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Understanding Finance

Updated on September 7, 2009

Finance is essentially the process of providing funds for economic activities. The producer, the businessman, the consumer, governments, and others often do not have available the funds necessary to complete their transactions. Yet, funds are required as a means of payment- the catalyst that makes production or exchange possible. The funds must be made available in (1) the proper amount of means of payment and (2) the right kinds of funds, such as francs for an American's purchase of French goods.

Financial institutions have grown up to create, provide, exchange, and utilize funds. Taken together, these institutions constitute the financial structure of a modern country. They serve individuals, businesses, and governments, within the country and across international boundaries.

Finance is not to be interpreted in the strict sense of lending only, or of cash only, or of private activity only. The creation of credit by banks or the guaranteeing of a loan is as significant as the granting of the loan itself. Credit money - which takes the form of bank demand deposits and is represented by checks- is even more important than cash or currency in most of the more highly developed economies of the world. Also, governmental finance is nearly equal to private finance in quantitative importance and is often more significant qualitatively and politically. Thus finance is an extremely broad area encompassing many different fields that are bound together by their origin in the same economic fact: an economic entity needs funds, and it attempts to acquire them through society's numerous and varied financial institutions.

The study and practice of finance are concentrated in specialized fields, each of which constitutes an income-making endeavor. These financial specialties include (among others) banking, consumer finance, business or corporation finance, insurance, real estate finance, international finance, and public (governmental) finance. The fields are not mutually exclusive, however. For example, banks often extend loans on real estate, so that the fields of banking and real estate finance overlap. The integrating entity for all financial fields is money- money in the broad sense of all generally accepted media of exchange.

To facilitate the transfer of needed funds to those areas and groups requiring them (and willing to pay for their use), specialized organizations have developed. They accumulate the funds of savers or investors and make them available to users of funds, usually but not always in the form of loans. As a group, such organizations are called "financial intermediaries". In addition to banks and other institutions of deposit such as savings and loan associations, they include pension funds, life insurance companies, investment companies, and many others.

Banking

Banks are of many different kinds, but they all have the same basic characteristics: they serve as depositories for the funds of the public and lend funds to individuals or businesses. Banking deals essentially with the process of providing loan funds to borrowers, primarily in the form of bank credit. Commercial banks are in the unique position of being able to create money by establishing or adding to checking accounts (demand deposits) of borrowers by means of commercial loans. In many economically advanced nations, banks' credit money constitutes the bulk of the total money supply. A strong commercial banking system operating on a fractional reserve basis is essential for a nation's economic growth and prosperity.

Consumer Finance

Providing loan funds to consumers to buy consumer durable goods, such as automobiles or furniture, is a specialized area of finance. It differs from all others in that the good acquired does not usually provide the means of repaying the loan.

Special and separate institutions have developed for the extension of consumer credit. These are called "consumer finance companies" or simply "finance companies". Operating with a combination of equity funds, retained earnings, and borrowings from banks, finance companies make relatively small (under $2,000), unsecured loans of up to three years' duration to individuals. Most are installment loans calling for repayment in equal monthly installments that include both principal and interest. Banks, which formerly avoided loans that were not self-liquidating, have generally expanded their activities to include consumer loans. 

Business or Corporation Finance

Business enterprises often need funds in addition to their own. These funds may be used to provide working capital, expand inventories, or replace or expand plant and equipment. Smaller businesses usually must turn to institutional lenders, such as banks, for financing. Larger enterprises, however, typically are corporations, which are able to turn to the public, through organized security markets in most cases, for financing both equity and debt funds. Thus this area is often treated as corporation finance, since the corporate form of business enterprise accounts for the dominant share of business activity.

Business or corporation finance involves securities markets, investments, and investment banking. Securities markets handle the issuance, sale, and purchase of both equity shares (stocks) and evidences of indebtedness (bonds). Investments are the placement of funds in business enterprises by individuals or institutions, usually with the aid and advice of investment counselors or brokers. Investment banking is a specialized activity developed through the highly institutionalized process of issuing new securities. Investment bankers facilitate this process by acting as selling agents and by underwriting the issues. Underwriting involves a guarantee to the issuing corporation that a minimum sum will be realized from the sale of the securities.

Insurance

Certain types of risk are involved in all economic activity. Some of these risks are subject to pooling or shifting through a financial intermediary. These risks are insurable, and the intermediary to which they are shifted is an insurance company. The essential function of an insurance company is to substitute a small, certain loss (the insurance premium) for a large uncertain loss (the risk hazard). In doing so it accumulates large sums of money, which are invested or lent out in many fields. Insurance companies thereby provide a vast amount of investment or loan funds annually.

Real Estate Finance

The acquisition and transfer of real property and its improvement involve a considerable use of credit. In both residential and business property the purchaser usually has only a small part of the purchase price and must obtain financing on a long-term basis for the rest. Intermediaries frequently play a major role in bringing borrower and lender together in this field.

International Finance

The exchange of goods and services and the extension of credit across national boundaries follow much the same principle as similar transactions in the domestic economy. Government generally plays a more active role in international transactions than it does in internal affairs.

Foreign Exchange Markets

The outstanding characteristic of international finance is the employment of different currencies. Because national currencies are normally accepted only in the domestic economy, some means must be devised for exchanging one currency for another on an equitable and economic basis. The foreign exchange market performs this function by establishing the ratio of exchange for two or more currencies. International exchange markets, gold exchanges, and such agencies as the International Monetary Fund help maintain international currency stability. They permit national governments, central banks, and individuals to buy and sell other currencies at rates set both by agreement and by the forces of supply and demand

Public Finance

Government must acquire funds to finance its activities, just as private enterprise does. Great care must be taken in this area because the revenues of government are mostly compulsory, derived from taxes. Sound principles of finance are particularly important because national governments typically have control over the money supply and in extreme circumstances can greatly affect the value of their money and hence the entire credit and financial structure of the economy. 

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