to the government.

  • Certificate of deposits: Certificates of Deposits (CDs) are a dematerialised (electronic) form for cash placed in a bank for a certain length of time.

  • Commercial paper: Commercial paper is a type of unsecured short-term financial instrument issued by businesses.

Financial services

Asset management and liability management firms provide services. They assist in obtaining the necessary cash as well as ensuring that they are invested effectively.

The financial services in India include:

  • Banking services: Any little or large service given by banks, such as lending money, depositing money, providing debit/ credit cards, opening accounts and so on.

  • Insurance services: Insurance services include services such as issuing insurance, selling policies, insurance undertakings and brokerages among others.

  • Investment services: Asset management is a common example of investment services.

  • Foreign exchange services: Foreign exchange services include currency exchange, foreign exchange and so on.

The primary goal of financial services is to aid people in selling, borrowing and acquiring assets, as well as permitting payments and settlements, lending and investing.

Financial markets

A financial market is a marketplace where buyers and sellers engage and trade money, bonds, stocks and other assets.

The financial market can be further divided into four types:

  • Capital market: The capital market, which is designed to finance long-term investments, deals with transactions that take place in the market for more than a year. The capital market may be further broken down into three categories:
    • Corporate Securities Market
    • Government Securities Market
    • Loan Market

  • Money Market: The market is mostly dominated by the government, banks and other large institutions and it is only permitted for short-term investments. It is a wholesale debt market that specialises on low-risk, high-liquid securities.

    The money market is broken further into two types:
    • Organised Money Market
    • Unorganised Money Market

  • Foreign Exchange Market: The foreign exchange market, one of the most established marketplaces in the world, deals with multi-currency requirements. In this market, monies are transferred based on the foreign exchange rate.

  • Credit Market: The Credit Market is a market where short-term and long-term loans are issued to individuals or organisations by various banks, financial institutions and non-financial institutions.

Classification of Financial Institutions

In the financial market for capital flows, there are many distinct sorts of financial bodies. These are categorised mostly according to the kinds of transactions they undertake, with a few of them being involved in depositary transactions. Others, on the other hand, are involved in non-depositary dealings.

Let us discuss the classification of financial institutions in detail.

Commercial Banks

Banking, as every other business, is a busi- ness. Profits are the reason that banks and other financial entities exist. A commercial bank is a pretty straightforward business. Its main goal is to deliver specific services to clients in exchange for payment.

These banks offer a comprehensive variety of banking services, including savings and current accounts, as well as loans for various types of businesses. Commercial banks are generally geared to provide long-term or capital funding, as well as to finance the production, distribution and sale of goods (as the State Bank of India is doing with its capital market business).

Because of the diversification of commercial banks into various operations other than commercial lending, such as consumer banking, mortgage banking, commercial sales financing, international banking and many other functions, the term full-service banking has become a more appropriate term in recent years.

Mutual Funds

These are investment companies that issue and sell redeemable securities that represent an undivided interest in the funds’ assets, also known as management companies or unit investment trusts, they pool the resources of many investors to provide diversification and professional management.

Investment Banks

Investment banks are regulated by the Securities and Exchange Board of India (SEBI) and participate in banking operations such as securities underwriting, develop- ing a market in securities and arranging mergers, acquisitions and restructuring.

Credit Unions

Credit unions are non-profit cooperative societies created by people who are linked by a common bond such as a shared employer or labor union. Members of a credit union typically hold each other’s savings accounts and have access to the combined savings of all members.

Central Bank

A financial organisation with exclusive authority over the creation and distribution of money and credit for a country or a group of countries is known as the central bank. In contemporary economies, the central bank is typically in charge of monetary policy formulation and member bank regulation. Inherently non-market-based or even anti-competitive entities are central banks. Many central banks, despite the fact that some have been nationalised, are not part of the government and are thus frequently hailed as being politically independent.

However, even though a central bank isn’t technically the government’s property, its rights are still created and safeguarded by the law. The crucial characteristic that sets a central bank apart from other banks is its legal monopoly position, which grants it the right to print money and bank notes. Only demand liabilities, like checking deposits, may be issued by private commercial banks.

