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AOF Principles of FinanceLesson 3Financial IntermediariesStudent ResourcesResourceDescription Student Resource 3.1Reading: Financial Intermediaries Student Resource 3.2Reading: Importance of Capital to Financial IntermediariesStudent Resource 3.1Reading: Financial IntermediariesDirections: Read the following resource individually. As you read, highlight any new words and ideas and underline two important sentences or phrases that will help you remember the meaning of the new word. When you have completed the reading, reconvene with your original partner and share your responses. Your friend has been getting into a lot of trouble lately, and he has just received some more bad news. He lost his science textbook and the replacement fee is $100. He has turned to you for some help. After some thought, you decide to capitalize on your friend’s misfortune and ask your uncle if you can borrow $100. Your uncle agrees to lend you money but explains that he will charge you 5% interest. As expected, your friend asks if he can borrow some money from you and in exchange he agrees to pay you 10% interest on the amount borrowed. The following week your friend lives up to his promise and pays you back $110 and in turn you pay your uncle back $105. With a smile on your face, you realize that you have just acted as a financial intermediary. You were the bank and your friend was the borrower. You have made an easy $5 profit by managing the flow of cash between your relative and friend. The following day you receive a $50 check from your great-grandmother for your outstanding report card. You decide that you need to do something with it other than keep it stashed under your mattress. You make a decision to visit your local savings and loan bank. Once there you open an account and deposit your money. Without realizing it, you have just made your neighbor Mrs. Lopez extremely happy. The local savings and loan has taken your money and aggregated it with 5,000 other people who have made deposits and has now loaned Mrs. Lopez the money that she needs to purchase her first home! Financial IntermediaryA financial intermediary is an institution or even an individual who acts as the middleman between those who want to lend money and those who want to borrow it. Financial intermediaries make their profit from the difference between the interest paid and the interest earned in the transaction. The borrower who borrows money from the financial intermediary pays a higher amount of interest than that received by the actual lender. So, in the example above, your friend paid 10% interest and your uncle received 5% interest. The financial intermediary―in this case, you―keeps the difference.Although many of the financial intermediaries listed below provide basic banking needs, they also specialize in specific services and products. Knowing this difference can help you make informed and educated decisions that can best serve your financial needs. Common Financial Intermediaries and Their FunctionsAs you have learned, commercial banks are one of the most common financial institutions. Banks take in deposits from people who want to save their money or keep it in a safe place, and use them to make loans to people who want to borrow. Some of the most common banking services include:Personal and business checking accountsPersonal and business lending servicesSavings and investment accountsCredit card servicesCurrency exchange services (this is when you exchange one currency for another, for example $100 US for the equivalent in euros or Canadian dollars) Banks offer ATM machines and a variety of online services to their customers. Some banks also offer a variety of nontraditional services, such as insurance, financial planning, and much more. Commercial bank accounts are insured by the Federal Deposit Insurance Corporation (FDIC).Thrifts are typically savings institutions and include savings and loans and savings banks. You might recall that they are called “thrifts” because they originally offered only savings accounts (and thrifty people are good at saving money). They specialize in saving accounts and real estate financing. Most savings and loans institutions are known for specializing in home mortgages; however, many thrifts are diversifying, or branching out and participating in traditional banking services as well. Thrift accounts are insured by the FDIC.Credit unions are financial institutions formed by an organized group of people with a common bond such as the one that exists between teachers, government employees, or even people residing in a particular geographical location. Credit unions are not-for-profit cooperatives that are owned by their members. Because of this, credit unions can usually offer lower loan rates and higher savings rates. Although credit unions offer many of the same financial services as banks, they are known for specializing in consumer deposit and loan services. Insurance companies are designed to protect individuals and businesses from risks. By buying an insurance policy, an individual or a business can partially or completely protect itself from monetary damages resulting from fire, theft, lawsuits, or various other risks. They are considered financial intermediaries because they invest the money they collect as premiums (similar to how banks invest the money you deposit into your account), and because