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In economics, financial institutions provide services for capital and debt markets as an intermediary. There are three major types of financial institution such as deposit taking institution, insurance companies and pension fund, and also brokers, underwrite and investment fund. They perform the economic function of channeling fund from surplus to deficit. They are responsible in transferring funds from investor to companies in need of those funds.
In most countries, financial institutions are critical parts of the countries and operate in a heavily regulated environment. Regulation structures differ in each country, but typically involve prudential regulation as well as consumer protection and market stability. Some countries have one consolidated agency that regulates all financial institutions while other have separate agencies for different types of institutions such as banks, insurance companies and brokers.
Financial institutions receive savings from households, businesses, and the government and invest these savings. This role is crucial for two reasons. First, an efficient financial sector assures the movement of savings to the most efficient investments. Second, households do not spend all of their income. Some is saved. If household saving is not injected back into the circular flow in the form of investment, then income will fall and the country will have a recession.
In a well-functioning economy, capital will flow efficiency from saver to borrower. The transfer of fund can make by three different ways such as direct transfer, indirect transfer through investment bankers and indirect transfer through financial intermediary.
Bonds and share2.2.1 Direct transfer
The first way to transfer the fund is through direct transfer. It refers to a transfer of assets from one type of tax-deferred retirement plan or account to borrower. The diagram above shows the processing of direct transfer. Direct transfers are not considered to be distributions and not taxable as income or subject to any penalties for early distribution. Most transfers take several days to complete, although this process is now generally faster in the electronic than in the past. Direct turnover from qualified plans are a form of direct transfer. It occurs when firms direct sell their stock or bond to saver without going through any financial institution. In this situation, firms act as borrowers who need the money to use in business. The borrower borrowed the money from saver and need to give the saver share dividend.
The advantages of direct transfer are more convenience, save times and simple to trade between borrower and saver. The reason is when both borrower and saver agree with the term and condition, the transaction will be in process. Besides, it will be save time and cost. By do the transaction online, without paying high commission to intermediaries and it is saving transaction time.
Even though it is a lot of advantages using this method, there also bring some disadvantages to both parties. The savers will face lack of professional information and advice from expertise. This will lead to the saver making wrong decision in investment, risk of losing money from the investment. Besides, the savers will suffers loss when they are not really understand the term and there is hide term in the contract with the borrowers.
2.2.2 Indirect transfer through investment bankers
Investment banking house
Savers Share/bond Share/bond
The second way is indirect transfer through investment bankers. Investment bank refers to a financial institution that helps individuals and corporations to raising their capital by underwriting. They also act as the client's agent when issuance of securities such as stock and bond. An investment bank may also help organization involved in mergers and acquisitions and provides ancillary services. In investment banking there are two main which are trading securities for cash or other securities and promotion of the securities.
In this way, the investment banker assumes the risk of selling a new security issue at a satisfactory price. This is called underwriting. An underwrite serve as a middleman and facilitates the issuance of securities. The company's securities and saver's money will pass through the investment banking house. The investment banker will buy the entire issue of securities from the company that needs of financial capital. Then investment bank will turn sells these same securities to savers at a higher price. However, the investment bank taking the risk when they buy and hold the company's a security for certain time and it may not resell to savers for as much as they paid after a period of time. The reason is new securities are involved and company receives the proceed of the sale, which is called a primary market transaction. In addition, the investment banker also advises firms on the details of selling securities.
The advantages for this method are the business will get professional suggestion from expertise about the details of selling securities. The business can raise the capital more efficient, the reason is the investment banker will buy over the securities and hold to sell for savers. This will help to business dispense with the pending time to wait saver transfer the money.
The disadvantages for this method are the business may face risk in reduction price of securities. The reason is when the business need capital emergency, the investment banker will reduce the price of securities in order to make more money. The savers may also face receive inaccuracy information from investment banker. Because of the investment banker wants to resell the hold securities. Besides, the investment banking house will also take risk when holding business share because the share price is not maintain at all the times.
2.2.3 Indirect transfer through financial intermediary
Business Share Share
The third way is indirect transfer through financial intermediary. Financial intermediary consists of "channeling funds between surplus and deficit agents". A financial intermediary is a financial institution that connects surplus and deficit agents. Financial intermediary can divide into three major types such as depository institution, saving contractual institution and investment companies. The depository institution includes commercial bank, it transforms bank deposits into bank loans. The saving contractual institution includes credit union, it is a cooperative financial institution that is owned and controlled by its members and operated for the purpose of promoting thrift, providing credit at reasonable rates, and providing other financial services to its members. Pension fund also include in this category. Pension fund is any plan, fund, or scheme which provides retirement income. The investment companies include mutual fund, it is a professionally-managed type of collective investment scheme that pools money from many investors to buy securities
Through the process of financial intermediation, certain assets or liabilities are transformed into different assets or liabilities. As such, financial intermediaries channel funds from savers to those borrowers. As example, saver will save the surplus money in bank and get the deposit certificate, the bank will use the money to borrow to borrower by term of mortgage.
Financial intermediaries provide important advantages to savers. Lending through an intermediary is usually less risky than lending directly. The major reason for reduced risk is that a financial intermediary can diversify. Financial intermediary will give many loans to different borrower. When mistake happen, the financial intermediary can cover by others loan interest. But if savers borrow direct to business, the risk will face by individual. Another reason is financial intermediary specialize in lending and better predict which of the people able to repay compare to individual savers.
Second advantage financial intermediaries give savers is liquidity. Liquidity is the ability to convert assets into form money quickly. A house is an illiquid asset; selling one can take a great deal of time. If an individual saver has lent money directly to another person, the loan can also be an illiquid asset.
Third advantage financial intermediaries give savers is cost advantage. Using financial intermediaries can reduce the costs of borrowing. The reason is there are a lot of borrowings complete in financial intermediaries, it can lead to economic of scale and save cost for savers.
The transfer of fund can transfer through three different ways, such as direct transfer, indirect transfer through investment banker and indirect transfer through financial intermediary. It is important to country economic. The reason is if all the surplus money are just saving and not borrowed or invest, the economic will recession. Therefore, financial institution is very important to household, business and government. The surplus money will go through financial institution to invest to deficit business. It will gain interest or dividend to savers.