Role Of Financial Institutions

Updated on April 4, 2024
Article byNiti Gupta
Edited byNiti Gupta
Reviewed byDheeraj Vaidya, CFA, FRM

What Is The Role Of Financial Institution?

Financial institutions play a pivotal role in every economy. The central government organization regulates banking and non-banking financial institutions. In addition, these institutions help bridge the gap between idle savings and investment and its borrowers, i.e., from net savers to net borrowers.

Role of Financial Institutions

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Financial institutions are the backbone of the economy. Without the help of these institutions, the economy will go down and cannot stand up. Due to their pivotal role in the development and growth of the economy, the government regulates these institutions through the central bank, insurance regulators, pension fund regulators, etc. Over the years, their role has expanded from accepting and lending funds to larger service areas.

Key Takeaways

  • Financial institutions perform a critical role in the economy. The central government organization controls banking and non-banking financial institutions. 
  • Moreover, these institutions fill the gap between idle savings and investment and its borrowers, i.e., from net savers to borrowers.
  • The roles such as money supply regulation, banking services, insurance services, capital formation, investment advice, brokerage services, pension fund services, trust fund services, financing small and medium-scale enterprises, and acting as a government agent for economic growth are played by the financial institutions. 

Role Of Financial Institution Explained

The roles of financial institution is extremely crucial in any economy. Finance is the backbone of a country because it helps in procuring funds for creation of investment opportunities, development of infrastructure, boosting trade and commerce and overall development.

The financial institutions are the ones that facilitate in conducting transactions related to loans, deposits, investment opportunity, buying and selling or making and receiving payments related to any kind of business. The role of financial institutions in economic development lies in the fact that such institutions help in channelizing funds that are earned and saved by individuals or corporates. It is important to direct those funds towards proper uses where they will be invested in projects or areas where finance is urgently required for development and expansion.

These institution facilitate allocation of money efficiently by facilitating flow of money within business, banks, credit unions, insurance companies and individuals which highlights the role of financial institutions in economic development.

The following is the list of roles performed by financial institutions: –

  1. Regulation of monetary supply
  2. Banking services
  3. Insurance services
  4. Capital formation
  5. Investment advice
  6. Brokerage services
  7. Pension fund services
  8. Trust fund services
  9. Financing the small and medium-scale enterprises
  10. Act as a government agent for economic growth

In this article we will study the various roles that these institutions play in order to distribute the money and assets effectively among every part of the society. The role of financial institutions and markets also require that however, they need to abide by various rules and regulations that influence their workings and keep their operational procedure in check. This monitoring ensures that there is transparency and accountability at every level of the institutions. This also helps in reducing fraud and mismanagement of funds.

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Let us discuss each nature and role of financial institutions in detail: –

#1 – Regulation Of Monetary Supply

Financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more like the Central Bank help regulate the money supply in the economy to maintain stability and control inflation. For example, the Central Bank applies various measures like increasing or decreasing repo rate, cash reserve ratio Cash Reserve RatioCash Reserve Ratio refers to the share of a Bank’s total deposits that need to be maintained with the respective Country’s Central Bank to control financial supply in the economy. read more, and open market operationsOpen Market OperationsAn Open Market Operation or OMO is merely an activity performed by the central bank to either give or take liquidity to a financial institution. The aim of OMO is to strengthen the liquidity status of the commercial banks and also to take surplus liquidity from more, i.e., buying and selling government securities, to regulate liquidity in the economy.

#2 – Banking Services

Among various nature and role of financial institutions, these institutions, like commercial banksCommercial BanksA commercial bank refers to a financial institution that provides various financial solutions to the individual customers or small business clients. It facilitates bank deposits, locker service, loans, checking accounts, and different financial products like savings accounts, bank overdrafts, and certificates of more, help their customers by providing savings and deposit services. In addition, they offer credit facilitiesCredit FacilitiesCredit Facility is a pre-approved bank loan facility to businesses allowing them to borrow the capital amount as & when needed for their long-term/short-term requirements without having to re-apply for a loan each time. read more like overdraft facilities to the customers to cater to the need for short-term funds. Commercial banks also extend loans like personal loans, education loans, mortgages, or home loans to their customers.

#3 – Insurance Services

Financial institutions, like insurance companies, help to mobilize savings and investment in productive activities. In return, they assure investors against their life or some particular asset at the time of need. In other words, they transfer their customer’s risk of loss to themselves.

