FINANCIAL MARKETS AND INSTITUTIONS: IMPORTANT FUNCTIONS

Economic system relies heavily on financial resources and transactions, and economic efficiency rests in part on efficient financial markets. Financial markets consist of agents, brokers, institutions, and intermediaries transacting purchases and sales of securities. The many persons and institutions operating in the financial markets are linked by contracts, communications networks which form an externally visible financial structure, laws, and friendships. The financial market is divided between investors and financial institutions. The term financial institution is a broad phrase referring to organizations which act as agents, brokers, and intermediaries in financial transactions. Agents and brokers contract on behalf of others; intermediaries sell for their own account. Financial intermediaries purchase securities for their own account and sell their own liabilities and common stock. For example, a stockbroker buys and sells stocks for us as our agent, but a savings and loan borrows our money (savings account) and lends it to others (mortgage loan). The stockbroker is classified as an agent and broker, and savings and loan is called a financial intermediary. Brokers and savings and loans, like all financial institutions, buy and sell securities, but they are classified separately, because the primary activity of brokers is buying and selling rather than buying and holding an investment portfolio. Financial institutions are classified according to their primary activity, although they frequently engage in overlapping activities. The classification of financial market participants is outlined in Figure 1. Financial markets provide our specialized, interdependent economy with many financial services, including time preference, distribution of risk, diversification of risk, transactions economy, transmutation of contractual arrangements, and financial management.

Time Preference
Time preference refers to the value of money spent now relative to money available for spending in the future. Businesses are frequently making decisions among short-term and long-term uses of funds, and business executives must judge between outlays which provide a return in the near term and those which pay off many years from now. They must decide upon commitments requiring funds now and those requiring funds later, by allocating not only funds that they expect to receive currently, but also those that they expect to receive in the future. The money and capital markets price funds so that businesses and governments can make rational economic allocations of capital. The price of capital is set in a competitive marketplace by supply and demand forces. The market price of capital is compared by businesses to the expected returns in proposed capital expenditures. Businesses allocate their capital to real investments whose return is at above the cost of capital. Long-term investments are compared to short-term investments using the financial-market-determined cost of capital. Consequently, the allocation of capital between short-and long-term investments depends on the free play of supply and demand in an open market. Like businesspersons, consumers may decide upon a time pattern for expenditures that does not necessarily coincide with their current or expected income flows. Financial markets allow us to implement time adjustments in the payments for goods. Without them, there would be no opportunity to earn interest on savings, and expenditures would be limited to current receipts and cash. Savings allows many consumers to postpone consumption and to receive returns from investments.

Risk Distribution
The financial markets distribute economic risks. Employment and investment risks are separated by the creation and distribution of financial securities. On a larger scale, the money and capital markets transfer the massive risks from people actually performing the work (employment risks) to savers who accept the risk of an uncertain return. The chance of failure for a 100 million mobile phones manufacturer may be divided among thousands of investors living and working all over the world. If the mobile phones business fails, each investor loses only part of his or her wealth and may continue to receive income from other investments and employment. Figure 1 Classification of participants in the financial markets

Participants
Commercial Banks Savings Banks Savings and Loans Credit Unions Finance Companies Life Insurance Companies Financial Pension Funds Institutions Investment Companies Real Estate Investment Funds Mortgage Bankers Agents and Investment Bankers Brokers Securities Dealers and Brokers Clearing Houses Stock Exchanges People who own stocks, bonds, and other securities

Classification

Financial Intermediaries

Financial Institutions

Securities Institutions

Market

People who borrow money with mortgages, installment loans, Investors and Borrowers and other instruments Businesses (Non financial) Governments

Diversification of risk
In addition to permitting individuals to separate employment and investment risks, the financial markets allow individuals to diversify among investments. Diversification means combining securities with different attributes into a portfolio. Ordinarily, a diversified portfolio of financial claims is less risky than a portfolio consisting of one or at most a handful of similar securities. Total risk is reduced because losses in some investments are offset by gains in others. The benefits of

diversification are possible due to the existence of large, diversified financial markets where investors may buy and sell securities with minimum transactions cost, regulatory interference, and so forth.

