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Chapter 3 - Financial Institutions A banker is a fellow who...

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44 Financial Institutions “A banker is a fellow who lends his umbrella when the sun is shining and wants it back the minute it begins to rain.” —Mark Twain Too Big to Fail? Fannie Mae, Freddie Mac, Lehman Brothers, AIG, Bear Stearns, Countrywide Financial, and Washington Mutual were huge financial institutions. Each of these had names that signaled financial strength. All had been around for many years. They all failed in 2008. Financial institutions are essential to the financial system. We rely on them to make business and mortgage loans, to stand behind the insurance policies issued, and to stand behind promises made in financial instruments. When promises are broken, businesses can fail, state governments can have financial crises, and the whole economy can tank resulting in millions of lost jobs. Financial institutions take in funds from some while providing funds to others. Promises are made to those who put their funds into a financial institution. The promise may be to pay interest and principal according to specified terms. It may be to insure a house, boat, or life. It may be to provide retirement income according to a specified formula. Promises are also made by some financial institutions via “credit default swaps” to some bond investors to pay scheduled interest and principal if the issuer of the bond defaults. Sometimes financial institutions make promises to each other. When large amounts of money are at stake the breaking of a promise by one large financial institution can cause the failure of another large financial institution that was relying on that promise. This has the potential to cause a chain reaction of failures by financial institutions. Most financial institutions are regulated by the federal, state, and local governments in a variety of ways. These regulations are being rethought in light of our financial crisis. The public needs to be protected while not intruding on the rights of private sector owners. This will be a challenging balancing act.
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45 © Robert Brown (http://www.fotolia.com/p/4167) Learning Objectives After reading this chapter, you should be able to: 1. Explain financial intermediation and the role of financial institutions. 2. Define commercial banks and explain how reserve requirements influence their operations. 3. Describe how the Federal Reserve regulates financial institutions. 4. Explain how savings and loan associations differ from commercial banks. 5. Describe how credit unions operate. 6. Distinguish among finance companies, insurance companies, and pension funds. Chapter Overview In the preceding chapter we discussed how the financial system makes it possible for deficit and surplus economic units to come together, exchanging funds for securities to their mutual benefit. In this chapter we will examine how financial institutions help channel available funds to those who need them. We will also see the important role the Federal Reserve plays in regulating the financial system, protecting both deficit and surplus economic units.
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