What Is the Role of Financial Institutions?

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The primary role of financial institutions is to provide liquidity to the economy and permit a higher level of economic activity than would otherwise be possible. According to the Brookings Institute, banks accomplish this in three main ways: offering credit, managing markets and pooling risk among consumers.

The most obvious source of the liquidity provided by financial institutions comes in the form of available credit. According to Brookings, bank-issued credit helps drive economic expansion by allowing businesses to undertake new ventures without saving up the necessary money. This permits economic actors to take advantage of opportunities as they arise, rather than miss out on potential profits through lack of cash on hand.

Financial institutions have other tools at their disposal for providing liquidity. One of these, also outlined in the Brookings Institute’s report, is the buying and selling of securities. By “making a market” in this way, banks put themselves at the heart of financial markets.

Still another way financial institutions serve the market is by acting as repositories for risk. By pooling the risk of, say, commodities fluctuations, institutions that trade in derivatives can act to stabilize what are otherwise volatile markets. According to Brookings, these derivatives transactions help shield smaller investors from exposure to price fluctuations.