Functions of Financial Intermediaries

Financial markets facilitate the movement of funds from those who save money to those who invest money in capital assets. Savings are distributed among investments and expenditures through securities traded in the financial markets. Financial institutions facilitate and improve the distribution of funds, money, and capital in several respects: 1. 2. 3. 4. 5. Payments mechanism Security trading Transmutation Risk diversification Portfolio management

All of these functions are important to an efficient financial system, and managers are improving execution capability through improved electronic communication, computer processing, and institutional design. Note that these functions are characteristic of agents. Financial intermediaries are special types of agents that collect information about economic entities, evaluate financial information, and package financial claims. The financial intermediary, by purchasing primary securities and issuing secondary securities adds choices to borrowers and lenders. Issues of financial intermediaries are termed secondary securities. The process of changing the terms of money bought and sold by financial intermediaries is termed transmutation. For example, savings and loan associations obtain money with short-term, smallbalance savings deposits to make 20- to- 30 year mortgage loans in amounts usually exceeding 10,000 . Timing and amount are usually changed through transmutation, with alterations limited only by the creativity of the financial institution and the acceptance of its customers.

Financial institutions also act as portfolio managers and advisers over most of the primary securities owned by investors. The private financial sector manages most of the home mortgages, commercial mortgages, consumer loans, state and local government securities, and business loans. In addition, nearly one-fourth of outstanding common stocks are managed by investment companies, and a large portion of the remaining shares of stock are invested with the advice of trust institutions. The most important reasons for obtaining institutional management are:
convenience, protection against fraud, quality of investment selection, and a low transaction cost. Financial institutions provide a convenient place where savers can safely invest excess money and consumers can easily borrow funds. Investments are protected against unscrupulous borrowers by the institutions qualified loan officers and a bevy of collectors and attorneys. Well-trained investment analysts and loan officers seek good investment opportunities and screen prospective securities so as to obtain the best yield available for the risk level that suits the investors preferences.

Income tax differentials among individuals and businesses are mitigated by intermediaries which transfer tax deductions from low-to high-income taxpayers and provide tax-free services in place of taxable interest. For example, pension funds owe their existence to tax differentials. Income invested

in and earned by pension funds is not taxed until retirement when rates are generally lower than before retirement. Commercial banks reward depositors with free services, which are nontaxable, rather than pay interest, which is taxable. The depositors receive nontaxable benefits such as checking accounts, travelers checks, and low-rate loans in return for the use of their money. Leasing intermediaries, a type of finance company, pass depreciation tax shields from equipment users in lowtax brackets to equipment owners in high-tax brackets. The depreciation expense reduces income taxes more for high-than for low-tax-bracket owners.

This PDF is a selection from an out-of-print volume from the National Bureau of Economic Research Volume Title: Financial Intermediaries in the American Economy Since 1900 Volume Author/Editor: Goldsmith, Raymond W. Volume Publisher: UMI Volume ISBN: 0-870-14101-5 Volume URL: http://www.nber.org/books/gold58-1 Publication Date: 1958 Chapter Title: Types of Financial Intermediaries Chapter Author: Raymond W. Goldsmith Chapter URL: http://www.nber.org/chapters/c2581 Chapter pages in book: (p. 50 - 55)

CHAPTER III TYPES OF FINANCIAL INTERMEDIARIES

In a modern economy we may distinguish four main types of units that participate in the economic process, always remembering that

the units as we find them in life are only approximations of the

ideal types set up in a scheme of classification: (1) households (as consumers and as suppliers of labor services); (2) business enterprises; (3) nonprofit organizations; and (4) government. Business enterprises as well as nonprofit and government organi zations may be further subdivided according to the nature of their predominant economic activity. For this study we need to consider only one of the many possible subdivisions, that into financial and nonfinancial enterprises or organizations. This subdivision classes as financial enterprises all economic unitsbusiness enterprises as well as nonprofit and government organizationsthat are primarily engaged in the holding of and trading in intangible assets (claims and equities). Nonfinancial enterprises, of course, also hold intangible assets,

e.g. cash and receivables, and have liabilities and equity which
of necessity always are classified as intangible. Conversely, financial enterprises own some tangible assets, at least office equipment and often the buildings in which they operate and the land on which the buildings stand. The differences between financial and nonfinancial enterprises are, nevertheless, fairly clear-cut in practice. The tangible assets of financial enterprises almost always constitute

