Types of financial institutions

The financial system consists of the following major institutions:

Banks are financial intermediaries that collect deposits and give out credits. Some credits are investment-oriented and serve to buy real estate, machines, and equipment. Other credits are short-term oriented and allow firms and households to pay wages, utilities, and make other current payments. The chart shows that bank credit has expanded significantly over time.

Stock markets allow people to become part owners in companies. The ownership of each firm traded on the stock exchange is broken down in many shares. An investor can then buy, for example, 100 shares in IBM, 50 shares in General Motors, 200 shares in Apple, etc. Each share represents part ownership in the company and gives the investor a vote in the company decisions.

The chart shows the market value of all companies traded on all stock exchanges as percent of world GDP, that is, the number of shares multiplied by the market price of each share. That number is called stock market capitalization. The chart shows that the growth in stock market capitalization has not been as rapid as the growth of bank credit. Nonetheless, stock markets are clearly an important part of economic activity.
Bank and stock markets are the main players in the financial systems of most countries. There are, however, some additional institutions and assets that are important in advanced economies:

Bonds are credits extended by an individual/bank/firm to a firm/bank/government. Think of the bond as a piece of paper on which it is written that “IBM owes $100,000 plus 5 percent interest in one year to whoever owns this piece of paper.” At the end of the year, you give the piece of paper to IBM and they give you $105,000. However, you can also sell the bond to another investor before the bond reaches maturity, i.e. before the end of the year.

Insurance provides compensation when something undesired happens. For example, you have a car accident and the insurance company pays for the repairs. A doctor is sued by a patient and the insurance pays the lawyer fees. The idea is that many people pay a premium to the insurance company but not all of them need a payment at the same time. We all pay for the ones in need. Tomorrow we may be in need and others pay for us.

Leasing companies, pawn shops, and other smaller institutions provide credit to consumers and firms but are not that important in most countries.


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