Customers and Investors: A Framework for Understanding the Evolution of Financial Institutions

54 Pages Posted: 18 Mar 2018 Last revised: 17 May 2018

See all articles by Robert C. Merton

Robert C. Merton

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

Richard T. Thakor

University of Minnesota - Carlson School of Management

Date Written: March 17, 2018

Abstract

Financial institutions are financed by both investors and customers. Investors expect an appropriate risk-adjusted return for providing financing and risk bearing. Customers, in contrast, provide financing in exchange for specific services, and want the service fulfillment to be free of the intermediary’s credit risk. We develop a framework that defines the roles of customers and investors in intermediaries, and use it to build an economic theory that has the following main findings. First, with positive net social surplus in the intermediary-customer relationship, the efficient (first best) contract completely insulates the customer from the intermediary’s credit risk, thereby exposing the customer only to the risk inherent in the contract terms. Second, when intermediaries face financing frictions, the second-best contract may expose the customer to some intermediary credit risk, generating “customer contract fulfillment” costs. Third, the efficiency loss associated with these costs in the second best rationalizes government guarantees like deposit insurance even when there is no threat of bank runs. We further discuss the implications of this customer-investor nexus for numerous issues related to the design of contracts between financial intermediaries and their customers, the sharing of risks between them, ex ante efficient institutional design, regulatory practices, and the evolving boundaries between banks and financial markets.

Keywords: Customers, Investors, Credit Risk, Financial Intermediaries, Real-World Financial Contracts, Information-Insensitivity

JEL Classification: D81, D83, G20, G21, G22, G23, G24, G28, H81

Suggested Citation

Merton, Robert C. and Thakor, Richard T., Customers and Investors: A Framework for Understanding the Evolution of Financial Institutions (March 17, 2018). Journal of Financial Intermediation, Forthcoming; MIT Sloan Research Paper No. 5358-18. Available at SSRN: https://ssrn.com/abstract=3142737

Robert C. Merton

Massachusetts Institute of Technology (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)

Richard T. Thakor (Contact Author)

University of Minnesota - Carlson School of Management ( email )

19th Avenue South
Minneapolis, MN 55455
United States

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