#4 – Capital Formation

Financial institutions help in capital formation, i.e., increase in capital stockCapital StockThe capital stock is the total amount of share capital (including equity capital and preference capital) that has been issued by a company. It is a way of raising funds by the company to meet its various business more like the plant, machinery, tools and equipment, buildings, transport, communication, etc. Moreover, they mobilize the idle savings from individuals in the economy to the investor through various monetary services.

#5 – Investment Advice

There are many investment options available at the disposal of individuals and businesses. But it is not easy to choose the best option in the current swiftly changing environment. Almost all financial institutions (banking or non-banking) have an investment advisory desk that helps customers, investors, and businesses to select the best investment option available in the market according to their risk appetiteRisk AppetiteRisk appetite refers to the amount, rate, or percentage of risk that an individual or organization (as determined by the Board of Directors or management) is willing to accept in exchange for its plan, objectives, and more and other factors.

#6 – Brokerage Services

These institutions provide their investors access to several investment options available in the market, ranging from stock bonds (common investment alternative) to hedge fundsHedge FundsA hedge fund is an aggressively invested portfolio made through pooling of various investors and institutional investor’s fund. It supports various assets providing high returns in exchange for higher risk through multiple risk management and hedging more and private equity investment (lesser-known alternative).

#7 – Pension Fund Services

Through their various kinds of investment plans, financial institutions help individuals plan their retirement. One such investment option is a pension fundPension FundA pension fund refers to any plan or scheme set up by an employer which generates regular income for employees after their retirement. This pooled contribution from the pension plan is invested conservatively in government securities, blue-chip stocks, and investment-grade bonds to ensure that it generates sufficient more. The individual contributes to the investment pool by employers, banks, or other organizations and gets the lump sum or monthly income after retirement.

#8 – Trust Fund Services

Some financial organizations provide trust fundTrust FundA trust fund is a legal entity formed as part of an estate planning tool which holds a grantor’s assets and duly distributes them to the inheritors after the grantor passes more services to their clients. They manage the client’s assets, invest them in the best option available in the market, and take care of its safekeeping.

#9 – Financing The Small And Medium Scale Enterprises

Financial institutions help small and medium-scale enterprises set up themselves in their initial business days. They provide long-term as well as short-term funds to these companies. The long-term fund helps them form capital, and short-term funds fulfill their day-to-day working capital needs.

#10 – Act As A Government Agent For Economic Growth

The government regulates financial institutions on a national level. They act as a government agent and help grow the nation’s economy and ensures that there is an important role of financial institutions in rural marketing as well. For example, to help out an ailing sector, financial institutions, as per the guidelines from the government, issue a selective credit lineCredit LineA line of credit is an agreement between a customer and a bank, allowing the customer a ceiling limit of borrowing. The borrower can access any amount within the credit limit and pays interest; this provides flexibility to run a more with lower interest rates to help the industry overcome the issues it is facing.

Thus, we see that the role of financial institutions in rural marketing and urban development help to perform various services that connect the savings to the investment opportunities so that money flows in a useful direction and facilitates growth and expansion of the economy. But some amount of reules and regulations are also important which will keep track of their operations to ensure that these institutions act in the best interest of the society and not only concentrate of profit motive. Every government has a variety of law and rules to keep them under continuous monitoring and check.

Frequently Asked Questions (FAQs)

What is the role of financial institutions in financial markets?

Financial institutions are essential because they offer a marketplace for money and assets. Therefore, they can efficiently allocate capital where it is most beneficial.

What is the role of financial institutions in the economy?

The financial sector performs a crucial role in financial operations through intervention. In other words, the financial industry is an intermediary between savers and borrowers. It takes funds from savers and grants them to those who need to borrow, whether they are households, businesses, or governments.

What are the three role of financial institutions?

The financial institutions leading role is to facilitate liquidity in the economy and allow a higher level of financial movement. According to the Brookings Institute, banks may achieve this by offering credit, managing markets, and pooling risk among consumers.

What is the main role of financial institutions?

Financial institutions provide financial transactions and play as a mediator in economic activities. There are different financial institutions’ roles which include monetary supply regulation, pension fund services, the economic growth of a nation, banking services, and capital formation.

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This article is a guide to what is the Role Of Financial Institutions. We explain the concept along with different roles of the institutions in an economy. You may learn more about financing from the following articles: –