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Types of financial institutions and banks

Types of financial institutions and banks

With a bank on every corner, navigating the financial world as a small business owner can be challenging if you don’t know what type of institutions best serve your needs.

While the Federal Deposit Insurance Corporation regulates both (FDIC), traditional banks and non-banking financial institutions can help support your business in numerous ways — if you know the key differences and what each can offer.

Whether you’re looking to establish checking accounts, home mortgages, or credit services, here’s everything you need to know about the different types of financial institutions and how they can serve you and your business.

What is a financial institution?

A financial institution is an organization that engages in financial and monetary transactions. These transactions can be investments, loans, deposits, or currency exchanges.

But “engaging in financial transactions” is a broad description. There are a lot of financial and banking service providers that can fall under this umbrella. Some of them are banks — for example, commercial banks and credit unions are types of financial institutions.

Other institutions, like brokerage firms and mortgage loan companies, provide loans and investment services but do not engage in traditional banking services. These are known as non-banking financial institutions (NBFIs).

In short: While banks are a type of financial institution, not every financial institution is a bank.

What is a bank?

Banks are financial institutions that can accept deposits from the public and offer loans to borrowers from those deposits and the interest gathered from them. To function as a bank, an institution has to get a bank license from the federal or state government.

A banking license validates that a bank has all the processes and policies in place to protect its customers’ money, such as holding a certain amount on reserve. Without a license, a financial institution has no legal right to take deposits and issue withdrawals, nor can it act as an intermediary between depositors and borrowers.

But NBFIs offer a lot of the financial services that banks also provide. For example, mortgage companies provide mortgage loans. However, the key difference is that a bank uses customers’ deposits as funds for loans, while mortgage companies use their own funds.

Banks play a unique role in ensuring a functioning economy: They’re the intermediaries facilitating the movement of capital from those who deposit funds and those who want to borrow.

A diagram showing the flow of deposits, loans, and withdrawals between a bank and borrowers and savers

Many bank customers are both depositors and borrowers. When your business, for instance, deposits money, you earn a little interest. You can send or receive money from that account through debit card withdrawals, wire transfers, ACH payments, or other transactions.

But your business also needs capital. So, you use your business credit card or take out a small business loan to get the funds you need to invest in new growth, purchase equipment, and supplies, or pay for operational expenses.

In this way, your business pretty much does everything it needs to with money — deposit, send, exchange, borrow, and receive funds — all because the financial institution with your business account has a bank license, adheres to current banking regulations, and offers all these essential banking services.

How do banks make money?

Banks make money in two main ways:

  • Lending out the funds they’ve pooled from customers’ deposits
  • Collecting fees from customers’ deposits

Let’s break down how exactly these methods work.

Lending out funds

Have you ever noticed that your bank deposits a small amount of money in your savings account? This is called interest; banks offer it if you keep a balance. But while your bank might pay you interest, those earnings pale compared to what the bank brings in from lending money.

For example, the average savings account interest rate in the US is 0.24%. But the bank earns a much higher rate for lending their pooled deposits from customers.

Additionally, according to Business Insider, the average mortgage lending interest rate in the US as of January 2023 is approximately 6.3% — and rates for credit cards, business loans, or personal loans can be even higher. These interest rates are where banks get the majority of their money from.

Collecting fees

Banks also make money through account fees for monetary transactions and financial services they provide to customers. Think interest, yearly fees, late fees, and account opening fees.

But, unlike other types of financial institutions, banks have stringent regulatory standards. The Federal Reserve requires banks to hold a percentage of their deposits on reserve, which impacts their interest rates, lending abilities, and, consequently, how much banks can earn.

Are central banks considered financial institutions or banks?

A central bank is not a traditional bank: It’s an institution that governs the operations of all commercial banks and credit unions within its purview. The Federal Reserve, for example, is the United States central bank.

So, does that mean that the Federal Reserve and other central banks around the world are considered actual banks?

Central banks don’t deal with deposits and withdrawals like traditional banking institutions do. Their role is to set monetary policy at the national level and keep the money supply stable.

