What Is a Financial Institution?
A financial institution (FI) is an organization that facilitates the flow of capital between savers and borrowers. It offers a wide range of financial products and services that enable individuals, businesses and governments to manage their money, invest for the future and access the capital they need to grow.
FIs come in many forms and sizes, each serving specific needs. For example, commercial banks focus on everyday banking services and lending, while investment banks specialize in complex financial transactions and corporate finance.
Beyond traditional banking, there is a diverse array of non-bank financial institutions (NBFIs), including brokerage firms and asset managers. These organizations collectively ensure capital flows efficiently through the economy, fueling innovation, funding business expansion and supporting economic growth. Given their pivotal role, FIs operate under regulatory oversight to maintain stability and protect consumers, striking a balance between innovation and security in the ever-changing financial world.
PART 1
Banks
Banks accept funds from individuals and businesses, and lend a portion of these deposits to other entities. This core function not only defines banks as depository institutions but also subjects them to specific regulations and legislation, which often determine their service offerings and operational scope.
Types of Banks
Commercial banks
The most common type of FI is the commercial bank. Commercial banks are large, multifaceted financial institutions that operate across local, regional and international borders. Their primary functions are to accept deposits from individuals and businesses, and then lend out a portion of those deposits to other entities. This is the characteristic that sets commercial banks apart.
But that’s far from all that commercial banks offer. One of the additional services they offer is facilitating foreign currency transactions, which allows companies to buy or sell internationally traded currencies for immediate (spot) or future (forward) use. This helps businesses manage their cross-border financial operations and mitigate FX risks.
Additionally, commercial banks provide risk management services, which help clients mitigate the effects of adverse changes in interest rates, foreign exchange rates and commodity prices. In addition to these specialized offerings, commercial banks fulfill common financial needs, too. They offer checking and savings accounts, process payments, facilitate wire transfers and provide wealth management guidance.
Investment banks
Investment banks specialize in providing a wide range of financial services related to the issuance and trading of securities. One of their core functions is securities underwriting, which helps companies issue and sell stocks, bonds and other securities to the public. They also offer custodial services (i.e., safeguarding financial assets on behalf of institutional clients). In addition, they facilitate mergers, acquisitions, divestitures and other complex corporate reorganizations. Finally, investment banks act as brokers and financial advisors, executing trades and providing strategic guidance for institutional investors.
Universal banks
Universal banks are financial institutions that combine both commercial and investment banking under one roof. They offer retail banking services, such as savings and checking accounts, loans and mortgages, alongside corporate banking solutions like business loans and cash management. In addition, they engage in investment banking activities, including underwriting, mergers and acquisitions, and securities trading, as well as wealth management services tailored for high-net-worth individuals.
These banks function by diversifying their services, which allows them to reduce reliance on any single revenue stream. However, because of their involvement in both commercial and investment banking activities, they are subject to stringent regulatory frameworks.
Industrial banks
Industrial banks, also known as industrial loan companies, are a specialized type of FI with a more limited scope of services compared to traditional commercial banks. Industrial banks primarily sell investment shares and accept customer deposits, which they then lend via installment loans to consumers and small businesses. Unlike commercial banks, industrial banks do not offer checking account services and are, therefore, not subject to the same general banking regulations. Instead, they are locally chartered and may even be owned by non-bank holding companies. This flexible structure has allowed some industries to establish their own industrial loan companies in order to facilitate consumer financing and sales, e.g., automotive companies.
Central banks
The role of central banks in the financial system is to serve as the bank for the government and the banking sector. In this capacity, their primary role is to implement monetary policy. Central banks use methods such as setting reserve requirements, conducting open market operations, and adjusting interest rates to manage the money supply and influence inflation and economic growth. They are also often responsible for issuing the national currency and overseeing the country's payment systems and financial institutions.
Central banks may also provide various banking services to the government, such as holding deposits and facilitating transactions. Additionally, they can act as a lender of last resort, providing loans to financial institutions that cannot access funding elsewhere, ensuring stability and liquidity in the financial system.
