Page 529 - Introduction to Business

CHAPTER 14 Understanding the Financial System, Money, and Banking 503

• Private information. Financial institutions are considered to be special in that
they obtain a lot of private information about individuals and businesses.
Imagine being able to view all the checks or payments made by a person or
business. You would be privy to a great deal of inside information about the inside information Private information
person or business that others do not have. Since this information enables about individuals or business firms
obtained by financial institutions
institutions like commercial banks to better understand and evaluate the
probability of being repaid in a loan agreement, many experts believe that
financial institutions are unique. With this private, or inside, information,
institutions can signal others without this information by means of the loans
they make and the prices and conditions they set on loans, for example. In
providing signaling services about the credit quality or earning potential of
firms in the economy, institutions serve to increase allocational and market
efficiency in the financial system.

Depository Institutions
Because they are central to the payments system in the economy, depository depository institutions Financial
institutions are foundational to the financial system. Deposits of individuals, busi- institutions that hold deposit accounts
of individuals, business firms, and
ness firms, and government are pooled and channeled to investment into business,
government
consumer, agricultural, and real estate loans in communities. Depository institu-
tions are made up of commercial banks and thrift institutions, with the latter insti-
tutions consisting of savings and loan associations, mutual savings banks, cooper-
ative banks, and credit unions. In terms of total assets, commercial banks ($5,522
billion) are much larger in size than savings institutions ($1,408 billion) and credit
unions ($589 billion).
Of course, due to deposit insurance, depository institutions are more heavily
regulated by the government than nondepository institutions. The government is a
stakeholder in depository institutions in the sense that their failure means that
insured depositors must be paid by the government insurance agency, the FDIC in
the United States. If the insuring agency does not have sufficient funds to cover the
losses of depository institutions, then the public must pay the losses through higher
taxes. Clearly, the failure of depository institutions is more serious than the failure
of nonfinancial firms, whose losses are borne by the creditors and shareholders of
such firms but not the taxpaying public.

Commercial Banks. Among depository institutions, commercial banks are commercial banks The most dominant
dominant in most countries. Historically, commercial banks focused their atten- type of depository institution that takes
2
public deposits of funds and channels
tion on business customers, with emphases on commercial loans. Prior to the Great
these savings to loans and investments
Depression, banks were relatively unregulated and could offer most financial serv-
ices demanded by business customers. Due to the large numbers of failures of
banks in the United States and other countries during the Great Depression, laws
were passed to severely restrict the financial activities of banks. In general, banks,
securities firms, and insurance firms were separated and not allowed to compete
with one another. It was not until the 1980s that deregulation of the financial sys-
tem began to take place around the world. Deregulation relaxed previous restric-
tions on
• The interest rates that depository institutions can offer to depositors
• The geographic location of offices in a country or region
• The financial services that can be produced and delivered to customers
By the year 2000, most of the deregulation had become effective.
At the present time, due to deregulation, rapid changes in the structure of the
financial system are taking place. In effect, we are reverting back to the preregula-
tion days prior to the Great Depression—a sort of “back-to-the-future” change in
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