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.

As the authors, Donald L. Tuttle and William L. Wilbur, indicate in footnote 1 of their article, “A Multivariate Time-Series Investigation of Annual Returns on Highest Grade Corporate Bonds,” the equations tested in this paper seem to me to be ad hoc. The problem is not that I think the authors should have estimated a general equilibrium model of the economy, but rather that they have not provided a satisfactory explanation of the single equation they have tested. The use of a technique to choose among alternative variables on the basis of their ability to shrink the coefficient of multiple correlation could be taken as further evidence of the absence of a well-articulated theoretical relationship explaining annual returns on corporate bonds.