Why do financial institutions exist?

Financial institutions have made the news over the last few day, albeit for very strange reasons. But why, you could ask, do such institutions exist in the first place?

Professor Philip Booth argues the answer is very simple, they reduce transaction costs.

Financial institutions exist to reduce transactions costs. Without them, somebody saving money for a rainy day or for their pension would have to seek out and assess the creditworthiness of a vast number of individuals or companies before lending them money. And, without securities markets and banks providing on-demand deposits, the cost of individuals realising their investments at convenient times would be huge.

That firms exist since they reduce transactions costs is the point made by Ronald Coase way back in 1937. According to Coase we carry out a transaction within a firm when doing so costs less than carrying out that transaction across the market.

Of course this is dependent on technology. As technology changes so does the relative advantage of markets compared to firms. This is just as true in finance as anywhere else. For example:

Peer-to-peer lending radically simplifies the “middle-man” in credit transactions; and other innovations are on their way in finance. In China, 2,000 platforms intermediate £100bn of peer-to-peer lending.

Such changes in technology does mean that it is quite possible that banks will go the way of the dodo. The market may become cheaper than the firm. But it doesn't mean that charging interest will go the same way.