Non-Banking Institutions

Financial institutions that provide a range of banking services without a banking license are referred to as non-banking financial businesses (NBFCs), often known as non-banking financial institutions (NBFIs). Typically, the public’s easily accessible monies, including those in checking or savings accounts, cannot be accepted as demand deposits by these organisations. This restriction keeps them out of the purview of traditional federal and state financial regulatory scrutiny.

Non-banking Financial Companies are deemed to be “predominantly engaged in a financial activity” by the Dodd-Frank Wall Street Reform and Consumer Protection Act when more than 85% of their consolidated yearly gross revenues or consolidated assets are of a financial character. Investment banks, mortgage lenders, money market funds, insurance firms, hedge funds, pri- vate equity funds, and peer-to-peer lenders are a few examples of NBFCs.

Insurance Company

A firm whose major and dominating commercial activity throughout the tax year is the issuance of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies is referred to as an insurance company.

The nature of the business actually conducted during the tax year determines whether a company is taxable as an insurance company under the Internal Revenue Code, even though a company’s name, charter powers, and compliance with state insurance laws are important factors in determining the business that a company is authorised to conduct and intends to do.

Role of Financial Institutions in Economic Development

The principal function of financial institutions is to supply liquidity in the economic sector of the country allowing for greater economic activity. Banks are able to achieve this in three ways: by providing credit, controlling markets and pooling risk among consumers.

Every economy relies heavily on financial institutions. For banking and non-banking financial institutions, they are governed by a central government entity. Furthermore, these institutions aid in the transition from net savers to net borrowers by bridging the gap between idle savings and investment and their borrowers.

The following points explain the role of financial institutions in economic development:

Regulation of monetary supply

To preserve stability and prevent inflation, financial institutions such as the Central Bank assist regulate the money supply in the economy. The Central Bank, for example, regulates liquidity in the economy through changing the repo rate, cash reserve ratio and open market activities, which include buying and selling government assets.

Banking services

Savings and deposit services are provided by financial organisations such as commercial banks to their consumers. Customers can also take use of credit services such as overdrafts to meet their short-term financial needs. Commercial banks offer a variety of loans to its customers, including personal loans, student loans, mortgages and house loans.

Insurance services

Financial institutions, such as insurance firms, assist in mobilising funds and directing them toward productive endeavors. In exchange, they guarantee investors’ lives or a specific asset in the event of a disaster. In other words, they take on the risk of their customer’s loss.

Capital formation

Financial institutions aid capital formation, or the expansion of capital stock such as plant, machinery, tools and equipment, buildings, transportation and communication. Furthermore, they use a variety of monetary services to channel idle money from individuals in the economy to investors.

Investment advice

Individuals and corporations have a variety of investing alternatives at their disposal. However, in today’s fast-changing climate, selecting the best solution is difficult. Almost every financial organisation (banking or non-banking) has an investment advising desk that assists consumers, investors and companies in choosing the best investment choice in the market based on their risk appetite and other considerations.

Brokerage services

These organisations give its investors access to a variety of investment possibilities, ranging from stock bonds (a typical investment option) to hedge funds and private equity investments (lesser-known alternative).

Pension fund services

Financial institutions assist individuals in planning their retirement through a variety of investment options. A pension fund is one such investing option. Employers, banks and other institutions make contributions to the investment pool and the person receives a lump payment or monthly income after retirement.

Trust fund services

Some financial institutions provide their clients trust fund services. They manage the client’s funds, invest them in the finest possible options and ensure that they are safe.

Financing the Small and Medium Scale Enterprises (MSMEs)

Financial institutions assist small and medium-sized businesses in their early stages of operation. They supply both long-term and short-term capital to these businesses. Short-term funds assist businesses meet their day-to-day working capital needs, while long-term funds help them form capital.

Act as a government agent for economic growth

On a national level, the government controls financial institutions. They work for the government and aid in the development of the country’s economy. For example, to assist a struggling industry, financial institutions might provide a selected credit line with reduced interest rates in accordance with government requirements, allowing the business to overcome its problems.

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