Question

How finance companies are distinguishable from savings institutions and credit unions?

Two major risks faced by finance companies based on their uses and sources of funds

Answer 1

We see savings institutes and credit unions, for the sake of the answer, as banking institutions while finance companies as non banking institutions, like Investment banks, NBFCs(non banking financial institutions),Insurance companies etc.

The major difference between these is that a banking institution gets deposits from various depositors, pays them interest on it, while uses these savings to lend loans at a higher rate. This is how they pay the interest on savings and make money for themselves.

While the non banking institutions do not have the luxury to enjoy savings/deposits, in some form they do have sources of funds but these are to be directly used for the purpose, like for an insurance company the premium paid on policy safeguards us from potential calamity for which we would be paid out.

Two major risks for finance companies are

1. Liquidity risk: say a calamity happens a pile of insurance policies come for claim, now the insurer is liable to pay up the amount covering each of these policies, now the sources of funds are the policy premiums while the uses are the policy pay outs.

2. Market Risk: When we say market risk we mean the risk associated with for example any stock, bond etc one holds with changes in its demand equating to a change in its price. Say a investment bank(IB) in facilitating an IPO, the usual transaction is that they underwrite the price of a stock based on their due diligence, say the market doesn't agree with the fundamentals which then used for price derivation and now the market has changed due to changes in industry etc, the IPO isn't fully subscribed, now due to the market risk the IB would need to purchase these non subscribed portion of shares(as a part of usual IPO underwriting transaction)