The Role of Financial Institutions

We often have a negative view of finance. We blame the recklessness of financial institutions and financial investors for when things go wrong in the economy. Financiers and bankers are accused of greed and insensitivity to the struggles of ordinary people or to the needs of small firms and entrepreneurs.

It is true that financial scandals and improprieties damage the reputation of many investors and financial institutions. Excessive debt arguably led to the financial crisis that started in 2007, the effects of which are still being felt. Highly complex financial instruments are developed, which can be misused, resulting in large losses for unwary investors.

However, we should acknowledge that financial innovations can be very powerful in funding investments that would not otherwise be possible and financial institutions can play an important role in enabling firms to grow.

Financial Institutions

Each of the different institutions that exist in financial markets specialises in catering for the specific needs of some segments of the market. This is true for banks, which specialise in offering loans and financial services to individuals and small businesses, and contribute to the money supply and to the liquidity of the financial system; and for investment banks, which deal with large corporations. Insurance companies offer highly specialised and crucial services for the management of a wide variety of risks faced by individuals and companies. Insurance contracts are essential to lessen the impact of natural disasters and other adverse events.

Specialised Financial Roles

A number of highly specialised roles exist in financial markets. Bankers assess the past and expected future performance of the businesses which apply for loans. Investment bankers specialise in selling new securities to investors. They carry out due diligence on companies who plan to issue new shares, and make it possible for companies to fund their projects by selling new shares at the best obtainable prices to new or existing shareholders.

Mortgage lenders match homebuyers with a mortgage contract suitable for their needs, providing them with the necessary funds to purchase their property. Mortgage lenders work directly for lending institutions, whereas mortgage brokers act as intermediaries between the borrower and a number of mortgage banking institutions.

Market makers facilitate the buying and selling of financial securities. They buy the securities that investors wish to sell, and supply the securities that investors wish to buy. Therefore they ensure that markets are liquid, so that securities can be traded at short notice and with low transaction costs. In turn, this reduces the possible risk for investors that they may not be able to trade their assets, if there is a temporary shortage of buyers or sellers.

High-Frequency Trading

In recent years, financial markets have seen a large increase in the volume of high-frequency trading, where automated algorithms execute large volumes of trades in fractions of a second. This high-frequency trading has the potential to generate instability in financial markets, particularly if most trading algorithms adopt very similar instructions about when clients should be buying or selling.

Investment Managers

Investment managers specialise in managing portfolios of financial securities: shares, stocks, or other investments. They include money managers, portfolio managers, and private bankers. Investment managers provide a number of professional services, such as the safekeeping of securities, but also manage their clients’ portfolios. They may seek to diversify their holdings of securities in line with their clients’ needs and preferences, and to obtain adequate returns on their investments. Sometimes they also try to outperform the market, but this might lead them to take on excessive risk and could result in potentially large losses for their clients.