FINANCIAL INSTITUTIONS

A financial institution is one that facilitates allocation of financial resources from its source to potential users. A large number of different types of financial institutions in the United States create a rich mosaic in the financial system. Some institutions acquire funds and make them available to users. Others act as middlemen between deficit and surplus units. Still others invest (manage) funds as agents for their clients. The key categories of financial institutions are: deposit taking; finance and insurance; and investment, pension, and risk management. There are also government and government sponsored institutions that carry out regulatory, supervisory, and financing functions. Historically, each type has performed a specialized function in the financing and investment management needs of different industries and economic activities, as well as development of regional areas of the country.

DEPOSIT TAKING

Deposit-taking institutions take the form of commercial banks, which accept deposits and make commercial, real estate, and other loans; savings and loan associations and mutual savings banks, which accept deposits and make mortgage and other types of loans; and credit unions, which are cooperative organizations that issue share certificates and make member (consumer) and other loans. Altogether, there were more than 9,000 deposit-taking institutions with more than 92,000 branches spread across the U.S. economy in 2005.

The U.S. commercial banking system practiced competition through a large number of firms in the industry from 1776 to 1976. It was designed to be a unit-banking system in which state charters of banks allowed only one-office banking. The system also encouraged thrift and use of local savings for investment in the local economy. The unit-banking system not only forced competition among existing and new banks in a given banking market, it deliberately avoided the emergence of monopolies in the industry. The founding fathers in the original thirteen states understood the harm monopolies could inflict on the economic and financial systems. In due course the U.S. Congress passed the Sherman Antitrust Act of 1890—and subsequent laws and regulations—making monopoly and monopolistic practices unacceptable and therefore illegal.

The commercial banking industry dominated the U.S. financial industry from the beginning to the 1970s when financial product innovation and the resulting business and consumer financial choices exploded to create competition across financial services industries. The commercial banking industry and its limited product offerings on both sides of the balance sheet were the only choices available to the general public until the late 1960s. This is because the commercial banks specialized in taking checking account deposits on the liability side and making commercial loans on the asset side. For the safety of their operations, they relied on maturity-based hedging of mostly short-term liabilities with short-term self-liquidating commercial loans as assets. This also meant that households, farmers, students, and other groups did not have access to financial capital as commercial banks were not equipped to manage risks inherent in such loans.

Savings and loan associations, mutual savings banks and credit unions, and money market mutual funds are other deposit-taking institutions. Savings and loan associations take savings deposits and primarily make mortgage loans throughout the country. They have provided funds to create millions of housing units in the country. Their key function is maturity intermediation when they accept short-term deposits and make long-term mortgage loans. Mutual savings banks exist mainly in the eastern part of the United States. Like savings and loan associations, they, too, accept short-maturity deposits and make long-term mortgage loans. They also issue consumer and other loans, making them somewhat more diversified, and therefore their loan portfolio is less risky in terms of loan defaults. Credit unions specialize in member savings and loans, although they also make mortgage-type loans and other investments similar to other deposit-taking institutions.

FINANCE AND INSURANCE INSTITUTIONS

Finance (credit) companies are different from deposit-taking banking institutions in that their sources of funds are not deposits. They acquire funds in the market by issuing their own obligations, such as notes and bonds. They make loans, however, on the other side of the balance sheet in full competition with deposit-taking and other types of financial institutions, such as insurance companies. Finance companies specialize in business inventory financing, although they also make consumer loans, mostly indirectly through manufacturers and distributors of goods and services. Some of the finance companies are huge and operate in domestic as well as foreign markets. Several are bigger than most of the commercial banks in the United States.

Insurance companies provide the dual services of insurance protection and investment. There are two types of insurance companies: life insurance companies and casualty and property insurance companies. Insurance companies' sources of funds are primarily policy premiums. Their uses of funds range from loans (thus competing with finance companies, commercial banks, and savings and loan associations) to creation of investment products (thus competing with investment companies). Life insurance companies match their certain mortalitybased needs for cash outflows with longer-term riskier investments such as stocks and bonds. Casualty and property insurance companies have more uncertainty of cash outflows and their timing. Therefore they have more conservative investment policies in terms of maturity and credit risk of their investments in a diversified portfolio of assets.