only a very small proportion of their total assets. Although for nonfinancial enterprises the share of intangibles in total assets is usually not negligible, and in many cases quite substantial, the nature of operations usually permits the allocation of a specific enterprise to either the financial or the nonfinancial category with out unduly stretching the definition used here and without doing violence to current practices of Financial intermediaries include most of the units falling within
the classification of financial enterprises, but are not identical with them. (The slightly more descriptive designation "financial intermediaries" is used in this study in preference to the common term "financial institutions," because it indicates at once their position in the process of saving and investment.) Financial intermediaries are taken to include all financial enterprises with the exception of 50 TYPES OF FINANCIAL INTERMEDIARIES two types: (1) units whose assets consist predominantly of the securities of, or of claims against, wholly owned or majority-owned subsidiaries and affiliates (holding companies); and (2) units owned by one or a small group of individuals, or by corporations or non profit

organizations, if they make no substantial use of outside 6

funds; i.e. enterprises identical with or similar to what are usually called personal holding companies. A further distinction is sometimes helpful in analysis: that be tween primary and secondary financial intermediaries. Primary financial intermediaries are those which draw their funds from households, business enterprises, or government and make them available in turn to the same groups. Secondary financial intermediaries rely for most of their funds on primary financial intermediaries, or use their own funds chiefly to acquire the securities of or claims against primary financial intermediaries. Unler this definition most financial intermediaries operating in the United States are primary. At the present time the only important second ary financial intermediaries are sales finance, personal finance, fac toring, and mortgage companies, all of which obtain most of their funds from commercial banks. This group also includes some governmental organizations financed by other government-owned financial intermediaries (e.g. Banks for Cooperatives and Federal In termediate Credit Banks) or which make most of their funds avail able to financial intermediaries (e.g. Federal Home Loan Banks,
whose assets consist mostly of loans to savings and loan associations). In the case of some financial intermediaries, for example certain investment companies, a substantial proportion of assets consists of the

securities of other financial intermediaries. However, as long as these constitute the minority of total assets, the holders may still be classified as primary financial intermediaries. Further classification of the individual economic units that fall within the definition of financial intermediaries varies from coun try to country, changes over time, and depends on the nature of financial intermediaries operating at a given time and place, which in turn is greatly influenced by prevailing legal arrangements and financial customs. In the United States the definition of financial intermediaries includes for the period with which this study deals the types of institutions listed below, each of which is made up of individual units reasonably similar in the nature of their operations and in the character of assets and liabilities. In presenting the statistical material in the rest of this study, several of these groups

5'
TYPES OF FiNANCIAL iNTERMEDIARiES are further subdivided, and a few are omitted from most parts of the study for lack of adequate data. A. The banking system 1. Federal Reserve Banks 2. Commercial banks 3. Savings banks 4. Postal savings system B. Other depositary organizations 1. Savings and loan associations 2. Credit unions

C. Insurance organizations 1. Private life insurance organizations (including fraternal and savings bank life insurance) 2. Private noninsured pension funds 3. Government insurance and pension funds 4. Property insurance companies D. Other financial intermediaries 1. Investment companies (including investment-holding and installment investment companies) 2. Land banks 3. Mortgage companies 4. Finance companies (including sales finance, personal finance and factoring companies) 5. Security brokers and dealers 6. Government lending institutions E. Personal trust departments (including common trust funds) The above grouping of financial intermediaries into one to two dozen distinct types is a functional classification which has become established by time. No such grouping, of course, is entirely satisfactory, and several other principles of classification exist that are defensible from various points of view and are possibly preferable for purposes differing from those of this study. The first two groups of financial intermediaries bring together all those organizations which function primarily as depositories of short-term funds of nonfinancial economic units (plus the Federal Reserve Banks). The right-hand side of their balance sheet con sists, apart from intra-group entries, primarily of short-term liabili ties to households, nonfinancial business enterprises and govern52 TYPES OF FINANCIAL INTERMEDIARIES ment and nonprofit organizations, liabilities which are regarded by the owners as being ordinarily realizable at any time without delay and at a definitely known and unchanging face value. The separation of intermediaries belonging to the banking system from other depositories is made more in deference to custom than as a reflection of a genuine difference. One very important difference among the financial intermediaries in the two groups exists, but it does not separate the banking system in a broad sense from other deposi tories. It rather distinguishes between (1) those depositories which are able to create money (Federal Reserve Banks and checking de partments of commercial banks) and which thus in their lending and investment activities are to some extent freed (not individually but as a group) from the limitations imposed by previous receipt

of deposits; and (2) all other depositories, which are not able to create money and thus are limited in their lending and investment
activities to the receipt of deposits and the increase in net worth. The common feature of the financial intermediaries combined under the heading of insurance organizations is their primary pur pose, the provision of a specialized serviceprotection against specified

