What Is the Importance of Financial Institutions?

Financial institutions provide consumers and commercial clients with a wide range of services and different types of banking products. The importance of financial institutions to the wider economy is apparent during market booms and recessions. During economic upturns, financial institutions provide the financing that drives economic growth, and during recessions, banks curtail lending. This can exacerbate a country's financial problems and draw attention to the fact that economies are heavily reliant upon the financial sector.

Moneylenders and insurance companies have been lending money to people and insuring against loss for centuries, but in the 20th century, governments around the world began to recognize the importance of financial institutions and passed legislation that made it easier for more people to obtain products and services from these entities. In many countries, banks are encouraged or even compelled to lend money to home buyers and small businesses. Readily available loans encourage consumer spending, and this spending leads to economic growth.

Consumers are often either people with cash who are seeking returns on their money or people without cash who need to borrow money in order to cover their short-term expenses. Banks act as intermediaries between these two groups. People with cash lend money to the back in return for a nominal rate of interest, and banks lend that same money to consumers at a much higher rate of interest. The difference between the price a bank pays to borrow and the price it charges its own customers to borrow enables the bank to generate a profit. In many instances, the importance of financial institutions is most vivid during recessions when savers run short of cash and banks lack the cash to finance consumer lending.

Financial institutions offer various types of insurance, ranging from life insurance to insurance on mortgage contracts. Insurance firms and banks also insure other financial institutions. If one bank becomes insolvent, its losses are partially absorbed by the other institutions that insured it. In some instances, this can lead to systemic risk, which describes the danger of a major bank's collapse having a filter down effect on other banks and the economy as a whole.

When major banks and insurance firms become insolvent, government regulators are reminded of the importance of financial institutions to the economy and the dangers presented by systemic risk. Regulators in many countries regularly audit financial institutions to try to resolve short-term cash flow issues before those issues evolve into major banking industry problems. In many countries, government regulators have imposed caps on the amount of loans a bank can write and on the amount of insurance policies that any one firm can issue. Such moves are intended to ensure that no bank becomes so important to the economy that its failure could put the health of the entire economy in doubt.