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

Harvard Business School Working Paper No. 02-074

HBS Finance Working Paper No. 02-074

44 Pages Posted: 9 Jun 2002

See all articles by Zvi Bodie

Zvi Bodie

Boston University

Robert C. Merton

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

Multiple version iconThere are 2 versions of this paper

Date Written: June 22, 2004

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.

Keywords: financial system; financial structure

JEL Classification: G1, G2

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: https://ssrn.com/abstract=313651 or http://dx.doi.org/10.2139/ssrn.313651

Zvi Bodie

Boston University ( email )

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Robert C. Merton (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

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National Bureau of Economic Research (NBER)

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Harvard Business School - Finance Unit ( email )

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