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The Design of Financial Systems: Towards a Synthesis of Function and Structure


Zvi Bodie


Boston University - Department of Finance & Economics

Robert C. Merton


MIT Sloan School of Management; National Bureau of Economic Research (NBER); Harvard Business School - Finance Unit

June 22, 2004

Harvard Business School Working Paper No. 02-074
HBS Finance Working Paper No. 02-074

Abstract:     
This paper proposes a functional approach to designing and managing the financial systems of countries, regions, firms, households, and other entities. It is a synthesis of the neoclassical, neo-institutional, and behavioral perspectives. Neoclassical theory is an ideal driver to link science and global practice in finance because its prescriptions are robust across time and geopolitical borders. By itself, however, neoclassical theory provides little prescription or prediction of the institutional structure of financial systems - that is, the specific kinds of financial intermediaries, markets, and regulatory bodies that will or should evolve in response to underlying changes in technology, politics, demographics, and cultural norms. The neoclassical model therefore offers important, but incomplete, guidance to decision makers seeking to understand and manage the process of institutional change. In accomplishing this task, the neo-institutional and behavioral perspectives can be very useful.

In this proposed synthesis of the three approaches, functional and structural finance (FSF), institutional structure is endogenous. When particular transaction costs or behavioral patterns produce large departures from the predictions of the ideal frictionless neoclassical equilibrium for a given institutional structure, new institutions tend to develop that partially offset the resulting inefficiencies. In the longer run, after institutional structures have had time to fully develop, the predictions of the neoclassical model will be approximately valid for asset prices and resource allocations. Through a series of examples, the paper sets out the reasoning behind the FSF synthesis and illustrates its application.

Number of Pages in PDF File: 44

Keywords: financial system; financial structure

JEL Classification: G1, G2

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Date posted: June 9, 2002  

Suggested Citation

Bodie, Zvi and Merton, Robert C., The Design of Financial Systems: Towards a Synthesis of Function and Structure (June 22, 2004). Harvard Business School Working Paper No. 02-074; HBS Finance Working Paper No. 02-074. Available at SSRN: http://ssrn.com/abstract=313651 or http://dx.doi.org/10.2139/ssrn.313651

Contact Information

Zvi Bodie
Boston University - Department of Finance & Economics ( email )
595 Commonwealth Avenue
Boston, MA 02215
United States
617-353-4160 (Phone)
617-353 6667 (Fax)
HOME PAGE: http://smgnet.bu.edu/mgmt/profiles/BodieZvi.html
Robert C. Merton (Contact Author)
MIT Sloan School of Management ( email )
77 Massachusetts Avenue
E62-634
Cambridge, MA 02139-4307
United States
617 715 4866 (Phone)
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Harvard Business School - Finance Unit ( email )
Boston, MA 02163
United States
617-495-6678 (Phone)
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