INVESTMENT, PENSION, AND RISK MANAGEMENT

Investment companies pool together funds and invest in the market to achieve goals set for various types of investments, matching liquidity, maturity, return, risk, tax, and other preferences of investors on the one hand and users of funds on the other. Investment companies are organized as open-end or closed-end mutual funds. Open-end funds accept new investments and redeem old ones, while closed-end funds accept funds at one time and then do not take in new funds. Investment companies have become very popular with investors, and thus they have mobilized trillions of dollars.

Another type of company is investment banks, which provide investment and fund-raising advice to potential users of funds, such as commercial, industrial, and financial companies. They also create venture capital funds or companies. Some of them also have brokerage and dealerships in securities. Many of them underwrite securities and then place them in the market or sell them to investors.

Pension funds in the private and the government sectors collect pension contributions and invest them according to goals of the employees for their funds. Increasingly, employees are able to indicate their personal preferences for risk and reward targets with respect to their own and sometimes their employers' contributions.

Other institutions that are significant participants in the U.S. financial system are the stock, bond, commodity, currency, futures, and options exchanges. The various types of exchanges make possible not only creation and ownership of financial claims but also management of liquidity and risk of price changes and other risks in under-lying commodities in the market. They greatly expand investment opportunities for savers and access to funds by small, medium, and large business enterprises. They have deepened and broadened markets in financial products and services, helped manage price risk, and improved allocation efficiency in financial markets where every attribute desired in a financial product has a counterparty with which to trade. The banking and investment intermediaries have extended their services to the global saver-investor with the cross-border flow of funds and trading of financial products facilitated by cross-border investing, listing, and trading of securities in home and foreign markets in home and foreign currencies.

HISTORICAL DEVELOPMENT OF THE U.S. FINANCIAL SYSTEM

Specialization and division of labor, identified as sources of creativity and efficiency by Adam Smith, led to the creation of other specialized deposit-taking and investment-type financial institutions that began to meet the demand not fulfilled by the commercial banking industry. Similar institutions were created to finance agriculture and housing in rural areas, public works, and education. Laws and regulations recognized and strengthened the separation, and thus specialization, of the financial function different intermediaries performed in the financial system.

The system was further strengthened by establishing government and semigovernment intermediaries to increase liquidity in the market, manage maturity risk, and broaden the sharing of the market (price) risk through secondary markets for mortgages, agency (government and sponsored) securities, and other asset-based securities. Examples of these institutions are: Commodity Credit Corporation, Farm Credit Banks, Farm Credit Financing Assistance Corporation, Farmers Home Administration, Federal Home Loan Mortgage Corporation, Federal Financing Corporation, Federal National Mortgage Association, Federal Housing Administration, Federal Home Loan Banks, Government National Mortgage Association, Resolution Funding Corporation, Small Business Administration, and Student Loan Marketing Association.

THE MONETARY SYSTEM

The U.S. monetary system is based on credit. The U.S. currency is issued by its central bank, the Federal Reserve System, as a liability on itself. The value of the currency is based on its purchasing power in the economy and around the world and has not been linked to or defined in terms of any particular commodity or an index since 1968. The issuance of currency was tied to the U.S. gold holdings prior to 1968. The U.S. money supply consists of currency and coins and checkable public deposits in the banking system.

The Federal Reserve System, created in 1913, was established to furnish elastic currency to the economy and to supervise the banking system. Prior to 1913 there had been financial crises that were due to absence of a systematic way to provide money and credit in the economy. Large bank failures—due to fraud and mismanagement, as well as economic fluctuations and boom and bust in commodity prices—had also occurred.

The Federal Reserve System consists of the Board of Governors of the Federal Reserve and the twelve regional or district Federal Reserve banks. The Board of Governors in Washington, D.C., is the central decision-making organization. The board has seven members who are nominated by the president of the United States and confirmed by the Senate. Each board member is appointed for fourteen years, so as to ensure that the board remain immune from political influence of any administration in office. The board is set up as an independent agency; it does not report to the president, but it does report to Congress. Nevertheless, it actively coordinates its research and analysis with the White House and the secretary of the U.S. Department of Treasury in formulating policy. The regional Federal Reserve banks' Board of Directors is also structured to represent banking, industry and commerce, and the general public. There is a formal statutory requirement to have three directors from the three groups in the district area on the board.

The monetary policy-making body within the Federal Reserve is the Federal Open Market Committee (FOMC), which meets regularly (generally eight times per year). Its voting members are the seven governors of the board of governors and five presidents of the regional banks. The president of the Federal Reserve Bank of New York is a permanent member of FOMC, and the other four presidents serve on annual rotation from among four groups formed from the remaining eleven regional banks.

