1.2 Financial Institutions

To become financially literate, you must understand the lay of the land. In a perfect world, there is complete trust between borrowers and lenders, and they are able to find one another at no cost. However, in reality, the financial system is imperfect, and trust must be established before money is exchanged between parties. Financial institutions help lower information asymmetries and reduce search costs. Imagine if a complete stranger asked you for a $1,000 loan. Would you lend the stranger the money? Probably not, because you do not know the individual well enough to trust that he will pay you back. In other words, the stranger has not established any credit with you. Financial institutions often act as intermediaries between two parties attempting to negotiate a deal. These same institutions also use their established networks to connect people.

Deposit Financial Institutions

The major types of deposit institutions in the U.S. are banks and credit unions. One of the primary roles of deposit, or banking, institutions is to be a place of storage and safehouse for money that has been saved by individuals and organizations. These funds can be deposited into different bank accounts, such as a checking account and a savings account. Many employers offer direct deposit options, which can allow the organization to deposit your paychecks directly into your bank account. This removes the circulation of physical checks and usually gives you access to your money sooner. Some businesses have even started day pay options, which gives employees access to their money moments after finishing a work shift.

A checking account is a type of transaction account that allows you to deposit and withdraw money with ease. The institution will likely issue a debit card that is linked to the checking account that can be used to withdraw money from that account. Many institutions have safeguards in place to help you avoid overdrawing your account, which occurs when you attempt to purchase something with insufficient funds. Be careful with safeguards like overdraft protection plans, as they might charge a fee for borrowing money—even if it is for a few hours. In a subscription-based society (e.g., mobile phone, Wi-Fi, gym membership, gaming services, etc.) it is critical that you know how much, and when, money is being withdrawn from your checking account. It is important to frequently check the balance of your checking account, particularly before purchasing a new good or service.

A savings account is a bank account that earns interest. When you deposit money into a savings account, you are essentially lending money to the bank, and in return the bank pays you interest. A common practice among banks is to limit the number of withdrawals that can be made from a savings account in a particular month (this generally includes transfers to other accounts as well). Since 2013, the U.S. national average interest rate on savings accounts has been 0.06%. You will not get rich by storing your money in checking and savings accounts, but you will have almost instant access to your money, known as liquidity. A good rule of thumb is to have enough cash in a liquid account to cover three to six months of non-discretionary cash flow.

Non-Deposit Financial Institutions

There are many other financial institutions that help intermediate transactions and circulate cash in the economy but cannot accept deposits. These non-deposit financial institutions generally include insurance companies, securities firms, and mutual fund companies.

Insurance companies collect money, or premiums, from individuals and businesses in exchange for protection against financial loss. Generally, people pay for protection against unexpected death, illness, and damage to property. For example, suppose you are the only person earning money in your household. If you were to pass away unexpectedly, the people depending on your money would not have enough to cover non-discretionary expenses. You can enter into a contractual agreement with the insurance company in which a pre-determined amount of money is to be paid out to your dependents in the event of your death in exchange for regular payments. This reallocates some of your cash flow away from liquid accounts into an insurance account that can only be accessed by filing a claim. Of course, you would rather live than file the claim, and the insurance company is banking on this. To be profitable, the regular cash inflows that the insurance company receives must be greater than the irregular cash outflows that it pays.

Mutual fund companies are financial services organizations that pool money together from investors and use the proceeds to purchase financial assets. These bundled assets are called mutual funds. The fund managers are in charge of investment research and selecting assets. There are two main types of mutual funds: open-end funds and closed-end funds. An open-end mutual fund receives regular infusions of cash flows from investors in exchange for shares of the fund. The term “open” means that the mutual fund is open to new investors. Investors buy and sell (or redeem) shares of an open-end fund directly with the mutual fund company. A closed-end mutual fund operates with a fixed amount of cash provided by investors. The term “closed” means that the fund is closed to new investors. After the initial offering, investors buy and sell shares of a closed-end mutual fund from one another. Mutual fund companies also offer many other services, such as financial advisors, automatic reinvestment plans, and tax record keeping.

Securities firms help facilitate trade between buyers and sellers of financial assets. Many securities firms are registered brokers, dealers, or both. A broker trades financial assets on behalf of its customers, while a dealer trades for its own account. Full-service brokerage firms, such as Charles Schwab, Fidelity Investments, E*Trade, and TD Ameritrade, offer a large variety of services to their customers, including research, tax advice, retirement planning, and so forth. In exchange for these services, brokerage firms charge fees. Before 2019, most brokerage firms charged a commission per transaction. Since then, most have transitioned to commission-free trading. However, a brokerage fee is still charged. This fee is known as the bid-ask spread, which is the difference between the buying price (ask quote) and the selling price (bid quote). This fee is larger for financial assets that are traded less actively. There is no better time than the present to open up a brokerage account and begin trading.