they sell investment products such as annuities. Annuities are a type of investment where you put down a lump sum of money in exchange for a series of equal payments over time. These payments often include interest on the original sum plus income from investments. People purchase annuities to provide retirement income and to shift the responsibility for investing to the investment company, in this case an insurance company.A mutual fund is a professionally managed investment company that pools money from investors and invests the money into stocks, bonds, or other securities. Stocks are shares of ownership in a company that companies sell in order to raise money. Individuals and organizations buy and sell stock with the goal of making a profit. A bond is a loan an investor makes to a government or corporation for a specified amount of time for the purpose of raising money for the government or corporation. In return, the investor is repaid the initial investment plus interest. When you buy bonds, you are not purchasing a piece of ownership as you do with stocks.Mutual funds allow people with small amounts of money to diversify their investments (in other words, reduce their risk by not putting all their money into one investment) and make it easier for people to invest without spending a lot of money. Mutual funds are not guaranteed by the FDIC and carry some level of risk. In other words, you may lose some or all of the money you invest. Pension funds are workplace plans designed to provide income for employees when they retire. They function by gathering periodic payments from employers, and sometimes workers; they then invest these payments so that they can accumulate to provide enough money at retirement. Pension funds control large amounts of capital and represent the largest institutional investors in many nations. TIAA-CREF is an example of one such pension fund. As you see, the financial system in the United States is made up of many different types of financial institutions that help to manage the flow of money between the savers and the spenders. All financial intermediaries have their own role in society, and the health of these institutions is important to the overall health of the economy. Financial intermediaries ultimately create money in the economy by making loans to others who can then use it to buy homes, support businesses, send children to college, plan for retirement, and much more. Student Resource 3.2Reading: Importance of Capital to Financial IntermediariesLet’s say you’re looking to start your own lawn-mowing business. Take a moment to think about the type of capital that you’ll need. It’s likely you’ll need a few things, most importantly a lawn mower and gasoline. Depending on your business you may also want to purchase some garden supplies: lawn seed, fertilizer, rakes, hedgers, and shovels.Capital is a business’s cash or property. Capital is something that touches everyone, from individuals to small businesses to financial institutions to government. Capital is necessary to start and run a business. When a business has enough capital it can purchase items to produce more capital. Without capital, businesses cannot build inventory or purchase new materials. The fact of the matter is that all firms, and all individuals, need capital. Capital and Financial Intermediaries76200610870One of the roles that financial intermediaries perform is to facilitate the transfer of capital from those who have excess (more than they need) to those who need more than they have. This graphic shows what happens if a financial institution has problems.If a financial institution is struggling, the money it needs to support itself and the economy becomes unavailable. Consumers have trouble getting financing for their activities and then the economy slows down and purchasing stops. When consumers stop purchasing, businesses don’t have that money coming in, and as a consequence some businesses fold and others might lay off workers, resulting in more of an economic slowdown. Without financing, people cannot purchase homes or cars or acquire loans for college. Small businesses cannot get financed and existing businesses cannot grow. All of this has a profound effect on the overall health of the economy—which was demonstrated during the financial crisis of 2008. One of the most profound challenges to banking is raising and maintaining sufficient capital. Because of this, there is a lot of debate between banks and regulators over how much capital banks should be required to hold. Governments want to reduce risks, so they place regulations, or rules and laws, that dictate how much capital banks should hold. With government regulations in place, consumers have a tendency to trust that their money will be safe and borrowing practices can continue. In terms of banking regulations, the Federal Deposit Insurance Corporation (FDIC) is one of the primary regulators. The FDIC works independently of the federal government and was created in 1933 by Congress as a result of the bank failures of the 1920s and 1930s. The FDIC now monitors and regulates banks and ensures that a depositor’s money is safe. The FDIC is needed by the government to ensure as well as restore consumer confidence in the banking system. This element of trust is crucial to a bank’s—and a nation’s—economic stability. ................
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