Therefore, a central bank is not a typical bank. But it does typically act as a banker for other national banks by holding their reserve deposits. A central bank can also act as a lender of last resort for financial institutions.

The major types of financial institutions

While every business needs a good-standing account at their local bank, companies might also use services offered by non-depository institutions. Here are some examples of other financial institutions you might encounter.

Brokerage firms

A brokerage firm acts as an intermediary between buyers and sellers of securities. If your company wants to trade shares of mutual funds, exchange-traded funds (ETFs), stocks, bonds, or other financial instruments, you need a brokerage company to execute the transaction.

Insurance companies

Insurance companies insure against any potential risks. As a small business owner, you need an insurance company to address business risks such as liability risk and commercial property risks. That way, if something were to happen, your business would not lose money.

Investment banks

Even with “bank” in their name, investment banks do not take deposits and loan out funds like traditional banks. Instead, this financial institution facilitates capital markets and is considered part of the banking industry.

Investment banks help businesses raise capital by issuing securities. So if your company is ready to issue shares of stock as an initial public offering (IPO) or an additional stock offering, you’d use an investment bank.

Investment banks also assist with complex financial transactions like mergers, acquisitions, and corporate debt financing through corporate bonds.

Mortgage companies

If your business wants to take out a mortgage to purchase commercial property, you will need a loan from a bank or a mortgage company.

Mortgage companies only fund mortgage loans, so they don’t offer other financial services like banks. But, because they’re laser-focused on mortgage lending, they can usually streamline the process and help you close your loan faster, which is critical for commercial real estate transactions.

The major types of banks

Depending on your banking needs, your business will likely interact with different types of banks. Here are the major types of banks you might need an account with to run your business:

Retail and commercial banks

The most well-known banks in the industry fit this mold: Citi, Bank of America, Chase, and Wells Fargo all offer both retail and commercial banking services.

You can open business checking and savings accounts at one of these banks, take out a business loan or mortgage loan, get a credit card, or open certificates of deposit (CDs) for your business savings.

Because the larger retail and commercial banks have branches across the country, you can find a branch location in most towns and cities, making these banks convenient for companies that want to expand their business presence.

Credit unions

Credit unions offer many of the same services as retail and commercial banks but operate differently from other types of banks.

First, they’re not-for-profit financial institutions. So, while they still take deposits and bring in revenue from loans, they’re not trying to turn a profit but rather sustain themselves and their members. And unlike a for-profit bank, which aims to increase profits for shareholders and other stakeholders, a credit union serves its members only.

As such, you’ll tend to find lower fees and higher interest rates on savings accounts at a credit union, which might be why more than one-third of Americans bank with a credit union.

Like the big banks, most credit unions serve small businesses too, so you can also open your savings and checking account and take out a business credit card from your local credit union.

Online banks

Online banks are the newest financial institution that only provides services through a digital medium. Because they don’t have branches, they can offer customers higher interest rates.

Like credit unions, many online banks have low or no fees. And you can still do most of your banking at an online bank — they offer CDs and various business loan products, and some even offer brokerage accounts.

An online bank is a good option if you’re looking for a high-interest savings account for your business. However, if you need to withdraw cash, you’ll likely be charged a small fee since you’ll have to use ATMs from other banks.

Savings and loan associations

Falling between a credit union and a commercial bank, savings and loan associations — also called S&L associations or “thrifts” — are institutions that specialize in providing residential loans and savings accounts.

Since only 20% of their lending can be commercial, savings and loan associations aren’t ideal for businesses. Another difference is that S&Ls are owned and operated by their customers and shareholders, unlike any other type of banking organization.

The bottom line: What’s the difference between financial institutions and banks?

Whether you’re drawn to commercial banks with lower rates or local credit unions that help fuel your town’s economy, the financial space is wide and varied. You can explore different options to get the best services and ideal rates for your financial needs. Here are the key takeaways you should remember when choosing between banking institutions and NBFIs.

A table showing the difference between different types of financial institutions

Sync with AP software for easier business banking

As a business owner, your bank account will always be at the heart of your financial activities, including making payments, tracking spending, and balancing the books.

The best part? Tracking your banking transactions and habits has never been easier.

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