Financial Institutions

Financial institutions allocate the economy’s money to many different people for many different purposes. This groups includes banks, asset management firms, insurance companies, and more. Their actions provide capital to those who want to use it.

 

Benefits to Society

Financial institutions primarily lend money. Banks loan large amounts of money into the economy. Banks, as do other financial institutions, create new money when they originate loans. This is because of fractional reserve banking. This expands the money supply, providing stability and liquidity for the economy. These organizations also work to put capital to the most productive use possible. They are incentivized to do so, as allocating capital more productively will result in higher returns for them.

 

“It is not by augmenting the capital of the country, but by rendering a greater part of that capital active and productive than would otherwise be so, that the most judicious operations of banking can increase the industry of the country.”- Adam Smith

 

Means of Income

Money is earned by financial institutions in the form of interest. Interest is the cost of borrowing money. Lenders use interest payments to cover expenses, and are left with a profit. There are also financial institutions that earn money in the form of investment returns. This includes hedge funds, venture capital funds, segments of investment banks, and certain insurance company investments.

 

 


The free enterprise system creates an economic environment for financial institutions to thrive in. As a result, consumers, businesses, and governments all have better access to financing. A proper financial system is important for a growing economy. To read about related topics, visit the page “How the Free Enterprise System Works.”