Role(s) Financial Institutions Play in Financial Decision Making
As the manager at Abel Athletics, I have prepared the following paper to help me discuss the role of financial institutions with my staff during the coming weekly status meeting. The term ‘Financial Institution’ describes all types of institutions that in one way or the other handles funds as they move from savers to users of funds in the economy. These financial intermediaries form the physical structure of the financial market and comprise of commercial banks, insurance companies, and Stock brokerage firms, foreign exchange bureaus, hedging firms, stock exchange bourses and even the Federal Reserve Bank or central bank. (Petty et al 2009 pg 62)
Financial institutions provide five important services without which the economy which is comprised of individuals, businesses and the government would grind to a halt. These are: facilitation of trade, risk management, mobilization of resources corporate management, and capital allocation (Levin pg.5)
1. What role(s) do financial institutions play in the financial decision making of individuals? Use personal examples to explain.
To illustrate; I work for Abel Athletics who deposit my salary into a bank account. The bank keeps my money safe. I use a check, or credit card provided by the banks to withdraw cash which to make payments for my expenses. I save the surplus with the bank. My insurance company covers for my life, health as well as other assets. The Pension fund looks after my old age, and the capital market is there when I want to invest in stocks as well as speculate in day trading at the New York stock exchange.
It is easy for me to take mortgage for a home, as well as acquire expensive equipment and assets like cars. If I am short of cash I can get an overdraft from the bank which will see me through the end of the month.
2. How do financial institutions facilitate transactions between individuals, businesses, and governments?
Individuals work in firms. In return these businesses pay workers wages and other benefits like insurance and pension through financial institutions. Businesses source for capital from financial institutions in the form of loans and share capital. Cash inflows and outflows occurring during business operations are channeled through financial institutions.
The government collects taxes from citizens and businesses through financial institutions. When it spends on projects such as roads, hospitals and defense it disburses funds through financial intermediaries. The government also controls the quantity of money in circulation through either increasing or reducing the cash reserves banks hold with the federal bank.
3. Why are these roles necessary?
Without reliable means for conducting trade, economic activity and growth would be impeded. In the absence of risk management services there would be no “wealth creation.” (Petty at al 2009 pg.61) Without adequate financial information on and proper evaluation of firms it would be impossible to know the most profitable and well managed firms for one to invest in.
Without financial institutions, it would be impossible to mobilize resources from net savers to net users of funds by pooling savings from individual account holders and then providing large sums to investors for the funding of worthwhile investment projects that create economies of scale (Petty et al 2009 pg 60). It would also be impossible to control actions of agents (managers) and devise ways of mitigating principal –agent problem.
4. What role(s) do financial institutions play in financial matters for businesses?
They act as a source of capital to finance profitable business projects. Firms need to insure as well as diversify their assets against risk. Corporate governance: information they have on business compel businesses to perform. Financial institutions capacity to gather data and generate information for business owners helps mitigate the agency problem. (Levin pg.232)
5. Are the roles the same or different than for individuals? Explain.
The five fundamental roles played by financial institutions are the same for individuals, businesses as well as the government. The only difference is the level of operation and structure. If it is risk, all recipients of financial services face risk. If it is mobilization of resources individuals, governments and business need to save as well as invest. If it is trading all need the financial instruments provided by financial institutions to ease trade. All players need information on mangers as well as the best firms to invest with.
Petty, w., Keowon, A.J., Scott JR, D.F., Martin, O.N., Burrow, M., Martin, P., Nguyen, H. (2009) Financial Management, Frenchs Forest, NSW, Australia, Pearson Education Australia.
Levin R., (1997) Foreign Banks, Foreign Development and Economic growth. Kiel Working Papers 1070, Kiel Institute for the World Economy. ideas.repec.org/p/ces/ceswps/_1100.html