Customers and Investors: A Framework for Understanding the Evolution of Financial Institutions
© 2018 Elsevier Inc. 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...
| Main Authors: | , |
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| Format: | Article |
| Language: | English |
| Published: |
Elsevier BV
2021
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| Online Access: | https://hdl.handle.net/1721.1/134745 |
| _version_ | 1811087105568276480 |
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| author | Merton, Robert C Thakor, Richard T |
| author_facet | Merton, Robert C Thakor, Richard T |
| author_sort | Merton, Robert C |
| collection | MIT |
| description | © 2018 Elsevier Inc. 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. |
| first_indexed | 2024-09-23T13:39:49Z |
| format | Article |
| id | mit-1721.1/134745 |
| institution | Massachusetts Institute of Technology |
| language | English |
| last_indexed | 2024-09-23T13:39:49Z |
| publishDate | 2021 |
| publisher | Elsevier BV |
| record_format | dspace |
| spelling | mit-1721.1/1347452021-10-28T03:49:33Z Customers and Investors: A Framework for Understanding the Evolution of Financial Institutions Merton, Robert C Thakor, Richard T © 2018 Elsevier Inc. 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. 2021-10-27T20:08:56Z 2021-10-27T20:08:56Z 2019 2019-09-25T15:08:31Z Article http://purl.org/eprint/type/JournalArticle https://hdl.handle.net/1721.1/134745 en 10.1016/J.JFI.2018.06.002 Journal of Financial Intermediation Creative Commons Attribution-NonCommercial-NoDerivs License http://creativecommons.org/licenses/by-nc-nd/4.0/ application/pdf Elsevier BV Other repository |
| spellingShingle | Merton, Robert C Thakor, Richard T Customers and Investors: A Framework for Understanding the Evolution of Financial Institutions |
| title | Customers and Investors: A Framework for Understanding the Evolution of Financial Institutions |
| title_full | Customers and Investors: A Framework for Understanding the Evolution of Financial Institutions |
| title_fullStr | Customers and Investors: A Framework for Understanding the Evolution of Financial Institutions |
| title_full_unstemmed | Customers and Investors: A Framework for Understanding the Evolution of Financial Institutions |
| title_short | Customers and Investors: A Framework for Understanding the Evolution of Financial Institutions |
| title_sort | customers and investors a framework for understanding the evolution of financial institutions |
| url | https://hdl.handle.net/1721.1/134745 |
| work_keys_str_mv | AT mertonrobertc customersandinvestorsaframeworkforunderstandingtheevolutionoffinancialinstitutions AT thakorrichardt customersandinvestorsaframeworkforunderstandingtheevolutionoffinancialinstitutions |