Descriptive Theories of Financial Institutions under Uncertainty

This paper is a selective review of the received theory of financial institutions with some suggestions regarding future research on this topic. The major emphasis is placed on the positive economic theory of these firms. Financial institutions are considered to be firms that supply financial securities and contracts held as assets by other sectors of the economy and that use the proceeds of these sales to finance the purchase of financial securities and contracts which are the liabilities of other economic units. The theory discussed here is stripped of much of the regulatory and legal framework surrounding financial institutions. The primary reason for so limiting the scope of this paper is a conviction that a reasonably complete model of a simple financial institution is a necessary precursor to useful models of the positive economic behavior of financial institutions in any specific legal, regulatory, and operational framework. While recognizing that no tractable model of a financial institution is likely to be so general as to avoid the problem of model specificity, I take the view that many of the questions asked in the literature would be better answered in less specific models, i.e., in models capable of explaining additional important aspects of the behavior of the financial institution in question.