PART 2
Nonbank Financial Institutions
Nonbank financial institutions (NBFIs) are a diverse group of entities that operate outside the traditional banking system. While NBFIs provide many of the same financial services as banks, such as extending credit and accepting deposits, they are not subject to the same regulations and oversight.
This lack of regulation means NBFIs do not offer the same protections as banks, such as access to central bank funding or deposit insurance. Regulators have become increasingly aware of the significant role played by NBFIs, particularly in areas like asset management and the use of financial derivatives. The collapse of a major NBFI, such as a hedge fund or money market fund, could have ripple effects throughout the financial system.
Types of Nonbank Financial Institutions
Broker-dealers
Broker-dealers, or brokerage firms, are entities that trade securities for their own account or on behalf of their customers. They facilitate transactions by finding counterparties and executing the trades. When executing trades for their own account, they take positions in various securities. This allows them to act as market makers, providing liquidity by standing ready to buy and sell securities.
Broker-dealers earn revenue through the difference, or "spread," between the prices at which they buy and sell securities. They may also engage in repurchase agreements to finance their own inventories of securities. Additionally, they assist investment banks in the process of issuing new securities, such as during initial public offerings (IPOs), and help distribute these new securities to the market.
Broker-dealers can be categorized as institutional, focused on large institutional clients, or retail, serving individual investors. They may operate as independent firms or be affiliated with banks, investment banks or other financial institutions.
Private equity firms
Private equity firms are specialized investment management companies that focus on acquiring and actively managing privately held companies. They raise capital from institutional investors (such as pension funds) and high-net-worth individuals to fund private company investments.
The private equity model identifies underperforming or undervalued private businesses, acquires controlling stakes, and then works to improve the company's operations, efficiency and financial performance. The ultimate goal is to unlock value that the private equity firm can then realize when it eventually exits the investment, typically through a sale or public offering.
Captive finance companies
Captive finance companies are subsidiaries of large industrial corporations. Their primary purpose is to provide financing solely for the purchase of products manufactured by their parent corporation. These captive lenders typically raise funds in the commercial paper market and then lend that capital to other companies or individuals to facilitate the sale of the parent firm's products. This allows the parent corporation to extend credit to its customers without directly exposing itself to the associated financial risks.
Many major manufacturers, particularly in the automotive industry, have established their own captive finance subsidiaries to support sales. They do so by offering customized financing options, enabling the parent firm to maintain tighter control over customer financing and leverage its product knowledge to generate additional revenue streams.
Asset-based lenders
Asset-based lenders offer loans that are secured by the borrower's assets, such as accounts receivable or inventory. The amount of credit extended is determined by a "borrowing base" calculation that multiplies the value of the eligible collateral by an advance rate.
Given the reliance on collateral, asset-based lenders closely monitor the pledged assets and frequently adjust the available credit accordingly. This collateral-focused lending model allows asset-based lenders to provide financing to companies that may not qualify for a traditional bank loan.
Insurance companies
Insurance companies are considered NBFIs due to the range of financial services they provide beyond insurance products. Insurance firms make substantial investments in commercial real estate and bond markets, competing with banks for short- and medium-term loans. They also offer mortgage funding, leasing services and long-term savings products.
Asset managers
Asset managers invest client funds across money market and capital market instruments. They offer specialized funds and diversified portfolios to meet different investment requirements. By delegating assets to professional managers, companies can achieve greater diversification across asset classes, issuers and geographies.
Credit unions
Credit unions provide many of the same services as traditional banks; however, they operate under a different structure. As member-owned, not-for-profit cooperatives, credit unions focus on serving their members rather than maximizing profits. They offer a variety of financial services such as savings, loans and access to payment networks, often at more favorable rates than banks. Originally limited to individuals sharing a common affiliation, membership has expanded to include businesses. In the U.S., credit unions are chartered and regulated at both the federal and state levels, with deposit insurance provided through the National Credit Union Administration.
