How Financial Institutions Differ from Other Companies

A financial institution is an intermediary between providers and recipients of capital or debt that provides banking, insurance, and investment services. There are various types of financial institutions consisting of banks (deposit-taking, loan-making institutions), investment banks, clearinghouses, credit card companies, brokers, dealers, exchanges financial advisors, investment managers, depositories, and insurance companies. However, there exists an overlap across financial institutions. In other words, life insurance companies not only provide mortality-related insurance services but also offer saving vehicles. However, we are going to focus on only banks and insurance companies in this reading.

Systemic Risk

A unique feature of financial institutions, particularly banks, is their systemic importance. A systemic bank is simply a bank whose failure might trigger a financial crisis. These banks are “too big to fail” informally. Banks create interlinkages across all types of entities as they act as intermediaries. Therefore, the larger the bank and the more widespread its inter-linkages, the more significant its potential impact on the whole of the financial system.

Financial institutions face systemic risk. Systemic risk is the possibility that an event at a company level might impair all or parts of the financial system or collapse the entire industry or economy. Financial contagion refers to the spread of financial shocks from their place or sector of origin to other locales or sectors. In other words, a declining economy may infect other healthier economies.

Regulation

Financial institutions call for heavy regulation due to their systemic importance. Regulators address various issues, including the amount of capital that must be maintained, the minimum liquidity, and the riskiness of assets in an attempt to constrain excessive risk. Additionally, the liabilities of most banks consist mostly of deposits. Therefore, if a bank fails to honor its deposits, depositors lose trust and may stop making the deposits. The expectation that a bank may fail to honor its deposits drives depositors to withdraw vast sums of money suddenly, ultimately leading to the failure of the entire banking system.

Financial Assets

Assets of financial institutions are typically financial assets such as loans and securities. On the contrary, non-financial companies hold tangible assets. For that reason, financial assets face direct exposure to risks such as credit risks, liquidity risks, market-rate risks, and interest rate risks. Unlike many tangible assets, fair market value measures financial assets for financial reporting purposes.

Supra-National Entities

Besides banks and insurance companies, other financial institutions are supra-national entities. These are international entities such as the World Bank, which focus on lending activities in support of the member’s specific missions.

Question

An analyst trainee at ABC Ltd. meets with a senior analyst to discuss some of the firm’s investments in banks and insurance companies. The senior analyst asks the trainee to explain why the evaluation of banks is different from the evaluation of non-financial companies. The trainee answered as follows:

Statement 1: “The assets of banks mostly consist of deposits which face direct exposure to different risks than the tangible assets of non-financial companies.”

Statement 2: “Banks are more likely to be systemically important than non-financial companies because they act as intermediaries.”

Which of the trainee’s statements regarding banks is (are) most likely accurate?

    A. Only Statement 1

    B. Only Statement 2

    C. Both Statement 1 and Statement 2

Solution

The correct answer is B.

Financial institutions, particularly banks, have a unique feature in that they have a systemic importance. As intermediaries, banks create financial linkages across all types of entities. These linkages mean that the failure of one bank negatively affects other financial and non-financial entities. This phenomenon is known as financial contagion. A large bank with a more widespread network of linkages is more likely to have a higher potential impact on the entire financial system.

A and C are incorrect. Bank assets are mainly financial assets, such as loans and securities (not deposits, which represent most of a bank’s liabilities). These assets create direct exposure to a different set of risks, including credit risks, liquidity risks, market risks, and interest rate risks compared to the tangible assets of non-financial companies.

Reading 14: Analysis of Financial Institutions

LOS 14 (a) Describe how financial institutions differ from other companies.