The regional banks are located in Boston, New York, Philadelphia, Richmond, Atlanta, Cleveland, Chicago, Dallas, St. Louis, Kansas City, Minneapolis, and San Francisco. These cities were chosen as representatives of the regional economies of the United States in 1913. It was thought at the time that the regional economies had different characteristics in terms of the type and level of economic activity, so they needed different accommodation with respect to supply of money and finance, rediscounting mechanisms, and interest rates. In other words, it was thought that there were twelve different money markets in the U.S. economy, so each one needed special attention for its needs.

This structure of the Federal Reserve System continues to this day, even though the money market has become one market because of institutional and technological advancements. Now there are truly national financial institutions, not just in terms of their national charter, with interstate deposit taking and lending of commercial and numerous other types of loans to businesses and households.

The Federal Reserve policy serves the needs of the entire economy and all its parts by taking into account economic and financial information concerning all economic segments and activities in the U.S. economy. There are many advisory committees, such as the Federal Advisory Committee representing the interests of the banking industry, the Consumer Advisory Committee representing consumer interests, and similar other committees representing interests of other segments to the Federal Reserve System. Legislative, regulatory, monetary policy, and day-to-day operations of the central bank consider relevant details in their deliberations and policy decisions, including research from a wide variety of sources—private and public—about the economy.

LEGAL AND REGULATORY STRUCTURE

The key laws governing the U.S. financial institutions are: National Bank Act of 1863; Federal Reserve Act of 1913; McFadden Act of 1927; Banking Act (Glass-Steagall) of 1933 and 1935; Securities Act of 1933; Securities Exchange Act of 1934; Federal Credit Union Act of 1934; Investment Advisers Act of 1940; Investment Company Act of 1940; Bank Holding Company Act of 1956 and Douglas Amendment of 1970; Bank Merger Act of 1966; Employment Retirement Income Security Act of 1974; Depository Institutions Deregulation and Monetary Control Act of 1980; Depository Institutions (Garn–St. Germain) Act of 1982; Competitive Equality in Banking Act of 1987; Financial Institutions Reform, Recovery, and Enforcement Act of 1989; Federal Deposit Insurance Corporation Improvement Act of 1991; Interstate Banking and Branching Efficiency Act of 1994; and Financial Services Modernization Act of 1999.

The federal agencies that regulate depository institutions are: Office of the Comptroller of the Currency, Federal Reserve System, Federal Deposit Insurance System, National Credit Union Administration, and Office of Thrift Supervision. The Securities and Exchange Commission, the Commodity Futures Trading Commission, and the U.S. Department of Justice monitor and enforce relevant laws and regulations concerning securities and futures markets. State authorities regulate, monitor, and enforce laws concerning depository, insurance, finance companies, and other financial institutions. The laws and regulations on financial institutions in the United States have made them competitive, efficient, fair, safe and sound, and transparent with the use of both carrots and sticks.

FINANCIAL SERVICES MODERNIZATION ACT OF 1999

The U.S. financial system in the twenty-first century has evolved into the largest, most developed, most efficient, and most sophisticated financial system in the world. The financial system has grown enormously since the founding of the first insurance company by Benjamin Franklin, as Philadelphia Contributionship, in 1752. The first banks in the United States were the Bank of New York, founded by Alexander Hamilton in 1784; the Bank of Boston, also founded in 1784; and the First Bank of the United States, chartered in 1791.

The economic structures and forces that have made this success possible are the concepts (or the foundation stones) of competition, specialization, thrift, entrepreneurial culture, and innovation. These concepts were just as well understood and vigorously practiced in the American colonies as they were expounded on by Adam Smith in Scotland in 1776 in An Inquiry into the Nature and Causes of the Wealth of Nations, his synthesis of a competitive market system. The United States has structured its economic and financial systems on Smith's economic model since its founding in 1776.

The Financial Services Modernization Act, signed into law by President Bill Clinton in late 1999, removed many of the restrictions on the banking and securities institutions imposed in the 1920s and 1930s. For example, financial conglomerates were again be able to organize commercial banking, insurance business, investment banking, securities underwriting, and other financial services under the umbrella of a holding/parent company. The McFadden Act and the Glass-Steagall Act are now in the history books. Financial innovation made possible by computer and communications technologies and spawned by competition and deregulation has brought U.S. financial institutions and the entire financial system to the exciting financial structure of the twenty-first century.

see also Federal Reserve System

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Surendra Kaushik