Financial Institution

Financial Institution play two indispensable roles in financial system. The first role is providing support for various financial market.For instance,exchanges of various types are institutions that facilitate the functioning of market, by setting rules of trading and providing clearinghouse and margin logistical support. Those services alleviate many of the information asymmetries between buyers and sellers that may lead to market failures. The second role that financial Institution perform is providing financial solutions where market failures exist despite the existence of market-supporting institutions. For example,although any company should -in theory- be able to access debt markets by issuing bonds, commercial paper,and the like ,transactions costs may be disproportionately high, and investor information maybe extremely lacking. In such cases, the terms at which a small investor can borrow from the market may be prohibitive.

In contrast, a bank that retains professional staff specializing in the assessment of loan applications or business plans,for example,can provide loans to investors with limited market experience. The same argument applies even more force-fully to consumer financing,since consumers suffer the additional disadvantages of lacking a legal structure that would allow them to borrow directly from the market. Banks solve the information asymmetries that lead to market failure by capitalizing in economies of scales in processing information on creditworthiness, business plan prospects and the like. They also rely on economies of scale to enhance their abilities to pool the savings of numerous very small investors. Thus specialization together with the unique set of corporate structures and regulatory frameworks for retail and investment banks allow them to fulfill various roles in society for which financial markets fail.

Moreover, the theoretical ability of financial markets to provide risk mitigation and transfer mechanisms has its efficiency limit. For instance, it is possible for me to seek the writer of a pot option on my car that would specify that the writer will have to buy my car at the strike price,even if it had been damaged in an accident. With millions like me seeking such options ,there should be a way to structure the writing of those option,circumventing the market failure stemming from information asymmetries . This information problem and the associated statistical problem of utilizing sufficient diversification are again solved through economies of scale. Insurance companies train clerks who specialize in assessing the eligibility of various customers and build statistical models to diversify the risks and price them properly. At a later stage the insurance companies can further mitigate risks by tapping financial markets and wholesale reinsurance companies.

A third group of institutions that we consider are venture capital and private equity firms. Those companies specialize in acquisition and control of prospective or existing companies with financial values that may increase substantially for one reason or another. Venture capital firms typically invest in companies the bulk of whose capital takes the form of human knowledge, thus restricting their abilities to access capital in more conventional forms, such as secured borrowing or issuing stock.

The probability of success of the average company at an early stage of development is very small, but the profitability of investing at the stage can be substantial if the company succeeds. This high risk/high return profile and lock of sufficient expertise on the part of high net worth individuals who may be willing to invest in such companies lead to market failure. By specializing in specific areas venture capital firms can increase the probability of picking future winner and enhance the probability future by proving advice to entrepreneurs. They further mitigate risk exposure for investors by pooling the resources of a number of like-minded investors and diversifying their portfolio across a number of investment prospects. Of course,the ultimate success of a venture capitalist is realized when he can take one or more of his investments to market, typically through an initial public offering . Hence, one may think of the venture capital firm as another form of financial intermediary.