Financial Crisis 2000s: The Basics of Financial Services

Financial Services companies are a fundamental part of a capitalist economy. These businesses make money by helping their clients (people and businesses) use money productively. There are lots of different kinds of financial services businesses, and they all work together, so it is important to understand what they each do so you can understand why they act the way they do and how the financial system is supposed to work. This won't tell you why the system failed and the crisis unfolded. For that, see the next post.

A bank is a common financial services company that many people interact with. You can deposit your money into a bank, the bank keeps a record of your money and you can get it back when you need it. The bank may also pay you a fee for keeping your money with them. That fee is called interest. The bank may also loan that money to someone else who needs it (collecting a larger fee for loaning the money).

Many large financial companies help their clients borrow money from one or more different clients. The legal framework for this is called a bond, and that bond can be bought and sold until the bond is paid off by whoever borrowed the money. This way of making money is called brokering a bond.

When a bond is created, part of the definition of that bond is how much extra money the borrower will pay for the right to borrow the money. That extra money is also called interest. A second way that financial service firms make money is by agreeing to collect the money that borrowers owe and distributing it to whomever loaned the money (and therefore, owns the right to get that money). This way of making money is called servicing a bond.

A third way that companies make money is by providing an expert opinion on how likely a borrower will fail to pay the interest and the original amount of the loan. This way of making money is called rating a bond. A rating company is profitable as long as the fees it collects to rate bonds is more than the cost to rate those bonds. One important fact in how a rating company makes money is that it is paid by a borrower to rate a bond. So, if you were a rating agency competing to rate lots of bonds, borrowers may be happier the higher you rate their bonds.

A fourth way that companies make money is by providing financial protection against lenders losing their money if a borrower can not pay back his bond. This kind of protection is one form of insurance. An insurance company is profitable as long as the fees it collects to provide this insurance is more than the amount it will have to pay out because borrowers can not pay back their bonds.

So, when everything goes well, all of these different kinds of financial services companies make money. The brokers collect brokerage fees; the rating agencies collect rating fees; the insurance companies collect enough in premiums so that when bonds aren't paid then the insurance companies have enough money to pay instead; the bond service companies are paid enough to take payments from borrowers and distribute the money to lenders. So what went wrong?