Define: Financial Institution

A financial institution is an organisation that provides financial services and products to individuals, businesses, and governments. These institutions play a crucial role in the economy by facilitating the flow of funds between savers and borrowers and by providing essential financial services that support economic activities and growth. Financial institutions offer a wide range of services, including deposit-taking, lending, investment management, insurance, payment processing, and financial advisory services. They include banks, credit unions, insurance companies, investment banks, brokerage firms, pension funds, and other entities that engage in financial intermediation. Financial institutions are subject to regulatory oversight and supervision to ensure stability, integrity, and consumer protection in the financial system. They operate within a framework of laws, regulations, and industry standards designed to safeguard depositors’ funds, promote fair and transparent financial markets, and mitigate systemic risks. Overall, financial institutions play a central role in the functioning of modern economies, providing essential services that support economic growth, investment, and wealth creation.

In financial economics, a financial institution acts as an agent that provides financial services for its clients or members. Financial institutions generally fall under financial regulation from a government authority. Common types of financial institutions include banks, building societies, credit unions, stock brokerages, asset management firms, and similar businesses.

Function

Financial institutions provide service as intermediaries of the capital and debt markets. They are responsible for transferring funds from investors to companies, in need of those funds. The presence of financial institutions facilitates the flow of money through the economy. To do so, savings are pooled to mitigate the risk brought to provide funds for loans. Such is the primary means for depository institutions to develop revenue. Should the yield curve become inverse, firms in this arena will offer additional fee-generating services including securities underwriting, and prime brokerage.

Corporate Valuation

Relative metrics: Price/Equity Price/Book Value

Use Equity Multiples (as opposed to Enterprise Multiples). In order to consider how valuing a Financial Institution’s balance sheet is different from a non-Financial firm. Consider how an industrials firm wields capital machinery (asset) and the loans (liabilities) is used to finance that asset. The line is blurred in Financial Institutions, which must hold deposit accounts (liabilities) to fuel the issuance of loans (assets). The same accounts are considered loans as they are held in ownership not of the bank, but of the individual client.

Dividend Discount Model: Earnings-per-share

Dividends-per-share

Discounted Cash Flow (DCF) Model: You’ll need the FCFE (Free Cash Flow for Equity), which is the amount of money that is returned to shareholders. Calculate an FCFF (Free Cash Flow to the Firm): EBIT (1-tax rate) -Capital Expenditures+ (Depreciation & Amortization) – (Net increase in working capital)= FCFF

FCFF-Debt+Cash=FCFE

Use the Capital Asset Pricing Model, not the Weighted Average Cost of Capital (for the same reasons one uses Equity Multiples in relative valuation) to determine the cost of equity (the return required by shareholders in order to make the decision to invest in a financial institutions)

Excess Return Model: A model where valuation is expressed as the sum of capital invested currently in the firm and the present value of dollar excess returns that the firm expects to make in the future.

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This glossary post was last updated: 29th March, 2024.