Fintech companies
Fintech companies are technology-driven
firms that offer financial services, either in competition with or in partnership with traditional FIs. These companies leverage innovative technologies to provide a wide range of services, such as payment processing, digital banking and financial management
tools. Some aim to disrupt traditional financial systems by offering faster, more efficient solutions directly to consumers. Others collaborate with established FIs, providing technology platforms and services, like treasury management systems, to enhance
the capabilities of traditional financial operations.
PART 3
Fiduciaries
A fiduciary is an individual or institution entrusted with managing property or assets on behalf of another party, in accordance with a trust agreement. While not all fiduciaries are financial institutions, both banks and nonbank institutions frequently offer fiduciary or trust services. Fiduciaries are legally obligated to act with prudence and responsibility and in a timely manner, ensuring the interests of the beneficiaries are prioritized.
For corporate clients, fiduciary services often include managing employee pension plans, acting as corporate trustees for bond or stock issues, and ensuring compliance with bond indenture agreements. Fiduciaries may also function as transfer agents, maintaining shareholder records, or as registrars, compiling stockholder lists for dividend and interest payments. Other roles include acting as issuing and paying agents, distributing securities and payments to investors, and offering custody services for safekeeping and managing securities transactions.
PART 4
The Role of Financial Institutions in Treasury Management
Financial institutions play a crucial role in treasury management by offering a range of services that help organizations manage their financial resources efficiently. They provide essential solutions such as cash management, liquidity services and risk management tools that enable businesses to optimize cash flow, handle day-to-day transactions and minimize financial risks. FIs also facilitate payment processing, investment of excess funds, and the management of debt through loans or bond issuances, and sometimes offer specialized treasury management systems.
PART 5
Choosing a Financial Service Provider
Selecting a financial service provider (FSP) can be a complex and time-consuming process, given the many available options. Plus, the decision to engage with one FSP for a service or product often impacts broader FSP relationship management, particularly when choosing a new banking partner.
The need for a new FSP may arise from business changes, such as expansion into new markets or the need for additional credit facilities. It can also result from dissatisfaction with the current provider or from policies requiring periodic reviews and tenders for services. Whether a formal selection process (an RFP) is necessary depends on a company’s procurement policies and the involvement of other departments in evaluating and documenting responses from alternative providers.
To learn about the RFP process, be sure to read our article, “How to Conduct a Successful RFP for a Financial Services Provider.”
Find your next financial service provider on the AFP Marketplace.
PART 6
Bank Relationship Management
Bank relationship management centers on maintaining high-quality service. To ensure service standards are met, companies should clearly define their performance expectations based on the service levels agreed upon in the service-level agreements (SLAs) and outlined in the original request for proposal.
Regular performance measurement is key to maintaining a strong relationship. Two of the most common methods for assessing service quality are scorecards and relationship reviews. Scorecards allow companies to quantitatively and qualitatively measure an FSP’s performance by providing structured feedback on service quality and cost. This helps companies evaluate the relative value of their service providers, identify areas for continuous improvement and allocate future business based on performance.
Relationship reviews offer a more dynamic way to assess and strengthen the FSP relationship. Whether formal or informal, relationship reviews involve regular meetings between senior management from both sides to discuss service levels, responsiveness and future strategies. They provide FSPs with an opportunity to present new products or process improvements while ensuring that any changes in services or market strategies are communicated well in advance. By fostering a two-way dialogue, relationship reviews help both parties align their goals and ensure the relationship remains productive and beneficial.
For more information about bank relationship management, be sure to check out the following articles: “What is the Ideal Number of Banking Relationships?” and “Five Insights on Bank Relationship Management.”
PART 7
Learn More About Banking and Financial Institutions
- 2024 AFP Bank Relationship Management Survey Report
- How to Conduct a Successful RFP for Banking Services
- AFP Digital Badge: Bank Fee Analysis (complimentary for members)
Not yet a member? Join AFP and gain access to training, insights and events that will drive your career in treasury and finance.