The financial sector refers to the businesses and institutions that manage money and provide intermediary services to transfer and allocate financial capital in an economy.
Types of Financial Institutions
The institutions can be broken down into major categories, as follows:
1. Retail Banks
Retail banks are the classic deposit-taking institutions that accept cash deposits from savers and pay interest on those savings. They generate revenue by lending out the deposits to borrowers at a higher interest rate than is paid on savings.
The bank earns the differential between the interest paid on deposits and the interest earned from loans. Some well-known examples of retail banks worldwide are Bank of America, Royal Bank of Canada, BNP Paribas, Mitsubishi UFJ, HDFC Bank. They are also known as commercial banks.
2. Investment Banks
Investment banks are non-deposit-taking institutions. They are primarily focused on the practice of corporate finance. They provide advisory services to businesses to help them raise funds from the financial markets, e.g., helping a company raise equity via an Initial Public Offering (IPO). They also offer other services like prime brokerage, which are brokerage services like securities lending to large institutional clients.
Investment banks generate revenue primarily through fees earned by providing advisory and underwriting services. They also generate profits through trading in the financial markets.
Most commercial banks oversee an investment banking arm, though more recently, they are required to separate the two business units under the Dodd-Frank Act and other laws. Some well-known investment banks include Morgan Stanley, Barclays, and Goldman Sachs.
3. Investment Managers
Investment managers are professional firms that provide investment management services to individual and institutional clients. They include a variety of players, such as mutual fund and exchange-traded fund (ETF) managers and hedge funds.
Mutual fund and ETF managers primarily serve retail investors by offering pre-packaged investment vehicles. They generate revenue by charging a small fee on managing the total money, also called assets under management.
On the other hand, hedge funds clients are primarily institutions and a few high-net-worth individual investors. The term hedge fund here refers to the many kinds of alternative asset managers like private equity and venture capital, commodity trading advisors (CTAs), highly specialized public markets investors, etc.
Popular examples of investment managers include Fidelity (mutual funds), BlackRock (ETFs), D.E. Shaw (hedge fund), Carlyle Group (private equity).
4. Government Institutions
The government is a major player in the financial markets. Through its various institutions, it regulates the functioning of the markets. The biggest and the most influential government institution in any financial market is the central bank.
A central bank is the sole issuer of legal tender or currency in an economy. It also controls the interest rates in the domestic market and, in many cases, the exchange rate for a currency in the foreign exchange (FX) markets.
Outside of the central banks, some securities regulators lay down the rules that regulate the functioning of financial markets. Securities regulators ensure that the financial markets operate in a fair and transparent fashion. To this end, they require elaborate disclosures from various players in the financial markets to ensure transparency, as well as penalize those who indulge in illegal activities like insider trading.
These are venues where the actual trading of financial assets takes place. The most common kind of exchange is the stock exchange. For a stock to be traded on an exchange, it must be listed there.
Stock exchanges set out specific criteria that a company must meet to be listed. They collect orders from different market participants and post them on an order book. As buy and sell orders match, the trades are executed. Today’s electronic exchanges are capable of executing millions of trades per day.
Clearing houses serve a different purpose. They are responsible for settling accounts between various participants in a market. They are common in the derivatives market, where many contracts are cash-settled, i.e., one party pays the other based on the price of the underlying security. It is the job of the clearing house to assign the payer, receiver, and amount of payment.
A clearing house is often referred to as the Central Counterparty Clearing (CCP) party. An example is CME Clearing, the clearing house for the Chicago Mercantile Exchange (CME).
6. Payment Processors
Payment processors are intermediaries that facilitate the exchange of funds between disparate parties. They network various institutions and ensure a secure transfer of funds between them.
Most day-to-day electronic transactions are processed by payment processors. Whenever one uses a debit or credit card, the payment processor securely transmits the transaction information to the user’s bank and routes the funds from the user’s account to the vendor’s account.
Payment processors generate revenue by charging a small fee on every transaction that is routed through their network. Examples of payment processors include Visa, MasterCard, Interac, and American Express.
7. Insurance Providers
Insurance providers encompass another large portion of the financial sector. They provide protection against unforeseen financial losses arising from events like accidents and disasters in exchange for a small premium paid at regular intervals. They serve both individuals and institutions.
In the case of individuals, they provide products like life insurance, health insurance, auto insurance, and house insurance. For businesses, they provide products like marine insurance for goods on ships, data breach insurance, worker’s compensation insurance, etc.
There are also reinsurance companies that provide insurance to insurance companies. They help cover an insurance firm’s liabilities in case of a major disaster. Examples of insurance companies include Manulife and MunichRe (reinsurance).
Financial Sector in Macroeconomics
In macroeconomics, the economy is often modeled as a circular flow between households, companies, and the government. In the aftermath of the Great Financial Crisis, economists realized that the financial sector exerted a significant influence on the economy and must be added to their models. It led to the development of models that included the financial sector as an integral part of the economy. It was further necessitated by the introduction of unconventional monetary policy by central banks.
Monetary Policy and the Financial Sector
To counter the effects of an economic depression, central banks use expansionary monetary policy. The policy is implemented by increasing the amount of monetary reserves available in the financial system. The expectation is that the reserves will be used for lending activities, thereby increasing economic activity.
A specific method of implementing monetary policy is known as quantitative easing (QE). Under QE, the central bank purchases high-quality securities from banks in exchange for cash. The cash is then used to meet the regulatory reserves and for increased lending and investment.
We’ve seen that the modern financial sector is not a monolith but is composed of many different players, each playing an important role. Money is often called the blood of an economy, and the financial sector is the system that circulates money throughout the economy, enabling transactions at all levels. From buying a chocolate bar to acquiring a company, nothing escapes the touch of the financial sector.
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