risks in consideration for definite payments by or for the account of the Most of these organizations accumulate a considerable amount of funds in performing their basic function,
and the size of the funds is essentially determined by the nature of their insurance contracts. In principle, and for the most part also in practice, the liabilities of insurance organizations are of a longterm nature, falling due only in accordance with the terms of con tract. Although part of the claims of the insured may be liquidated before the originally stipulated time, the exercise of this right re mains

the exception rather than the rule and is precluded for a large part of the total liabilities of this type, specifically those of
government and private pension and retirement funds. Thus, while the liabilities of insurance organizations to their policyholders may at some times acquire a character close to that of short-term de posits, the actual nature of most of them remains quite different as is evidenced by their much slower rate of turnover. No similar unifying principle can be claimed for the financial intermediaries in group D. This indeed is a catch-all category. It includes intermediaries, which finance themselves primarily by the issuance of their own securities (investment companies and land banks), those which draw their funds for the most part from other financial intermediaries (mortgage companies, finance companies, 53 TYPES OF FINANCIAL INTER.MEDIARIES security brokers and dealers), and those which are financed directly by the government and thus indirectly by the buyers of government securities. Personal trust departments, finally, have been treated as a separate group because they administer assets on the basis of a trustee relationship rather than, as do the other financial intermediaries, as debtors (or issuers of equity securities) who invest what in law are their own funds.

Grouping of financial intermediaries is not a matter of great importance for the interpretation of the data. A word, however, is
necessary on the reasons for excluding from the study a few specific

types of enterprises that might be regarded as falling within the definition of financial intermediaries that was adopted. 1. Investment counsel organizations have been excluded, notwithstanding their similarity in some respects to the personal trust
departments of banks, because they generally do not have the power of independent action with respect to the funds they administer but

are limited to advising the beneficial owners. This factor alone

might not have been regarded as decisivesome of the trust funds administered by personal trust departments are subject to similar

limitationsbut the absence of reliable data both on the total

amount of funds administered by investment counsel organizations

and on their distribution (except for one rough estimate for the
middle 1930's)' made exclusion unavoidable.

2. Trustees other than banks and trust companies have been 9

omitted for two reasons. First, many of them are individuals who do not make a continuing and primary occupation of the activity, an argument perhaps not decisive in the case of a limited number of law firms which specialize in this type of business and are re putedly of substantial importance in some financial centers. Second, complete lack of data again forces exclusion, irrespective of whether or not the basic definition used is interpreted as including nonbank trustees. 3. Also excluded were a few groups of financial organizations which are known or believed to be of relatively small size or for which no satisfactory information was available. Commercial paper and discount houses, acceptance dealers, and title guaranty com panies belong to this category, although most of their assets consist
Investment Counsel, Investment Management, Investment Supervisory and Investment Advisory Services, Securities and Exchange Commission, 1939,
1 See

pp. 8-9.

54 TYPES OF FINANCIAL INTERMEDIARIES

of intangibles, and their operations are not too different from

those of some banks. 4. Pawnbrokers were omitted not only because of their relatively small importance and the limited information available,2 but also because their operations combine trading in tangible assets with the holding of intangibles. 5. Jn excluding labor unions and foundations we are following usual practice. Notwithstanding that most of their assets consist of intangibles, the exclusion can be justified by the subsidiary char acter of their financial operations as corppared with their activities in their main field of operation.

6. It is debatable whether the U.S. Treasury should be treated as a financial intermediary to the extent that it issues metallic or paper currency. This has not been done here, primarily because
the issuance of Treasury currency has been regarded as an attribute of basic governmental power. While accurate data about the size of the omitted organizations are generally lacking, it is safe to say that those that should or could be included within the basic definition of financial intermedi aries (i.e. category 3 and perhaps also 1, 2, and 6 of the above list) have throughout the period covered by this study held assets amounting to only a small fraction of the assets of those included. The types of omitted organizations that would fall under the basic definition adopted (e.g. 3 ?Ibove) are known to be negligible in size and importance as compared with the financial intermediaries covered by the study.
2 Estimates

on the receivables of pawnbrokers since 1923 may be found in A

-

Study of Saving - . , Vol. I, Table D-6 ((igures for 1923 to 1937 from R. Nugent,

Consumer Credit and Economic Stability, Russell Sage Foundation, 1939, p. 115; 1938-1949 figures are Federal Reserve Board estimates).

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